Treasury Secretary Henry Paulson's response to the sinking fortunes of Fannie Mae and Freddie Mac might boil down to picking which investors get hurt and by how much.
At stake if Paulson does intervene: the fate of worldwide bondholders of $5.2 trillion of agency and mortgage-backed debt and scores of large banks, insurers and pension funds that own the firms' common and preferred shares.
Paulson's choices probably include buying Fannie's and Freddie's bonds, a special class of preferred shares or preferred shares convertible into common stock, analysts and investors said. The terms and conditions of any purchases would put the government ahead of other creditors and stockholders, while ensuring that bondholders are protected, they said.
“He's had zero clarity on this whole issue, and until the market knows where Hank's going to be in the capitalization structure, then it gets worse not better,'' said Paul McCulley, a fund manager at Pacific Investment Management Co., which has the world's largest bond fund.
“The presumption'' is that holders of the government- chartered companies' subordinated bonds “will be covered,'' McCulley said in an interview on Bloomberg Television from Jackson Hole, Wyoming. Common shareholders would be wiped out, he predicted.
Paulson got the power to make purchases of the two companies' debt or equity in legislation enacted July 30 that was aimed at shoring up confidence in the beleaguered mortgage- finance companies.
The Treasury chief could also forego using that authority, and wait until Fannie Mae's and Freddie Mac's capital is so eroded that regulators can put them into receivership.
“I don't think they'll do half-measures if it means using taxpayer funds,'' said Andrew Laperriere, managing director at International Strategy & Investment Group, a money management and research firm in Washington.
“That requires steps including complete control,'' said Laperriere, who used to work as chief economic adviser to former Republican House Majority Leader Richard Armey.
Paulson telephoned Senate Banking Committee members this week to tell them the Treasury is closely monitoring the situation and, for now, doesn't plan to inject taxpayer funds, according to a Senate aide who spoke on condition of anonymity.
“We are staying on top of the situation and communicating with the companies and their regulators,'' Treasury spokeswoman Jennifer Zuccarelli said.
Meanwhile, “top executives'' at Freddie Mac “have been talking with many potential investors this week,'' said Sharon McHale, a spokeswoman for the McLean, Virginia-based company.
Shares in Washington-based Fannie have dropped 60 percent and those of Freddie have lost 64 percent since July 30 quick payday loan.
“Private shareholders should be concerned,'' said Edwin Truman, a senior fellow at the Peterson Institute for International Economics in Washington and a former official at the Treasury and the Federal Reserve. Traders “will drive the price of the stocks down to nickels and dimes,'' at which point Paulson will step in, he predicted.
Truman forecast the Treasury would end Fannie and Freddie dividend payments, with officials taking over management.
Fannie, the largest mortgage-finance provider, was created in the 1930s and became a publicly owned company in 1968. Freddie was started in 1970. Designed to boost homeownership, the companies issued debt to finance purchases of mortgages and package home loans into bonds sold on to investors.
Banks at Risk
Their debt is held by companies including MetLife Inc., the largest U.S. life insurer, American Equity Investment Life Holding Co., and GE Asset Management Inc. Preferred shares are held by banks from Philadelphia-based Sovereign Bancorp to Frontier Financial Corp. of Everett, Washington.
As mortgage defaults climbed, concern mounted Fannie and Freddie lacked sufficient capital. Paulson asked Congress for emergency powers to shore up support for the firms.
If either company has trouble selling bonds to finance maturing debt, Paulson's hand may be pressed. They have about $20 billion of unsecured debt due on average every week, with more than $220 billion maturing by the end of next month.
A takeover could also be triggered if either company fails to meet its regulatory capital standards, to be released by the Federal Housing Finance Agency next month.
“Treasury might be forced to act soon to fight a market- psychology problem instead of being able to act on its own time,'' said Joshua Rosner, an analyst with independent research firm Graham Fisher & Co. in New York.
There's no consensus about how widespread the losses would be in an intervention. Pete Davis, president of Davis Capital Investment, an independent advisory firm in Washington, argued that both equity and subordinated bondholders wouldn't be protected, with owners of mortgage-backed securities and senior debt kept secure.
Davis wrote in a note yesterday that Paulson will probably aim to put off using taxpayer funds as long as Fannie and Freddie are still able to fund the U.S. mortgage market.
“Paulson does not want his legacy to be that he committed $50 billion or more of taxpayer money to bailing out the'' firms, Davis wrote.