Fannie Mae and Freddie Mac: A Damage Report

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Writedowns for Many

The accounting firm KPMG has been more aggressive about directing clients to write down the value of impaired assets than some of its peers, so all financial institutions that use KMPG as their auditor would be expected to take writedowns at the end of September, says Caldwell. And certainly, if the preferreds continue to trade underwater and the government hasn't made any decision on a bailout, all firms that have invested in the agencies' preferreds would have to take a writedown by the end of this year, he adds.

At least the preferred holders are still getting the dividend they expected when they bought the shares. Earlier this month, Fannie's board slashed the quarterly dividend on its common stock to 5 cents from 35 cents a share to preserve $1.9 billion in capital through 2009. Freddie sliced its 50 cent quarterly dividend to 25 cents in late 2007.

The implications for debt issued by the two agencies are harder to figure.

The housing bill that President Bush signed into law at the end of July made explicit the federal government's guarantee of $5.2 trillion in U.S. mortgages backed by Fannie and Freddie, so that debt is presumably free of risk.

Although no one has any doubt that the debt Fannie and Freddie issue to finance their own operating costs, all of which seems to be actively traded, would be made whole, the securitized mortgages the agencies have packaged and sold to investors are a different story, says Bill Larkin, a portfolio manager for fixed income at Cabot Money Management, based in Salem, Mass.

"The fear here is that the market participants—most of the stuff was purchased by foreign central banks—will see the risk and stop purchasing it. If that happens, then [mortgage] rates would rise [substantially]," he says.

Guaranteed to Guarantee

If the government does intervene, bondholders' principal and accrued interest would be protected, but that doesn't mean they would be able to trade the debt easily, he says. Strategists agree that the Treasury wouldn't risk the sanctity of a global banking system by not guaranteeing that debt.

Fannie and Freddie need to refinance about $250 billion in debt in September, and the market will be watching to see how successful they are. Neither agency has had difficulty attracting subscribers to its monthly bond auctions, which makes Larkin think they won't have a problem rolling over the debt that matures next month.

Outside of a bailout, the agencies' subordinated debt would be at risk only if the credit ratings were downgraded to junk, which would force many financial institutions to sell their holdings at big losses, says Larkin. In an Aug. 18 story, Barrons estimated that there is a total of $19 billion of GSE subordinated debt that would be at risk under a government bailout.

The ratings on the subordinated debt are hovering just above investment grade. On Aug. 22, Moody's Investor Service (MCO) lowered its rating outlook on the agencies' AA2 subordinated debt to negative from stable but affirmed their senior debt ratings at AAA. Moody's also downgraded Fannie's and Freddie's preferred stock ratings to BAA3 from A1, Standard & Poor's Ratings Services on Aug. 26 affirmed its AAA/A-1+ rating on Freddie's senior unsecured debt with a stable outlook but lowered the subordinated debt rating to BBB+, and the preferred stock rating to BBB- from A-, also placing those ratings on CreditWatch Negative.