Fannie, Freddie Downgraded by Derivatives Traders Over Capital

By Shannon D. Harrington and Dawn Kopecki

July 9 (Bloomberg) -- Fannie Mae and Freddie Mac, ranked Aaa by the world's largest credit-rating companies, are being treated by derivatives traders as if they are rated five levels lower.

Credit-default swaps tied to $1.45 trillion of debt sold by the two biggest U.S. mortgage finance companies are trading at levels that imply the bonds should be rated A2 by Moody's Investors Service, according to data compiled by the firm's credit strategy group. The price of contracts used to speculate on the creditworthiness of Fannie Mae and Freddie Mac and to protect against a default doubled in the past two months.

Traders are overlooking the government's tacit guarantee of the debt as credit losses grow and concern rises that the companies don't have enough capital to weather the biggest housing slump since the Great Depression. Even an implied guarantee isn't enough to convince credit investors that there's little risk to owning Fannie Mae and Freddie Mac debt, said Tim Backshall, chief strategist at Credit Derivatives Research LLC in Walnut Creek, California.

``Investors are viewing even an implicit guarantee from the government as potentially troublesome,'' Backshall said.

Worries that Fannie Mae and Freddie Mac may need more capital were heightened this week after Lehman Brothers Holdings Inc. released a report saying a new accounting rule may require them to raise $75 billion. Freddie Mac dropped 18 percent June 7 in New York Stock Exchange composite trading and Fannie Mae dropped 16 percent.

The companies' congressional charters provide exemption from state and local corporate income taxes and give the Treasury the authority to buy as much as $2.25 billion in each of their securities in the event of possible default. Fannie Mae spokesman Brian Faith and Freddie Mac spokesman Michael Cosgrove declined to comment.

Gap Widens

Credit-default swaps tied to Washington-based Fannie Mae's senior debt climbed 39 basis points to 74 basis points since May 1, while contracts on McLean, Virginia-based Freddie Mac's senior debt increased 40 basis points to 75, according to London-based CMA Datavision. A basis point is 0.01 percentage point.

The cost to protect the companies' subordinated debt from default has risen at a faster rate amid concern the government may not honor the subordinated debt, Backshall said. The subordinated debt of both companies is rated Aa2 by Moody's because the owners would be paid after the senior bond investors.

Credit-default swaps tied to Fannie Mae's subordinated debt have jumped 108 basis points to 195 basis points since May 1. Contracts on Freddie Mac's subordinated debt have risen 105 basis points to 193 basis points.

Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on a company's ability to repay debt. They were conceived to protect bondholders against default and pay the buyer face value in exchange for the underlying securities or the cash equivalent should the company fail to adhere to its debt agreements.

A basis point on a contract protecting $10 million of debt from default for five years is equivalent to $1,000 a year.

Combined Losses

Fannie Mae and Freddie Mac, which reported combined losses of more than $11 billion, have raised more than $20 billion since December. Merrill Lynch & Co. analyst Kenneth Bruce said in a report yesterday the ``highly levered financial institutions'' will have pretax credit-related losses of $45 billion.

``Fannie and Freddie are going to have to raise more capital and nobody thinks they're going to be able to raise capital when they need to,'' said Paul Miller, an analyst at Friedman, Billings, Ramsey & Co. in Arlington, Virginia. ``It's going to be very expensive.''

Recouping Losses

Fannie Mae rose 12 percent and Freddie Mac gained 13 percent yesterday, recouping some losses from a day earlier, after the companies' regulator said they were adequately capitalized and Treasury Secretary Henry Paulson said they can still be a ``constructive force,'' in the economy.

The companies own or guarantee about 46 percent of the $12 trillion U.S. mortgage market.

``It concerns me that people sort of extrapolate well beyond what the facts are,'' James Lockhart, the director of the Office of Federal Housing Enterprise Oversight, said in an interview with Bloomberg Television yesterday.

The government is leaning on the companies to help revive the mortgage market. Congress lifted growth restrictions on the companies, eased their capital requirements and allowed them to buy bigger, so-called jumbo mortgages to spur demand for home loans as competitors fled the market.

Their share of new conforming mortgages, or loans of $417,000 or less, almost doubled to 81 percent in the first quarter, Ofheo said.

The bailout of Bear Stearns Cos. arranged by the Federal Reserve in March shows the government won't allow the companies to fail, Robert Millikan, who manages $5 billion as director of fixed income at BB&T Asset Management in Raleigh, North Carolina.

``We're looking at it from a standpoint of, if the Fed is not going to allow a problem with Bear Stearns, they're certainly not going to allow a problem with Fannie and Freddie,'' Millikan said. ``With all the exposure that banks have to Fannie and Freddie, the ripple effect through the whole financial system would be unbelievable if they were allowed to fail,'' he said.

To contact the reporter on this story: Shannon D. Harrington in New York at sharrington6@bloomberg.net; Dawn Kopecki in Washington at dkopecki@bloomberg.net.