Paulson's GSE `Bazooka' Shakes Investors He Aimed to Soothe

By Brendan Murray
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Aug. 21 (Bloomberg) -- U.S. Treasury Secretary Henry Paulson's ``bazooka'' may be intimidating the same investors he intended to reassure.

The powers Paulson won from Congress last month enabling a government rescue of Freddie Mac and Fannie Mae -- authority he likened to a weapon whose mere existence made it unlikely it would have to be fired -- may end up making a bailout more likely, say analysts and investors.

They say the threat of government action is creating uncertainty that is raising the companies' borrowing costs and increasing the odds Fannie and Freddie will need taxpayer funding.

``It is the lack of clarity of what exactly the government is going to do, and what Congress is going to do, that is sending shivers'' through investors, said Axel Merk, president and portfolio manager of Merk Investments LLC in Palo Alto, California.

``To make this politically viable, why would the government even think about coming in junior to somebody else?'' he said.

Shares in Fannie and Freddie, government-chartered companies that together account for almost half the $12 trillion U.S. mortgage market, reached their lowest levels in two decades in New York Stock Exchange composite trading yesterday; their preferred shares have lost about one-third of their value this week. Central banks are also balking, paring purchases of new Fannie and Freddie debt the past two weeks by more than a quarter.

Paulson's Lobbying

In lobbying for the rescue plan, Paulson told lawmakers that giving him authority to bail out the beleaguered lenders would reassure their private sources of capital.

``If you have a bazooka in your pocket and people know it, you probably won't have to use it,'' he told U.S. senators at a July 15 hearing in Washington.

Instead, investors are betting Fannie and Freddie will have little option but to tap the Treasury.

Washington-based Fannie Mae stock has fallen 74 percent and McLean, Virginia-based Freddie Mac is down 63 percent since the law was signed. Fannie shares closed at $4.40 and Freddie's at $3.25 yesterday, bringing their combined market capitalization to about $6.8 billion from $92.6 billion two years ago.

Fannie Mae's 5.5 percent perpetual preferred shares have dropped 28 percent this week to $15.18. Freddie Mac's 5.57 percent preferred stock has fallen 38 percent this week to $7.15.

The companies' preferred securities are typically held by insurance companies, mutual funds and banks, analysts said. That may cause Paulson to stop short of eliminating their holdings in any government intervention.

`Wiped Out'

``The common shareholders will probably be completely wiped out,'' Paul Miller, an analyst at FBR Capital Markets, said in a Bloomberg Television interview. ``Preferred will also see a lot of pain. But that is up in the air because a lot of banks own the preferred. You put a lot of banks in trouble if you just wipe out the preferred also.''

Fannie Mae and Freddie Mac's securities probably would have performed even worse without the rescue plan Paulson pushed through Congress last month, said former Federal Reserve Bank of St. Louis President William Poole.

There ``might have been a total failure'' at Freddie Mac's sale of bonds this week ``if there had not been this legislation,'' said Poole, a Bloomberg contributor. Paulson's plan ``was necessary under the circumstances,'' he said.

``We continue to stay in touch with the companies and their regulators and are staying on top of the situation,'' Treasury spokeswoman Michele Davis said.

Maturing Debt

Paulson's intention to not use the authority hinges on the ability of the companies to sell debt to finance their portfolios of mortgages and asset-backed bonds. The companies have $223 billion of bonds due by the end of the quarter, according to data compiled by Bloomberg.

``They need support from the U.S. Treasury'' to finance maturing debt, said Sean Egan, president of Egan-Jones Ratings Co., a Haverford, Pennsylvania-based credit-rating company that has met with lawmakers and officials about the Treasury's options.

Freddie on Aug. 19 sold $3 billion of five-year notes at the highest yields over benchmarks in at least 10 years. Asians bought 30 percent of the debt, down from 41 percent in a May sale, company data showed. Fannie paid a record-high yield in a $3.5 billion sale of three-year notes last week, with Asian investors buying just 22 percent, almost half the demand in May.

The jump in borrowing costs belies Paulson's testimony to Senate lawmakers last month that ``the credit spreads are very strong and holding in there. I think there's confidence in the market.''

``Explicit government support leaves the GSEs in an unpredictable situation,'' said Alec Phillips, who heads Goldman Sachs Group Inc.'s Washington office and is a former staffer on the Senate Finance Committee. Fannie and Freddie ``do not yet have additional public sector capital, but this possibility may hinder attempts to raise private capital,'' he said.

To contact the reporter on this story: Brendan Murray in Washington at brmurray@bloomberg.net