Fannie, Freddie Takeover Jolts Preferred Market as Prices Fall

By Caroline Salas

Sept. 10 (Bloomberg) -- Treasury Secretary Henry Paulson's takeover of Fannie Mae and Freddie Mac is roiling the market for preferred securities.

Prices of fixed-rate preferred stock fell an average of 9 cents to 71.5 cents on the dollar this week, according to Merrill Lynch & Co. index data, the biggest two-day drop in more than a decade. The 11 percent decline compares with a 1.4 percent drop in the Standard & Poor's 500 index over the same time.

In putting Fannie and Freddie in conservatorship, Paulson scrapped dividends on the mortgage finance companies' equity securities and said the U.S. would buy as much as $200 billion of preferred stock ranking ahead of existing issues. Investors are more hesitant to invest in similar securities of other financial institutions on concern Paulson set a precedent for issuers. Unlike common stock, preferreds typically carry fixed dividends.

Paulson's ``actions have damaged the preferred market,'' said Thomas Hayden, the investment strategist for Liberty Bankers Life Insurance in Dallas. ``Somebody is going to be looking at an issue of Fannie or Freddie preferred shares that were rated AA up until a few months ago. If that's not money good then what about the small regional bank in some part of the country?''

Hayden, whose $1.5 billion fixed-income portfolio contains preferred shares of Fannie and Freddie, said he's ``not interested'' in buying any more preferred securities.

Rising Costs

The market's tumble is making it more expensive for banks and brokers trying to raise fresh capital after taking $506 billion of writedowns and losses on the collapse of the subprime- mortgage market.

Sales of preferred securities in the U.S. have risen 48 percent this year to about $44 billion from more than $30 billion in the same period of 2007, according to data compiled by Bloomberg. The average yield as measured by the Merrill index has risen to 10.1 percent from 8.8 percent on Sept. 5 and 7.9 percent at the end of last year.

The takeover was ``unambiguously bad'' for preferred investors and ``likely set a precedent for any future rescue transactions,'' Kathleen Shanley, an analyst at bond research firm Gimme Credit LLC in Chicago, wrote in a Sept. 7 report.

Preferred shares of Washington-based Fannie and Freddie of McLean, Virginia were cut to the second-lowest rating by Standard & Poor's and Moody's Investors Service on Sept. 7. The grades were slashed 11 levels by S&P to C and 10 rankings to Ca by Moody's. Moody's rated their preferred stock Aa3, the fourth- highest grade, until July.

Biggest Losers

Freddie preferred shares have lost 83 percent the past two days, while Fannie's have declined 80 percent, the biggest losers in the Merrill index. The two companies account for about $24 billion of the $190 billion par amount in the index. Forty of the top 50 issuers have declined in the last two days.

The declines are particularly stinging for Fannie and Freddie investors because the companies have sold $20.4 billion of the preferred securities since November.

Paulson tried to calm preferred stock investors when he announced the rescue of the government-sponsored enterprises and said the takeover shouldn't have negative implications for the wider market.

``Preferred stock investors should recognize that the GSE's are unlike any other financial institutions and consequently GSE preferred stocks are not a good proxy for financial institution preferred stock more broadly,'' Paulson said in a Sept. 7 statement. ``The broader market for preferred stock issuance should continue to remain available for well-capitalized institutions.''

Lehman, Merrill

Lehman Brothers Holdings Inc. is down 42 percent, while Merrill Lynch has tumbled 16 percent.

``In the primary market it's going to be much more difficult for financials across the board,'' Hayden said. ``If Lehman Brothers thought they needed to go to the market and had any chance at all of issuing preferred stock to raise capital, it is now three times more difficult than it was last Friday.''

Mark Lane, spokesman for Lehman Brothers, and Danielle Robinson, spokeswoman for Merrill, declined to comment. Lehman and Merrill are both based in New York.

Investors will be ``gun-shy'' about buying preferred shares, said Thomas Houghton, who manages $2 billion of corporate bonds at Advantus Capital Management in St. Paul, Minnesota.

``There are a number of financial institutions that are experiencing distress right now, so the dividend on the common and the preferred share are going to be the first to go,'' he said.

To contact the reporter on this story: Caroline Salas in New York at csalas1@bloomberg.net