Business Times: Fannie, Freddie rescue plan could be costly for many

(WASHINGTON) A government rescue of Fannie Mae and Freddie Mac could be costly for scores of investment, banking and insurance companies that hold billions of dollars in preferred shares in the mortgage finance giants.

Speculation has been building on Wall Street that a government investment to rescue Fannie and Freddie would come in the form of a cash infusion through the acquisition of preferred shares in the companies.

Preferred shares usually pay a fixed dividend and have priority over common stock when it comes to dividends and bankruptcy liquidation. While slightly riskier than bonds, which have the highest priority in times of trouble, companies often invest in preferred shares for certain tax advantages.

Investors appear to believe existing common stockholders could be wiped out if there is a government bailout.

Fannie and Freddie’s shares have lost more than 90 per cent of their value this year.

But what happens to preferred stockholders is less certain.

‘That depends on how big Fannie and Freddie blow up,’ said Michael Shedlock, an investment adviser for SitkaPacific Capital Management.

On Wall Street, investors think it could be big. Fannie and Freddie’s existing preferred shares are trading like junk bonds: yielding around 17 per cent to 19 per cent instead around their 6 per cent dividend levels. The higher yield is an inducement to investors to accept the higher level of risk that the companies won’t be able topay their dividends.

‘There’s enormous investor concern,’ said Bert Ely, a banking industry consultant.

Fannie Mae has 17 classes of preferred stock, with more than 600 million shares outstanding. Freddie Mac has 24 classes of preferredstock, with about 460 million shares outstanding.

Congressional analysts estimate a government rescue of the mortgage giants could cost taxpayers US$25 billion, with the exact amount based on how far the US housing market falls and how severe their financial situation turns out to be in the long run.

Another uncertainty is political: The final resolution of Fannie and Freddie’s future is likely to be determined after the Bush administration leaves office in January. It remains unclear how much in taxpayer resources the next administration and Congress would be willing to commit.

Source: Business Times – 23 Aug 2008