The future of Fannie and Freddie is the bond market’s call

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Now that Wall Street has hammered down the stock market values of Fannie Mae and Freddie Mac to a combined total that is less than the capitalization of toymaker Mattel Inc., the widespread assumption is that the Bush administration must soon announce a taxpayer-funded bailout of the mortgage giants.

Because if the stock market says the companies are goners, it must be true, right?

But Treasury Secretary Henry M. Paulson Jr., who persuaded Congress last month to give Treasury the authority to rescue Fannie and Freddie if necessary, may not much care what the stock market thinks at the moment.

One reason is that Fannie and Freddie still are able to borrow in global credit markets to fund their mortgage finance operations. They’re paying up to do so, but there continue to be buyers for their debt, as Freddie demonstrated when it sold $3 billion of five-year notes on Tuesday.

The decision about the financial viability of the companies ‘will be made in the bond market, not in the equity market,’ said Alex Pollock, a fellow at the American Enterprise Institute and an expert on Fannie and Freddie. ‘The day the bond investors get reluctant to buy is the day [Treasury’s] hand will be forced,’ he said.

That raises the question of whether foreign investors, in particular, will have enough confidence to continue buying Fannie and Freddie bonds with what now is an implied Treasury guarantee. For decades, investors worldwide have assumed that the companies’ debt was 100% safe; only in recent months has the market begun to have doubts.

‘What is really important is to figure a way to convince the [foreign] investors and central banks to keep supporting the debt rollovers,’ said Michael Cheah, a bond fund manager at AIG SunAmerica Asset Management in Jersey City, N.J.

They might well feel better if Uncle Sam just took control of the companies and made the debt guarantee official. But there are other complications with the idea of Treasury rushing in at this point.

Fannie and Freddie continue to insist that they have adequate capital to carry out their mortgage missions, and their regulators agree. The stock market may have abandoned hope, but the companies are open for business every working day. It doesn’t look like an emergency -- yet.

What’s more, although there are some big names in the financial world calling for the companies to be nationalized -- wiping out shareholders immediately -- that doesn’t fit with the long-term plan Paulson laid out last month to Congress.

He wants to preserve the companies as shareholder-owned entities. So any financial help Treasury might have to provide would be just ‘a bridge to get the companies through this period of market turmoil,’ said Margaret Kerins, a debt strategist at RBS Greenwich Capital in Chicago.

If the goal is for the companies to eventually stand on their own feet again, ‘you can’t burn down the entire capital structure now,’ she said.

Of course, the minimum effect of any Treasury capital infusion would be to severely dilute current shareholders’ stakes. If Treasury bought into the companies via new preferred stock, for example, those securities certainly would be senior to the common stock but presumably also to all other preferred shares outstanding (and there are a lot of Fannie and Freddie preferred issues in the market).

In other words, if the companies eventually got back to strong financial health, Treasury (i.e., taxpayers) would be repaid, with interest, before any other investors got a penny.

In that context, investors may be correct in assigning near-penny-stock prices to the common shares of Fannie and Freddie today, or even zero worth. But if Paulson is serious about the idea of ultimately returning the companies to shareholder control after any bailout, in theory he still wants Wall Street in the picture -- even if, for now, the stock market’s views on the companies are practically irrelevant.