Fannie, Freddie Subordinated Debt May Be Cut by S&P

Fannie, Freddie Subordinated Debt May Be Cut by S&P

July 25 (Bloomberg) -- Standard & Poor's may downgrade the subordinated bonds of Fannie Mae and Freddie Mac, surprising investors who had anticipated the securities would be supported by any Treasury rescue plan.

The potential cut would affect $19.2 billion of AA- rated subordinated debt at Fannie Mae and Freddie Mac, according to data compiled by Bloomberg. The cost to protect the bonds from default rose for the first time in three days. S&P said it may also downgrade $26 billion of preferred stock, pushing down the securities in New York trading. The AAA ratings on the companies' senior debt were affirmed with a stable outlook.

New legislation authorizing a backstop of the mortgage- finance companies leaves it up to the Treasury Secretary to decide whether to honor preferred dividend payments or to repay subordinated bondholders before the government, S&P analyst Victoria Wagner said in a telephone interview. That ``ambiguity'' casts a cloud over the securities, she said. Once analysts have fully analyzed the final legislation, the ratings may be cut one or two levels, she said.

``We had factored in some federal support for these securities, but now I think the financial risks are now outweighing support and have to be reflected in the rating,'' Wagner said.

The House of Representatives approved Treasury Secretary Henry Paulson's request for the authority to extend credit and buy unlimited equity stakes in Fannie Mae and Freddie Mac if needed. The Senate plans to vote as early as tomorrow.

`Confidence Crisis'

Paulson moved to shore up the companies as concern grew that they may not have enough capital to weather the worst housing slump since the Great Depression. Fannie Mae and Freddie Mac shares are down more than 70 percent this year.

Fannie Mae dropped 47 cents, or 3.9 percent, to $11.55 in New York Stock Exchange composite trading. Freddie Mac dropped 54 cents, or 6.1 percent, to $8.27.

Freddie Mac's 5.57 percent preferred stock fell 1.9 percent, and Fannie Mae's 5.5 percent preferred shares dropped 10 percent.

The plunge in the stocks is ``adding to the already-stressed business cycle'' and may make it difficult for the companies to raise capital, Wagner said.

``We feel that given the changing market dynamics and the changing legislation landscape, that that heightened risk should be more of a factor in our current,'' Wagner said.

`Questionable'

Investors had anticipated any government rescue would come in the form of equity, which would rank behind subordinated debt for repayment, said Jamie Jackson, a portfolio manager at Minneapolis-based RiverSource Investments, which manages $93 billion of fixed-income assets.

The potential downgrade of the preferred stock isn't as surprising, Jackson said.

``The fact that they lumped the sub debt in there seems questionable,'' Jackson said. ``If we are talking about equity capital being contributed by the government, by any measure that we can come up with, that should protect the subordinated debt.''

Credit-default swaps on Freddie Mac's subordinated debt, which is repaid after senior bonds, climbed 42 basis points to 182 basis points, while contracts on Fannie Mae's subordinated debt rose 40 basis points to 180 basis points, according to CMA Datavision. The contracts rise as investor confidence falls.

The difference between credit-default swaps on Fannie Mae and Freddie Mac subordinated and senior debt widened.

For Fannie Mae, the gap widened about 38 basis points to 135 basis points, CMA data show. The gap for Freddie Mac widened 42 basis points to 138. The median gap in the past year for both contracts has been about 51 basis points, CMA prices show.

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.

BLOOMBERG