Fannie and Freddie shareholders facing wipe-out of their investments

A US government takeover of Fannie Mae and Freddie Mac may be inevitable, writes Proinsias O'Mahony

A PLETHORA of negative news stories saw continued selling of global financial stocks yesterday, with embattled US mortgage lender Fannie Mae falling in European trading to its lowest level in 19 years.

That extended Monday's 22 per cent slide on Wall Street, with investors running for the exits after US magazine Barron's reported that Fannie Mae and Freddie Mac shareholders were facing nationalisation and a likely wipe-out of their investments.

Freddie Mac's 25 per cent haircut on Monday meant its share price has fallen by almost 90 per cent this year, even worse than Fannie's 85 per cent fall.

The worst housing slump since the Great Depression has cost both companies dearly, with combined losses of almost $15 billion (€10 billion) over the last four quarters. With defaults on residential mortgages continuing to soar, those losses are not expected to end any time soon. Almost three times as many US houses were repossessed in July compared to a year earlier.

Housing market weakness continues to dominate headlines, with economists yesterday estimating that the number of housing starts in July hit a 17-year low.

Despite raising over $14 billion since December, Fannie recently admitted it may need to raise additional capital. Freddie Mac plans to raise $5.5 billion in addition to the $6 billion raised in November but has said it's waiting for market conditions to improve.

With their market capitalisations having shrunk to below $7 billion and $3 billion respectively, any attempt to raise the necessary billions through common share sales would be extremely dilutive to existing shares. Furthermore, some analysts have speculated that the companies may need more money than currently estimated - and soon.

Freddie Mac "needs to raise capital today, not wait and hope for a chance to raise cheaper capital in the future", said Friedman, Billings, Ramsey & Co in a recent research report. "We continue to estimate that it needs to raise $10 billion to $15 billion."

The share price sell-off indicates that investors believe Barron's premise that the companies will not be able to raise such funds and that a government takeover is inevitable.

Another person who sees nationalisation and shareholders losing all their money is Kenneth Rogoff, the respected Harvard economics professor and former chief economist to the International Monetary Fund (IMF). Rogoff yesterday contributed to the prevailing sense of financial nervousness by saying that "the worst is yet to come" in the current financial crisis, with a major bank failure likely.

"We're not just going to see mid-sized banks go under in the next few months, we're going to see a whopper, we're going to see a big one, one of the big investment banks or big banks," Rogoff told attendees at a financial conference in Singapore.

Rogoff said that early bargain hunters in financial stocks had neglected the fact that the financial system had become "bloated in size" and "needed to shrink". Just "like any shrinking industries, we are going to see the exit of some major players", adding that he did not think that "simply having a couple of medium-sized banks and a couple of small banks going under is going to do the job".

As for Fannie Mae and Freddie Mac, "these giant mortgage guarantee agencies are not going to exist in their present form in a few years".

Investors should look for "more consolidation" in the financial sector as a sign that the credit crisis might be nearing its end.

Rogoff, who was chief economist at the IMF until 2004, said the US housing market would continue to deteriorate and that the US was already in recession. He could see the slowdown lasting into the second half of 2009, with Europe and Asia enjoying an earlier recovery.

Rogoff declined to speculate on who the next bank failure might be, although troubled Lehman Brothers has been more dogged by such rumours than any other firm over the last few months.

Its woes continue, with JP Morgan Chase yesterday estimating that Lehman might write down $4 billion when it reports third-quarter earnings next month.

Lehman has already reported credit losses of $8.2 billion over the last year. The firm is widely reported to be weighing up capital raising options, with many analysts expecting it to offload Neuberger Berman, its highly prized asset management business.

Analysts have estimated Neuberger to be worth between $7 billion and $13 billion.

After further share price falls yesterday, Lehman's actual market capitalisation is now below $10 billion, implying that the market is possibly placing a negative value on the company minus its asset management business.