Things look grim for Fannie and Freddie, if market reaction is the benchmark.? The action in their stocks, preferred stocks, and subordinated debt was ugly on Monday.? Not only did you have the article in Barron’s, which made the case that the equity of the firms wasn’t worth much, but you had selling of their senior debt, and guaranteed MBS by foreign investors.? It may not be that Fannie and Freddie fail, but that they get recapitalized by the government in a way that massively dilutes the equity.? Or, going back to my old idea, they get nationalized and become part of GNMA.? The equity and preferred stock go out worthless, and the subordinated debt gets some sort of haircut (partial conversion to senior, plus an earn-out based off the losses the the government has to bear).? I’m not sure a bailout is inevitable, but the odds are rising.

Now, Fannie and Freddie have been through a lot in the last three weeks.? Freddie has changed servicer guidelines possibly in an effort to forestall current period losses.? They have also both reported huge losses:

Freddie:

• Credit losses are in their early phases.
• The Alt-A loans look horrid.
• Reported a large loss.? This brought them to a negative net worth for GAAP purposes, even counting in the questionable deferred tax asset.? With the negative fair value net worth, aside from the US government, who would pump in capital?? They want to raise 10 billion, but it is hard to raise more than your market cap — the dilution kills.

Fannie:

• Posts a big loss.? Stops buying Alt-A securities.
• Warns that July was worse than June.
• FBR suggests that Fannie needs $5-10 billion in capital, and the market behaves as if it is true.

Then there is the insult added to injury, as S&P downgrades the preferred stock and subordinated debt.

So, after all of this, we should steer clear of the securities of Fannie and Freddie?? Steer clear of the common and preferred stocks, yes.? Subordinated debt, I’m not sure, but when I’m not sure, I don’t take positions.

Now, the senior debt is another matter.? Spreads are very wide, and the possibility of nationalization is significant.? As Accrued Interest says:

The trade is to be long senior Agency debt. There is just no way the Treasury allows anything to happen to senior debt holders. I don’t know who is playing in sub notes or preferred shares in here. No amount of investment analysis is going to help you figure what the Treasury’s next move is.

I agree, and when I was a bond manager with a good thesis, I would ask which bonds offered me the best advantage.? This article ends with an idea that is practical to some institutional fixed income managers.? Both Fannie and Freddie have a small amount of long non-callable zero coupon bonds.? These bonds will have a significant rally in the case where the US government nationalizes them.? And, if the US government decides to let them slip into default, well, you are buying them at 20-35 cents on par value.? No way in an insolvency you get less than that.

The worst case scenario is that long interest rates rise generally, and the zero coupon bonds get killed.? Sophisticated managers could sell short Treasury zeroes to hedge.

PS — Now, as I wrote this, the estimable Jeff Miller put up a good post on the GSEs.? It is worth a read.

UPDATE — 11 AM 8/19

Manto’s comment below is correct, and I apologize.? Bonds originally issued as discount bonds have bankruptcy claims equal to their accreted value.? Bonds issued at par, that subsequently become discount bonds have a claim value of par.? Why did I make this mistake?? I improperly generalized from my experience trading discount bonds, and other structures (such as zero-to-full bonds created from bonds originally offered at par) where the claim would be par in bankruptcy.