By availing itself of a new housing bill signed into law last month, the U.S. Treasury Department is growing increasingly likely to recapitalize Fannie Mae (FNM) and Freddie Mac (FRE) in the months to come – all on the taxpayer’s dime, the weekly financial newspaper Barron’s reports in its edition yesterday (Monday).

Both shares took another beating yesterday, as Fannie Mae’s stock slid over 22% with a decline of $1.76 to close at $6.15. Freddie Mac, seen by many as the weaker of the two, fared even worse with a decline of over 24%, as shares shed $1.43 to close at $4.42.

According to the published report, this recapitalization play will likely wipe out the common shareholders of both government-sponsored enterprises. Also suffering losses: The preferred stockholders and the owners of both companies $19 billion worth of subordinated debt, Reuters reported.

According to Barron’s, the capital infusion is envisioned as a sale of preferred stock. These preferred shares would be imbued with such seniority, dividend-preference and convertibility rights that the current Fannie and Freddie common shareholders “effectively would be wiped out, and their preferred shares left bereft of dividends.”

The report labeled the government-engineered equity injection as a quasi-nationalization; it wouldn’t have to put the agencies’ liabilities on the U.S. balance sheet, doubling the U.S. debt.

A Bush administration insider told the newspaper that Fannie and Freddie “are being jawboned” to raise more equity by both the Treasury Department and their new regulatory overseer, the Federal Housing Finance Agency (FHFA).

But government officials don’t expect the agencies to succeed, according to Barron’s.

If the two mortgage giants can’t raise the needed capital, the Bush administration is likely to mount its own recapitalization, with the Treasury Department injecting taxpayer money into the agencies, according to the Barron’s source.

Fannie and Freddie each may have a negative $50 billion in asset value, and little prospect of digging themselves out of the hole, Barron’s said.

News and Related Story Links:

• Barron’s:
  
  The Endgame Nears For Fannie and Freddie

• Reuters:
  
  U.S. likely to recapitalize Fannie, Freddie: report.

• Money Morning News:
  Fannie Mae and Freddie Mac Shares Boosted by Plans for Capital Raise, Government Help.

• Money Morning Special Investment Research Report:
  
  Fishing for Profits in the Fannie/Freddie Flotsam.

A government-backed rescue of Fannie Mae (FNM) and Freddie Mac (FRE) could end up costing $25 billion in taxpayer money according to a letter released yesterday (Tuesday) by the Congressional Budget Office (CBO).

The letter from the CBO, addressed to Congress, stated there is “a significant chance — probably better than 50% — that the proposed new Treasury authority" to lend Fannie Mae and Freddie Mac money or buy their stock would not be needed before the authority’s expiration date at the end of 2009. However, if the authority were exercised, the tab for the government’s aid could easily top the CBO’s $25 billion estimate.

“I am well aware that financial market and housing challenges continue to concern America’s families. Progress will not come in a straight line, and we need to remain patient as we work through these challenges,” Treasury Secretary Henry Paulson said in a speech yesterday during his visit to New York City to drum up Wall Street support for his plan to rescue Fannie Mae and Freddie Mac.

Paulson remains committed to government aid for the struggling lending giants, despite the potential $25 billion price tag for taxpayers. Together, Fannie Mae and Freddie Mac secure almost half of the $12 trillion U.S. home mortgage market.

“We need to act in the short-term because the [government-sponsored entities] are vital institutions in our capital markets today and are vital to emerging from the housing correction,” Paulson said in a speech in New York, Bloomberg News reported. Fannie Mae and Freddie Mac are among the “most interconnected of all global financial institutions,” he said, referring to the large number of Fannie Mae and Freddie Mac securities held by financial institutions worldwide.

Lawmakers are expected to vote this week on the Bush Administration’s plan to help Fannie Mae and Freddie Mac through their current liquidity crisis. Paulson has been one of the most vocal advocates for government intervention.

“This is about not only our housing markets, but it’s about our capital markets more broadly,” Paulson said yesterday in a Bloomberg Television interview. “This goes well beyond the two institutions — Fannie and Freddie — it has to do with investors in the United States and investors all over the world.”

News and Related Story Links:

• CNNMoney:
  Fannie, Freddie rescue could cost $25B

• Bloomberg News:
  Fannie, Freddie Rescue May Cost Taxpayers $25 Billion, CBO Says

• MarketWatch:
  U.S. on ‘right path’ to end of turmoil: Paulson

• The Washington Post:
  Fannie Mae, Freddie Mac Rescue Could Cost $25 Billion

• Money Morning:
  Fishing for Profits in the Fannie/Freddie Flotsam

The bailout of mortgage giants Fannie Mae (FNM) and Freddie Mac (FRE) is extremely confusing to holders of their debt and equity securities, because it’s very difficult to figure out what the final outcome of the “rescue" might be, and if so, who benefits.

However, as a service to Money Morning readers who are unfortunate enough to have been holding Fannie or Freddie paper, or to the venturesome few who wonder whether there is any among the debris, I thought I’d peer through the fog of uncertainty and try to figure out what the different classes of Fannie and Freddie securities may be worth.

Tread Lightly and Bury a Big Debt

Let’s start – gingerly – with the politics. It would be politically impossible to allow $5 trillion of mortgage debt to default, particularly since its purchasers had been told that it was “just as good as" U.S. government paper. The economically logical course would be to take Fannie and Freddie fully into government ownership, sweeping all their debt onto Uncle Sam’s balance sheet (thus roughly doubling its reported debt/gross domestic product (GDP) and debt/export ratios), and then winding down Fannie and Freddie’s operations, since neither entity serves a useful purpose in a proper free market.

That won’t happen, for two reasons:

• First, it would make U.S. debt ratios look bad, possibly increasing the nation’s cost of borrowing from foreign central banks.  In not formally accounting for the liability, Uncle Sam is basically pulling the same scam the banks did when they shoved all their worst mortgage assets into Structured Investment Vehicles (SIVs), but so what? Do you actually expect the government to follow the same rules of honest accounting as the private sector?

• Second, Fannie and Freddie top management are politically plugged in – in the biggest ways possible – and won’t allow themselves to be “demoted" from cushy slots as big shots earning $12 million a year and transformed into lowly GS-15 government wage slaves (civil servants who will top out at $155,000) simply because the companies they ran were “nationalized."

Therefore, Fannie and Freddie will remain members of the private sector, but will be given taxpayer handouts to keep them in business. In return for those handouts, they may be forced to raise extra capital from the market, or in an extreme case their existing capital may be wiped out and replaced by government loans or equity injections. Holders of Fannie and Freddie debt will probably be protected; holders of their shares probably won’t.

Given the outlook for Fannie and Freddie, what’s the outlook for their holders of particular securities? Let’s look at individual securities.

• Direct Agency Debt: These are obligations of Fannie and Freddie directly, generally with ordinary fixed-term maturities. They are currently trading very close to government paper, within 0.05% of it in yield, much closer than they were before the bailout. There’s a tiny risk you will lose money on these, but if you do, you will lose most of it because Fannie and Freddie’s assets may not be worth much. Buying Treasury bonds directly looks to be a much better bet.

• Mortgage-Backed Securities (MBS): These have a final maturity of 30 years, but their average maturities are much less than that, depending upon the repayments on the underlying mortgages. If interest rates were to drop, they would mature quite quickly; if interest rates were to shoot up, they would behave like a 30-year bond, as nobody would refinance the cheap mortgages. They trade at yields around 1% above long-term Treasuries. Here you should ignore the Fannie and Freddie guarantee altogether and try to find out when the MBS you are buying was originated. If it dates from before 2003 or so, it will contain mortgages on houses that later appreciated substantially in price – so may still have a cushion above the mortgage value. MBS originated in 2006, on the other hand – no matter how fine their initial quality – today will be suffering from the housing-price decline, which will have lowered the potential sale prices of many of the houses below the value of their mortgages. Among older mortgage-backed securities, however, there will be bargains that will very likely never use the Fannie/Freddie guarantee.

• Common Stock: No matter how cheap it may look, I’d avoid stock altogether. First, the government may insist on it being wiped out as a condition of a bailout. Second, both Fannie and Freddie are talking about raising $10 billon or more of new capital – but their market capitalizations are below that figure, so these stock offerings would be hugely dilutive to existing shareholders. If Fannie and Freddie issued preferred stock, the dividends would be huge, wiping out the possibility of dividends on the common stock for several years.

• Preferred Stock: This is the most interesting flotsam among the debris. In order to bolster their capital, Fannie and Freddie are each talking about issuing $5 billion to $10 billion worth of preferred stock. To get sold, that preferred stock would have to carry a very high dividend yield – people are talking of 13%, although I’d say 11%-12% is more realistic. If the preferred stock is genuine “equity preferred" – in which the dividends are not tax-deductible for Fannie and Freddie (which it would have to in order to be counted as capital) – then its dividends would be taxable at 15%, just like common-stock dividends. While there’s obviously a possibility that Fannie and Freddie could make large preferred stock issues and then declare bankruptcy, it’s fairly unlikely given the announced bailout – investors in a new preferred issue could reasonably sue the government for seducing them into investing with promises of a bailout that didn’t materialize. So, these issues would offer a reasonably secure yield of say 11%-12%, taxable at 15% (provided a newly elected U.S. President Barack Obama doesn’t remove the dividend-tax break, an move that’s not near the top of his list). That looks pretty attractive.

Cautious investors should probably avoid Fannie and Freddie securities altogether, selling any they have left to be on the safe side. More-adventurous investors may find Fannie and Freddie-backed MBS attractive, providing they’re old enough, and any new issues of preferred stock extremely tempting. Even the most hardened thrill-seeker should probably avoid the common stock; the odds appear stacked against it.

[Editor's Note: With each successive financial mess that appears in the U.S. securities markets, the odds of the much-feared “SuperCrash" become greater and greater. But those who fear the SuperCrash do so only because they know nothing of the once-in-a-lifetime profit plays that will emanate from the this cataclysmic event. For a report on these profit plays - an offer that includes a free copy of New York Times bestseller "Crash Proof: How to Profit from the Coming Economic Collapse" - please click here.]

News and Related Story Links:

• Money Morning Market Commentary:
  Inside Wall Street: The Fannie Mae/Freddie Mac Bailout is Necessary – But Don’t Expect a Happy Ending.

• Money Morning News Analysis:
  As Treasury’s Paulson Prescribes Bailout for Fannie Mae and Freddie Mac, Guru Jim Rogers Predicts an "Unmitigated Disaster".

• Money Morning News:
  Fannie Mae and Freddie Mac Shares Boosted by Plans for Capital Raise, Government Help.

• Wikipedia:
  Preferred Stock.

• Wikipedia:
  Structured Investment Vehicles.

• Money Morning:
  Election 2008: The Achilles’ Heel of Obamanomics.

The future of Fannie Mae (FNM) and Freddie Mac (FRE) remains uncertain, but Treasury Secretary Henry Paulson continues to go to bat for the struggling mortgage titans that together secure half of the $12 trillion U.S. mortgage market.

Speaking on CBS News’ "Face the Nation," Paulson said, "I’m very optimistic that we’re going to get what we need from Congress," when asked about his plan for a government-sponsored rescue of Freddie Mac and Fannie Mae. "Congress understands how important these institutions are."

Paulson, with backing from President Bush, is urging Congress to expand the $2.5 billion government credit lines of Freddie Mac and Fannie Mae. The Treasury Secretary also would like authorization to purchase equity stakes in the two government-sponsored entities (GSEs), if needed.

"We’re very close to getting reform," Paulson said in a separate interview on CNN’s "Late Edition" program, Bloomberg News reported. "These are very important organizations — they have a very important role to play — and we need to make sure that [Fannie Mae and Freddie Mac] have access to adequate capital to get through this period."

News of Paulson’s government rescue plan halted the multi-day slide and gave the two largest U.S. lenders a slight boost on Friday. Fannie Mae stock gained over 22% with an increase of $2.47 to close at $13.40. Freddie Mac, regarded as the weaker of the two, climbed 10% with a gain of $0.85 to close at $9.18.

Not content to pin its hopes on the whims of a Congress that is hesitant to shoulder U.S. taxpayers with a potential $6 trillion liability, Freddie Mac filed with the U.S. Securities and Exchange Commission to sell $5.5 billion in securities. Freddie Mac first pledged to its regulator, the Office of Housing and Enterprise Oversight, it would raise the capital in May in order to prop up its weak balance sheet. But due to its recent stock woes, Freddie could seek to raise as much as $10 billion in fresh capital, The Wall Street Journal reported.

"The market conditions that have contributed to this price decline are likely to affect our approach to raising new core capital including the timing, amount, type and mix of securities we may issue," Freddie said in its filing, The Financial Times reported.

Fannie Mae and Freddie Mac investors, worried about the solvency of the huge lenders and the dilution of shares any issuing of new securities will cause, led to widespread selling over the past several days that put downward pressure on both stock prices.

Fannie Mae is down over 65% year-to-date and Freddie Mac is down over 75% year-to-date. The loss in share value will cause Freddie Mac to sell a larger number of shares to raise the $5.5 billion in promised capital. Freddie Mac said it expects second-quarter results to be adequate to not require additional capital, Reuters reported.

"While this is encouraging, as it means that there does not appear to be a large loss (in the second quarter) that would have required a larger capital raise, we would note that weaker credit results will pressure near-term results," Credit Suisse Group AG (ADR: CS) analyst Moshe Orenbuch said in a research note concerning Freddie Mac’s plan.

News and Related Story Links:

• The Financial Times:
  Freddie Mac secures SEC registration

• Reuters:
  Freddie Mac files with SEC; first step to capital

• Bloomberg News:
  Paulson Says ‘Very Optimistic’ Freddie, Fannie Plan Will Pass

• Money Morning:
  Inside Wall Street: The Fannie Mae/Freddie Mac Bailout is Necessary – But Don’t Expect a Happy Ending

• Money Morning:
  As Treasury’s Paulson Prescribes Bailout for Fannie Mae and Freddie Mac, Guru Jim Rogers Predicts an "Unmitigated Disaster"

It’s the end of the “American Dream.” It’s the story of how the inevitable bailout of insolvent housing giants Fannie Mae (FNM) and Freddie Mac (FRE) – with the Federal Housing Administration soon to follow – will ultimately lead to such sorrowful sequels as “TheDeath of the Dollar,” “The Downgrading of U.S. Government Debt” and, yes, “The Depression.”

Let’s be very clear on one point, however: There’s no question about it – Freddie and Fannie have to be supported. If the doctrine of “too big to fail” didn’t already exist, it would have to be invented – immediately. Although many are arguing against a “bailout,” those “experts” never seem to address the fallout that would emanate from such a strategy. Nor do they ever discuss the sad series of events that brought us to this financial brink. On that latter point, the truth is so ugly and the failure of governance and its resulting greed so disgusting that to not understand it will guarantee the loss of the American Dream for generations.

Fannie Mae and Freddie Mac: From Dream to Drama

Because it was designed to foster capital creation – and directly promote the American Dream of home ownership, as well as a vibrant economy – the creation of Fannie Mae and Freddie Mac involved some of the best and brightest legislation ever enacted.

That brings us to the most obvious question of all: What went wrong?

First and foremost, both Fannie and Freddie should long ago have been phased out as “government sponsored enterprises,” or GSEs. The implicit (now explicit) guarantee of U.S. government backing allowed the firms to borrow cheaply in the capital markets. If fixed-income (debt) investors – and equity investors as well, for that matter – believe their investments are guaranteed, they will likely invest more and with greater comfort.

The result: These enterprises are able to borrow more cheaply than their rivals – namely banks, investment banks, mortgage companies and other non-bank lenders.

Since Fannie and Freddie were able to borrow more for less, they were also able to post fatter profit margins and dwarfed all potential competitors. The federal government should have gradually unshackled itself from this implicit backing by simply declaring a timetable over which future debt issuance would be explicitly exempt from any government guarantees. This graduated phaseout would have resulted in existing debt being guaranteed up to its maturity, while any new debt would have to be raised competitively, and not at preferential rates. This would have fostered competition, reduced the swelling balance sheets of both enterprises, and kept U.S taxpayers from having to be on the hook for both institutions.

How simple that would have been.

Secondly, and manifestly because of their ability to cheaply fund their balance sheets, both enterprises diverged from their mandates and began to buy and hold the securities they were supposed to create and sell to investors. They bought their own products. The more they created, the more they bought. Ultimately, both enterprises were making more on an operating basis – by fattening their own balance sheets with trillions of dollars of their own securities – than they were making in fees from originating, guaranteeing and selling mortgage debt.

Both enterprises began to borrow aggressively and fund their purchases by borrowing shorter. Their “protected” status enabled them to tap the market whenever they wished.

After recognizing they were creating the classic dilemma of borrowing short and lending long, Fannie and Freddie decided to mitigate their interest rate exposure by hedging with swaps and derivatives. They also bought insurance from the monoline insurers, expecting that their investments would be further protected by these insurers whose own capital was so inadequate that they could never pay 1/100th of their contingent liability exposure.
So, just how big did the balance sheets of Fannie Mae and Freddie Mac actually get? Together, the two housing giants currently guarantee or hold approximately $6 trillion of mortgage-related securities.

Those Missed Opportunities

The capital base underlying their bloated balance sheets was never adequate.

Never.

But again – because of their importance in the grand scheme of capital formation and the implicit government guarantee – investors didn’t focus on their equity or capital base. Just like what happened with technology stocks in the late 1990s, housing prices just kept moving higher.

Both companies saw their share prices escalate as the investments they held made money. Everyone’s eyes were diverted. People were getting rich – debt and equity investors, and especially management.

All hell should have broken loose when, in 2003 and 2004, Fannie Mae suffered from massive accounting scandals. Its top three executives pocketed over $115 million. They were cooking the books. After billions of dollars of the company’s money was spent to “fix” the accounting problems and $400 million of fines were paid by the company, no one went to jail.

Yes, you heard that correctly.

Where were the regulators? Where was the congressional outrage? Where were the analysts and ratings agencies?

There are myriad technical aspects to the workings and investments of both Fannie and Freddie. And there are many questions as to how they were allowed to grow and expose taxpayers to their massive liabilities, and how they are able to manipulate and coddle regulators when it comes to their accounting and specifically their capital adequacy. The day of reckoning has finally arrived. The Painful Payoff of the Fannie/Freddie Debacle Because of the precipitous drop in both companies’ share prices, the resulting erasure of their capital, and the fact that Freddie Mac was yesterday (Monday) scheduled to auction off $3 billion worth of 3-month and 6-month notes (they reportedly sold), the rescue was inevitable. In a classic attempt to calm the markets Sunday, U.S. Treasury Secretary Henry Paulson said the Treasury Department and the Federal Reserve will provide a “liquidity backstop” by offering a line of credit that is “to be determined.” Furthermore, “if needed,” it will supply “temporary authority to purchase equity” in the enterprises. [For a more-detailed story on Treasury Secretary Paulson's bailout plan - including some harsh criticism's from investing guru Jim Rogers, check out our news story on the Fannie Mae/Freddie Mac bailout plan also published in today's edition of Money Morning.]

The Treasury Department and the Fed also will strengthen regulatory measures.
 Now, I’m relieved!

The bailout has begun. The $6 trillion burden will be shouldered by U.S. taxpayers. U.S. debt will double to the equivalent of our gross domestic product (GDP). Borrowing costs will rise for homebuyers, further depressing the housing market and leading to hundreds of billions of additional bank write-offs, hedge-fund losses and failures of financial institutions and enterprises ranging from banks to hedge funds.

The Fed has no concern about inflation relative to the demise of the economy, and will have to keep interest rates low for critical liquidity demands and to stave off a deep recession. The building inflationary pressures in the face of the Fed’s efforts to provide liquidity and keep interest rates low will crush the dollar.

We are facing the prospect of a depression and the end of the American Dream. What can be done? Will the housing legislation on the table be the rescue plan we desperately need?

Absolutely not.

This crisis can’t wait. I’ll address the legislation, why it will fail and what should be done later this week.

Don’t be fooled by any bounce in the markets. Every bounce is an opportunity to sell and add to shorts. This is no time to be picking bottoms. The trend is your friend – and that trend is clearly down.

[Editor's Note: Contributing Editor R. Shah Gilani has toiled in the trading pits in Chicago, run trading desks in New York, operated as a broker/dealer and managed everything from hedge funds to currency accounts. In his new column, "Inside Wall Street," Gilani vows to take readers on a journey through the "shadowy back alleys" of the U.S. capital markets - and to conduct us past the "velvet rope" that guards Wall Street's most-valuable secrets - in an ongoing search for the investment ideas with the biggest profit potential.]

News and Related Story Notes:

• Money Morning News Analysis:
  MBIA on the Hook for $7.4 Billion After Moody’s Downgrade.

• MSNBC:
  Report: Fannie Mae Manipulated Accounting.

• RebelTraders:
  Updates on Market, Washington Mutual, Freddie Mac Bond Sale.

• Money Morning Special Investors Research Report:
  Nine Ways to Profit From the Diving Dollar.

• Money Morning Weekly Forecasting Commentary:
  Subprime Crisis Again in the Spotlight as the Meltdowns of Fannie Mae and Freddie Mac Fuel Fears of a Deeper Downturn.

Standing on the steps of the U.S. Treasury building across the street from the White House, Treasury Secretary Henry Paulson asked Congress for the power to prop up Fannie Mae (FNM) and Freddie Mac (FRE), the two failing mortgage giants involved with nearly half of the $12 trillion U.S. mortgage market.

"The president has asked me to work with Congress to act on this plan immediately," Paulson said Sunday. "Fannie Mae and Freddie Mac play a central role in our housing finance system and must continue to do so in their current form as shareholder-owned companies. Their support for the housing market is particularly important as we work through the current housing correction."

But half a world away – in his new home in Singapore – peripatetic investing guru Jim Rogers blasted the federal government for its new activist approach, which conflict with the very idea of a free market. A rescue of Fannie Mae and Freddie Mac – the second federally sponsored corporate bailout in four months after the Treasury Department rode to the rescue of The Bear Stearns Cos. Inc. (BSR) in March – is shifting the cost of errant financial strategies away from shareholders and onto U.S. taxpayers.

"I don’t know where these guys get the audacity to take our money, taxpayer money, and buy stock in Fannie Mae," Rogers, the best-selling author and famed investor told Bloomberg News. "These companies were going to go bankrupt if [the feds] hadn’t stepped in to do something, and they should’ve gone bankrupt with all of the mistakes they’ve made. What’s going to happen when you … put some Band-Aids on it for another year or two or three? What’s going to happen three years from now when the situation’s much, much, much worse?"

Clearly, a sweeping rescue of the government sponsored entities, such as the one planned, will bring with it a broad new range of liabilities for the American taxpayer, who will be financing institutions that are widely regarded as insolvent.

The debt securities issued by Fannie and Freddie are widely owned by pension funds, mutual funds, institutional investors, and even foreign governments. So a collapse of the two government-sponsored enterprises would send shockwaves through an economy that is already struggling to overcome the worst housing recession in a quarter-century, tight global credit markets and soaring inflation thanks to rising food and energy prices.

Paulson asked Congress for the authority to buy equity in – and lend to – the companies, while also substantially increasing their lines of credit.

The Treasury Department did not specify the amount of credit that would be made available to Fannie Mae and Freddie Mac, but those briefed on the plan told the International Herald Tribune that administration officials are lobbying Congress to extend the line of credit to $300 billion.

Each company currently has a $2.25 billion credit line that was established close to 40 years ago. At the time, Fannie Mae had only $15 billion in outstanding debt according to IHT.  Now, Fannie has a total debt of about $800 billion and Freddie has roughly $740 billion.

Many on Capitol Hill, particularly Senator Charles Schumer (D-NY), greeted the plan with enthusiasm.

"The Treasury’s plan is surgical and carefully thought out and will maximize confidence in Fannie and Freddie while minimizing potential costs to U.S. taxpayers," Schumer said.

"While Fannie and Freddie still have solid fundamentals, it will be reassuring to investors, bondholders and mortgage-holders that the federal government will be behind these agencies, should it be needed."

But Rogers – who contends that the U.S. economy is in the midst of its worst recession since World War II – referred to Paulson’s plan as an "unmitigated disaster."

"They’re ruining what has been one of the greatest economies in the world," Rogers said, making a collective reference to both Paulson and U.S. Federal Reserve Chairman Ben S. Bernanke.

 Said Rogers: Paulson and Bernanke "are bailing out their friends on Wall Street … but there are 300 million Americans that are going to have to pay for this."

[Editor's Note: For an insider's explanation of the catalysts for the Fannie Mae/Freddie Mac financial crisis - as well as the long-term fallout investors can expect - check out Contributing Editor Shah Gilani's " Inside Wall Street" column also contained in this issue of Money Morning. Global Investing guru Jim Rogers has been particularly critical of the U.S. government's willingness to bail out Wall Street's financial miscreants. Indeed, in an exclusive interview with Money Morning earlier this year, Rogers predicted the failure of the U.S. Federal Reserve for this very reason. And while that's very bad news for U.S.-focused investments, there is an alternative - Asia, and more specifically, China, Rogers says. For more details of this global investing game plan, and to obtain a free copy of Rogers' new bestseller, "A Bull in China," check out this investing report.]

News and Related Story Links:

• Bloomberg:
  Fannie Plan a ‘Disaster’ to Rogers; Goldman Says Sell.

• Money Morning Exclusive Interview:
  Jim Rogers: More Pain for the Greenback, and the Failure of the Federal Reserve.
• International Herald Tribune:
  U.S. unveils vast plan to save mortgage giants.
• Money Morning:
  Freddie Mac and Fannie Mae Rocked by Liquidity Concerns

Speculation that the U.S. government would have to step in to bail out struggling mortgage-giants Freddie Mac (FRE) and Fannie Mae (FNM) escalated as the markets set to close for the weekend.

Shares recovered slightly after Reuters reported U.S. Federal Reserve Chairman Ben S. Bernanke granted Freddie Mac and Fannie Mae emergency access to the Fed’s discount window.

Freddie Mac shares pared earlier losses to shed just $0.25 Friday, a 3% decline, to close at $7.75. Earlier in the day, the stock had traded as low as $4.01. Freddie Mac is down over 77% year-to-date as of Friday’s close. The stock has traded between $3.89 and $67.20 over the past 52 weeks.

Fannie Mae stock had a similar fate, shedding $2.95, a 22% to decline to close at $10.25, after climbing from $7.25 in early hours trading. Fannie Mae shares are down 45% in the past week and 74% year-to-date. Shares have traded between $6.68 and $70.57 over the last 12 months.

Rumors of a government-sponsored bailout swirled, with The New York Times reporting that President Bush & Co. were mulling over options. But Citigroup Corp. (C) issued a bold research note supporting the two government-sponsored entities (GSEs) in their current incarnations.

"We believe that no one in Washington desires for a nationalization of the GSEs, which would bring the burden of providing mortgage access and liquidity on to the shoulders of taxpayers," Citigroup Global Markets analysts Bradley Ball and Arren Cyganovich wrote in a research note Friday concerning Freddie Mac and Fannie Mae.

"We believe the market needs to be reminded that the GSEs were structured as shareholder-owned institutions for a reason – to provide non-federal capital support for the U.S. housing and mortgage markets, and that the GSE structure has worked in the past (such as during 1998) and continues to work today," the analysts continued, MarketWatch reported.

And while it’s true that the government might be hesitant to step in after what many considered a taxpayer-sponsored bailout of The Bear Stearns Cos. Inc. (BSC), it’s also true that the government can’t afford to let Freddie Mac and Fannie Mae fail. Together, the two lenders guarantee about half of the $12 trillion U.S. home mortgage market.

"The impact of a failure of Fannie and Freddie, though technically insolvent, is beyond imagining, far greater than the bankruptcy of a Bear Stearns," said Barron’s Randall W. Forsyth on Friday. "For that reason alone, such an eventuality is unthinkable."

Foreclosures Hit Fannie Mae and Freddie Mac in the Bottom Line

Rocketing foreclosure rates are only serving to exacerbate the problems of the largest U.S. lenders as one in every 501 households was at some stage of the foreclosure process in June, industry watchdog RealtyTrak announced Thursday.

"The foreclosure problem is getting worse and will stay with us well into the next decade," Mark Zandi, chief economist for Moody’s Economy.com (MCO) said in an interview with Bloomberg News. "The job market is eroding and homeowners have less equity. Lenders are much less willing to work with you if you’ve got negative equity, and you’re more likely to give up your house if you’re deeply underwater."

U.S. Treasury Secretary Henry Paulson tried to reassure investors about Freddie Mac and Fannie Mae, saying both firms remain "adequately capitalized," The New York Times reported.

"Fannie Mae and Freddie Mac are also working through this challenging period," Paulson said in testimony before the House Financial Services Committee earlier this week. "They play an important role in our housing markets today and need to continue to play an important role in the future."
But former St. Louis Federal Reserve President William Poole questioned the solvency of Freddie Mac and Fannie Mae, saying the government might need to step in to rescue the struggling lenders.

"Congress ought to recognize that these firms are insolvent, that it is allowing these firms to continue to exist as bastions of privilege, financed by the taxpayer," Poole, who left the Fed in March, said in the interview Wednesday, Bloomberg reported.

Poole has long been a critic of Freddie Mac and Fannie Mae, saying as early as 2003 that the companies would not be able to weather a serious market destabilization.

While the two firms are considered government-sponsored enterprises, neither Freddie Mac nor Fannie Mae receives funding from the U.S. government. Likewise, the government does not guarantee any debt-issued by the firms.

"At some point we’re going to reach that inflection, where the government is going to have to either guarantee explicitly or Fannie and Freddie are going to have be left to fend for themselves," Peter Boockvar, an equity strategist at Miller Tabak & Co. in New York, said in an interview with Bloomberg Television. "We’re getting to that point where a decision has to be made by Washington."

News and Related Story Links:

• Money Morning:
  Freddie Mac and Fannie Mae Rocked by Liquidity Concerns

• MarketWatch:
  Citi analysts say Fannie, Freddie selling ‘overdone’

• Barron’s:
  Failure Is Not an Option For Fannie and Freddie

• Reuters:
  Fannie, Freddie stocks and bonds plummet

• Bloomberg News:
  Foreclosures Rose 53% in June, Bank Seizures Triple

• The New York Times:
  Fannie Mae and Freddie Mac Shares Tumble

• Bloomberg News:
  Fannie, Freddie Tumble on Bailout Concern, UBS Cut

Investor worry over the solvency of U.S. mortgage-giants Freddie Mac (FRE) and Fannie Mae (FNM) have gutted the stocks over the last few days more than halving their market capitalizations.

News of a possible government-sponsored bailout sent Freddie Mac and Fannie Mae shares plunging yesterday (Thursday) dangerously close to new 52-week lows.

Freddie Mac shares sank $2.15 yesterday, a 20% decline to close at $8.11. Freddie Mac is down 76% year-to-date as of Thursday’s close.

Fannie Mae stock had a similar fate, shedding $1.95, an almost 13% to decline to close at $13.36. Fannie Mae shares are down nearly 67% year-to-date.

Rocketing foreclosure rates are only serving to exacerbate the problems of the largest U.S. lenders as one in every 501 households was at some stage of the foreclosure process in June, industry watch-dog RealtyTrak announced yesterday.

“The foreclosure problem is getting worse and will stay with us well into the next decade,” Mark Zandi, chief economist for Moody’s Economy.com (MCO) in West Chester, Pennsylvania, said in an interview with Bloomberg News. “The job market is eroding and homeowners have less equity. Lenders are much less willing to work with you if you’ve got negative equity, and you’re more likely to give up your house if you’re deeply underwater.”

U.S. Treasury Secretary Henry Paulson tried to reassure investors about Freddie Mac and Fannie Mae yesterday, saying both firms remain “adequately capitalized,” The New York Times reported.

“Fannie Mae and Freddie Mac are also working through this challenging period,” Paulson said early in his testimony before the House Financial Services Committee. “They play an important role in our housing markets today and need to continue to play an important role in the future.”

But former St. Louis Federal Reserve President William Poole questioned the solvency of Freddie Mac and Fannie Mae, saying the government might need to step in to rescue the struggling lenders.

“Congress ought to recognize that these firms are insolvent, that it is allowing these firms to continue to exist as bastions of privilege, financed by the taxpayer,” Poole, who left the Fed in March, said in the interview Wednesday, Bloomberg reported.

Poole has long been a critic of Freddie Mac and Fannie Mae, saying as early as 2003 that the companies would not be able to weather a serious market destabilization.

While the two firms are considered government-sponsored enterprises, neither Freddie Mac nor Fannie Mae receives funding from the U.S. government. Likewise, the government does not guarantee any debt-issued by the firms.

“At some point we’re going to reach that inflection, where the government is going to have to either guarantee explicitly or Fannie and Freddie are going to have be left to fend for themselves,” Peter Boockvar, an equity strategist at Miller Tabak & Co. in New York, said in an interview with Bloomberg Television. “We’re getting to that point where a decision has to be made by Washington.”

News and Related Story Links:

• Reuters:
  Fannie, Freddie stocks and bonds plummet

• Bloomberg News:
  Foreclosures Rose 53% in June, Bank Seizures Triple

• The New York Times:
  Fannie Mae and Freddie Mac Shares Tumble

• Bloomberg News:
  Fannie, Freddie Tumble on Bailout Concern, UBS Cut

Like several of its ailing peers, Fannie Mae (FNM) reported a wide quarterly loss and stocked its financial armory for continued financial strain with a dividend cut and $6 billion planned in raised capital.

The largest U.S. mortgage-finance company said it lost $2.19 billion, or $2.57 per share, in the first quarter, citing widening of credit spreads, higher-than-expected home price declines and "loan loss severity."

Chief Executive Officer Daniel Mudd was almost defensive in a company statement, mentioning nearly every ailment to the economy before speaking of company results. The statement also said the company expects "housing weakness will lead to increased delinquencies, defaults and foreclosures on mortgage loans." 

"Our first quarter results, although an improvement over the last quarter, reflect these challenging market conditions," Mudd said.

To help recover, Fannie cut its divided for the second time this year, to 25 cents a share from 35 cents. Previously, it’d been cut from 50 cents to 35 cents.

Fannie Mae also said it plans to raise $6 billion in capital through stock sales.

But Barclays Capital fixed-income strategist Ajay Rajadhyaksha told Bloomberg that it won’t be enough to weather the housing slump should it continue into 2009.

"They are now starting to realize the fact that their credit losses will be considerably higher than they were in 2007," Rajadhyaksha said. "Things in the housing and credit markets are deteriorating very fast and this will not be the last capital raising this year."

Banks Bracing 

Top financials know they’re hurting and know there’s more pain to come. Write-downs sparked by the subprime crisis have ballooned to $319 billion and led to 65,000 eliminated jobs in the financial industry. But each financial firm has taken measured steps to shield itself from further damage.

After posting a 50% drop in quarterly revenue, JPMorgan Chase & Co. (JPM) added $2.5 billion to credit reserves, including $1.1 billion related to home equity loans.

Washington Mutual Inc. (WM) reported a $1.14 billion first-quarter loss, but a week earlier, the Seattle-based lender announced it raised $7 billion in capital, and would slash its dividend and cut 3,000 jobs.

Merrill Lynch & Co. (MER) announced 3,000 job cuts after it posted a $1.96 billion, or $2.19 a share, loss for the first quarter – its third consecutive quarterly loss.

Likewise, Citigroup Inc. (C) announced it would cut 9,000 jobs this year when it reported a $5.11 billion loss for the first quarter. Since the credit crisis took hold last year, Citigroup has been on the receiving end of massive cash infusions from around the world. 

Despite the measures, analysts are equally guarded about financials.

"I’m not sure if I’m more disappointed about the earnings for this quarter or for the [housing] outlook for next year," Charles Lieberman, chief investment officer of Advisors Capital Management, told Reuters, referring to Fannie Mae. "They are clearly still having repercussions from the subprime and market valuation problems."

News and Related Story Links:

• Bloomberg:
  Fannie Mae Has Loss, Cuts Dividend, to Raise Capital

• Fannie Mae:
  Fannie Mae Reports First Quarter 2008 Results

• Money Morning:
  JPMorgan Chase Posts 50% Profit Drop, Predicts "Weak" Markets "Through Remainder of Year or Longer"

• Money Morning:
  Merrill Misses Expectations, Thain’s Mettle to be Tested

• Money Morning:
  Why Some of the World’s Savviest Investors Are Buying – Gasp! – Citigroup

• Reuters:
  Fannie Mae posts loss, to cut payout, raise capital