Bailout Blues: Beware of the Unseen Fallout From the Fannie/Freddie "Rescue" Plan

[The first of two parts analyzing the upside and downside of the Fannie Mae/Freddie Mac bailout. Part II appears tomorrow.]

By Keith Fitz-Gerald
Investment Director
Money Morning/The Money Map Report

Many of the largest financial institutions - including banks, insurance companies and mutual funds - own huge blocks of Fannie Mae (FNM) and Freddie Mac (FRE) shares.

Still, millions of investors who thought they were "safe" from this whole bailout mess because they didn't own Fannie or Freddie directly might get blindsided anyway. The reason: These investors may have indirect ownership in one or both of the two mortgage miscreants, thanks to shares held in their mutual funds, 401(k) plans, pension funds or annuities.

Let me explain.

Since last year, both Fannie and Freddie have been the focus of much speculation, with analysts figuring the government would take over and "rescue" the beleaguered mortgage giants. As we've reported to you here in Money Morning, most concerns focused on how the government would actually take over the two government sponsored enterprises (GSEs), and whether or not the process would eliminate the common stock and preferred shares of both.

U.S. Treasury Secretary Henry M. Paulson & Co. ended the betting on that issue on Sunday, announcing that neither class of stock will be eliminated, as some had feared - although the point may be moot. Especially since a "rescue" is not going to stop the meltdown of the nation's $12 trillion mortgage market (in which about half the paper is backed by Fannie and Freddie, incidentally).

As part of the government's plan, shareholders have been stripped of both their corporate-governance powers and management rights, while both common and preferred shareholders saw their income eliminated when the government ended dividend payments to both.

This could lead to serious - and perhaps irreparable - declines in the portfolios of a number of regional banks, mutual funds and major insurance companies, which used holdings in both companies to shore up assets by virtue of the stability they offered and the income they provided.

The list of "at risk" names is as distinguished and it is long.

Some, like longtime superstar fund manager William "Bill" Miller of Legg Mason Inc. (LM) fame, were no doubt shell-shocked yesterday (Monday). And with good reason. Fannie's shares dropped another 81.38% yesterday, while Freddie's were down an additional 82.75%. All told, both stocks are down 99% from their respective 52-week highs.

Miller - an avowed value investor - displayed real brilliance in his ahead-of-the-crowd decoding of the business models of, and inherent value in, such New Economy stalwarts as (AMZN) and direct seller Dell Inc. (DELL). And he's best known for beating the Standard & Poor's 500 Index for 15 straight years - the mutual fund sector's version of Cal Ripken Jr.'s "Streak." But Miller's streak ended in 2006 and he's yet to regain his former momentum. Bets like those he placed on Freddie can't help.

At a time when Fannie and Freddie have lost most of their value, most institutional investors have been net sellers or active hedgers, at the least. We don't know whether Miller hedged his bets; we only know that he bet big.

According to a report, Legg Mason owned 15 million Freddie Mac shares at the end of 2007, when the stock was trading at $34 a share. Legg's holdings climbed to 50 million shares in the first quarter, a point at which the fallout from the Bear Stearns collapse had helped push Freddie's shares down into the teens. As of July 31, when the Freddie Mac's shares were trading at less then $10 each, Legg and Miller actually held 80 million shares of the mortgage GSE.

In other words, Miller's been doubling down - and in a big way. And the bill has now come due. As of Dec. 31, 2007, Legg Mason held paper worth a cool $1.7 billion. As of yesterday, it's worth less than $53 million. And we're not even counting the losses on any shares he's picked up since then. It's going to be hard for him to argue to his shareholders that this is anything more than an unmitigated disaster.

Of course, we hope he's engaged in systematic hedging along the way - a question we won't be able to answer until the next set of quarterly reports come out. We'll want to know - as will scores of investors who thought they'd escaped this catastrophe.

Unfortunately, the story is much the same at a whole host of other institutions, including AllianceBernstein Holding LP (AB), Capital Research Global Investors, Fidelity Investments, Citigroup Inc. (C), Lord, Abbett & Co., and Barclays Global Investors Ltd. (ADR: BCS), for example. According to MSN, they were not only net long Fannie, as of June 30th, but each firm added net positions during the second quarter while the prices were tanking.

And insurance companies. According to reports in Fortune magazine yesterday, Genworth Financial Inc. (GNW) and MetLife Inc. (MET), among others, own large preferred share positions that have just effectively been wiped from the face of the earth. And The Associated Press reported that a number of regional banks - such as Sovereign Bancorp Inc. (SOV) - will take a hit because of their holdings of GSE preferred stock.

So, the bottom line here is that last weekend's so-called "rescue" is really nothing more than the government playing "pass the hat."

None of the stories I've seen reference exactly where all this money for the rescue is coming from. Which makes the whole rescue concept more than a little suspect.

The real question at the end of the day is one that my good friend - author and financial columnist Jon Markman - posed to me over the weekend:

Will domestic spending increase as a result of the Fannie/Freddie bailout and does this increase gross domestic product (GDP) in any way shape or form?

I think not.

Which once again leaves regular taxpayers like you and me on the hook for an open-ended bar tab that we don't have the power to shut down.

[Editor's Note: In Part II tomorrow (Wednesday), Contributing Editor Martin Hutchinson looks at ways for investors to capitalize on the fallout from the Fannie/Freddie Bailout.]

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About the Author

Keith is a seasoned market analyst and professional trader with more than 37 years of global experience. He is one of very few experts to correctly see both the dot.bomb crisis and the ongoing financial crisis coming ahead of time - and one of even fewer to help millions of investors around the world successfully navigate them both. Forbes hailed him as a "Market Visionary." He is a regular on FOX Business News and Yahoo! Finance, and his observations have been featured in Bloomberg, The Wall Street Journal, WIRED, and MarketWatch. Keith previously led The Money Map Report, Money Map's flagship newsletter, as Chief Investment Strategist, from 20007 to 2020. Keith holds a BS in management and finance from Skidmore College and an MS in international finance (with a focus on Japanese business science) from Chaminade University. He regularly travels the world in search of investment opportunities others don't yet see or understand.

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