Freddie, Fannie debt protection costs fall

NEW YORK (Reuters) - Debt protection costs on senior and subordinate debt of Fannie Mae and Freddie Mac plunged on Wednesday and their bond prices rallied as investors saw a potential government bailout of the U.S. mortgage giants as likely hurting mostly shareholders.

Credit spreads tightened even as investors continued to dump Fannie and Freddie shares, sending them to the lowest levels in more than 18 years.

"Fannie Mae and Freddie Mac credit spreads are tightening, which is consistent with a rescue plan that will eliminate the value of the common stock," Seabreeze hedge-fund manager Doug Kass said in an interview.

The cost to insure Freddie Mac senior debt against a default with credit default swaps fell 18 percent to 40 basis points, or $40,000 a year to insure $10 million of debt for five years, according to Markit Intraday. Fannie's spreads also tightened about 16 percent to 40 basis points.

And the spread over U.S. Treasuries on the new $3 billion Freddie Mac five-year notes tightened to about 97.5 basis points on the bid side on Wednesday from a record 113 basis points set during Tuesday's sale.

Market participants worried that a bailout may be imminent after The Wall Street Journal reported that Freddie Mac executives would meet with Treasury officials on Wednesday, possibly to get clarity about how the government will support the company.

Anxiety about the companies has risen in recent days following a weekend report in Barron's newspaper that the government officials may have no choice but to effectively nationalize Fannie and Freddie.

While the Treasury is going to try to avoid nationalization, other rescue scenarios include the Treasury purchasing agency mortgage-backed securities, or their senior debt or preferred or senior preferred shares, according to Ira Jersey, U.S. interest rate strategist at Credit Suisse in New York.

"(It could be) something like a convertible preferred deal that might end up diluting shareholders, but at the same time the rest of the capital structure winds up doing OK," Jersey said.

CreditSights analysts said in a report that it was a "highly remote" possibility that senior debt would be impaired in a government investment in U.S. mortgage giants.

However, UBS analysts in a report said coupon payments on qualifying subordinated debt could be suspended if the Treasury were to take some kind of a preferred equity stake in the government-sponsored enterprises.

Reflecting this risk, debt protection costs on the subordinated debt have risen in recent months and the difference between the spread on senior and subordinated debt has hit record levels.

Nevertheless, credit spreads could continue to tighten.

"As long as the intervention does not entail a restructuring of the debt, and ensures the viability of the enterprises, debt/CDS spreads can tighten," an analyst at a Wall Street bank said.

(Reporting by Anastasija Johnson, Jennifer Ablan, Lynn Adler and Dena Aubin; Editing by Jonathan Oatis)