Short U.S. Government Debt, Buy Fannie Mae, RBS Tells Clients

Investors should buy default protection on U.S. Treasuries as the odds increase that the government will have to bail out Fannie Mae and Freddie Mac, analysts at RBS Greenwich Capital Markets told clients today.

The possibility that the Treasury could lose its top AAA credit rating if it's forced to bail out the two government- sponsored enterprises will likely cause credit-default swaps on government debt to widen while contracts tied to the senior debt of Fannie and Freddie narrow, Kenneth Hackel, the managing director of fixed-income strategy at RBS Greenwich in Greenwich, Connecticut, said in an e-mailed note to clients today.

``It was only a couple of months ago that Standard & Poor's came out and said that if they had to do a full-blown bailout, they could see taking down the rating on the U.S. Treasury,'' Hackel said in an interview today. ``And then how wide would it get? A lot wider than it is now.''

Washington-based Fannie Mae and McLean, Virginia-based Freddie Mac, the nation's biggest mortgage finance companies, are insolvent under fair value accounting rules and the chances are increasing that the government will need to bail them out, Former St. Louis Federal Reserve President William Poole said in an interview.

Freddie Mac owed $5.2 billion more than its assets were worth in the first quarter. The fair value of Fannie Mae's assets fell 66 percent to $12.2 billion, data provided by the company show, and may be negative next quarter, Poole said.

While Fannie Mae and Freddie Mac may be technically insolvent, the government can't afford to let the companies' senior debt holders lose money, Hackel said.

``The largest holders, foreign central banks, are so critical to the financing of U.S. deficits that the federal government has no choice but to keep them comfortable,'' he said.

Staying Solvent

The two companies own or guarantee about half the $12 trillion in U.S. home loans outstanding. Congress, which chartered Fannie Mae and Freddie Mac decades ago to boost home financing, has lifted growth restrictions on the companies, eased their capital requirements and allowed them to buy bigger jumbo mortgages to help revive the housing market.

``They can stay solvent as long as people are willing to buy their debt,'' Michael Vogelzang, the chief investment officer at Boston Advisors LLC, said in a Bloomberg Television interview today. ``It's when that spigot gets shut off that they would have some real problems and the government would have to step in.''

Five-year credit-default swap contracts tied to Treasuries were quoted at about 10.5 basis points today, down from 12 basis points on April 3, according to CMA Datavision in New York.

Contracts tied to the senior debt of Fannie Mae and Freddie Mac were trading at about 81 basis points and have more than doubled the past two months.

A Narrow Bet

Hackel said investors should buy Treasury credit-default swaps while at the same time selling protection on Fannie Mae and Freddie Mac via the contracts, a bet that the difference between the two will narrow.

A basis point on a credit-default swap contract protecting $10 million of debt from default for five years is equivalent to $1,000 a year.

Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on a company's ability to repay debt. They were conceived to protect bondholders against default and pay the buyer face value in exchange for the underlying securities should the company fail to adhere to its debt agreements.