Fannie, Freddie Stocks Are Roiled by Short Sellers

Heightened expectations of a government bailout of U.S. home-funding giants Fannie Mae and Freddie Mac continued to roil their stocks as investors feared such government action would wipe out shareholders.

CHECK OUT FULL COVERAGE ON FANNIE MAE AND FREDDIE MAC

Both Freddie and Fannie have plummeted in recent days, losing more than half of their value just this week and sinking to the weakest in nearly two decades.

On Thursday, shares tumbled more than 10 percent at the opening bell but then turned higher within the first hour of trading as investors made some short-term plays in the stocks.

"It's short covering—that's all it is," said Dave Rovelli, managing director of equity trading at brokerage Canaccord Adams. "That’s why you see the voiolent snapback—everyone’s chasing to cover their shorts."

Short selling occurs when a buyer borrows stock at a higher price, betting it will decline, then buys it back at the lower price to profit from the difference. When a lot of short-sellers buy back the stock, which is called short covering, it can give the stock a temporary boost.

"It's gonna be like that every day," Rovelli said of the short covering. "They're gonna press it, press it, press it."

The two federally chartered companies own or guarantee almost half of all outstanding U.S. mortgages. The government is relying heavily on them to step up mortgage purchases to hold down home lending rates and help stabilize the worst U.S. housing market since the Great Depression.

The near-collapse of Fannie Mae and Freddie Mac may signal a turning point for stock markets. See video at left.

Closely watched analyst Dick Bove of Ladenburg Thalmann said the government should recruit financial industry leaders to oversee dismantling of the two companies.

"The only rational action'' to be taken relative to Fannie and Freddie 'is to get rid of them,'' Bove wrote in a research note.

In contrast, the debt issued by Fannie and Freddie has surged relative to Treasuries this session and last, on the view that a government bailout would secure repayment.

Investors are closely watching the performance of the companies' debt, given that they will need to roll over $225 billion of debt by the end of September, according to Barclays Capital.

The companies' ability to access the debt markets is essential for them to keep buying mortgages and helping stabilize the worst U.S. housing market since the Great Depression.

A new Freddie Mac five-year note that was sold on Tuesday to yield 1.13 percentage point more than Treasuries has since drawn enough investor demand to slash the risk premium to 0.98 percentage point on Wednesday and about 0.89 percentage point early Thursday.

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

A Treasury spokeswoman, however, said that while the agency is in regular contact with the government-sponsored enterprises, it declined to confirm whether it was meeting with Freddie officials Wednesday.

"It's not just the housing picture that one has to fathom, but it's also public policy. What is the government going to do?" said Marshall Front, chairman of investment firm Front Barnett Associates in Chicago. "We continue to be concerned about what dilution would be required to stabilize Fannie and Freddie, and what that would leave over for existing shareholders."

© 2009 CNBC