November 30 2007: 6:21 AM EST
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Freddie and Fannie's Achilles' heel

Both troubled lenders need capital, but they cannot raise it in the way that many companies would. Fortune's Carol Loomis explains their vulnerability.

By Carol Loomis, Fortune senior editor at large

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Neither Fannie Mae nor Freddie Mac can make use of the most popular form of preferred stock.

NEW YORK (Fortune) -- Mortgage giants Freddie Mac and Fannie Mae need capital - in today's credit crisis, there's no doubt about that. Freddie even said last week that it was "seriously considering" cutting its $2 annual dividend by half, a radical step indicating how strapped the company is. Freddie also reported it had hired two Wall Street firms to explore "capital-raising alternatives."

And Freddie and Fannie are going to need some especially creative alternatives. Why? When either Freddie or Fannie attempt to build capital, they are handicapped by a peculiarity that very few investors know about: They cannot sell the most popular kind of preferred stock, the "cumulative" variety, because their regulator will not let these securities count toward capital.

What "cumulative" signifies in this context is that if dividends are missed, they pile up to be paid on some brighter day, if that arrives. To the extent that Freddie and Fannie issue preferred shares, therefore, they are forced into selling the "non-cumulative" variety. That means if a dividend is missed, say, in the first quarter of 2008, the owners of the preferred will never get that dividend. It's just gone, zip!

Naturally, prudent investors are not wild about owning non-cumulative preferred shares, which is why there are not many of these securities around. What smart investor unnecessarily wants to put himself in the position - no matter how remote - of missing a dividend and never thereafter being able to capture it?

But the fact is that many investors don't read their prospectuses, don't get full disclosure from their brokers, and are not clued-in to this market wrinkle. For example, Fannie Mae (Charts) sold $500 million of preferred shares on November 16th. Go to Fannie's website, where the security is described: "non-cumulative, perpetual, fixed-rate preferred stock at a dividend rate of 7.625% per annum." How many investors, particularly those being solicited by retail firms to buy these $25 securities, really understood the implications of the term "non-cumulative"?

Of course, the dividend on that preferred will keep on being paid as long as any common dividend is paid. A company can't deny a payout to its preferred shareholders while continuing to reward its common shareholders, and thus far there are no signs that Fannie will stop paying its common stock dividend. Still, the $500 million that Fannie just raised will not solve its total capital needs; it'll be coming to the market again.

But it's Freddie that right now has the emergency. Because of big losses Freddie has taken, its capital has fallen perilously close to the minimums required by its regulator. So that's why it's seeking "capital-raising alternatives."

All this, of course, means dilution for Freddie's existing common shareholders. During a Freddie conference call this past week, analyst Fred Cannon of Keefe Bruyette & Woods probed what the damage could be by asking whether Freddie might not have to raise $2 billion to $4 billion in capital. The company's chief financial officer ducked, saying simply, "This will be a large transaction." It won't be, he added, a sale of common stock.

That leaves the world expecting Freddie to offer a boatload of convertible preferred - non-cumulative, of course. The security will have to be priced well, with a good dividend and a conversion price not way above the market.

And speaking of that market, Freddie (Charts, Fortune 500) closed at $26.47 a share last week. That's 35% below its price a week earlier. If Freddie wants to calm investors, it had better figure out its "alternatives" quickly.  To top of page

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