Aug. 22 (Bloomberg) -- Fannie Mae and Freddie Mac's $36 billion in preferred stock was downgraded to the lowest investment-grade rating by Moody's Investors Service, which said the increased likelihood of ``direct support'' from the U.S. Treasury may devalue the securities.

The ratings were lowered five steps to Baa3 from A1, New York-based Moody's said today in a statement. Moody's kept its Aaa senior debt ratings on Fannie and Freddie stable and affirmed the subordinated debt because the Treasury will likely make sure the companies continue to make interest payments in any bailout.

Moody's joins a chorus of analysts and investors who say Fannie and Freddie's limited access to ``economically attractive'' capital will give Treasury Secretary Henry Paulson little choice but to bail out the beleaguered mortgage-finance companies. The preferred shares had already lost at least half their value since June 30 on concern that intervention would mean a stop in dividend payments or involve an injection of preferred stock that ranks ahead of current holders.

Regional banks including Midwest Bank Holdings Inc., Sovereign Bancorp and Frontier Financial Corp., may have the most to lose. Melrose Park, Illinois-based Midwest has $67.5 million, or as much as 23 percent of its risk-weighted assets, in the preferred stock, while Philadelphia-based Sovereign owns about $623 million and Everett, Washington-based Frontier about $5 million.

Pressure on Banks

The downgrade ``puts a little more pressure on banks to record some sort of impairment charge on these securities,'' Daniel M. Arnold, an analyst at Sandler O'Neill & Partners LP in New York, said in a telephone interview. ``The more and more likely it becomes that the value of these isn't going to return back to where it was,'' the harder it is to avoid writedowns.

Paulson last month was granted the power to make unlimited capital injections into Washington-based Fannie and McLean, Virginia-based Freddie should he and the companies deem it necessary. The Treasury has repeatedly said Paulson doesn't expect to have to exercise that authority.

Moody's so-called bank financial strength ratings on Fannie and Freddie, which reflect the odds of a government bailout, were cut four steps to D+ from B-.

``The game is over'' for Fannie and Freddie, billionaire investor Warren Buffett, the 77-year-old chairman of Berkshire Hathaway Inc., said in an interview on CNBC today.

Share Trading

Fannie's $7 billion of 8.25 percent perpetual preferred stock rose 2.1 percent to $11.29 today. They are down 26 percent this week, with the yield rising to 19 percent from 13.9 percent. Fannie common shares rose 15 cents, or 3.1 percent, to $5 in New York Stock Exchange composite trading and have lost 93 percent in the past year.

Freddie's $1.1 billion of 5.57 percent preferred stock rose 2.1 percent to $7.40 and is lower by 36 percent this week, pushing the yield to 19.5 percent. Freddie common shares dropped 35 cents, or 11 percent, to $2.81 and are down 96 percent in the past year.

Preferred shares rank one level above common stock in the capital structure, which is used to determine the priority of payment in the event of a bankruptcy. Senior debt holders rank first, then the companies' subordinated bondholders followed by preferreds then equity.

Losses

The companies, which own or guarantee about $5 trillion of the $12 trillion of U.S. residential loans, were developed to expand financing to homebuyers by buying mortgages from lenders and packaging others into securities that they then guarantee. They have struggled amid rising loan delinquencies, posting $14.9 billion in combined net losses over the past four quarters.

``As we've been saying, we maintain the highest capital rating from our regulator, a strong liquidity position and continued access to the debt markets at attractive spreads,'' Freddie spokesman Douglas Duvall said today. ``We are also pleased that Moody's has affirmed our long-term, short-term and subordinated debt ratings.''

A Fannie spokesman, Brian Faith, didn't immediately respond to a request for comment.

New York-based Standard & Poor's on Aug. 11 cut its ratings on the preferred stock and subordinated debt of Fannie and Freddie to A- from AA. S&P said any U.S. equity injections would probably raise the odds of default on their subordinated debt.

Any deferrals on subordinated debt payments ``may also affect senior-debt funding'' costs, something that the government wants to avoid, Brian Harris, an analyst at Moody's, said in an interview. At the same time, ``it's more difficult for the government to explain the rationale for supporting a form of equity holder, such as preferred stock.''

Fluid Situation

Moody's outlook on its Aa2 ranking of the subordinated debt was reduced to negative because of the ``fluid situation,'' the firm said. S&P rates the securities four levels lower than Moody's, and the preferred shares three levels higher.

The cost to protect the subordinated debt of Fannie and Freddie from default dropped today to the lowest in almost two weeks today after reaching a record on Aug. 19.

Credit-default swaps on Fannie's subordinated debt fell 41 basis points to 258 basis points, according to CMA Datavision. Contracts on Freddie's debt fell 48 basis points to 250. 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. A decline signals improvement in investor confidence.

To contact the reporter on this story: Jody Shenn in New York at jshenn@bloomberg.net.

Last Updated: August 22, 2008 16:26 EDT