July 15 (Bloomberg) -- Hedge fund manager William Ackman, who is betting against shares of Fannie Mae and Freddie Mac, criticized any government plan to buy equity in the existing mortgage-finance companies and said shareholders should be wiped out.

Ackman, 42, has his own plan that would see Fannie Mae raise about $86 billion in capital by giving investors in $750 billion of senior unsecured notes 90 cents on the dollar in debt of a new company, with the balance in equity. Investors in Fannie Mae's $11 billion of junior debt would get warrants, while common and preferred shareholders would get nothing, according to Ackman.

``We've not yet heard Secretary Paulson's plan but it would be a grave error for the government to invest in the equity of Fannie Mae and Freddie Mac as they are currently capitalized,'' Ackman, who oversees $6 billion at Pershing Square Capital Management in New York, said in a telephone interview.

Ackman, who recommended selling shares of bond insurer MBIA Inc. before they tumbled 93 percent over the past year, made his comments on the same day Securities and Exchange Commission Chairman Christopher Cox told the Senate Banking Committee in Washington that he plans to crack down on short selling.

Moody's Investors Service today said the risk for Fannie Mae and Freddie Mac shareholders may outweigh the benefits and it downgraded each company's bank financial strength and preferred stock ratings.

Fannie Mae dropped 27 percent today, the most since at least 1980. The stock, down 82 percent in the past year, closed down $2.66, or 27 percent, to $7.07 in New York Stock Exchange composite trading. Freddie Mac dropped 26 percent, the most since Nov. 20, falling $1.85 to $5.26. Freddie Mac is down 85 percent this year.

Ackman's Plan

Ackman said he had discussions last week with the Treasury, Federal Reserve and Senate Finance Committee about his plan for Fannie Mae and Freddie Mac, which guarantee or own almost half the $12 trillion in U.S. home loans outstanding.

Under Ackman's plan, Fannie Mae's senior unsecured debt would be reduced by 10 percent and the junior debt would be completely eliminated, adding $86 billion in equity capital.

``The good news is that Fannie Mae has all the capital that it needs,'' Ackman said. ``It just has the capital in the wrong form with too much debt and not enough equity.''

Ackman also suggested the government put in place a stand-by purchase commitment for the new common stock for three years. The government is unlikely to be asked to buy any shares as there would be market demand for equity in the better-capitalized companies, Ackman said.

`Only If Necessary'

On July 13, Paulson asked Congress for authority to buy equity stakes and increase the government's credit line to Fannie Mae and Freddie Mac in an effort to restore confidence in the mortgage companies. The stocks plunged more than 70 percent this year on concern the companies didn't have enough capital to offset credit losses from mortgage delinquencies. Paulson's proposal signals a shift toward an explicit guarantee of Fannie Mae and Freddie Mac debt.

Paulson today said the government would buy shares in Fannie Mae and Freddie Mac ``only if necessary''

``Let me stress that there are no immediate plans to access either the proposed liquidity or the proposed capital backstop,'' Paulson said in testimony to the Senate Banking Committee. ``If either authority is used, it would be done so only at Treasury's discretion, under terms and conditions that protect the U.S. taxpayer and are agreed to by both Treasury and the'' companies.

The shareholder-owned companies are government-sponsored enterprises, which most investors interpret as an implied federal backing.

Driving Up Rates

Ackman, who has waged battles to change the capital structure of companies including McDonald's Corp. to benefit his investors, said it would be a mistake for the federal government to provide equity capital to Fannie Mae and Freddie Mac in their current form. If the government were required to account for such an investment in the same way as a corporation, it would have to take all the mortgage finance companies' debt on its balance sheet, he said.

``That will drive up interest rates and increase the cost of mortgage debt, in my opinion,'' Ackman said. ``Under this plan, no taxpayer money is used, the hierarchy of claims is respected and no one is being cheated.''

Moody's cut the bank financial strength ratings for each company today to B-, the fifth-highest rating. The ratings measure the likelihood a company will need ``extraordinary financial assistance from third parties.'' Moody's lowered the preferred stock ratings to A1 from Aa3. The ratings remain under review for downgrades, according to statements by New York-based Moody's. The senior and subordinated debt rankings were affirmed.

Short Selling

Short selling of Fannie Mae and Freddie Mac jumped last month before a slide in the stocks accelerated on concern that shareholders would be wiped out in a government-led rescue of the firms. Short interest on McLean, Virginia-based Freddie Mac rose 22 percent to 82.8 million shares since May 30, according to data compiled by Bloomberg. Short interest on Washington-based Fannie Mae was 138.7 million shares at the end of June, up 7.5 percent.

Cox told the Senate Banking Committee that an emergency order will be released today, that will subject short sales Fannie Mae and Freddie Mac to a ``preborrowed requirement.''

Ackman told CNBC television he began betting July 10 that the stocks would fall further. Freddie Mac slumped 31 percent since the July 9 close and Fannie Mae is down 36 percent.

``The shares are down and I think they're going to continue to go down,'' Ackman told CNBC.

Already Insolvent

Freddie Mac is already insolvent under fair value accounting rules, and Fannie Mae is likely to follow, former St. Louis Federal Reserve President William Poole said in a recent interview. Fannie Mae and Freddie Mac raised a combined $20 billion since December to cover losses of more than $11 billion generated since the credit crisis began last year.

MBIA, once the world's largest bond insurer, and the rest of the industry suffered a loss of confidence after guaranteeing billions of dollars of bonds backed by mortgages that fell in value. Ackman sent a letter to the board of Armonk, New York- based MBIA earlier this month calling on directors to seek outside advice on whether the company was insolvent. He said Fannie Mae and Freddie Mac board members faced the same question.

``Fannie Mae and Freddie Mac are bond insurers,'' said Ackman. ``Fannie Mae is like MBIA except it only insures mortgage-backed securities and they perform a vital market function.''

To contact the reporter on this story: Christine Richard in New York at crichard5@bloomberg.net

Last Updated: July 15, 2008 16:15 EDT