July 14 (Bloomberg) -- Freddie Mac received higher-than- average demand for its $3 billion of short-term notes as the U.S. Treasury's rescue plan buoyed confidence the government will back the company's debt. Freddie Mac and Fannie Mae stocks fell on concern shareholders will be left out of any bailout.

U.S. Treasury Secretary Henry Paulson's decision to seek authority to buy equity stakes and increase the government's credit line to Fannie Mae and Freddie Mac spurred demand from bond investors who interpreted the move as a step closer to an explicit backing of the companies' debt. That support may not extend to shareholders, who would have their holdings diluted in any new equity raising, said Dan Castro, chief risk officer at hedge fund Huxley Capital Management.

``If you're a bondholder, this helps,'' said Castro, who is based in New York. ``But if you're an equity shareholder, that is a different thing. You can make the argument that they are too big to fail, but that still doesn't mean the equity holders deserve to get bailed out. Shareholders will only get as much help as is absolutely needed to keep them afloat.''

Freddie Mac, based in McLean, Virginia, dropped 64 cents, or 8.3 percent, to $7.11 today in New York Stock Exchange composite trading. Washington-based Fannie Mae fell 52 cents to $9.73. Almost 263 million Freddie Mac shares changed hands, 41 percent of the stock outstanding. Almost 216 million Fannie Mae shares were traded, 22 percent of the total.

Fannie Mae's 5.5 percent perpetual preferred shares declined about 5.4 percent to $24.30 today and have slid 50 percent in the past year. Freddie Mac's 5.57 percent preferred stock dropped 4.6 percent today to $11.16 and is down 52 percent since being sold in January 2007.

Dilutive

Freddie Mac and Fannie Mae dropped almost 50 percent last week on concern shareholders would be wiped out. Freddie Mac is down 79 percent this year and Fannie Mae has declined 76 percent.

The declines by Fannie Mae and Freddie Mac combined with a slump in regional banks to push down U.S. stocks. Financial shares fell to their lowest level since October 1998 and the Standard & Poor's 500 Index dropped 0.9 percent.

Fannie Mae and Freddie Mac debt yields narrowed compared with U.S. government notes. The difference between yields on Fannie Mae's 5-year debt and 5-year Treasuries fell to as low as 76.4 basis points, the lowest since June 5, before settling back at 80.8 basis points, according to data complied by Bloomberg. The spread on Freddie Mac's 5-year debt was also at 80.8 basis points after being as low as 76.1 basis points earlier today.

``It's something that gives equity holders probably a little less of an upside and that solidifies the debt,'' said Andrew Harding, chief investment officer for fixed income at Allegiant Asset Management in Cleveland, which manages $20 billion in fixed-income assets.

Credit-Default Swaps

The cost to protect debt of Fannie Mae and Freddie Mac from default fell to the lowest in 10 weeks, credit-default swaps show. Swaps on the senior debt of Fannie Mae dropped 24 basis points to 36 basis points and Freddie Mac fell 22 to 36, according to CMA Datavision.

Both contracts more than doubled in the past two months to more than 80 basis points last week on concern the companies didn't have adequate capital to weather the housing slump. The contracts were as low as 4 basis points in December 2006.

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 pay the buyer face value in exchange for the underlying securities or the cash equivalent should a company fail to adhere to its debt agreements. An increase indicates a deterioration in the perception of credit quality. 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.

`By the Wayside'

The bid-to-cover ratio Freddie Mac's bill auction, gauging demand by comparing total bids with the amount of securities offered, was more than 50 percent above the average of the past three months, according to Stone & McCarthy Research Associates.

Freddie Mac sold $2 billion of three-month bills at a yield of 2.309 percent and $1 billion of six-month reference bills at 2.496 percent, the company said today in a statement.

``The issues of them having liquidity or not have gone by the wayside for another day,'' said Andrew Brenner, who trades the companies' debt as co-head of structured products and emerging markets at MF Global Ltd. in New York, the world's largest broker of exchange-traded futures and options contracts. ``I think it would have gone well anyway. I don't think there's ever been any question that the government would be behind the debt.''

`Begrudging Acceptance'

Paulson's proposal, which the Treasury anticipates will be incorporated into an existing congressional bill and approved this week, signals a shift toward an explicit guarantee of Fannie Mae and Freddie Mac debt. The shareholder-owned companies are government-sponsored enterprises, giving investors the indication of an implicit federal backing.

``It is time to recognize that the GSEs were always dependent upon government support and now we must make the implicit explicit,'' said Christopher Whalen, co-founder of independent research firm Institutional Risk Analytics in Torrance, California.

Paulson proposed that Congress give the Treasury temporary authority to buy equity in the firms ``if needed,'' and to increase their lines of credit with the department from $2.25 billion each. The temporary authority may be for 18 months, a Treasury official told reporters on a conference call on condition of anonymity.

Preferred Shares

The stock being purchased would be preferred shares, Representative Barney Frank, chairman of the House Financial Services Committee said. The proposal is ``entirely appropriate,'' Frank said in an interview with Bloomberg Television. The moves will probably be included in legislation being considered by Congress this week, he said.

Reaction from lawmakers wasn't uniform. While Senator Charles Schumer, a New York Democrat who chairs the congressional Joint Economic Committee, expressed support, the head of the Senate Banking Committee refrained from any specific endorsement.

Christopher Dodd, the Connecticut Democrat who chairs the banking panel, said he planned to call over ``coming days'' a hearing with Paulson, Bernanke and Securities and Exchange Commission Chairman Christopher Cox.

President George W. Bush in a statement called on Congress to enact the legislation.

Discount Window

The Fed Board of Governors also authorized the New York Fed to lend directly to Fannie Mae and Freddie Mac through the discount window to meet their liquidity needs if necessary, the central bank said yesterday in a news release.

The discount window offers direct loans to commercial banks at an interest rate that's now 2.25 percent, a quarter point above the Fed's benchmark rate. Bernanke opened it to investment banks at the time of the collapse of Bear Stearns Cos. in March to alleviate the credit crisis.

Fannie Mae last week paid record yields over benchmark rates on $3 billion of two-year notes amid concern the company didn't have enough capital. The 3.25 percent notes priced to yield 3.27 percent, or 74 basis points more than comparable Treasuries. That's the biggest spread since Fannie Mae first sold two-year benchmark debt in 2000.

``We directly bought the agency bonds in the latter half of last year when credit spreads widened,'' said Kwag Dae Hwan, head of global investments at South Korea's $220 billion National Pension Service in Seoul. ``An increasing number of funds investing in that market are sprouting up as spreads have widened abnormally.'' Kwag is considering adding to his agency holdings.

To contact the reporter on this story: Dawn Kopecki in Washington at dkopecki@bloomberg.net

Last Updated: July 14, 2008 16:25 EDT