July 9 (Bloomberg) -- Fannie Mae and Freddie Mac, ranked Aaa by the world's largest credit-rating companies, are being treated by derivatives traders as if they are rated five levels lower.

Credit-default swaps tied to $1.45 trillion of debt sold by the two biggest U.S. mortgage-finance companies are trading at levels that imply the bonds should be rated A2 by Moody's Investors Service, according to data compiled by the firm's credit strategy group. The price of contracts used to speculate on the creditworthiness of Fannie Mae and Freddie Mac and to protect against a default doubled in the past two months.

Traders are overlooking the government's implied guarantee of the debt as credit losses grow and concern rises that the companies don't have enough capital to weather the biggest housing slump since the Great Depression. Washington-based Fannie Mae fell 73 percent in the past year on the New York Stock Exchange and McLean, Virginia-based Freddie Mac lost 60 percent.

``Investors are viewing even an implicit guarantee from the government as potentially troublesome,'' said Tim Backshall, chief strategist at Credit Derivatives Research LLC in Walnut Creek, California. Fannie Mae and Freddie Mac, which reported combined losses of more than $11 billion, have raised more than $20 billion since December.

Congress created Freddie Mac and expanded Fannie Mae in 1970 to promote home buying in the U.S. The companies' congressional charters provide exemption from state and local corporate income taxes and give the Treasury the authority to buy as much as $2.25 billion in each of their securities in the event of possible default.

Default Swaps

Concerns that Fannie Mae and Freddie Mac may need more capital were heightened this week after Lehman Brothers Holdings Inc. released a report saying a new accounting rule may require the companies to raise $75 billion. Freddie Mac shares dropped 18 percent after the report was issued June 7. Fannie Mae fell 16 percent.

Freddie Mac rallied yesterday, rising 13 percent, while Fannie Mae gained 12 percent, after the companies' regulator said they were adequately capitalized. The stocks retreated today, with Fannie Mae lower by $1.05, or 5.9 percent, at 1:31 p.m. in New York trading, and Freddie Mac down 11.4 percent to $11.92.

Credit-default swaps tied to the senior debt of Fannie Mae and Freddie Mac climbed 35 basis points to 70 basis points since May 1, according to London-based CMA Datavision. A basis point is 0.01 percentage point.

The cost to protect the companies' subordinated debt from default rose at a faster rate. That debt is rated Aa2 by Moody's. Credit-default swaps on Fannie Mae's subordinated notes jumped 103 basis points to 190 basis points since May 1, while contracts on Freddie Mac's rose 102 basis points to 190 basis points.

Counterparty Risk

The median credit-default swap on debt rated Aaa by Moody's was 26 basis points as of yesterday, the strategy group's data show. It was 76 basis points for debt rated A2, and 180 basis points for debt rated Baa3, the lowest investment-grade ranking.

The costs likely reflect counterparty risk, or the risk that the bank or securities firm on the other end of the contract fails, according to Ira Jersey, an interest-rate strategist at Credit Suisse Group AG in New York.

For most companies, the counterparty risk embedded in credit-default swap costs wouldn't be as pronounced because the risk of a default on the underlying debt would be greater than that of the bank backing the protection, he said. In the case of Fannie Mae, Freddie Mac and other companies with AAA ratings, the default risk for lower-rated banks is greater.

`Constructive Force'

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 borrower fail to adhere to its debt agreements. A rise indicates deterioration in the perception of credit quality; a decline, the opposite. A basis point on a contract protecting $10 million of debt for five years is equivalent to $1,000 a year.

``It concerns me that people sort of extrapolate well beyond what the facts are,'' James Lockhart, the director of the Office of Federal Housing Enterprise Oversight, said in an interview with Bloomberg Television yesterday.

Treasury Secretary Henry Paulson said yesterday that the companies can still be a ``constructive force'' in the economy.

U.S. Charter

The U.S. charter and the companies' role in guaranteeing about 46 percent of the $12 trillion U.S. mortgages outstanding led to expectations that the government would stand behind the companies' debt. Standard & Poor's assigned the debt top ratings, citing the companies' ``explicit and implicit support'' from the government.

The bailout of Bear Stearns Cos. arranged by the Federal Reserve in March signals the government won't allow the companies to fail, Robert Millikan, who manages $5 billion as director of fixed income at BB&T Asset Management in Raleigh, North Carolina.

``We're looking at it from a standpoint of, if the Fed is not going to allow a problem with Bear Stearns, they're certainly not going to allow a problem with Fannie and Freddie,'' Millikan said. ``With all the exposure that banks have to Fannie and Freddie, the ripple effect through the whole financial system would be unbelievable if they were allowed to fail,'' he said.

Fannie Mae spokesman Brian Faith and Freddie Mac spokesman Michael Cosgrove declined to comment.

Note Sale

The risk surrounding Fannie Mae was reflected today in the company's sale of $3 billion of two-year benchmark notes at higher yields over benchmark rates than in previous offerings.

The 3.25 percent notes, which mature Aug. 12, 2010, priced to yield 3.27 percent, or 74 basis points more than comparable U.S. Treasuries, the company said today in a statement. A basis point is 0.01 percentage point. The company last month sold $4 billion of 3 percent notes maturing July 12, 2010, that priced to yield 3.036 percent, or 65 basis points more than Treasuries.

The government is leaning on the companies to help revive the home-loan market. Congress lifted growth restrictions on the companies, eased their capital requirements and allowed them to buy bigger, so-called jumbo mortgages to spur demand for home loans as competitors fled the market.

The decision to use Fannie Mae and Freddie Mac as part of a $300 billion housing stimulus plan strengthens perceptions of the government's support of the companies, S&P said in May.

Their share of new conforming mortgages, or loans of $417,000 or less, almost doubled to 81 percent in the first quarter, Ofheo said.

Merrill Lynch & Co. analyst Kenneth Bruce said in a report yesterday the ``highly levered financial institutions'' will have pretax credit-related losses of $45 billion.

``Fannie and Freddie are going to have to raise more capital and nobody thinks they're going to be able to raise capital when they need to,'' said Paul Miller, an analyst at Friedman, Billings, Ramsey & Co. in Arlington, Virginia. ``It's going to be very expensive.''

To contact the reporter on this story: Shannon D. Harrington in New York at sharrington6@bloomberg.net; Dawn Kopecki in Washington at dkopecki@bloomberg.net.

Last Updated: July 9, 2008 13:33 EDT