Sept. 15 (Bloomberg) -- Treasury Secretary Henry Paulson's decision to seize Fannie Mae and Freddie Mac may choke off the biggest source of funding for financial companies suffering from the collapse of the subprime mortgage market.

When Paulson took control of Fannie and Freddie on Sept. 7, he scrapped dividends on the preferred stock of the government- sponsored enterprises. He also said the U.S. would buy as much as $200 billion of new securities that would rank ahead of existing issues.

The plan sent shares tumbling on concern it will become a model for financial institutions reeling from $511 billion of writedowns and credit losses since the start of 2007. Financial companies raised $361 billion in capital to replenish their balance sheets, data compiled by Bloomberg show. Banks with the 10 biggest writedowns sold at least $85 billion of preferred securities, or 47 percent of the total, the data show.

Paulson's ``decision has been devastating to the market,'' said Marilyn Cohen, President of Envision Capital Management in Los Angeles, which oversees $200 million in fixed-income assets. ``We all thought they would never help exacerbate the banking crisis and that's exactly what they did.''

Cohen, whose clients own Fannie and Freddie preferred shares that are now ``about the cost of a cappuccino,'' is ``absolutely not'' interested in buying more of the securities from financial institutions, she said.

Prices Tumble

Concern about financial companies' ability to raise capital escalated after Lehman Brothers Holdings Inc. today said it will file for bankruptcy protection and Merrill Lynch & Co. agreed to be bought by Bank of America Corp. American International Group Inc. the insurer struggling to avoid credit downgrades, is seeking a $40 billion bridge loan from the Federal Reserve as it tries to sell assets, the New York Times reported.

Preferred stock ranks behind bonds and ahead of common shares in a company's capital structure. Unlike common stock, the securities pay either a fixed- or floating-rate dividend, and can have a set maturity or no due date.

As investors abandoned preferred stocks, prices of the fixed-rate portion of the market fell an average of 13 cents last week to an average 67.1 cents on the dollar, the lowest in at least a decade, according to Merrill Lynch index data. That pushed the average yield to 10.8 percent from 8.8 percent on Sept. 5 and 7.9 percent at the end of last year.

Paulson said his rescue of Fannie and Freddie shouldn't have negative implications for the wider market. Fannie said last week it will pay third-quarter dividends on the securities.

Not a `Proxy'

``Preferred stock investors should recognize that the GSEs are unlike any other financial institutions and consequently GSE preferred stocks are not a good proxy for financial institution preferred stock more broadly,'' Paulson said in a Sept. 7 statement. ``The broader market for preferred stock issuance should continue to remain available for well-capitalized institutions.''

The Treasury needed to bail out Fannie and Freddie because they own or guarantee more than $12 trillion of mortgages, or about half the U.S. home-loan market. The takeover came four months after the government pressed Fannie to raise $4.25 billion with preferred stock after mortgage-market losses. Freddie agreed to raise $5.5 billion, though it never did.

Washington-based Fannie's preferred stock plunged more than 75 percent last week, and securities sold by McLean, Virginia- based Freddie tumbled 85 percent, New York-based Merrill's index data show. Of the top 50 issuers in the index, 46 fell.

`Hands Scorched'

Preferred stock has been the main source of new money for banks after the collapse of the subprime mortgage market last year caused credit markets to seize up.

Of the $49.1 billion raised by New York-based Citigroup Inc., about $40.6 billion was in preferred securities, Bloomberg data show. Bank of America, in Charlotte, North Carolina, sold $16.7 billion of preferreds, or 77 percent of its total new money.

New York-based JPMorgan Chase & Co., Merrill, and Lehman issued the securities, as did London-based Barclays Plc.

``Buyers have gotten their hands scorched,'' said Michael Donelan, who manages $2 billion of bonds at Ryan Labs Inc., a money management and research firm in New York. He isn't interested in buying preferreds from a financial institution. ``The demand for capital is going to be so huge. We're not going to buy something and then'' watch it fall, he said.

Lehman Collateral

Lehman's $2 billion offering in June wasn't enough to prevent the 158-year-old firm from filing for bankruptcy. Its common shares plummeted 94 percent on the New York Stock Exchange this year through Sept. 12. Its fixed-rate preferred lost 47 percent.

Moody's Investors Service said last week it may lower the company's credit ratings. Lehman said a downgrade would force it to come up with at least $4.4 billion in collateral postings. Mark Lane, a spokesman for Lehman, declined to comment.

Washington Mutual Inc., facing as much as $19 billion in bad home loans, was slammed by a 36 percent drop in its common stock last week. Fitch Ratings cut WaMu's debt to BBB- from BBB, citing a lack of ``flexibility'' to add capital. Brad Russell, a spokesman for Seattle-based WaMu, declined to comment.

The company said in a Sept. 11 statement that it is significantly above the ``well capitalized'' regulatory designation.

Wachovia Corp.'s fixed-rate preferred shares tumbled 24 percent and AIG lost 39 percent last week. Wachovia reported a record loss of $9.11 billion for the second-quarter, more than it ever earned in a year. AIG posted three quarterly losses totaling $18.5 billion.

Elise Wilkinson, a spokeswoman for Charlotte-based Wachovia, didn't return a phone call seeking comment. Peter Tulupman, a spokesman for AIG of New York, declined to comment.

Preferred stock offerings are ``just not in the cards for anyone given the current state of the market,'' said Scott Sprinzen, an analyst at Standard & Poor's in New York who covers finance companies. ``The economics are not at all attractive.''

To contact the reporter on this story: Caroline Salas in New York at csalas1@bloomberg.net

Last Updated: September 15, 2008 02:32 EDT