Moody's Investors Service slashed the preferred stock ratings of Fannie Mae and Freddie Mac to ‘Baa3’ from ‘A1’, today, and cut the bank financial strength ratings down to a meager ‘D+’ from ‘B-’. Both ratings remain on review for possible further downgrade.

The rating agency said it took these actions out of concern that both GSEs may not have enough financial flexibility to manage potential volatility in their mortgage risk exposures. The rating agency also affirmed a widespread market belief that both agencies may need assistance from the U.S. Treasury.

"Given Fannie Mae's and Freddie Mac's importance to the US mortgage market, we believe there is a very high level of support for their debt from the U.S. Treasury," Brian Harris, senior vice president at Moody's said in a release this morning. "And, given these GSEs more limited ability to raise capital and grow their portfolio to accomplish their public policy role in a time of mortgage market turmoil, we believe that there's an increased probability of actual support coming from the U.S. Treasury."

Not only have the GSE's mortgage portfolios performed worse than expected, Moody's said, but there is uncertainty about how these preferred securities would be treated if the U.S. Treasury lends its support. If a capital injection is done through existing preferred stock, or if there are any missed preferred dividends, then the preferred stock rating would be lowered further, Moody's said.

Indeed, Fannie Mae's and Freddie Mac's preferred stock has features that may lead to a suspension of a dividend if certain capital levels are not maintained.

Furthermore, the GSE's limited financial flexibility prevents them from promoting their public policy, which is to provide liquidity, stability and affordability to the U.S. housing market, the rating agency said.

Fannie Mae's and Freddie Mac's 'Aaa' senior long-term debt and Prime-1 short-term debt ratings were affirmed with stable outlooks. The firms' ‘Aa2’ subordinated debt ratings were affirmed, but the outlook was changed to negative from stable.

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