Fannie, Freddie Roil Financial Sector Funds

The uncertainty over when U.S. Treasury Secretary Henry Paulson may step in to use his new powers to recapitalize Fannie Mae(FNM Quote) and Freddie Mac(FRE Quote) roiled the financial sector this week. Paulson is also keeping the market guessing on how nationalizing these mortgage giants would look.

The common shares of Freddie Mac fell 46.8% in the five trading days ended Thursday, Aug. 21. Likewise, Fannie Mae crashed 41.1%. If the Treasury Department takes over and judges these companies to be insolvent, the common shares drop to zero.

The big question is, what will happen to the preferred shares? Worries that a government takeover might have a higher claim to assets than the preferred shares, held by upwards of 8,000 banks, sent financial stocks lower this week. Even if the preferred shares survive, their dividends may be cut.

The average financial fund we track, excluding inverse funds shorting the sector, sank 4.1% for the period.

The two worst-performing funds, both with 200% leverage, fell more than twice as much as the average financial sector fund. The Rydex 2X S&P Select Sector Financial ETF(RFL Quote) and Ultra Financials ProShares(UYG Quote) fell 10.6% and 9.2%, respectively.

Similarly, the 150% leveraged ProFunds Financial UltraSector ProFund(FNPIX Quote), a holder of Freddie and Fannie, fell 7%.

The more narrowly focused ProFunds Banks UltraSector ProFund(BKPIX Quote) sank 6.9% on 150% leverage. The fund holdings of Frontier Financial(FTBK Quote) were down 23.2%, Sovereign Bancorp(SOV Quote) was off 19.3%, and Cathay General Bancorp(CATY Quote) was down 12%. The drops in these funds can all be attributed to their sizable preferred security exposure.

Worst-Performing Financial Sector Funds for the Week Ending Thursday, Aug. 2
Fund	Ticker	Rating	Fund Type	1 Week Total Return
Rydex 2X S&P Select Sector Financial ETF	RFL	U	ETF	-10.58%
Ultra Financials ProShares	UYG	E	ETF	-9.24%
ProFunds Financials UltraSector ProFund	FNPIX	E-	Open-End	-7.00%
ProFunds Banks UltraSector ProFund	BKPIX	E-	Open-End	-6.85%
KBW Regional Banking ETF	KRE	D-	ETF	-6.61%
Morgan Stanley Financial Services Trust	FSVAX	E-	Open-End	-6.20%
Rydex Series - Banking Fund	RYKAX	E-	Open-End	-6.02%
Financial Select Sector SPDR Fund	XLF	D+	ETF	-5.80%
John Hancock Bank and Thrift Opportunity Fund	BTO	D	Closed-End	-5.70%
KBW Capital Markets ETF	KCE	D-	ETF	-5.13%
Source: Bloomberg & TheStreet.com Ratings

At the other end of the spectrum are the inverse funds. The 200% leveraged UltraShort Financials ProShares(SKF Quote) rose 10.2%, and the unleveraged Short Financials ProShares(SEF Quote) rose 4.9%.

Best-Performing Financial Sector Funds for the Week Ending Thursday, Aug. 21
Fund	Ticker	Rating	Fund Type	1 Week Total Return
UltraShort Financials ProShares	SKF	C	ETF	10.15%
Short Financial ProShares	SEF	U	ETF	4.94%
Burnham Financial Industries Fund	BURFX	D+	Open-End	0.50%
PowerShares Dynamic Insurance Portfolio	PIC	C-	ETF	-1.30%
Rydex S&P Equal Weight Financial ETF	RYF	D-	ETF	-1.71%
Burnham Financial Services Fund	BURKX	E-	Open-End	-1.72%
Senbanc Fund	SENBX	E-	Open-End	-2.32%
Legg Mason Partners Financial Services Fund	SFSLX	U	Open-End	-2.42%
Royce Financial Services Fund	RYFSX	C+	Open-End	-2.60%
Davis Financial Fund	RPFGX	E+	Open-End	-2.65%
Source: Bloomberg & TheStreet.com Ratings

Economic reports in July showing the index of leading indicators sliding 0.7%, consumer price inflation up 5.6%, and producer price inflation up 9.8% annually cast doubt on a second-half rebound in the economy and on homeowners' ability to afford the mortgages on their homes. This may hasten Treasury Department action on Fannie and Freddie.

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