AIG, Fannie Mae and Freddie Mac Rise From the Dead

AIG, Fannie Mae and Freddie Mac shares are rallying, as the living dead roam Lower Manhattan.
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(Updated with closing stock prices.)

NEW YORK (

TheStreet

) -- It took more than

28 days, but the so-called "zombie" stocks have started to show signs of life.

American International Group

(AIG) - Get Report

,

Fannie Mae

and

Freddie Mac

each enjoyed huge run-ups in their stock prices since Wednesday.

AIG catapulted more than 70% higher at times on Wednesday, eventually closing up $8.48, or 63%, at $22. Fannie and Freddie both sailed more than 40% higher Wednesday, eventually closing up more than 30% at 74 cents and 80 cents, respectively. Their movements on Thursday, however, seemed to prove that the zombie-stock run-up is unreliable, with each stock starting to cool suddenly by late morning after gaining more than 15% early in the session. AIG closed up 2.4% to $22.53, Fannie was up 6.8% to 79 cents and Freddie was up 5% to 84 cents.

"These things all feed into each other and when you have these positive feedback loops, those gains generally aren't permanent," says Len Blum, managing director of the investment bank Westwood Capital.

Against the Grain: Sell AIG!

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The government owns roughly 80% of each company, leading traders to refer to them as "zombies" since they are private in name only and largely controlled by the government. The run-up in their stocks on Wednesday seemed to be driven by speculation that their fiscal health may be stabilizing -- if not improving -- only heightened by pessimistic short sellers scrambling to cover their bets as prices began to soar.

Night of the Living Recession

The stocks of AIG, Fannie and Freddie fell off a cliff last fall after the government stepped in with massive bailout plans and placed Fannie and Freddie into conservatorship. Since that time, the government has funneled about $70 billion into AIG, and $85 billion into Fannie and Freddie.

Shares of the mortgage finance giants have largely been chained under $1 since rumors circulated about an impending nationalization in early September. AIG wasn't far off until the insurer underwent a 20-for-1 reverse stock split in July.

Several events conspired over the past two days to spur a zombie stock rally.

AIG is set to report second-quarter results on Friday, and Fannie and Freddie probably won't be far behind. Things aren't great for any of the companies, but each finally appears to be making headway -- slowly but surely -- toward independence.

AIG is expected to report a profit for the first time since the third quarter of 2007. S&P analyst Catherine Seifert believes the insurer may in fact return to positive book value again.

Fannie and Freddie may not be that close to recovery, but have shown improvement as the housing market has started to stabilize. The Treasury Department said earlier this week that it will borrow $109 billion less than expected this quarter, due in part to less investment than expected in Fannie Mae and Freddie Mac.

A report in the

Washington Post

on Thursday also indicated that the government is moving closer toward a plan to restructure the firms and get them back into private hands. One idea being floated is a so-called "bad bank" structure, which would leave the government holding a big sack of Fannie and Freddie's bad debt, and get them back on their feet again to begin making new, healthy loans.

While not especially favorable to taxpayers, some speculative investors see a reason to get a piece of the Fannie-Freddie action. If the "toxic" assets are taken off the mortgage firms' books while they continue to dominate the secondary mortgage market, the risk is mitigated and the business continues to grow.

On the other hand, shareholders are most at risk of losing their entire investment in any major restructuring. Common stockholders are the lowest rung on the liquidation totem pole, and the government is especially cautious of decisions that favor investors over taxpayers.

When asked why investors would buy into that type of rally, Blum responded, "Why do people do a lot of stupid things?" He went on to explain how speculative investors are drawn in by the "lottery aspect" of hitting a "one in a million chance."

"Shares run up to higher prices even though they have no value on the off chance that something's left over after liquidation," he says. "But in the case of Fannie and Freddie, things are so bad I think it's a tremendous long shot that the common has any value. Their asset quality is so tortured, I'd be surprised if even the government comes out whole."

Still, most major financial firms with significant exposure to credit, stock and housing markets topped expectations last quarter -- think

Bank of America

(BAC) - Get Report

,

Wells Fargo

(WFC) - Get Report

,

Citigroup

(C) - Get Report

,

JPMorgan Chase

(JPM) - Get Report

,

Goldman Sachs

(GS) - Get Report

and

Morgan Stanley

(MS) - Get Report

. The mortgage insurer

Radian

, a miniature reflection of the three zombie behemoths, on Wednesday reported a surprise second-quarter profit, debt paydown and improved liquidity, sending its stock surging 83% to $6.72.

Given their size and exposure some are clearly betting that AIG, Fannie and Freddie will prosper, despite their zombie status. However, the three stocks are much riskier bets than banking peers, because it's unclear how their ultimate structure will treat existing shareholders.

Forty-Seven Weeks Later

Besides broad fundamental improvements in the financial and housing markets, there are gears shifting internally at all three companies that seem to provide reason for optimism.

News reports were rife with speculation about an impending sale of AIG's valuable aircraft leasing business, which has been on the market for some time now. Holding out may have paid off for the firm, since it can likely sell the asset at a price that more accurately reflects its value rather than distressed pricing that was available when it was first put on the block.

AIG has made significant headway in selling off non-core assets, with dozens of deals announced since its initial bailout, several in just the past month or so. It is also moving forward in separating its core property, casualty and general insurance businesses into an entity called AIU Holdings. AIG announced last week the formation of a special purpose vehicle to advance the separation, naming Kristian Moor as president and CEO of the group.

The broader company also made a major staff announcement on Monday, naming former

MetLife

(MET) - Get Report

chief Robert Benmosche as its new CEO, replacing Edward Liddy. The

Financial Times

reported late Wednesday that former

American Express

(AXP) - Get Report

head Harvey Golub may be named chairman of the firm, if not former

General Electric

(GE) - Get Report

executive Dennis Dammerman, who is also on AIG's board of directors.

Naming either executive -- both of whom are well-known and respected among the corporate ranks -- would mark a turning point for AIG, putting in fresh blood to steer the ship forward after a tumultuous journey. Liddy announced his resignation after enduring contentious congressional hearings during which he was asked to answer for his predecessor's missteps and criticized over bonuses, bailouts and losses.

Fannie and Freddie may also have new stewardship, as their top regulator, Federal Housing Finance Agency head James Lockhart, is stepping down. Lockhart, a relic from the Bush administration, has served in his post for three years and oversaw the two companies' transition into government hands. On Thursday, the regulator named Chief Operating Officer Edward DeMarco to fill the position on an interim basis until a permanent replacement is selected.

Freddie also named

Charles Haldeman as CEO late last month, after its own chaotic course of leadership involving four CEOs within a year, and the apparent suicide of its CFO in April. Fannie is still led by Michael Williams, who took over the firm last September when Lockhart,

Federal Reserve

Chairman Ben Bernanke and then-Treasury Secretary Henry Paulson gave former Fannie head Daniel Mudd and former Freddie chief Richard Syron the boot.

Day of the Short Squeeze

Take a few zombie stocks that are heavily shorted, add a cup of fundamental improvements, a pinch of potentially rosy quarterly results and a dash of speculation, and you've got yourself a short-squeeze mess.

Market data and reports from

Bloomberg

shows high short interest in each of the companies. Fannie has 5.3% of its outstanding shares short, Freddie has 12% and AIG has more than 16% by mid-July, according to

Bloomberg

. Those figures have climbed mightily since the end of June, when they were 3.3%, 3.4% and 7.7%, respectively.

In AIG's case, the company also registered to sell common and preferred stock in a filing with the

Securities and Exchange Commission

on July 17. The price and amount of the sale were left indeterminate, but given the sudden

twists and

turns of Citigroup's share price caused in part by arbitrage plays between different types of securities, there may be some behind-the-scenes meanderings in AIG shares as well.

AIG shares first began lifting late Wednesday morning, and only accelerated over the next few hours until reaching a high right before 2:30 p.m., before tapering off and closing at $22. Fannie and Freddie's surge came later in the day, but followed a similar pattern.

What Thursday will hold for the stocks is unclear -- Has all the bullishness already been priced in? Will the shorts be back in play? Will rumors be confirmed? Will new ones emerge?

It's hard to tell. But until the operations of AIG, Fannie and Freddie are fully stabilized and back in private hands, the meandering of their zombie stocks will keep eating away at investors' brains.

--

Written by Lauren Tara LaCapra in New York

.