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Fannie, Freddie Find Legs in Shorts

Short-sellers covering their bets are most likely the reason for the government-sponsored mortgage lenders' rise Thursday.

Fannie Mae



Freddie Mac


shares recovered in a volatile session on Thursday after sinking to new lows, as short-sellers likely sought to cover their bets.

Fannie shares were up 7.7%, at $4.74 after earlier sinking as much as 20% to a new low of $3.53. Freddie was up a fraction of a percent, paring earlier declines of more than 30% to a new low of $2.26.

Short positions in both mortgage giants have accelerated rapidly as investors questioned their viability and profit-seeking speculators stepped into the fray.

Short-sellers accounted for 18.5% of outstanding Freddie shares at the end of July, according to the most recent


data available, more than double the 8.2% portion at the end of April. Shorts rose to nearly 14% of Fannie's stock, up from 8.1%, during the same period.

Short-sellers borrow stock to sell it at the current price, betting it will decline. If it does, short-sellers profit by buying back the shares at a lower price and pocketing the difference. The

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Securities and Exchange Commission

recently lifted a temporary ban on so-called "naked" short-selling of Fannie, Freddie and some other financial firms. Naked short-sellers do not borrow the shares first, and this sometimes forces them to scramble for equity to cover their bets.

Fannie and Freddie shares have plunged dramatically in recent sessions after a


article cited anonymous source who said the firms will

likely be taken over by the government

, wiping out shareholder equity. The naked shorts ban was lifted on Aug. 13, causing some to speculate that short-sellers are also causing an overstated decline in market value of the two companies.

FBR Research analyst Paul Miller said he expects the stocks to "show significant volatility" until Fannie and Freddie can raise new capital. That goal has become more difficult with the lack of investor confidence, which might only get worse if the companies dilute existing shareholders by issuing more stock. Freddie is obligated to raise at least $5.5 billion through a consent decree with the Office of Federal Housing Enterprise Oversight. The other capital-raising option for the companies -- an infusion from the government -- would be "the worst outcome for everyone involved," Miller says.

In a note to clients Thursday, Ladenburg Thalmann analyst Richard Bove said that he sees two options for the companies: insolvency or nationalization. The sheer size of the firms and their government mandate to increase their debt to help the ailing housing industry poses a problem, according to Bove.

He notes that Fannie and Freddie collectively hold over $5 trillion in mortgage debt -- nearly equivalent to the debt of the entire U.S. government. Combined with a record of accounting scandals and a poor decision to purchase so called "Alt-A" mortgages, which are below prime, Bove sees no other viable option than a government takeover.

"The only rational action to be taken relative to Fannie Mae and Freddie Mac is to get rid of them," Bove writes.

Executives at Fannie and Freddie, as well as Treasury Secretary Henry Paulson have said repeatedly that there are no plans to restructure or nationalize the firms. However, if the Treasury Department does not step in, Bove believes the market will no longer allow the companies to refinance their debt at sustainable prices, or perhaps at all.