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'Worthless' Fannie, Freddie Defy Logic

Shares of Fannie Mae and Freddie Mac have soared since last week, yet nothing has changed in their fundamentals to warrant such moves.

Updated with latest share prices, short interest information.

NEW YORK (

TheStreet

) -- Their penny stocks have been deemed worthless by government action, called worthless by analysts, and are apparently considered worthless by their own executives. Yet

Fannie Mae

and

Freddie Mac

have outperformed other major financial firms over the past year, and continue to soar.

In the latest twist of logic, an announcement by the Treasury Department on Christmas Eve that the two mortgage giants are allowed to lose an unlimited amount of money over the next few years sent Fannie and Freddie stocks far higher on heavy volume in a two-day rally.

Fannie closed down 2 cents at $1.25 on Tuesday after late-day profit-taking, but is up 19% since last Thursday. Freddie closed a dime lower yesterday at $1.50, but was up the same amount.

Yet nothing had changed in the companies' fundamentals to provide any more value for common stockholders. If anything, the outlook has gotten worse. In heavy trading during Wednesday's session, Fannie was down 7.6% at $1.16 and Freddie was down 8.7% at $1.37.

A telling detail is the huge proportion of short interest in both firms, which may account for the hard slumps and ensuing rises, as short sellers bet against the stocks, and then scramble to cover their positions if they move upward. At mid-December, 11% of Freddie Mac was sold short, and 10% of Fannie Mae. That compares to 3.5% for the entire New York Stock Exchange, and much smaller proportions for non-"zombie" financial stocks. For instance, while

American International Group

(AIG) - Get Report

had 16% of its stock sold short,

Bank of America

had just 0.9% -- which was

more than double the previous period -- and

JPMorgan Chase

(JPM) - Get Report

had 1% sold short.

Preferred shareholders were wiped out when the government placed Fannie and Freddie into conservatorship in 2008. Since that time, the government has used the two firms as tools to keep mortgage rates down and keep people in their homes by setting standards for loan modification programs. It has also infused more than $100 billion to plug Fannie and Freddie balance-sheet gaps as they continued to lose money on soured home loans.

Most analysts stopped covering the stocks at that time of the initial bailout, though KBW's Bose George downgraded both to underperform in October, calling them "worthless."

George cut the price targets on both stocks to $0 from $1, and even top executives of the firms appear to believe the stock is valued the same. There was much ado about the $6 million pay packages granted to Fannie CEO Michael Williams and Freddie CEO Charles Haldeman. But few took notice of an important difference between their pay structure and that of high-profile financial firms: Their pay was all in cash.

Government pay czar Kenneth Feinberg and public criticism have pressured firms like

Goldman Sachs

TheStreet Recommends

(GS) - Get Report

, Bank of America,

Wells Fargo

(WFC) - Get Report

, JPMorgan,

Citigroup

(C) - Get Report

and

Morgan Stanley

(MS) - Get Report

into shifting more compensation into long-term stock rewards. But the all-cash pay packages at Fannie and Freddie suggest there's no point in doing so.

The government plans to unveil a

long-awaited plan

for the future of Fannie and Freddie in February. It's unclear which of the six proposals outlined by the Obama administration in June will be favored -- if any -- especially since Fannie and Freddie represent a pet project for high-profile lawmakers like Barney Frank, as well as a political firestorm for opponents. But none of the options outlined thus far, including

one proposed by an industry group

, have put a priority on existing shareholders, or even mentioned them in any meaningful way.

Fannie and Freddie have undoubtedly helped stabilize the mortgage market by keeping rates low and working out more favorable mortgage terms for troubled borrowers. With the Treasury's blank check, they will now have additional leeway to help struggling homeowners, representing, in effect, the taxpayer bailout that populists have been rallying for since the Troubled Asset Relief Program was announced.

Still, nothing has happened to assure investors that their holdings are worth more than zero.

That hasn't stopped some traders from earning a pretty penny on Fannie and Freddie volatility. Much like so-called

zombie trading

in

American International Group

(AIG) - Get Report

and

Washington Mutual's

pink sheets, logic won't dictate when the Fannie and Freddie bulls will be corralled.

--

Written by Lauren Tara LaCapra in New York

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