Corporate Cushions and Lazy Capital

Capital requirements are driving large financial services companies to redefine themselves.
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Past performance is not a guarantee of future performance.

I remember a time when

Fannie Mae

(FNM)

was a failed financial company, viewed no better than a savings and loan during the lending crises of the 1980s.

The FDIC and Congress worked through the savings and loan debacle, while a restructured Fannie Mae provided much-need capital and liquidity for the financial lending system. Those shareholders who were patient with this stock saw it move from a low of $2 in December of 1987 to a high of $89 in December of 2000.

Flash forward six years.

This week, Ben Bernanke issued a warning that all financial crises involve the failure of a large entity and originate from oversight failure. He clearly spelled out a case against two government sponsored entities: Fannie Mae and

Freddie Mac

(FRE)

. In the process, he pointed out that their combined outstanding debt exceeds $5.2 trillion, more than the $4.9 trillion of public government debt.

So what's Bernanke's problem with the government sponsored entities (GSEs)?

The situation is pretty clear. These are two large entities at the heart of the financial markets where investors incorrectly continue to assume an implied government guarantee. And the misplaced incentives reward the companies for taking risks.

The effect, according to Bernanke, is a pair of undercapitalized entities that, unlike banks, will not protect investors. Shareholders must bear the burden of a restructuring when it occurs.

It seems the market agrees. Fannie Mae shares were down 3.5% to $54 during the last five days. In the same period, Freddie Mac shares were down 3.2% to $62 per share.

While these two stocks currently have yields around 3%, we think it's best to avoid adding more to positions in these two stocks until the recapitalization plans are clear. Who knows, maybe the investment bankers can help the GSEs attract some of that Far East excess capital. It may seem less risky an investment from abroad.

Speaking of the Far East and companies with foreign business franchises, this week

American International Group

(AIG) - Get Report

sold $1 billion in 30-year hybrid bonds to fund its $8 billion share repurchase program. It joins a variety of financial services companies, including

Travelers

(TPK)

and Liberty Mutual, that are using the debt markets to raise capital that qualifies as a form of equity with the rating agencies.

If the AIG repurchase program is completed during 2007, this would represent 4.5% of the shares outstanding.

It's clear that AIG President Martin Sullivan wants holders of junior bond securities to pay off shareholders while the company figures out where its excess capital is and how to get at it.

Those with long memories will recognize this debt-to-equity approach as a very successful strategy used by the formerly public American General, a company that is now part of AIG's U.S. operations. As American General's debt came to maturity, bondholders took the stock and increased shareholder value.

Unfortunately, no guarantee of the same excess returns for investors is baked into the new hybrid securities. While AIG management appears to have a recapitalization plan based on computer simulations, the challenge here will be to get key regulators, major agencies and shareholders to understand that less is more.

Over the last year, AIG shares have returned only 5%. Being the pragmatic types, AIG management also announced that we should expect acquisitions and divestitures that should free up capital too.

For those looking for a real buyback program, we recommend a closer look at

Prudential

(PRU) - Get Report

, which also has the benefit of a Far East connection with its significant life operations in Japan.

International business accounted for 25% of total 2006 revenue. The company appears to be hitting on all cylinders now and has returned 20% over the last year. Over the last year, Prudential shares returned 20%.This one looks like a more appealing use of shareholder capital.

Rudy Martin is the director of research for TheStreet.com Ratings. In keeping with TSC's Investment Policy, employees of TheStreet.com Ratings with access to pre-publication ratings data must pre-clear any potential trade through the legal department, and are prohibited from trading any security that is the subject of an unpublished rating revision until the second business day after the rating is published.

In keeping with TSC's Investment Policy, employees of TheStreet.com Ratings with access to pre-publication ratings data must pre-clear any potential trade through the legal department, and are prohibited from trading any security that is the subject of an unpublished rating revision until the second business day after the rating is published.

While Martin cannot provide investment advice or recommendations, he appreciates your feedback;

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