By John Spence

Analysts at Keefe, Bruyette & Woods on Monday said the common shares of Fannie Mae (FNM) and Freddie Mac (FRE) are likely worthless even if the troubled mortgage-finance giants end up being recapitalized by the banking industry.

KBW analysts led by Bose George downgraded shares of Fannie Mae and Freddie Mac to underperform from market perform and cut their price target on both stocks to zero from $1.

"In order for the government-sponsored entities to survive going forward, we believe they need to be recapitalized through investments from the banks that benefit from their role in the secondary market," KBW wrote in a research note.

"In this scenario, both the common and preferred equity of the GSEs should be worthless," they said, adding that since being put into receivership last summer, the U.S. has put $98 billion of capital into Fannie and Freddie.

Shares of Fannie and Freddie each were down more than 15% in recent trading. Representatives for both firms didn't immediately return calls for comment Monday morning.

"Fannie Mae and Freddie Mac have been at the heart of the U.S. housing boom, bust and recovery," KBW said. "As the mortgage market moves away from crisis mode, the future of the GSEs has to be addressed."

The pair plays a key role in the nation's housing market because they buy mortgages from lenders and bundle them up into securities, and guarantee payment. They also provide liquidity to the secondary mortgage market.

"There have been many recommendations made about potential structures for the GSEs," KBW said.

"The most noteworthy is the Government Accountability Office report which presents options for the companies ranging from becoming full government entities to returning to being stock-holder corporations," the analysts noted. "What all the recommendations to date have not done--including the ones in the GAO reports--in our view is address the most crucial issue regarding the agencies: how to recapitalize them."

Fannie and Freddie accounted for 68% of all mortgage originations in 2009 as they stepped in to provide credit during the lending crunch, according to KBW.

"In our view, the only viable option to limit taxpayer expense and recapitalize Fannie Mae and Freddie Mac is to set up a Bad Fannie and Bad Freddie with the existing portfolios, and a new Fannie Mae and Freddie Mac as cooperatives of bank mortgage lenders, along the lines of the other GSEs--the Federal Home Loan Banks," the analysts wrote.

Fannie and Freddie shares jumped along with the financial sector during the summer rally, but have been volatile recently amid questions about their future structure.

"There is general consensus that the primary role of the agencies in the future is in the loan-guarantee business and not in the investment business," KBW said. "By creating 'bad banks' of the existing portfolios and putting the existing portfolios into receivership, the government can limit its losses and define its role in supporting the mortgage industry through the crisis and create an exit strategy."

Fannie and Freddie are being hit by ongoing mortgage losses and higher borrowing costs during the housing downturn. Fannie reported a second-quarter loss of nearly $15 billion, after it lost more than $20 billion in the first quarter.

KBW said the GSE ownership structure should be shifted over time to a cooperative of banks similar to the Federal Home Loan Bank system.

"Under such an approach, the banks that originate an agency conforming loan would be required to retain 5% of the loan balance as an equity investment in either Fannie Mae or Freddie Mac," KBW said. "Thus the new agencies would be recapitalized at a solid 5% level of the new expanded balance sheets."

This level of capital "would allow the government to phase out an explicit guarantee of the new agencies' debt over time," George wrote. "We would expect the government to initially guarantee the debt of the new agencies for a period, possibly up to five years, in order to establish the credibility of the new agencies."

-John Spence; 415-439-6400; AskNewswires@dowjones.com