Fannie Mae and Freddie Mac

There are several ways that the stockholders can lose.

1) the company can file for bankruptcy, resulting in the value of the stock to go to zero, and the courts canceling dividends and eliminating entire classes of stock. 2) the firm can get new investors. They invest by buying stock. The existing stock goes down in value because it has been diluted with the new stock. In addition, reverse splits are common, such as 10,000 to 1 reverse. That means that someone who owned 1000 shares now only owns 1/10 of a share. 3) the firm simply doesn't perform, so the forces of supply and demand push the stock price down into the penny stock range, and then the firm is eventually delisted from any major exchange.

-john-

Thanks for your replies! They were really helpful!

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Since your interest is stock analysis, I'd suggest getting an intro-level finance textbook and learning about balance sheets - how to analyze a company's capital structure (the ways they raise the money they need to operate). Once you understand that you'll have a much better idea of why raising capital can be detrimental to current stockholders, and the circumstances where existing stock can become worthless or nearly so.

Cliffs notes version: Whether you're talking about a small local business, or a publicly traded company like IBM, all money-raising falls into two categories: equity and debt. Equity is common stock and preferred stock, and the holders of that stock collectively own the company, taking on the risks of its failure as an owner would. Debt is borrowing, done mostly by issuing bonds. Lenders (including bond owners) are not owners of the company, rather they have a contractual kind of relationship with fixed terms (such as: lend $10k for 5 years at 7% interest). These "creditors" do not take on the same risks as owners, and are treated differently if the company goes bankrupt.

If capital is erode due to losses, a company needs to find new capital to continue operating. And it only has those two broad options: equity and debt. If the new capital is common stock, that dilutes existing shareholders (e.g. doubling the stock outstanding means a former owner of 1/5th of the company now owns 1/10th of it). And distressed companies can't always raise capital by selling stock, because investors aren't willing to buy it - if they are, it's often on lousy terms (high dilution of prior shareholders). If the new capital is in the form of bonds, that should be better for shareholders, unless it happens in bankruptcy - where typically old stock is canceled and only creditors get anything.

Exactly how Fannie/Freddie recapitalize remains to be seen but as Elle said these are tough companies to begin your stock analysis with. Their financial statements have been in limbo for years, and their balance sheets are unusually complicated. Heck, Capital Research & Management (which manages American Funds mutual funds) was one of the biggest owners of these stocks, owning over 20% of each late last year. If their team of highly-trained expert analysts couldn't see the risks, what hope does a beginner have?

-Tad

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