Yesterday I mentioned that I couldn’t find a compelling reason to go long on Fannie Mae (FNM, $4.40, down $1.61) and Freddie Mac (FRE, $3.20, down $0.92) although the payoff could be huge. The problem was the risk. Even though the long call options were cheap, the fact that bankruptcy is now a much more realization than most people thought makes the trade impossible to go long right now.

An article over the weekend in Barron’s is what got the snowball rolling and it is quickly morphing into an avalanche for these two companies. Sure, there will be some crazy gyrations as any good news might breathe a little life into the shares, but the bankruptcy writing is on the wall.

The more we see this play out the more it looks as though the government will step in and bailout the two firms. The government could issue preferred stock which would wipe out the shareholders of common stock.

Some of you have written to me asking about buying puts for Fannie and Fannie. Sure, that strategy might payoff but both stocks are trading for under $5 so your gains are going to be limited if both go bankrupt. Others have written asking if a company goes bankrupt what would happen to the options? Don’t worry, you will still be able to close out your option positions before the stock is “delisted.” If a company declares bankruptcy, the stock will still trade on the exchanges, if it declares Chapter 11.

The Nasdaq and the New York Stock Exchange may “delist” a company that is in serious financial trouble and/or no longer meets their minimum listing requirements, but if the company is still doing business it can trade “over the counter.” However, if it’s a Chapter 7 bankruptcy, you time frame for getting rid of the stock or option will be much shorter.

Six months from now we will have a clearer picture for Fannie and Freddie but for now I think it’s best to take a “neutral” position on both companies and any trades up or down, calls or puts, should be played with limited time frames.

Rick Rouse