Most investors think that Fannie and Freddie are worthless as losses have continued to mount. But are they?
The US has continued to pump money into them. The latest tab totals $151 billion in preferred stock currently paying a 10% dividend that comes ahead of the common and the preferred stock owned by the public. Dividends have been suspended on the public preferred. These public preferred issues have a total market cap of about $800 million, but a stated value of about $30 billion. They are held by private investors, mostly banks. The US has also bought and guaranteed large amounts of Fannie and Freddie's debt. By conventional valuation both of these GSE's should have been liquidated long ago, with the public shareholders wiped out!
But a funny thing happened on the way to bankruptcy: the government thinks they are too big to fail. Currently, These GSE's guarantee almost all the conventional mortages that are being written, while FHA guarantees the smaller amount of risky mortgages that continue to be written.
Fannie and Freddie are back in the business of guaranteeing high down payment conventional loans to creditworthy borrowers, a business that continues to be very profitable. Were it not for their legacy costs and the high dividends the government receives on its preferred stock, Fannie and Freddie could do an IPO and perhaps raise enough capital to support a reduced role confined to their traditional, highly profitable business.
Will this happen? Maybe it will, if not soon, perhaps sometime in the not too distant future. Maybe it won't happen, and shareholders will lose the remaining 1%-2% or so of their former market cap. If that happens the common and preferred in the public's hands will be a total loss. But, if there is eventually a favorable outcome along the lines of the government's bailouts of AIG, Ally and the big banks, there will be something left for the stockholders, especially the holders of preferred stock, mostly small or regional banks that have been ignored in the effort to save the big banks. They had been told by regulators that Fannie and Freddie preferred was the only high yielding security they could own because it was so safe with AAA ratings.
If there is something left for stockholders, it is likely to be many times the current market cap for the preferred stock if the pattern of exchanging preferred for common that has taken place in unwinding the other bailouts holds. Therefore, there may be an asymetric risk/reward profile in owning the preferred.
Let's assume that there is a probability of some sort of a successful outcome. If we go by the pattern that has been set with the unwinding of other bailouts, that probability may be high, perhaps 90%. However, in view of the much worse shape of Fannie and Freddie than the other institutions, lets discount the probability of some sort of successful outcome to only 50%. Heads, you lose your investment. Tails, you win. But how much? A little? A lot?
Lets look at AIG. The common shareholders wound up with about 10 % of the equity. The government gave up its preferred priority and high dividends in exchange for common stock and chose not to exercise its warrants. If that pattern should hold in the event of a reorganization of Fannie and Freddie, the preferred shareholders might own 90% of the common, with perhaps 75% of the common in the hands of the government and 15% of the common in the hands of mostly banks that own the publically traded preferred. The government might put the remaining bad loans in runoff. Current common shareholders might retain 10% of the new common. If there is then an IPO to raise more capital, the former shareholders of the publicly traded preferred might eventually own less, perhaps 7/12% to 10% of the new common with the holders of the old common having a lesser amount, perhaps 6.7% to 5% of the new common.
How much might such a recapitalization be worth for a combined Fannie and Freddie with restrictions that was restricted to guarantees of solid, conforming mortgage loans with their bad loans behind them? Then, the new Fannie/Freddie wouldn't have to pay the crushing preferred dividends the US now receives. If the new Fannie/Freddie were worth $80 to $120 billion in a few years, the public preferred that would be exchanged for common might be worth 10 to 15 times its current market cap of about $800 million. However, the common with a current market cap of about $2.8 billion, might not fare so well in a recapitalization that is similar to the unwinding of other bailouts.
This is merely speculation. But, thinking through possibile outcomes may help prepare for an important event that may help clarify Fannie and Freddie's future. Under the terms of the financial bill passed last summer, the administration is supposed to present a plan for Fannie and Freddie's future by the end of January, 2011.
Is there a margin of safety in this speculative situation? Perhaps. Simply, wait a few days until the end of January, 2011 deadline. Then, there could be a margin of safety if the administration's plan is well received and favorable for recouping significant value for the publically traded preferred that's owned mostly by the banks. In the past, this preferred has often been overlooked by other investors because the common is much more liquid. We've made good money in the last two and a half years arbitraging the spread between the common and the relatively cheap preferred, and we continue to trade in and out of them. But, owning the preferred or common could be risky as the deadline for an announcement about their fate approaches by the end of this month. It's possible that the administration's plan might not follow the pattern of the other bailouts of leaving something on the table for current shareholders.
On the other hand, it's not out of the question that the plan might retain the full stated value of the public preferred issues, as was the case with Ally's recapitalization. If so, the banks might be made whole on their investment in the preferred, just as the holders of Fannie and Freddie's debt have been made whole. If so, the public preferred could eventually be worth their stated values that are about 40 times the current market prices.
Nevertheless, Fannie and Freddie's stockholders could fare worse than the stockholders of the private companies bailed out during the crisis. This would be a big political stink, especially as these GSE's have not been run entirely for the benefit of their shareholders during their conservatorship. Perhaps, the the plan the administration will announce soon will have important details about the future value of the common and preferred.