In this bull market, it has been the American pastime to speculate on stocks. Speculation is all fun and games until the music stops playing, and for Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC), that time may come very soon. Since the news that Fannie and Freddie may be profitable, their stocks have gone on an amazing run.
The recent run-up has given Fannie Mae a market capitalization of $21 billion and Freddie Mac a market capitalization of $11.3 billion. In perspective, in 2007 at the height of the housing market, Fannie had a market cap of $50 billion dollars and Freddie a market cap of $17 billion.
Investors are valuing these two companies that technically have intrinsic values of zero at 40-60% of their previous market caps in 2007. This speculation is unwarranted. Investors should strongly consider selling their shares for the following reasons:
1) All of Fannie and Freddie's profits are in the form of dividends (as in owner's profits) not payback.
Under the terms of an agreement with Treasury that went into effect this year, the enterprises will be allowed to retain only $3 billion in net worth. Any profits beyond that amount will go to taxpayers.
"They have no ability to recapitalize their business," Tim Rood, a managing director at Washington-based Collingwood Group LLC, a financial services consulting firm. "They could spin off $100 billion next year and it wouldn't make a stitch of difference." being used (or considered at least) to "pay down" the debt.
2) If Fannie and Freddie were allowed to count dividends as payback, they would still owe the government $130 billion.
So far, Fannie and Freddie have received nearly $188 billion from the U.S. Treasury and they have paid dividends of $58 billion, bringing the total cost of their rescues to $130 billion, with around $88 billion for Fannie and $42 billion for Freddie.
3) There is currently no plan in place to convert Fannie and Freddie into private hands.
Per Washington Post
The gains come after the U.S. Treasury Department changed the terms of the enterprises' bailout last year to force them to turn over profits to the government. The agreement provides no mechanism for them to repay the $187.5 billion they owe the government from their 2008 bailout, a prerequisite to a change in their status.
4) The political reality greatly diminishes the chance of conversion.
Congress has no incentive to throw away a cash cow. The money generated from Freddie and Fannie could be used to pay for social programs or pay down the national debt. If government did undergo the process of privation of Freddie and Fannie, it might disrupt the nascent housing recovery.
5) The preferreds that are senior to the common are trading only around 25 cents to the dollar.
If the equity slice of Fannie and Freddie truly had value, the preferreds would be trading at a much higher value.
Hedge funds including John Paulson's Paulson & Co. are lobbying for a privatization of Fannie Mae and Freddie Mac that could benefit preferred shares they've bought. Fannie Mae's 8.25 percent of preferred shares rose 10 percent today in New York to $6.14 and have climbed from $1.67 at the end of last year. The securities have a par value of $25.
6) Since 2008, Fannie and Freddie have seen major share dilution.
Some investors might look at the price and conclude that there is a lot of upside. They see that the prices were in $60s in 2007 and only $3 now. What they do not account for is the massive increase in share count for Freddie and Fannie after the bailout.
Given the current political and economic realities, Fannie and Freddie have very little intrinsic value. They currently pay all their profits in the form of dividends and not payback. In my opinion, the current run-up has been a result of a short squeeze and momentum traders with quick trigger fingers. If investors want to speculate, the preferred stock, while still risky, are a much saner bet than the common.
Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in OTCQB:FMCC, OTCQB:FNMA over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.