The Fannie and Freddie Anomaly

Can anyone explain the stock prices of Fannie Mae (FNM) and Freddie Mac (FRE), the two government-sponsored enterprises that are supporting our mortgage market?

On Friday, Fannie’s common stock closed at $2.04 per share, up 250% since the start of August. That values the company–to be precise, the privately-owned common shares in the company–at more than $2 billion.

Freddie Mac’s common shares closed at $2.40 per share, up almost 300% since the start of August. That values Freddie’s privately-owned common shares at more than $1.5 billion.

Collectively, then, the common stock of these two wards of the state totals almost $4 billion.

This seems a trifle high, however, since most observers think their common stock is worthless (see, for example, this AP story).

I think those observers are right.

The government drove a hard bargain last fall when Hank Paulson fired his “bazooka” and put the two companies under federal conservatorship. Under the deal, the federal government received warrants to purchase 79.9% of the common stock of each company. That sounds like common shareholders face enormous dilution if the government exercises those warrants. And that’s true, except that the common shares won’t be worth anything anyway. The more important part of the deal requires the federal government to inject enough capital into each company (up to $200 billion a piece) to ensure that their net worth never falls below zero. In return, the government gets preferred stock paying a 10% dividend.

That preferred has to be covered before private investors can hope for any payback. And then common shareholders face another hurdle: both companies also have privately-owned preferred stock that again comes before the common in the pecking order.

Unfortunately for both sets of private investors, the government has already injected $85 billion into the two companies combined. The companies would have to cover all of that–plus almost $9 billion a year in dividends–before private investors can ever see a dime.

That would be bad enough, but it’s likely that both companies will have to draw down more government money in the future, deepening the hole in front of private investors.

And that’s not all. In early 2010, Fannie and Freddie will have to start paying new fees to the government in return for their government support. We don’t know yet how large those fees will be, but they will be yet another factor standing between common shareholders and any returns.

Investors would usually look to private sector analysts to evaluate these risks and decide how much (if anything) the common stock might eventually be worth. In this case, though, it’s also helpful to look at what various government agencies are saying. These agencies are not usually the go-to source for investment advice, but these are not normal times, and Fannie and Freddie are not normal companies:

• The Federal Housing Finance Agency, Fannie and Freddie’s conservator: A few weeks ago, the outgoing head of FHFA, Jim Lockhart, said that he expected taxpayers would end up losing money on their investment in Fannie and Freddie. In other words, the government preferred won’t be paid off in full. If he’s right, there won’t be any money for the common shareholders or, for that matter, the owners of the private preferred.

• The Office of Management and Budget. In its newly-released budget projections, OMB forecasts that the government will end up investing $173 billion in the two companies by 2011 and will hold the same amount in 2019 (Table S-15). In other words, the companies will have a $173 billion hole to dig out of (more than twice as large as the hole thus far), and won’t make any progress in the next decade.

• The Congressional Budget Office: In its newly-released budget projections, CBO forecasts that the government will end up investing $162 billion in the two companies by 2013 (Table 1-1). (For more on the importance of FNM and FRE to the budget estimates, see this post.)

In short, the quants in Washington see a gaping hole at Fannie and Freddie, with significant risk that taxpayers don’t get repaid in full.

So why do investors think the common stocks have value? You’ve got me.

(For a counter view — largely focused, I think, on the idea that the private preferred may have value — check out the series of posts at Bronte Capital, starting with this one. His optimism is based on the assumption that Fannie and Freddie will continue holding large portfolios of mortgage securities and earning wide spreads on them; I find it hard to believe that will continue.)

P.S. This post reflects joint thinking with Phill Swagel, former Assistant Secretary of Treasury and current visiting professor at the McDonough School of Business at Georgetown (but all opinions and any errors are mine).

Disclosure: I do not have any positions, long or short, in any Fannie or Freddie securities. Also, a close relative once served as a board member of one of the companies, but that ended several years ago.

Comments

[Johnc222:]

What about the trillion of dollars that FRE holds in it's mortgage portfolio. Assest that for the most part bought at distressed prices.

When the banks were leverage to their eye balls and recieved a margin call, they were forced to liquidate their holding. FRE step-up and bought alot of these assets for 10 cents on the dollar.

So, when the Economy eventually turns up and these assets increase in valaue. FRE will sell them off at a huge profit.

Aug 31 03:03 PM

[Jasper M:]

GOOD article!
Author is correct on all points.
As for the notion that FRE's mortgage portfolios is of any value, I would remind all concerned: that those mortgages were originally valued at the peak of an unprecedented credit inflation, and they will most assuredly Never sees those leves again, in constant dollars.

Further, 'Mark-to-myth' means the shareholders won't see a market valuation on their holdings until it is way beyond too late.

I bought some FRE puts on Thursday. While it might take awhile (e.g., the next Republican admin, in 2012), this one is going to zero.

Aug 31 03:58 PM

[Jake Blues:]

Just because Fannie and Freddie are worth zero right now doesn't mean that the stock is going to go to zero. If that was the case there would be no airline stocks.

Aug 31 06:09 PM

[preferredsense:]

Maybe someone can explain why FRE/FNM have to pay 10% to the government while banks get scads of under the table assistance and pay 5% on preferred.

Aug 31 09:12 PM

[jstratt:]

I think you severely diminish the greatest asset of FNMA and FRMC. They are tremendous contributors to politicians. It is hard to find a revolving door situation where politicians grant an exclusive franchise to an entity and then extract huge political contributions.

Once you have something as rare and valuable as these companies you can never let it go. Certainly being punitive to shareholders would be a poor idea. Just let the Federal Reserve buy their bad assets at face value and the gravy train continues.

Aug 31 09:30 PM

[Poor Dude:]

They own 1-3rd of the real estate in America, and they've already written off and foreclosed on all the trash (or most of it). In case you haven't heard, the values of our real estate have bottomed out and have started rising again. Uncle Sam bought them with the conservatorship to keep them alive in the midst of our financial crisis, and their very words telling you today that they don't expect to recover their contributions for the taxpayers can mean only one thing --- they're going to write the losses off and leave the value of all the "good" real estate in the hands of the companies' owners. Which is to say, those few proud and brave enough (or crazy enough?) to stick by and support the companies through their troubled times. Because those companies represent the very underpinning of our financial system, and of America itself. In other words, the common stockholders.

And never forget, that whole "pecking order" of the capital structure only applies in a liquidation. And if you think our government will "EVER" let FNM and FRE fail and go through liquidation, then ... well ... ummm ... the value of FNM and FRE common stock will be the "least" of our worries!

This is the investment opportunity of a lifetime, delivered only once every hundred years or more. And especially so for FNM, IMHO. I already bought, and I plan on holding for as long as America still exists. Or doesn't.

:)

Aug 31 10:19 PM

[Poor Dude:]

P.S. - I don't think I'd pay too much attention to anyone who calls themself a professional Wall Street analyst and tells you that half the real estate in America is worthless. Most (if not all) of those guys and gals suffer from myopia, and can't see very far past the end of their nose. At best. They're so focused on this quarter's performance (and this year's bonus) ... and whatever their computer models might tell them (with their computer models being written by equally myopic programming nerds who might understand mathematical relationships very well ... but have no clue on how the real world - and real people - really work).

If you doubt me, then select any analyst and compare his or her predictions to what actually happened over a 10-year period. Almost without exception, they missed every turn and were wrong more often than they were right. They predicted stuff to go up, and it went down. When they predicted it to go down, it went up. They almost always follow the trend, until the trend reverses and makes them look like a fool for too terribly wrong. And then (and only THEN), they suddenly change their prediction and start getting it right for a while. Until the next reversal.


Analyst's predictions are a lagging indicator, with almost 100 percent certainty. If you're smart, you'll make your investment decisions on something other than what the so-called "experts" are recommending that you do. When they're wrong 90 percent of the time, it's probably best that you bet against them. And not "with" them.

Heck, that's only common sense!

;)

Aug 31 10:49 PM

[Spharticus:]

I agree with you Poor Dude. I'm fairly new to online stock trading but when I took classes to get a real estate license, we learned about cycles in real estate. The records only go back so far, so it’s hard to see larger trends. But if I’m not mistaken about the information I received in the class, the real estate market goes on 5, 10, 15, 30 and 50 year cycles. The depression was approximately 50 years ago and this just solidifies my resolve to invest in FNM and FRE now. I am still young and If Warren buffet started to make his money in the depression.... why shouldn't I try to do the same? "Be hungry when people are scared. Be scared when people are hungry" was a quote I read. It seems Day Traders follow him like “Midas” with the golden touch. Whatever he buys goes up in value just because he bought it. Even if it takes FRE and FNM 25 years to get to half the share price of what it was before the drop. I still figure my meager investment will pay off in the end. With the advent of online trading, more and more inexperienced middle class are investing. That HAS to change things a bit for you pro traders.

Sep 01 04:33 AM

[User 480619:]

By the looks of how the markets have been pouring money into both FRE and FNM, it sure looks like someone knows something OR has another point of view on the situation.

May be the glass is half full and not half empty as every reputed analyst seems to think ;)

Sep 01 06:57 PM