Individuals Could Win On Fannie, Freddie Preferreds

Bloomberg's “Fannie, Freddie Preferreds Batter Sovereign, Midwest” takes a closer look at the impact of Fannie Mae (FNM) and Freddie Mac (FRE) preferred stock on regional banks. Banks had liked the GSE preferreds because they can count as regulatory capital and give the banks a tax break. Now the banks face large write downs or possibly total losses on the preferreds, and they might have to raise more capital as a result. Worst case scenario is some banks face such a capital shortfall they might be forced out of business.

Let’s look at the impact of nationalization with the current common equity eliminated. The payment of dividends on preferred could not be justified with the scarcity of capital implied. Even if the preferreds are retained, the market will price them as zero coupon bonds. Remember, most if not all of the GSE preferreds are non-cumulative. At the point of nationalization, the Treasury would give some indication of when or if preferred dividends would be resumed. And as most of the analysts like to tout, the outstanding preferreds would be further subordinated. None of this would reduce systemic risk in the banking system.

Now let’s look at a second scenario. The Treasury guarantees new GSE debt, receiving stock warrants in exchange. The common and preferred would face dilution of say 50%, but the economic and systemic financial impact would be reduced compared with nationalization. The Treasury would incrementally incur more risk, so the impact on the treasury bills, notes and bonds would be minimized. Existing GSE debt holders would incur some moral hazard until their debt is rolled over, but this is necessary to prevent Bill Gross and friends from gaming the system. Preferred dividends might also be curtailed under this scenario, but there would be no question that these are still shareholder owned companies.

The debt guarantees would end when the companies are adequately capitalized through earnings. I envision the Treasury guaranteeing GSE bills and notes with terms up to five years, issued over the next five years. This would mean the Treasury guarantees would roll off in ten years or less.

A trade of Treasury guarantees for common stock warrants is “fair and balanced” for all constituencies. Best of all, it satisfies the cries for lower mortgage rates. Naturally, GSE spreads would narrow. And all constituencies would share the pain.

Once the retail investors understand the status of all classes of stock, opportunities will unfold. The best scenario for new retail investors is for the preferreds to survive with dividends curtailed. The prices could drop to mid single digits from their $25 to $50 par values because banks would be forced to unload. Sock them away for future retirement income.

Disclosure: Author is long FNM and FRE, but has no preferreds.