Fannie Mae And Freddie Mac, Short-Term Trade Or Deep Value Investment?

| About: Fannie Mae (FNMA)
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As a self-styled Warren Buffett / Benjamin Graham disciple and true value investor, I usually stay far away from short-term trading and speculative plays. But every once in a while, the gambler in me comes out and I take a chance and roll the dice on some speculative issue that somehow grabs my attention, always with varying levels of success. Last year's gamble on Arena Pharmaceuticals' (NASDAQ:ARNA) FDA approval was a very successful gamble, while my play on Arch Coal (ACI) turning around was less than memorable.

Last Monday evening, I read the Wall Street Journal's article detailing Fannie Mae's (OTCQB:FNMA) announcement that it was delaying its Q4 earnings report while it determined if it is able to reclaim a deferred tax asset (DTA), which in theory at least, would allow Fannie Mae to make a $61.5 billion repayment to the Treasury Department. I made a snap decision, and opened a small position in Fannie Mae common stock on Tuesday morning at .52 cents per share. I sold just before the close on Thursday at $1.04, exactly doubling my money in three days. This made for a very nice trade and a very happy trader, but it also led the value investor in me to take a closer look at the circumstances surrounding Fannie Mae and Freddie Mac (OTCQB:FMCC).

Fannie and Freddie are Government Sponsored Enterprises (GSEs) that provide liquidity and stability to the secondary mortgage market in the U.S., and securitize mortgage loans originated by lenders in the primary mortgage market into Fannie Mae mortgage-backed securities. Both companies suffered huge losses during the housing market meltdown, and were seized by the federal government and placed into conservatorship under the FHA by the U.S. Treasury Department.

To date, Fannie and Freddie have received $188 billion in bailout funds from the Treasury Dept. Under the terms of the federal bailout, the Treasury Dept was issued senior preferred stock in both companies, and the voting rights of common shareholders and all dividends on the common and all series of junior preferred stock in both companies were suspended, rendering both classes of stock virtually worthless. The exception being the senior preferred stock held by Treasury, which required a 10% quarterly dividend payment, against which the two companies have paid a total of $58 billion in dividends thus far. It is important to note that these dividend payments, while reducing the cost of the bailout to taxpayers, DOES NOT constitute a paydown of the actual bailout funds.

With the housing market finally recovering, Fannie and Freddie have returned to profitability, raising the possibility that the two companies could begin to repay the bailout funds borrowed from Treasury, much as bailed out insurer American International Group (NYSE:AIG) and banks such as Citigroup (NYSE:C) and Bank Of America (NYSE:BAC) did, and possibly allowing them to emerge from conservatorship.

In November, however, Treasury amended the terms of the senior preferred stock agreement, which eliminated the 10% dividend requirement, but instituted a complete dividend sweep of any profits the companies may have, eliminating the companies' ability to retain their earnings and making it impossible to pay back the bailout funds. So even if Fannie and Freddie are able to reclaim the total amounts of their deferred tax assets - $61.5 billion for Fannie and $31.7 billion for Freddie - there is nothing this author can see to keep Treasury from sweeping these amounts into its coffers as dividends without applying it to the debt owed.

There is much debate about the future of the GSEs, with many having called for complete GSE reform or even elimination of the two companies, but very little has actually been done to enact change. In a bit of a mixed development, a bipartisan group of senators recently introduced legislation that would bar Congress from using the companies' profits to pay for unrelated government spending (a good thing), but would also bar the Treasury from selling any of the senior preferred shares in the GSEs without a vote by Congress (a bad thing for those who want to see the companies back in the hands of private shareholders).

There is also talk of a Sallie Mae (NYSE:SLM) type wind-down, detailed here in an excellent article by fellow Seeking Alpha author David Sims. This type of a restructuring would be the best possible scenario for common or preferred shareholders in Fannie and Freddie, who could see their shares reclaim a large portion of their previous values. This scenario however is far from certain, and while the debate in Washington, D.C., goes on, nothing regarding the future of the GSEs is certain.

While there is money to be made in Fannie and Freddie's common and preferred shares on a short-term basis, the long-term story is even more interesting. These two companies are either dead and buried under the crushing weight of federal bailout funds and Washington, D.C. political objectives, or they are the deep value opportunity of a lifetime, a real "hero or zero" trade, as it was so aptly described on a recent Yahoo message board post. Either way, tread very, very carefully with shares in either of these two companies.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in OTCQB:FNMA, OTCQB:FMCC 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.

Additional disclosure: I am not a registered investment advisor and do not provide specific investment advice. The information contained herein is for informational purposes only. Nothing in this article should be taken as a solicitation to purchase or sell securities. Before buying or selling any stock you should do your own research and reach your own conclusion. It is up to investors to make the correct decision after necessary research. Investing includes risks, including loss of principal.