Warren Buffett, Benjamin Graham And The Case For Freddie Mac And Fannie Mae Preferred Stocks As Special Situation Investments

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Includes: FMCC, FNMA
by: Wayne Olson, CFA
Summary

The Freddie Mac and Fannie Mae preferred stocks are non-cumulative preferred securities. Warrant Buffett has identified the “terrible weakness” of noncumulative preferred securities.

Benjamin Graham, who was Warren Buffett’s teacher, friend, and mentor, referred to 1939-1942 as the “heyday” for investors in special situations and undervalued securities. The 2009-2015 period has also been.

FMCKJ is an example of a Freddie Mac preferred stock that trades at about 15 percent of redemption value. Thus, if FMCKJ ever goes back to its redemption value of.

This article applies Benjamin Graham evaluation methodology for “special situations” to an investment in FMCKJ. The same valuation methodology could be used to evaluate investments in Freddie Mac’s other preferred.

FMCKJ and FNMAS in a nutshell

Freddie Mac (OTCQB:FMCC) currently has $14.109 billion of preferred stock on its balance sheet at redemption value. Freddie Mac has a number of preferred stock issues.

Freddie Mac is in conservatorship and has not paid preferred dividends since the second quarter of 2008. Indeed, FMCKJ only paid dividends for two quarters before dividends were suspended. 240,000,000 shares of FMCKJ were issued on December 4, 2007 at $25 per share, with proceeds of $5.91 billion to Freddie Mac and the initial dividend rate was set at 8.375 percent (which was to be reset at no less than 7.875 percent beginning in 2013). Thus, even at a market price of about $3.75 per share, FMCKJ currently has a market cap of about $900 million.

Fannie Mae (OTCQB:FNMA) currently has $19.130 billion of preferred stock (at redemption value) on its balance sheet, with various ticker symbols. FNMAS is Fannie Mae's largest preferred stock issuance. Proceeds to Fannie Mae from the issuance of 80 million shares of FNMAS (at $25 per share redemption value) was $1.937 billion. Fannie Mae paid preferred dividends through the third quarter of 2008. At a current market price of about $3.75, FNMAS has a market cap of about $300 million.

Please note that the U.S. Treasury (Treasury) has $187.5 billion of senior preferred stocks in Fannie Mae and Freddie Mac (together known as the government sponsored enterprises or GSEs). The Treasury initially received a 10 percent cash dividend in compensation for draws on the Treasury by the GSEs. As announced on August 17, 2012, Treasury now receives a "net income sweep" of all of the GSEs' earnings. This will leave the GSEs with no book equity capital as of January 1, 2018. The 3rd Amendment is subject to ongoing litigation at the D.C. Court of Appeals, the federal Court of Claims, and the U.S. District Court in Iowa.

Warren Buffett's Critique of Non-cumulative Preferred Stocks

Warren Buffett has-correctly-critiqued the "terrible weakness" of noncumulative preferred stocks. Once a preferred stock's noncumulative dividend is cut, companies will tend to have an incentive to "go slow" when considering reinstating the preferred dividend. Not paying a cash dividend will help the company's cash flow position. The main impetus to restoring the preferred dividend will be when the company wants to raise new capital. Not paying a preferred dividend may prevent the company from paying a common dividend, which would make issuing new common equity difficult to achieve.

Noncumulative preferreds are "quasi-equity." Common equity holders get the residual after the company's obligations are paid. Noncumulative preferreds normally get a defined dividend, but if the company eliminates the preferred dividend, then the noncumulative dividends are foregone by investors until such time as the firm decides to resume the dividend. Thus, noncumulative preferreds are exposed to risk that a company's weak earnings and cash flows may cause it to eliminate the noncumulative dividend for a period of time.

Cumulative preferreds are "quasi-debt." A company with a cumulative preferred stock can defer dividend payments for a few quarters, but if it hopes to be able to maintain its financial flexibility it would eventually need to pay the cumulative dividends that had been temporarily deferred. Thus, a company would have a stronger incentive to maintain and resume a cumulative dividend.

Let's look more closely at FMCKJ as an investment opportunity. FMCKJ's preferred dividends must be paid before any FMCC common dividends can be paid. If FMCKJ's preferred dividends are paid, Freddie Mac's other preferred stocks must also be paid a dividend.

Warren Buffett objects to the fact that the GSEs have noncumulative preferreds, not cumulative. Currently, however, Buffett's objection to noncumulative preferreds is irrelevant given the 3rd Amendment to the Senior Preferred Stock Purchase Agreements (SPSPAs), which prevent the payment of any Freddie Mac or Fannie Mae preferred or common stock dividends and instead funnels all of their net income to the Treasury. Indeed, one reason why Treasury and the FHFA agreed to the 3rd Amendment instead of exercising the warrants to own almost 80 percent of the GSE's common equity may have been to try to avoid triggering an obligation to pay dividends to the GSE preferred and common holders (see page 54-55).

Benjamin Graham's Valuation Methodology for Special Situations

Benjamin Graham defined a special situation as one in "which a particular development is counted upon to yield a satisfactory profit in the security even though the general market does not advance." Mr. Graham preferred situations where the "particular development" is already underway-the corporate (not market) development should be estimable within a time period in the light of past experience. For example, Mr. Graham discussed investing in securities related to railroad and utility reorganizations, which he-writing in 1946-thought could lead to solid returns for "those who bought their issues at unpopular times and consequently at basement prices."

Graham's formula is as follows:

Indicated Annual Return = (GC - L (100-C)) / YP

Where G is the expected gain in the event of success.

C is the expected percentage chance of success

L is the expected loss in the event of failure

Y is the expected holding period

P is the current price of the security

The GC component is the probability-weighted "upside" from a successful investment. The L(100-C) component is the probability-weighted "downside" from a bad investment. YP is the holding period times the current price of the security. The numerator thus calculates a probability-weighted expected return from a transaction by evaluating a probability-adjusted successful return against a probability-adjusted low return. The denominator reflects the expected time period of investment and the current stock price. The result is the Indicated Annual Return from the investment.

Many investors in preferred and common stocks may find this methodology intuitively logical. With preferred stocks, the upside is often sizable but is typically capped at redemption value. The downside is usually floored as well (you can only lose the entirety of your investment). Mr. Graham emphasized that "careful study of each situation and the possession of sound though somewhat specialized judgment" is needed to successfully invest in special situations and undervalued securities.

Let us apply this valuation methodology to FMCKJ. Consider this assumed fact situation: an investor has examined an investment in FMCKJ and has concluded that FMCKJ will either return to redemption value in five years or drop to $1 per share. The investor does not know what the future will hold but estimates a 2/3rd chance of FMCKJ going to redemption value and a 1/3rd chance of FMCKJ going to $1. (For convenience, I've used the same 2/3rd/1/3rd success/failure probability as used by Graham in his example.) The investor assumes a holding period of five years.

FMCKJ is now at about $3.75, which would mean a 567 percent return (not adjusted for probability) if FMCKJ returns to its redemption value of $25. If FMCKJ went from $3.75 to $1.00 the loss would be 73 percent, again ignoring the probability weighting. Given an assumed 2/3 chance of success and a 1/3 chance of failure as well as a five year holding period and a stock price of $3.75, the resulting Indicated Annual Return is a decent 71 percent annual return. In this simple example, a $100,000 investment in FMCKJ would have an assumed 2/3rd chance of growing to $667,000 and a 1/3rd chance of dropping to $27,000.

This is just one possible outcome out of many. As one simple test of the valuation methodology, I tested the effect of switching the probability assumptions to a 2/3rd probability of failure and a 1/3rd probability of success. The resulting Indicated Annual Return in this case was 28 percent, which is still respectable.

For FMCKJ, the "particular development" that may-or may not-be currently underway has to do with somehow overturning the 3rd Amendment to the SPSPA or finding some way to have the preferred dividends restored. This could occur in a number of ways: the courts could mandate it, Congress could require it via legislation, or FHFA and Treasury could agree to it voluntarily. Cases are proceeding at the Court of Appeals D.C. Circuit, the U.S. Federal Court of Claims, and the U.S. District Court in Iowa. Action by Congress seems unlikely given political gridlock. As the court cases proceed, Treasury and FHFA could decide to restore the preferred dividends, perhaps as way to settle some or all of the pending litigation brought by investors in GSE preferred stocks.

Catalysts for a Shorter Holding Period

Catalysts of a shorter holder period and a more favorable outcome could include:

Favorable ruling by the U.S. Court of Appeals on the 3rd Amendment litigation. Briefing is scheduled to end in November 2015. Oral argument is not yet scheduled. A decision would be expected by June/July 2016-it is my understanding that the usual guess is that an appeals decision will issue 6-12 months after oral argument. Outcomes could include granting of the requested relief, i.e., remand to the lower court with instructions to reverse the 3rd Amendment, among others. Of course, far less favorable outcomes are also possible, including an appellate decision upholding Judge Lamberth's decision. Numerous filings have been made in this proceeding in the last two weeks.

Favorable ruling by the U.S. Federal Court of Claims. Discovery (document discovery, interrogatories, and depositions) is ongoing before Judge Sweeney. A status conference (closed to the public) is scheduled for August 13, 2015. Discovery is now scheduled to end by September 4, 2015. The discovery process is currently aimed at answering the question of whether the federal Court of Claims has jurisdiction in this matter. It seems plausible that additional briefing would occur on the jurisdictional issue once discovery is completed followed by a ruling by Judge Sweeney on the motions to dismiss, including the disputes about the plaintiffs' standing. Outcomes could include going forward on the 3rd Amendment takings claims in a trial before Judge Sweeney or approving the defendant's motions to dismiss, among others. While there are a number of uncertainties, it seems plausible that a decision on the motions to dismiss could occur during the next 12 months.

Narrow settlement with Treasury/FHFA on preferred stock dividends. While a comprehensive settlement of all of the disputes between plaintiffs and defendants is highly unlikely in the near term, one can imagine a scenario where the preferred stock plaintiffs settle with defendants in such a way that the GSE preferred stocks are allowed to resume their dividend payments. Assuming $30 billion of preferred stocks for both GSEs and an assumed six percent dividend, $1.8 billion of preferred dividends would go to the preferred stock investors annually. While unlikely, it is at least conceivable that a narrow settlement related to the preferred stocks could possibly occur in the next 12 months. After all, the GSE noncumulative preferred stocks are quasi-equity, they do not receive the residual after the firms obligations are met.

Numerous uncertainties remain.

Conclusion

While an investment in FMCKJ broadly fits into Benjamin Graham's "special situation" investment framework, Graham would likely not view an investment in FMCKJ as a "true special situation" as no plan of repayment has been announced. It remains to be said that investors should do their own due diligence before investing in GSE preferred or common stocks.

Disclosure: I am/we are long FMCKJ AND FNMAS, AMONG OTHER GSE PREFERREDS. 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 an attorney. I am long FMCCP, FMCCT, FMCKI, FMCKJ, FNMAK, FNMAN, FNMAS, and FNMFN.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.