Two Ways To Value The Freddie Mac Preferreds

Summary

The Benjamin Graham method of valuing special situations can be used to compare the Fannie Mae and Freddie Mac preferred issues.

In response to reader feedback, I changed a key assumption to calculate projected Freddie Mac preferred returns, then also did it the way I did the Fannie Maes.

While these issues are all highly speculative, some look like better buys than others.

My recent article on valuing the busted Fannie Mae preferreds received a number of excellent comments, some challenging the assumptions in my methodology.

Unlike the common stock of Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC), which have any number of possible valuations, the fate of the preferred issues appear to be all-or-nothing.

One possibility is the "net worth sweep" that captures all profits for the federal government will end, with shareholders' interests restored, either by court ruling or a decision of the incoming Trump administration. The other possibility is the sweep is upheld in the courts, the new administration does nothing to protect shareholders, and the government-sponsored mortgage enterprises are eventually liquidated or recapitalized with current shareholders getting nothing.

Because of its binary nature, the situation can be analyzed using the Benjamin Graham formula for special situation investing.

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

In the Fannie Mae article, to calculate G, I estimated an expected value by equalizing all of their yields as a percentage of the highest yielder, then subtracting the current price.

Several readers said this was wrong--I should have simply set the expected value to par, rather than trying to guess the future value of each security based on coupon rates.

For example, AlphaACK wrote: "I thought to myself: This is mostly a binary outcome, if all goes well, then they should trade at par if callable, over par if not as their div rates are higher than current yields. I think a simple ratio of current price to par gives the largest indication of bang for the buck."

At least one reader asked me to do a similar analysis for the Freddie Mac preferreds, which are in the same position as the Fannie Maes, with investors waiting for the Trump administration to reverse the profit sweep imposed by the Obama administration.

So, taking the suggestion of readers, I calculated the Freddie Mac preferred returns by setting the expected value at par. For simplicity's sake, I only included the ones found on Quantum online that pay a fixed rate. Most of them are callable immediately, except FMCKI, callable in September 2017.

Two other assumptions are the same as made for the Fannie Mae preferreds in the earlier article--a 50 percent chance of success, and a four-year waiting period (Some argue a deal will be done in the first year of the Trump administration, but this is a more conservative approach).

 Security Coupon Par Full value Current price Exp. Gain Exp. Loss Chance Years Expected return FMCKK 5% 50 50 12.36 37.64 12.36 0.5 4 0.256 FMCCH 5.10% 50 50 12.3 37.7 12.3 0.5 4 0.258 FREJP 5.30% 50 50 13 37 13 0.5 4 0.231 FMCKM 5.57% 25 25 6.35 18.65 6.35 0.5 4 0.242 FMCKN 5.66% 25 25 6.5 18.5 6.5 0.5 4 0.231 FMCKP 5.70% 50 50 12.15 37.85 12.15 0.5 4 0.264 FMCCK 5.79% 50 50 12.02 37.98 12.02 0.5 4 0.27 FMCCO 5.81% 50 50 13.25 36.75 13.25 0.5 4 0.222 FMCKO 5.90% 25 25 6.65 18.35 6.65 0.5 4 0.22 FMCCP 6% 50 50 12.66 37.34 12.66 0.5 4 0.244 FMCKL 6.05% 25 25 6.47 18.53 6.47 0.5 4 0.233 FMCCT 6.42% 50 50 13.5 36.5 13.5 0.5 4 0.213 FMCKI 6.55% 25 25 6.65 18.35 6.65 0.5 4 0.22

In general, the lower yielding securities do indeed produce more bang for the buck. But the highest expected annual return, 27%, goes to FMCCK, a mid-yielder. This may be related to liquidity--FMCCK has lower average daily volume than some of the others.

This methodology works better here than with the Fannie Maes because the range of yields is narrower. I still question whether a 5 percent Freddy Mac preferred would trade at par, especially in light of rising rates.

The analysis comes out differently if we change the "full yield" column so that the highest yielding security yields par and the others are priced to generate the same yield, the way I did the Fannie Mae analysis.

 Security Coupon Par Full value Current price Exp. Gain Exp. Loss Chance Years Expected return FMCKK 5% 50 38.46 12.36 26.1 12.36 0.5 4 0.139 FMCCH 5.10% 50 38.93 12.3 26.63 12.3 0.5 4 0.146 FREJP 5.30% 50 40.45 13 27.45 13 0.5 4 0.139 FMCKM 5.57% 25 21.25 6.35 14.9 6.35 0.5 4 0.168 FMCKN 5.66% 25 21.6 6.5 15.1 6.5 0.5 4 0.165 FMCKP 5.70% 50 43.51 12.15 31.36 12.15 0.5 4 0.198 FMCCK 5.79% 50 44.2 12.02 32.18 12.02 0.5 4 0.21 FMCCO 5.81% 50 44.35 13.25 31.1 13.25 0.5 4 0.168 FMCKO 5.90% 25 22.51 6.65 15.86 6.65 0.5 4 0.173 FMCCP 6% 50 45.8 12.66 33.14 12.66 0.5 4 0.202 FMCKL 6.05% 25 23.09 6.47 16.62 6.47 0.5 4 0.196 FMCCT 6.42% 50 49.01 13.5 35.51 13.5 0.5 4 0.204 FMCKI 6.55% 25 25 6.65 18.35 6.65 0.5 4 0.22

Here, the high-coupon securities look like better values than the lower-prices ones. The mid-yielding FMCCK comes out second best, behind the top yielder, FMCKI, but the difference is marginal.

If you want to bet on a positive outcome for the preferreds, which analysis should you use? If you think interest rates will stay low and Freddie will again become a top-tier credit, something like first one is better. If you think rates will rise considerably or the market will perceive the preferreds as risky, the second would be closer.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.

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