Seeking Alpha

Fannie, Freddie Preferreds Offer Value After Ruling

|
Includes: FMCC, FMCCH, FMCCK, FMCCO, FMCCP, FMCCT, FMCKI, FMCKJ, FMCKK, FMCKL, FMCKM, FMCKN, FMCKO, FMCKP, FNMA, FNMAG, FNMAH, FNMAJ, FNMAK, FNMAM, FNMAN, FNMAS, FNMAT, FNMFN, FREJP
by: Vlae Kershner
Summary

The recent federal appeals court ruling improves the outlook for the government-sponsored mortgage entity preferreds.

As a result, I reran my spreadsheet comparing the various issues.

The expected annual return is strong, and higher for lower-volume issues.

These issues remain speculative and are not for conservative income investors.

Last Friday's federal appeals court ruling in favor of stockholders in the mortgage giants legal case produced gains on Monday of over 40% in Fannie Mae (OTCQB:FNMA) and 30% in Freddie Mac (OTCQB:FMCC).

The various preferred issues of the two agencies also rose, but not as much.

Seeking Alpha's resident GSE expert Glen Bradford explained the ruling here, much better than I could. His basic conclusion was that the government has little choice but to settle with the preferred shareholders quickly, to allow it to execute its recapitalization plan before President Trump's first term ends in January 2021.

Last week's court ruling, if it stands, would allow any president to fire the Federal Housing Finance Agency director for any reason. This would make it easier for a Democratic president to reverse any pro-shareholder decisions made by the Trump administration.

That adds a significant risk factor. On the other hand, it means Treasury Secretary Steve Mnuchin and FHFA Director Mark Calabria will be feeling the heat to get something done before any possible change of control.

I've been keeping a spreadsheet on the preferred issues of Fannie for several years, first writing about them in 2016. That article drew a lot of suggestions, and as a result, I added the Freddie preferreds and changed from a model that showed the various issues reaching a full value based on their coupon rates (like most preferreds) to assuming they would be converted to common stock at par value. My most recent model before today was published in 2018.

This is a special situation as defined by legendary investor Benjamin Graham, with results independent of stock market factors. Thus, we can apply Graham's special situation valuation formula:

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

Here are assumptions I've made in the model:

  • The chance of a successful outcome (C) has been increased from 66.7% to 80% as a result of the court ruling. Legal and political risks remain.
  • Stock values have been increased to this week's valuation.
  • The expected holding period (Y) has been placed at 3 years, implying a payoff in 2022, a year later than in the last iteration. The government is defending its legal position and it will take a couple of years for the suit to go back to the District Court, back up to the Appeals Court, and then probably to the Supreme Court for resolution. There may be pressure on Mnuchin and Calabria to settle before the end of Trump's current term in January 2021, but that's not the base case.
  • Full value (used to compute expected gain and loss) has been left at 100% of par. Glen suggested preferred shareholders will be able to get 150% of par because of the government's need to quickly settle the preferred issue before recapitalization. However, owners of non-cumulative preferreds don't normally have a claim for missed dividends, and I'm taking the more conservative approach for the base case.
FANNIE MAE PREFERREDS
Ticker Coupon Par Full value Recent price Exp. Gain (G) Exp. Loss (L) Chance Years (Y) Indicated annual return (G) Avg. volume
OTCQB:FNMAG 5.38% 50 50 23.4 26.6 23.4 0.8 3 24% 5,170
OTCQB:FNMAH 4.5%* 25 25 12.04 12.96 12.04 0.8 3 22% 56,355
OTCQB:FNMAJ 7.63% 25 25 12.14 12.86 12.14 0.8 3 21% 30,968
OTCQB:FNMAK 5.50% 50 50 22.1 27.9 22.1 0.8 3 27% 5,998
OTCQB:FNMAM 5.81% 50 50 22.55 27.45 22.55 0.8 3 26% 11,860
OTCQB:FNMAN 5.13% 50 50 22.8 27.2 22.8 0.8 3 25% 3,868
OTCQB:FNMAS 7.75%* 25 25 13.3 11.7 13.3 0.8 3 17% 2,339,444
OTCQB:FNMAT 8.25% 25 25 12.75 12.25 12.75 0.8 3 19% 440,493
OTCQB:FNMFN 7%* 50 50 23.5 26.5 23.5 0.8 3 23% 73,468
FREDDY MAC PREFERREDS
Ticker Coupon Par Full value Price Exp. Gain Exp. Loss Chance Years Expected annual return Avg. volume
OTCQB:FMCKJ 7.875%* 25 25 13.16 11.84 13.16 0.8 3 17% 2,557,470
OTCQB:FMCCO 5.81% 50 50 22.77 27.23 22.77 0.8 3 25% 4,604
OTCQB:FMCCP 6% 50 50 23.1 26.9 23.1 0.8 3 24% 6,398
OTCQB:FMCCT 6.42% 50 50 22.64 27.36 22.64 0.8 3 26% 4,418
OTCQB:FMCKI 6.55% 25 25 12.15 12.85 12.15 0.8 3 22% 55,349
OTCQB:FMCKK 5% 50 50 22 28 22 0.8 3 27% 2,123
OTCQB:FMCKL 6.05% 25 25 12.65 12.35 12.65 0.8 3 19% 36,360
OTCQB:FMCKM 5.57% 25 25 12 13 12 0.8 3 22% 60,961
OTCQB:FMCKN 5.66% 25 25 11.85 13.15 11.85 0.8 3 23% 21,877
OTCQB:FMCKO 5.90% 25 25 11.85 13.15 11.85 0.8 3 23% 58,821
OTCQB:FMCKP 5.70% 50 50 22.22 27.78 22.22 0.8 3 27% 3,773
OTCQB:FREJP 5.30% 50 50 22 28 22 0.8 3 27% 20,515
OTCQB:FMCCH 5.10% 50 50 22.25 27.75 22.25 0.8 3 27% 22,392
OTCQB:FMCCK 5.79% 50 50 22.95 27.05 22.95 0.8 3 25% 9,795

*Variable, minimum rate.

Full value assumes conversion to common at par.

The first thing to notice is expected annual returns are highly dependent on the amount of time until settlement. If I'd used 1.33 years (the time left in Trump's term) instead of 3 years, expected annual returns would be in the 40-60% range rather than 19-27%.

A second point is that the most liquid issues - FNMAJ, FNMAT, FMCKJ - have lower expected returns than the rest. Hedge funds and other big players can't get in and out of lower-volume preferreds easily in the size they need to move the needle. Advantage, little guy!

Third, the market mostly agrees with commentators who think the preferreds will be converted to common at some percentage of par, rather than being reinstated. There is still a gap between the price of FMCCT (coupon 6.42%) and the similar FMCKK (5%), but it's less than in the last iteration of the model.

The issues have different relative valuation characteristics than other suspended preferreds, such as those of PG&E Corp. (NYSE:PCG), where investors' working assumption is that they will resume paying dividends at the conclusion of the bankruptcy process.

With the Fannies and Freddies, investors plausibly could buy whichever preferred is cheapest relative to par. That would be nonsensical with the PG&E's.

Conclusion: Even with conservative assumptions, the Fannie Mae and Freddie Mac preferreds offer good potential returns for investors able and willing to get into speculative situations. Lower-volume preferreds such as FNMAK, FMCCK, FMCKP, FREJP, and FMCCH have the best potential returns for those who don't mind negotiating ask/bid spreads. My own investment, FNMFN, offers a balance between liquidity and potential return.

Disclosure: I am/we are long FNMFN. 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.