The two best performing stocks this year are two names no one would have expected. After peaking at return in excess of 1400% in May, shares of Fannie Mae (FNMA) and Freddie Mac (FMCC) are up over 600% year-to-date.
What’s Behind the Rise of Fannie Mae and Freddie Mac?
Fannie Mae and Freddie Mac’s recent resurgence and subsequent rise from near bankruptcy during the 2008 financial crisis may evolve into one of the most interesting stories in finance. When the U.S. Government put Fannie and Freddie in conservatorship, it seized virtually all of the value in the government-sponsored entities. Common shares had their voting rights temporarily suspended. Government awarded itself warrants worth 80% of the common equity in the two GSEs in exchange for a cash infusion via preferred stock. Congress essentially took control.
It was at that point the market for the stock ceased to exist. Government would own any and all decisions, and presumably all the cash flows from the company’s vast portfolio of mortgage securities. Fannie and Freddie were broke and destined to be broke, investors thought.
What’s Happened Since
It turns out that Fannie and Freddie weren’t exactly broke. In fact, a rising home market served as the catalyst for profits. The GSEs earn billions of dollars each year, but the government’s getting all of it. Previously, the GSEs would have the option to repay bailout funds over time, drawing the balance of the loan to zero. The terms were changed in 2012, when the government forced the GSEs into a position where every payment from Fannie and Freddie is treated as a simple dividend. The result is that no matter how much Fannie and Freddie earn, it all goes to the U.S. Treasury. The debt cannot be repaid. All cash will flow to the U.S. Treasury and, as it stands today, investors have zero claim to either GSE’s profitability.
Hedge Funds Enter the Fray
A laundry list of world-class investors have entered into the trade. Bruce Berkowitz owns a stake worth roughly $2.5 billion at par value, which is the largest position I’ve heard of yet. Portfolio managers are banking on the long odds that government allows Fannie and Freddie to record a profit, pay back the sums government invested during the financial crisis, then make dividend payments to preferred and common stock holders just like any other company. Famed investors say that if it worked with AIG (the government converted its preferred shares to common stock to later sell out) then it should work with Fannie Mae and Freddie Mac.
Consider it a lottery ticket; the market does. Preferred shares with an almost ubiquitous par value of $25 trade all around $5 each. Should the government allow the GSEs to repay their bailout debt, dividends could once again flow to preferred shareholders. The preferred, which offer yields well above current interest rates, would immediately shoot to par value.
GSE Profits Won't Flow to Shareholders
Make no mistake: Fannie and Freddie are very, very profitable. Fannie, which claimed an extra $50 billion in income from a reversal of tax losses, earned pre-tax income of $8.1 billion in the first quarter of 2013. Freddie earned $4.6 billion in net income at the same time. Of course, neither company has anything to show from the gain. All cash generated goes to government. Other preferred shareholders and common stock holders have no claim to earnings.
It’s a Lottery, Not an Investment
Fannie and Freddie can and should pay off the US government’s initial cash infusions. However, the political will to make Fannie and Freddie public again doesn’t seem to exist. Congress has no reason to sell its position as part of an IPO to recapitalize both companies seeing as all profits flow to the Treasury, reducing the deficit. There are only two ways to make any money in Fannie or Freddie. Either the Treasury will have to give up a very valuable perpetuity received in dividends, or investors will have to beat the government in court. Neither outcome seems all that likely.
If you’re on the prowl for a lottery ticket stock, the trading in Fannie and Freddie common shares ensure a wild ride. Expect nothing more than a binary result – you'll either lose it all or double or triple up. As an alternative, the preferred securities are much safer (but very likely still money losers), trading at a fraction of par value.
What are your thoughts on Fannie Mae and Freddie Mac?