A Lottery Ticket With Huge Upside

Jordan is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Move over Exxon Mobil, Fannie Mae (NASDAQOTCBB: FNMA) and Freddie Mac (NASDAQOTCBB: FMCC) are quickly becoming the most profitable publicly-traded companies in the United States.

The U.S. government reported that it received a whopping $66.3 billion in dividend payments from the government-sponsored mortgage backers. Fannie contributed $59.4 billion, while Freddie Mac wrote a check to the U.S. Treasury for $7 billion.

Will the profits soon flow to shareholders?

The government’s cash cow

The U.S. government has turned Fannie and Freddie into cash cows. Following the 2008 financial crisis, the government seized control of the firms, placing them into conservatorship. The rights of common shareholders were suspended and the government issued itself warrants worth as much as 80% of each company.

The government became the new de facto owner of both Fannie and Freddie. At the time, it seemed necessary. Large mortgage losses would send Fannie and Freddie into insolvency, so this move ensured that losses would be backed by the U.S. Treasury – the only entity with a bankroll (printing press) sizable enough to cover potential losses.

In 2012, the rules of the game changed forever. Congress passed a law that would change the way Fannie and Freddie could repay the U.S. Treasury for being a financial backstop of last resort. You see, when the government saved the GSEs, it did so with preferred shares. Eventually, the GSEs were expected to rebound, repay the government, and exist again as public companies.

The government decided that such a policy was too forgiving. Rather than allow Freddie and Fannie to repay government, it now treats every payment made to the Treasury as “dividends” on its preferred stock. Thus, Fannie and Freddie deliver billions more than their minimum payments, yet the excess does not flow to repaying the debt. It’s akin to making a prepayment on a mortgage only to see the excess disappear. In reality, that money should be used to reduce the amount you (or, in this case, the GSEs) owe to the lender.

Why shareholder don't own the GSEs

Earlier this year, common shares of Freddie and Fannie rocketed as the two reported positive, multi-billion dollar net income. In any other situation, the shares would have kept their value. Fannie and Freddie are well into the black.

But holding common and even preferred shares of Fannie and Freddie is purely speculative at this point. Neither will have any true economic value, or any claim to the profits of either company, until the government allows its preferential preferred shares to be paid off. For now, the profits, no matter how large, are the U.S. Treasury’s and the U.S. Treasury’s only!

The only way that shareholders will profit is if a lawsuit can compel the U.S. government to allow Fannie and Freddie to repay the U.S. Treasury. Politicians aren’t so sure. Some want to simply allow the U.S. government to let the GSEs run off, eventually closing up the two firms as the mortgages they hold mature.

Others want to return Fannie and Freddie to public shareholders and remove some of the backing that the U.S. government provides them. A final group wants to simply allow the two GSEs to repay their debts and operate as a going concern with the help of the Treasury.

Certainly, there is ample money to be made from the GSEs, but it is very, very risky.

What we know

We know that the U.S. government will ultimately decide on a binary outcome: either the GSEs will be left as the Treasury’s cash cow, or returned to shareholders.

The best way to play this event is to move up the capital structure. Common stockholders are much more likely to get the screw than preferred shareholders. As such, one should consider playing Fannie Mae preferred stock alongside some of the world’s best hedge funds, who have every intention of bringing Fannie and Freddie back from their zombie status, much like AIG was brought back from the grave.

Fannie Mae’s 8.25% non-cumulative preferred shares (NASDAQOTCBB: FNMAT) trade hands at $7.40. If Fannie is released to shareholders, these should immediately trade at or above par, given their above-market interest rate.

Thus, it comes down to odds. The market currently prices Fannie’s preferred stock as if it is a one-in-three chance that the government sets Fannie free. I think the odds are better, given how many powerful hedge fund managers are in on the trade.

In a best case scenario, Fannie is returned to shareholders this year and investors turn their $7.40 investment into $25 in one year, for a 237% return. If it takes five years, then the compound annual return comes to 18.8%.

This is one of the rare cases where you get a binary outcome with a better than 50-50 payoff. If you believe hedge funds can ultimately convince the U.S. government to return the GSEs to their rightful owners following in the footsteps of AIG, this is the play of a lifetime.

Tax increases that took effect at the beginning of 2013 affected nearly every American taxpayer. But with the right planning, you can take steps to take control of your taxes and potentially even lower your tax bill. In our brand-new special report "How You Can Fight Back Against Higher Taxes," the Motley Fool's tax experts run through what to watch out for in doing your tax planning this year. With its concrete advice on how to cut taxes for decades to come, you won't want to miss out. Click here to get your copy today -- it's absolutely free.


Jordan Wathen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

blog comments powered by Disqus

Compare Brokers

Fool Disclosure