Will Fannie and Freddie Go to Zero?

If you'd seen the title of this article one year ago -- heck, one week ago -- I'd expect you to laugh at me.

But this isn't a joke. Shareholders' faith in the country's two mortgage powerhouses is growing slimmer by the day. And if one high-profile investor gets his way, as he has in the past, current shareholders will be left with nothing but worthless share certificates to line the walls of their homes -- 0.6% of which have already been foreclosed on this year.

No joke
Activist investor Bill Ackman has proposed a plan to save Fannie Mae (NYSE: FNM  ) and Freddie Mac (NYSE: FRE  ) from a complete demise, but it's anything but good news for shareholders.

Ackman's plan proposes giving investors who currently hold $750 billion worth of senior debt $0.90 on the dollar worth of new debt, and another $0.10 on the dollar worth of equity in a new company. Fannie's junior debt would get warrants in the new company, while common and preferred shareholders would get a handshake, a good-luck wish, and a box of Kleenex ... if they're lucky.

Will it work?
As absurd as it seems, there's a decent chance that Fannie and Freddie would already be toast without the implied government backing they receive. Few seem to argue that something must be done; these organizations are just too important to fail.

Given the severity of both companies' crisis, the government has two options: purchase equity in Fannie and Freddie, or recapitalize them, as Ackman has proposed. The latter plan would annihilate current shareholders, but it might silence the "moral hazard" critics. Given the options, Ackman's plan seems pretty reasonable.

Should we trust him?
The common denominator in Ackman's plans -- including this one -- is, surprise, surprise, he's set to make a killing if it goes through. He made a ruckus earlier this year by betting against bond insurer MBIA (NYSE: MBI  ) , which caused more than a few people to question his intentions. Ackman is betting against Fannie and Freddie (i.e., shorting their stocks). Truth be told, he's got a conflict of interest in proposing their future. But that alone doesn't mean he should be written off.

Here's one scarcely followed statistic that might make you side with Ackman. If the government purchases a slug of equity in Fannie and Freddie, its obligation would effectively become the taxpayers' responsibility. Under Ackman's plan, no taxpayer dollars are spent -- only current shareholders get crushed.

Short sellers are often shady and manipulative. But just because Ackman is set to profit here doesn't mean he's wrong. In this case, there are literally trillions of reasons why the average American taxpayer should embrace his plan. Sure, it's a tragedy for shareholders -- we Fools sympathize with our colleague Rich Greifner -- but amid this unprecedented real estate debacle, many will have to suffer. In all fairness, those who voluntarily took on the risk should be the first to take it on the chin.

For related Foolishness:

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article -- thank goodness. The Fool has a disclosure policy.


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