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Should You Buy Preferred Shares of Fannie Mae and Freddie Mac?

This article is part of a series of articles that looks at Fannie Mae  (NASDAQOTCBB: FNMA  )  and Freddie Mac  (NASDAQOTCBB: FMCC  )  from an investment perspective. To read the full analysis, click here.

Before the crisis, preferred stock in Fannie Mae and Freddie Mac was seen as a safe income security.

As such, conservative investors and small banks purchased it. But when the GSEs melted down and required a bailout, preferred stock dividend payments were suspended and have yet to be resumed.

Since the preferred stock available to private investors is junior to the senior preferred stock owned by the government, the junior preferred stock is in a similar situation as the common stock in that it provides no dividend and is not directly benefiting from the rebound in profits.

Most series of Fannie Mae and Freddie Mac preferred stock have liquidation values of $25 or $50 and trade at between $0.30 and $0.40 per dollar of liquidation value. Much of the difference in current value has to do with the original dividend rate on the series despite the dividend being suspended and non-cumulative.

Risks and potential return
If the plaintiffs lose their cases against the government, then the preferred stock is unlikely to have much value.

As previously discussed, most politicians favor a wind down of the GSEs leaving preferred shareholders in line after the massive senior preferred stock stake from the government. And until the current situation changes, the preferred stock pays no dividend and the GSEs would not be able to reinstate one.

But if the plaintiffs can succeed in ending the net worth sweep, returns for the preferred stock would be significant. All series would move back toward liquidation value since Fannie and Freddie themselves are solvent although some lingering market fears may cause a slight discount to liquidation value to occur.

As with other preferred stocks and income investments, preferred stock series with a higher yield would trade at a higher multiple to liquidation than lower yielding series.

Although I own the common stock and not the preferred stock of Fannie Mae and Freddie Mac, I understand the possibility of significant upside, coupled with major risks, to owning the preferred.

With the liquidation value defined, the preferred stock has a fairly well established upper value. Additionally, if the GSEs can begin returning profits to private investors, the preferred stocks should begin paying the dividends defined in their prospectuses.

The fate of the preferred stockholders is largely correlated with that of the common stockholders but the preferred stockholders do have two key advantages in a liquidation or wind down.

One is that they are ahead of the common stockholders in line for payment. This means anything left over from a wind down or liquidation, after the government's stake is repaid, will go to the preferred stockholders.

The second advantage is that the liquidation value clearly defines what the preferred stock should receive.

So if the GSEs have been dismantled by the time of a final ruling in favor of the plaintiffs, it would be easier for the court to determine what value the preferred stockholders should receive while the common shareholder value would require other formulas to be used leaving it more up in the air.

While upside of 100% to 200% is still very good, the common stock still has greater potential upside. This is because preferred stockholders are only entitled to liquidation value plus dividends while the common stockholders can share the remainder of the profits which, in the case of Fannie and Freddie, are quite large.

The bottom line
Preferred stock is generally seen as a safer income investment but Fannie Mae and Freddie Mac preferred stock is far from a safe income investment. Although it's still a lower risk investment than the common stock, the preferred stock currently has no dividend and its investors are relying on favorable legal or political developments to see any value at all.

If you do choose to go with the preferred stock, you'd be in good company. Bruce Berkowitz's Fairholme Funds owns preferred and common stock and Perry Capital owns the preferred stock as well.

There are also many series of preferreds at both Fannie and Freddie and each has its own liquidation value, yield, and daily trading volume. If you are considering the preferred stock, it is definitely worth the time to go through and pick out the series that best fits with your investment strategy.

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This article is part of a series of articles that looks at Fannie Mae and Freddie Mac from an investment perspective. To read the full analysis, click here.

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Alexander MacLennan

Alexander MacLennan is a Fool contributor covering Industrials, Airlines, and Financial companies. He is always ready for a good growth or turnaround story and tries to find them before the market does.

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9/4/2015 3:59 PM
FMCC $2.20 Down -0.06 -2.65%
Freddie Mac CAPS Rating: **
FNMA $2.31 Down -0.05 -2.12%
Fannie Mae CAPS Rating: **