Why Did Carl Icahn Buy Into Fannie Mae and Freddie Mac?

Joining the ranks of hedge fund managers Bruce Berkowitz and Bill Ackman, activist investor Carl Icahn has bought a $50 million stake in Fannie Mae (NASDAQOTCBB: FNMA  ) and Freddie Mac (NASDAQOTCBB: FMCC  ) .

While it's definitely exciting to see what companies the "whales" are jumping into, it's always important to take a closer look to see if it makes sense for you before considering it for your own portfolio. Why did Icahn jump in and what's his goal here? And what can you learn from it?

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Berkowitz hedges, Icahn gambles
In mid-May, it was announced that Berkowitz's Fairholme Capital had cut its stake in Fannie and Freddie, and we just recently discovered that Icahn was the buyer.  Fairholme sold 6.8 million shares of Fannie (exactly how many Icahn bought) and 2.2 million shares of Freddie in the first quarter, bringing its total stake down to 19.2 million shares of Fannie and 17.2 million of Freddie.

Berkowitz's reasons for doing this are not too tough to figure out. First, by selling the shares, he's locking in gains. The share price of both companies has more than doubled since Berkowitz bought in, and even though he seems reasonably confident in the future profitability of both investments, there's nothing wrong with taking some profits on the table.

Icahn, on the other hand, is more than likely looking at this as a speculative investment and nothing more. A $50 million stake is small potatoes for Icahn, whose investments typically are in the billions, like his stakes in Apple and Herbalife. So, Icahn is probably looking at Fannie and Freddie as a potential home run, and is probably willing to throw his weight around a little to help the cause, but is not willing to risk too much of his money.

Could be a ten-bagger, but could be nothing...
There is a lot that could potentially go wrong with this investment. Under the current arrangement, all profits earned by Fannie and Freddie go directly to the U.S. Treasury. There is currently a shareholder lawsuit led by Ackman and Berkowitz, alleging that investors were "duped" by the government who allowed shares to continue to trade even though they had no intention of letting investors share in the profits. Now that Icahn, one of the most "visible" investors is in the picture, you can bet he'll have something to add.

Additionally, there are continuing efforts in the U.S. Senate Banking Committee to dismantle both companies, which would effectively leave shareholders with nothing. As written, the current bill would wind down Fannie and Freddie and give all proceeds from the asset sales to the Treasury. Not surprisingly, shareholders aren't too happy about this one either.

So, there really is no grey area when investing in Fannie and Freddie. The stocks could indeed rise dramatically if a new profit-sharing arrangement is agreed upon, either as a result of the lawsuit or otherwise. Ackman has said that shares of Fannie Mae could be worth $47 each if the profits were shared equitably, and that figure takes into account the dilution caused by the bailouts.

On the other hand, if the lawsuit or congressional action doesn't work out in favor of the shareholders, the stocks could become worthless. So, with some good fortune, Icahn's stake could be worth half a billion dollars, but it could be worth next to nothing just as easily. You can be sure Icahn is well aware of this fact, and looks at this as a calculated risk.

Care to speculate?
While I think a new investment in Fannie or Freddie is much too risky considering all that is going on, if you decide to jump in, approach the situation much like Carl Icahn is. If you normally invest $10,000 in a new position, maybe $500 worth of Fannie or Freddie wouldn't be a bad speculative play, as long as you understand that big payday you're going after is hardly a certainty. Additionally, the stock isn't as liquid as others so be careful.

Still, if you take a lesson from Icahn here about good portfolio allocation and the right way to speculate, there's nothing wrong with taking a small, calculated chance on a potential home-run. Just be prepared and willing to accept the consequences if things don't work out in your favor.

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