Buying Fannie Mae and Freddie Mac Preferred Shares Isn't Investing - It's Gambling

Even though preferred shares are technically superior to common stock, in this case investors are likely to get wiped out with either variety

Jun 17, 2014 at 6:00AM

Fannie Mae (NASDAQOTCBB:FNMA) and Freddie Mac (NASDAQOTCBB:FMCC) are two of the most interesting stocks in the market right now.

Both companies have become profitable again, and shares are up more than tenfold over the past year and a half, despite the lingering threat of dissolving both agencies and leaving shareholders with nothing.

Aside from the common stocks, which get most of the media attention, the preferred shares of both companies are also trading at deep discounts to their par value. Generally, preferred stocks are a much safer and predictable form of investment than common shares, but in this case it may be just as much of a gamble.

How the preferred shares work
According to Fannie Mae and Freddie Mac's websites, there are many different varieties of preferred stock to choose from. In fact, there are a total of 33 different series of preferred stock between the two agencies.

The various types of preferred shares have either a $25 or $50 par value (original cost and theoretical redemption price) and have coupon, or interest rates ranging from 5% to 8.25% of the par value. For a full list, check Fannie and Freddie's stock information pages.

Well, because the preferred shares are not currently making interest payments as a result of the government bailout, the shares are trading at a deep discount to par value.

For instance, the Fannie Mae "Series T" preferred shares, which trade under the ticker symbol FNMAT, have an 8.25% interest rate and a par value of $25. However, the shares currently trade for just $12.80, a discount of nearly 50%, but an impressive price considering they dipped as low as $0.15 per share after the bailout.

So, if the government were to allow interest payments to resume, investors who buy in now could see 16% interest on their investments. Before that happens, shareholders have an uphill battle ahead of them.

Why are they not paying, and will they ever pay again?
As a condition of the bailout, Fannie and Freddie issued $117 billion in "senior" preferred stock to the Treasury, and all other series of preferred stock became "junior preferred", which are subordinate. Under the current agreement, 100% of the profits of Fannie and Freddie go straight into the Treasury's pockets.

Holders of the junior preferred stock are certainly taking a gamble, but a group of deep-pocketed hedge fund managers are making big bets for a payday. Now that both companies are profitable, shareholders are suing the government, claiming they are unjustly taking an excess of funds that should belong to the preferred shareholders.

The junior preferred shares have a collective face value of about $35 billion, and the primary aim of the lawsuits is to get a full payout on the shares. The bailout of Fannie and Freddie cost taxpayers $188 billion, and since the companies have returned more than $200 billion to the Treasury already, it's easy to see why shareholders feel they should be made whole on the par value of their investments.

Not worth the gamble
If the lawsuit works out in the favor of investors, the junior preferred holders could see their investments double or triple, depending on the particular series of stock they own. Still, it seems like too much of a gamble to be worth it.

Returning any capital to investors is certain to be a very unpopular idea with the American taxpaying public, and the FHFA assumed all powers and rights of the old shareholders when they were named conservator of the agencies.

There is definitely a case to be made for shareholders, and the lawsuits do raise some very valid points. For example, if the government was planning to wipe out common and preferred shareholders, why did they allow shares to continue to trade on the exchanges?

Regardless of the outcome, it seems like a silly risk to take on, especially considering the gains in share price so far. Buying Fannie and Freddie's preferred shares is definitely a "double or nothing" type of investment, and those rarely work out favorably.

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Matthew Frankel 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.

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