A Purchase of Fannie Mae and Freddie Mac's Common Stock is Speculation, Not Investing

Fannie Mae's and Freddie Mac's common stock continue to be of extremely high risk and are essentially a bet, that the companies will be returned to shareholders.

Jul 21, 2014 at 9:44AM
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Fannie Mae (NASDAQOTCBB:FNMA) and Freddie Mac (NASDAQOTCBB:FMCC) shareholders continue to face massive uncertainty with respect to the underlying values of the common stocks of these two companies.

Buying the common stock of the two government-sponsored enterprises is a speculation on Washington's inaction with respect to fundamental reform of the U.S. housing finance market. In addition, investors bet that U.S. courts will overturn the net sweep agreement and strengthen shareholder rights.

Difference between investing and speculating
There is a vast difference between being an investor and being a speculator. Investors do their research and are pretty much backed up by solid fundamentals relating to an investment target's business or industry.

Speculators, on the other hand, often bet on a price movement, either short-term or prolonged, which is expected to be precipitated by some projected catalyst. Buying the government-sponsored enterprises Fannie Mae and Freddie Mac, most notably their common stocks, certainly should be classified as a speculative action, not as an investment based on financial due diligence.

The outcome of a long position in Fannie Mae and Freddie Mac largely hinges on the courts and the inability of both political parties to reach a compromise about housing finance market reform.

Background
After the government-sponsored enterprises ran into serious solvency issues during the financial crisis, Fannie Mae and Freddie Mac were placed into conservatorship of its immediate regulator, the Federal Housing Finance Agency, or FHFA.

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Ultimately, because of extremely high mortgage losses, which threatened to push the two companies into bankruptcy, both GSEs received a capital infusion of $187 billion from the Treasury.

As a result, a 'net sweep agreement' was put in place, which requires both companies to transfer all of their (prospective) earnings to the Treasury.

The most important characteristic of the net sweep: The dividends swept over by Fannie Mae and Freddie Mac aren't applied against the bailout balance. In other words, though the GSEs keep on paying an ever increasing stream of dollars to the Treasury, the companies, technically, have not repaid their bailout funds.

High-profile investors involved
Some investors, most notably, Perry Capital, filed suit against the net sweep agreement and many investors including Bill Ackman from Pershing Square Capital Management, Bruce Berkowitz, Morningstar's mutual fund manager of the decade from Fairholme Funds and Carl Icahn from Icahn Enterprises have initiated contrarian, high-risk equity positions in the common stocks of Fannie Mae and Freddie Mac.

As you can imagine, investors easily got fired up by the involvement of highly successful investors -- many with extremely appealing activist records.

The common stock, said to be worthless because of the net sweep, kept soaring throughout much of 2013 and the first quarter 2014 until a Senate Banking Committee made its best effort yet in March of 2014 to wind down Fannie Mae and Freddie Mac.

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Though the Johnson-Crapo bill, which aimed at reducing the role of the government-sponsored enterprises in the mortgage finance market, was largely expected to not have any chances at all to succeed, the discussion of the bill and vote on it in the Senate Banking Committee forcefully injected volatility into the common stock of the two GSEs.

Expect high volatility going forward
After some volatile trading days and investors coming to terms with the fact, that the Johnson-Crapo reform bill will go nowhere, shares of Fannie Mae and Freddie Mac have found a bottom around the $4 mark, while both common stocks eagerly wait for new impulses.

Just last week, Fairholme Funds achieved a minor victory in court as Judge Margaret Sweeney in the U.S. Court of Federal Claims sided with Bruce Berkowitz and ruled that the discovery process in Fairholme Funds' suit against the government could proceed.

The news was responsible for sending shares of Fannie Mae and Freddie Mac up 9% and 10% respectively, indicating just how volatile an 'investment' in the GSEs can be. Investors should continue to expect high volatility in either stock going forward.

The Foolish Bottom Line
The purchase of Fannie Mae's and Freddie Mac's common stock is a high-risk bet that reform attempts of the mortgage finance market will be unsuccessful in an election year as well as beyond 2014.

Further, investors bet, that the courts will side with shareholders and overturn the net sweep.

There is an important distinction to be made between investing and speculating. If you buy the common stock of the two GSEs, you are speculating and you should only allocate a small amount of your funds to such a risky bet.

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