3 Potential Fannie Mae and Freddie Mac Multibaggers

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Investors in Fannie Mae (FNMA -4.76%) and Freddie Mac (FMCC -4.41%) are already well aware of the risk reward scenario surrounding the future of the GSEs. But different investors have picked different ways to play Fannie and Freddie with each having their own risk reward profile. Here I'll look at two widely known Fannie and Freddie investments and one you may never had heard of.

Maximum reward
Just a few years ago, shares of Fannie and Freddie traded around 30 cents per share but have since risen over ten fold. As the GSEs have returned to profit, and then to massive profit, speculation began that the GSEs could be freed from government control and give their new earnings power to private shareholders.

At this point, common shareholders have no power with the annual shareholder meetings cancelled, and have no share of the profits following the Sweep Amendment. With warrants to acquire 79.9% of both GSEs, the government could exercise its warrants and take a majority stake for a minimal cost.

Until recently, common shares of the GSEs have mostly been left alone by hedge fund investors. Bill Ackman changed this last year when his fund, Pershing Square, acquired nearly 10% of the publicly traded shares of each GSE. More recently, Ackman found a way to effectively increase his exposure beyond 11% in each GSE by taking out a deal with a counterparty.

Trading at around $3.80 per share, Fannie and Freddie common shares have the potential to increase ten times in value based on the estimates from Bill Ackman. In a previous article analyzing the potential for these shares, I reached a similar estimate in the $30 to $40 per share range.

Preferred stock
Even though Fannie and Freddie have returned to profitability, the dividends on the junior preferred stock (the non-government owned preferred stock) remain suspended. With no maturity date and no dividend, the GSE preferreds are speculation on the government loosening its grip on Fannie and Freddie.

Fannie and Freddie preferreds have attracted a lot of hedge fund buyers including Bruce Berkowitz, manager of Fairholme Funds, and Richard Perry, manager of Perry Capital. Both hedge funds have since filed lawsuits against the U.S. government challenging the legality of the Sweep Amendment.

Although Fannie and Freddie each have several series of preferred stock, they share similar characteristics. With liquidation value of $25 or $50, most series trade in the range of 30 to 40 cents on the dollar. If the GSEs are freed from government control and allowed to distribute profits to private investors, the preferred shares could increase to liquidation value making for a tripling of your investment.

The big preferred
While most series of Fannie and Freddie preferreds have a liquidation value of $25 or $50, one series is a major exception. Fannie Mae 5.375% 2004-1 Preferred Stock (NASDAQOTH: FNMFO) carries a few interesting characteristics for its investors.

First of all, this series has a liquidation value of $100,000 per share and has a last price of $32,750. FNMFO is also very low volume so it could take some waiting to get a reasonable buy order through. But for investors with patience and willing to make a large investment in Fannie Mae, FNMFO two features that create the potential for greater upside.

First of all, the liquidation value is $100,000 but Fannie Mae has to pay $105,000 to redeem the series if it chooses to do so. FNMFO is also the only series of Fannie and Freddie preferred stock that is convertible to common stock. At the holder's option, FNMFO can be converted into 1060.3329 shares of Fannie Mae common stock. To get $100,000 in value from FNMFO in the form of common shares, common shares would have to be at $94.31.

Although rising from $3.80 to $94.31 seems like a tall order now, it could happen under a certain set of circumstances. To see any major increase in the value of common shares, the government will need to release Fannie Mae and allow private investors their share of the profits.

The $30 to $40 per share estimate for the common stock takes into account the dilutive effect of the government's near 80% warrant stake.

However, some lawsuits against the government claim that the warrants were illegally taken during the bailout. If the warrants were to be nullified, it would eliminate the dilutive effect from the government stake allowing common shares to rise significantly higher possibly above the conversion price. Although nullifying the warrants poses an even greater challenge than ending the Sweep Amendment, it could still be possible and FNMFO offers preferred stock investors additional upside if this scenario were to play out.

GSE investments
Fannie and Freddie are some of the most binary return investments in the market today. While the common stock carries the greatest risk by being last in line among stakeholders, it also appears to have the greatest potential reward. The preferred stock also offers multibagger potential if the GSEs can begin paying dividends again.

For those willing to make a large investment, Fannie Mae 2004-1 Preferred Stock brings both the stakeholder position of preferred stock and some even more upside if the GSEs can return to private investors and the government warrant stake is deemed void.