Powerball Investing: Fannie and Freddie

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Admit it: You've dreamed of winning the lottery at some point in your life. Everyone knows, or at least everyone should know, that the statistical odds are against lottery players since the lottery itself wants to see a profit. For the 174.999999 million out of 175 million of us who don't have that winning powerball ticket, there are alternative ways to play a market of chance where the odds are not necessarily rigged against you. For this edition of Powerball Investing, we will take a look at two stocks that were once, ironically, considered among the safest in the entire market: Government sponsored entities Fannie Mae and Freddie Mac .

Giant profits, giant losses, and giant profits again
Fannie and Freddie were once highly profitable Wall Street darlings that conservative investors were told to park their spare cash in. Banks loaded up on GSE preferred stock since it paid reasonable dividends, and after all, everyone said it was the safe thing to do. Everything was running along smoothly until the mortgage market began to collapse and the government stepped in to rescue Fannie and Freddie from financial catastrophe.

Fannie and Freddie were delisted from the NYSE, fell to around $0.30 per share, and lived up to the title of zombie stocks as they issued more and more preferred stock to the Treasury. But even a zombie isn't completely dead. When the GSEs began to post profits again (even though the Treasury was getting them all because of the Sweep amendment), Fannie and Freddie rose back into the $1 range. Now both GSEs are reporting several billion in profits per quarter, yet still trade in the $1 range on the over-the-counter exchange.

Investing in the living dead
Financial institutions met various outcomes throughout the crisis, and some shareholders saw immense profits from buying at the bottom, while others were wiped out completely. American International Group was one of the survivors providing seven-bagger returns for investors who bought at the bottom. Today, AIG has repaid its government loan (with over $20 billion in profit to the Treasury), launched major share buybacks, and even reinstated a tiny dividend. AIG investors from before the crash are almost certain to never see those pre-crash highs again thanks to massive share dilution, but these investors will get something, and the bottom-buying investors have already gotten a lot. The same cannot be said for every institution, though.

Lehman Brothers represents the opposite side of the financial turmoil. When Lehman collapsed, everyone was hurt, be it bondholders, preferred stockholders, or common stockholders. Stockholders are not expected to receive anything -- a common theme of corporate bankruptcy. 

But Fannie and Freddie exist in a kind of middle area. They are making billions in profits like AIG and received a bailout in a similar manner to AIG, but the stock has not recovered like AIG's. The GSEs are in this situation because of the Sweep amendment, which takes all of their profits (with the exception of those needed to maintain necessary capital levels) and transfers them to the Treasury. With none of the profits retained by the GSEs, both trade for a fraction of one quarter's profits.

High risk, high potential return
Shares of Fannie and Freddie would be worth quite a bit more than they are now if they were allowed to retain their profits. With the amount the GSEs are earning, it would only be a few years before they'd be able to completely repay the Treasury. Even after factoring in dilution from the Treasury's common stock warrants, Fannie and Freddie would be worth significantly more based on earnings alone. 

Of course, this can only happen if the Sweep amendment is repealed, and Congress wouldn't want to give up a cash cow. That is why legal action is necessary if the Sweep amendment is to be repealed and the GSEs freed from government ownership. The lawsuits have already been filed with such plaintiffs as Perry Capital and Bruce Berkowitz, the manager of the Fairholme Fund with large stakes in many financial institutions. 

By going long on Fannie Mae or Freddie Mac (preferred or common), investors are buying warrants on the results of these lawsuits. The strike price: the cost of the Fannie/Freddie shares. The expiration: when the lawsuits are finished. But there is another factor at play. Congress could pass legislation to wind down Fannie and Freddie before the lawsuits are finished. If this is done, getting value for shareholders will become a lot more difficult -- but not impossible. A court could conceivably order the government to retroactively compensate Fannie and Freddie shareholders even after the GSEs have been dissolved. It's less likely but, again, not impossible.

GSE Powerball
The trading of Fannie and Freddie shares is Wall Street speculation at its finest. A double-digit percentage swing on a no-news day is commonplace among these securities, with actual news causing sharp pops or drops. Despite being an example of speculation, Fannie and Freddie shares are a multi-year investment as we wait for court rulings on the legal cases at hand. Shares of the GSEs could very well wind up worthless, or they could yield more than 20-bagger returns. The potential for massive gains or complete losses? Sounds just like a lottery ticket.

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The article Powerball Investing: Fannie and Freddie originally appeared on Fool.com.

Alexander MacLennan owns common shares of Freddie Mac. This article is not an endorsement to buy or sell any security and does not constitute professional investment advice. Always do your own due diligence before buying or selling any security. The Motley Fool recommends American International Group. The Motley Fool owns shares of American International Group and has the following options: long January 2014 $25 calls on American International Group. 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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