Why I Bought Shares of Fannie Mae and Freddie Mac

This article is part of a series of articles that looks at Fannie Mae  and Freddie Mac  from an investment perspective. To read the full analysis, click here.

Until solid profits started to show at Fannie and Freddie, the common stock was priced for liquidation trading at around $0.30.

But even as the profits started to appear, big investors like Fairholme Funds and Perry Capital purchased the preferred stock.

It was only late last year that the common stock received major interest from a major investor when Bill Ackman bought nearly 10% of the outstanding shares of each GSE.

The potential
Trading in the $4 range, shares of Fannie and Freddie have a lot of potential upside if the net worth sweep of the GSEs was removed.

In a recent presentation, Ackman gives long-term values of $23 to $47 to shares of Fannie and Freddie. In his calculations, Ackman factors in the exercise of the Treasury's 79.9% warrant stake and the dilution that would come along with it.

Ackman argues the GSEs have long-term earnings power of around $11 billion for Fannie Mae and $6 billion for Freddie Mac. These calculations are done at current fee levels and assume a 35% tax rate.

Although these estimates are lower than what Fannie and Freddie reported in 2013, last year's earnings were helped by one time events such as the recognition of deferred tax assets and legal settlements with major banks. Because of this, investors should not expect a repeat of the 2013 level of earnings.

In translating the earnings to a share price estimate, Ackman uses a price to earnings level of 14 times at the low end and 16 times at the high end, both levels being in line with the broader market.

As an owner of the common stock, it would make sense that Ackman would hold a bullish stance on the GSE shares. While his estimates are generally reasonable, they should still be considered the bull case for the common stock.

The risks
No analysis of Fannie and Freddie common stock would be complete without discussing the risks.

Of course the biggest risk is that the plaintiffs lose their lawsuits and the net worth sweep continues. If the sweep is given the legal go-ahead, the common stock would be worth essentially nothing as it would receive none of the profits and be last in line to receive any assets.

Additionally, if the plaintiffs lose their case and the GSEs are wound down, the common shareholders are last in line to receive proceeds. Due to the large amount of government owned senior preferred stock and concerns that even the junior preferred stock will take a hit, there is little chance for common shareholders to see any return in a liquidation scenario.

But even with the net worth sweep gone, other risks do remain. Ackman estimates the GSEs can repay the Treasury in three years if the net worth sweep is undone and the old 10% dividend rate reestablished. He also estimates that Fannie and Freddie can rebuild necessary capital in 7 years by retaining earnings.

However, the government may want its money back faster or may pressure the GSEs to raise necessary capital sooner.

Either of these events may result in the conversion of the remaining senior preferred stock stake (which would be around $60 billion using the old 10% agreement) into common shares similar to what the Treasury did with its preferred stock stake in Citigroup.

The conversion of the Citigroup stake temporarily flooded the market with new shares and resulted in significant share dilution. This caused Citigroup common shares to actually drop even as the government exited its stake in the bank.

While such a conversion would cause dilution to Fannie and Freddie shares, ending the net worth sweep should more than make up for this dilution.

However, any dilution that occurs would likely lower the value of Fannie and Freddie shares from Ackman's $23 to $47 bullish estimate.

High risk, high potential reward
After researching Fannie Mae and Freddie Mac, I have established positions in the common shares of each based upon the significant upside potential and the reasonable chance of the plaintiffs winning their lawsuits to end the net worth sweep.

Significant legal, political, and economic risks do remain so this is definitely not an investment for conservative investors.

But for those willing to assume a large amount of risk for large potential returns, I believe Fannie Mae and Freddie Mac are some of the best investments on the market today.

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This article is part of a series of articles that looks at Fannie Mae and Freddie Mac from an investment perspective. To read the full analysis, click here.

The article Why I Bought Shares of Fannie Mae and Freddie Mac originally appeared on Fool.com.

Alexander MacLennan owns common shares of Fannie Mae and 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 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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