The Fannie and Freddie Anomaly

Can anyone explain the stock prices of Fannie Mae and Freddie Mac, the two government-sponsored enterprises that are supporting our mortgage market?

On Friday, Fannie’s common stock closed at $2.04 per share, up 250% since the start of August. That values the company–to be precise, the privately-owned common shares in the company–at more than $2 billion.

Freddie Mac’s common shares closed at $2.40 per share, up almost 300% since the start of August. That values Freddie’s privately-owned common shares at more than $1.5 billion.

Collectively, then, the common stock of these two wards of the state totals almost $4 billion.

This seems a trifle high, however, since most observers think their common stock is worthless (see, for example, this AP story).

I think those observers are right.

The government drove a hard bargain last fall when Hank Paulson fired his “bazooka” and put the two companies under federal conservatorship. Under the deal, the federal government received warrants to purchase 79.9% of the common stock of each company. That sounds like common shareholders face enormous dilution if the government exercises those warrants. And that’s true, except that the common shares won’t be worth anything anyway. The more important part of the deal requires the federal government to inject enough capital into each company (up to $200 billion a piece) to ensure that their net worth never falls below zero. In return, the government gets preferred stock paying a 10% dividend.

That preferred has to be covered before private investors can hope for any payback. And then common shareholders face another hurdle: both companies also have privately-owned preferred stock that again comes before the common in the pecking order.

Unfortunately for both sets of private investors, the government has already injected $85 billion into the two companies combined. The companies would have to cover all of that–plus almost $9 billion a year in dividends–before private investors can ever see a dime.

That would be bad enough, but it’s likely that both companies will have to draw down more government money in the future, deepening the hole in front of private investors.

And that’s not all. In early 2010, Fannie and Freddie will have to start paying new fees to the government in return for their government support. We don’t know yet how large those fees will be, but they will be yet another factor standing between common shareholders and any returns.

Investors would usually look to private sector analysts to evaluate these risks and decide how much (if anything) the common stock might eventually be worth. In this case, though, it’s also helpful to look at what various government agencies are saying. These agencies are not usually the go-to source for investment advice, but these are not normal times, and Fannie and Freddie are not normal companies:

• The Federal Housing Finance Agency, Fannie and Freddie’s conservator: A few weeks ago, the outgoing head of FHFA, Jim Lockhart, said that he expected taxpayers would end up losing money on their investment in Fannie and Freddie. In other words, the government preferred won’t be paid off in full.  If he’s right, there won’t be any money for the common shareholders or, for that matter, the owners of the private preferred.

• The Office of Management and Budget. In its newly-released budget projections, OMB forecasts that the government will end up investing $173 billion in the two companies by 2011 and will hold the same amount in 2019 (Table S-15). In other words, the companies will have a $173 billion hole to dig out of (more than twice as large as the hole thus far), and won’t make any progress in the next decade.

• The Congressional Budget Office: In its newly-released budget projections, CBO forecasts that the government will end up investing $162 billion in the two companies by 2013 (Table 1-1). (For more on the importance of FNM and FRE to the budget estimates, see this post.)

In short, the quants in Washington see a gaping hole at Fannie and Freddie, with significant risk that taxpayers don’t get repaid in full.

So why do investors think the common stocks have value? You’ve got me.

(For a counter view — largely focused, I think, on the idea that the private preferred may have value — check out the series of posts at Bronte Capital, starting with this one. His optimism is based on the assumption that Fannie and Freddie will continue holding large portfolios of mortgage securities and earning wide spreads on them; I find it hard to believe that will continue.)

P.S. This post reflects joint thinking with Phill Swagel, former Assistant Secretary of Treasury and current visiting professor at the McDonough School of Business at Georgetown (but all opinions and any errors are mine).

Disclosure: I do not have any positions, long or short, in any Fannie or Freddie securities. Also, a close relative once served as a board member of one of the companies, but that ended several years ago.