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Archive for August 18th, 2008

A Way to Make Money Off of Fannie and Freddie

Monday, August 18th, 2008

Things look grim for Fannie and Freddie, if market reaction is the benchmark.  The action in their stocks, preferred stocks, and subordinated debt was ugly on Monday.  Not only did you have the article in Barron’s, which made the case that the equity of the firms wasn’t worth much, but you had selling of their senior debt, and guaranteed MBS by foreign investors.  It may not be that Fannie and Freddie fail, but that they get recapitalized by the government in a way that massively dilutes the equity.  Or, going back to my old idea, they get nationalized and become part of GNMA.  The equity and preferred stock go out worthless, and the subordinated debt gets some sort of haircut (partial conversion to senior, plus an earn-out based off the losses the the government has to bear).  I’m not sure a bailout is inevitable, but the odds are rising.

Now, Fannie and Freddie have been through a lot in the last three weeks.  Freddie has changed servicer guidelines possibly in an effort to forestall current period losses.  They have also both reported huge losses:

Freddie:

Fannie:

Then there is the insult added to injury, as S&P downgrades the preferred stock and subordinated debt.

So, after all of this, we should steer clear of the securities of Fannie and Freddie?  Steer clear of the common and preferred stocks, yes.  Subordinated debt, I’m not sure, but when I’m not sure, I don’t take positions.

Now, the senior debt is another matter.  Spreads are very wide, and the possibility of nationalization is significant.  As Accrued Interest says:

The trade is to be long senior Agency debt. There is just no way the Treasury allows anything to happen to senior debt holders. I don’t know who is playing in sub notes or preferred shares in here. No amount of investment analysis is going to help you figure what the Treasury’s next move is.

I agree, and when I was a bond manager with a good thesis, I would ask which bonds offered me the best advantage.  This article ends with an idea that is practical to some institutional fixed income managers.  Both Fannie and Freddie have a small amount of long non-callable zero coupon bonds.  These bonds will have a significant rally in the case where the US government nationalizes them.  And, if the US government decides to let them slip into default, well, you are buying them at 20-35 cents on par value.  No way in an insolvency you get less than that.

The worst case scenario is that long interest rates rise generally, and the zero coupon bonds get killed.  Sophisticated managers could sell short Treasury zeroes to hedge.

PS — Now, as I wrote this, the estimable Jeff Miller put up a good post on the GSEs.  It is worth a read.

UPDATE — 11 AM 8/19

Manto’s comment below is correct, and I apologize.  Bonds originally issued as discount bonds have bankruptcy claims equal to their accreted value.  Bonds issued at par, that subsequently become discount bonds have a claim value of par.  Why did I make this mistake?  I improperly generalized from my experience trading discount bonds, and other structures (such as zero-to-full bonds created from bonds originally offered at par) where the claim would be par in bankruptcy.

Disclaimer


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


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