Blessed by the Potato

Freddie Mac is one of the most ridiculous names I’ve ever heard for a business…

Stupid name aside, Freddie Mac is a Frankensteinian monstrosity of a company. Its main business is securitizing mortgages in the US: they buy a bunch of mortgages from banks, package them all together, then sell the bonds. The idea is that by buying the mortgages from the bank, the bank’s money will be freed up to make yet more mortgages, making it easier for Americans to buy homes. The investors in the bonds/mortgage securities get something reasonably safe to invest in — what are the odds everyone would default on their mortgage at the same time? — at a better rate than a government bond.

Of course, securitization is now a dirty word, because these sorts of schemes blew up so badly when subprime loans got into the mix. In Freddie Mac’s case, they made money by charging for insurance on these mortgage bundles, and they took on the credit risk. Things aren’t quite all that bad though since they didn’t get into the really nasty subprime dreck — for the most part, Freddie stuck to “conforming loans”. Nonetheless, Freddie got into some serious trouble last year as the housing and financial markets plummeted, and the US government took over, injecting capital at a cost of 10% per year (and that capital injection was larger than all the capital they had before — common and preferred equity — so that large dividend to the government is quite punitive).

John Hempton at Bronte Capital had a very long, very detailed, and — surprisingly — very interesting series on Freddie Mac, looking into their numbers, and suggesting that they were not totally worthless. If there is some value left in the company, then the preferred shares in particular should be worth something. I thought it was a very intriguing investment idea, but I didn’t have the time (or I fear, the ability) to reproduce his very thorough analysis (and importantly, to see where it might fail). I suspect not co-incidentally, the various preferred shares of Freddie jumped by about 40% after John published his analysis.

This week however, another analyst has stated that Freddie Mac is completely worthless, and the preferreds have fallen something like 25-30% in the last two days, which might make them worth looking at.

There are a number of different “series” of preferreds, designated by letters. The Z-series was the one issued most recently, and carries a variable interest rate of at least ~8%, and it’s also one of the most liquid. It has a face value of $25, and matures December 2012, or every 5 years thereafter — the option to redeem it is at the company’s discretion, not the investor’s. So, what that means is that this preferred share should fetch $2 in dividends every year, if the company is able and willing to pay them, and should be redeemed for $25 if the company is worth anything at all at some point in the future (or some fractional value thereof if the company is liquidated but has some value after the debt holders are paid). The dividends, right now, are not being paid. If the company, as the recent analyst says, is worthless, then these too are worthless.

However, if Freddie Mac does manage to turn itself around and pay the government back (and the government has to be paid first, even before the bondholders if my understanding is correct), and starts making a profit again, then a single dividend payment on these preferred shares would make you whole — indeed, provide you with a fairly decent return, even if that single dividend is a few years in the making. If the preferreds are redeemed for face value, then that would be a 20X return (times, not percent, since these are trading at about $1.25 today), though the timescale is unknown (they probably wouldn’t be redeemed at the 2012 maturity, but possibly at 2017). The first post in the series of Bronte Capital’s analysis his here — I recommend giving it a read even if you don’t plan on investing gambling on Freddie.

The payoff is huge, but of course the risk is also large. In particular, there’s the political risk of the US government not allowing Freddie Mac to continue as a going concern, and that political risk can come from the legislative side, or the treasury side (in having to support a $50B capital injection at 10%, or in being forced to reduce the size of their mortgage book). While I enjoyed John Hempton’s analysis, and I get what he’s saying that the worst of the losses are already accounted for, the other point of view has evidence too: Freddie currently has negative equity, and has to pay more than its net income in dividends to the government (but, not more than it’s pre-tax pre-provision income). With that punitive bailout, they might never be worth anything. But if they can repay the government, they do look to be generally profitable (at least on their core mission of insuring traditional mortgages), and could eventually be worth something someday. After all, the dividends owed to the preferred shares (if they are ever reinstated) are substantially lower than the interest they currently have to pay the government — so if they can get the government repayment off their back, the preferred shares should be worth substantially more than they are now. If they can’t… well, they’d be worth nothing. There doesn’t look to be a lot of middle ground.

If you do decide to invest into it — and I honestly can’t recommend it to anyone — then be sure to consider that money gone until 2017 at the earliest, and remember that this is a case where only investing what you can afford to lose definitely applies!

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