Pros and Cons Of a GSE Play

We usually like to wait until the ship sinks to the ocean floor before offering distress plays, but we jumped the gun a few weeks ago with a speculative recommendation on Fannie and Freddie preferreds. Our gut feeling is that, come hell or high water, the guvvamint isn’t about to let the GSEs sink into oblivion. So far, so good. We asked our friend Zane Binder, erstwhile car reviewer and armchair portfolio expert, for his take. He sees a play in these issues, albeit a speculative one, and writes as follows:

‘Few can see the future, but Fannie Mae and Freddie Mac, the government sponsored mortgage enterprises (GSEs) trapped in subprime Hell as surely as if glued to flypaper, can’t see their own past. Together these GSEs own or control more than half the nation’s mortgages. Worse, both have issued releases questioning their own past financial statements. Standard and Poor’s recently put the preferred stock and subordinated debt of the two giants on credit watch, which loosely means there’s a 50 percent chance their circa ‘A’ credit ratings might be history within three months. Does their situation offer opportunities for bears, bulls or both? Possibly, especially considering their common stock dividends will almost certainly vanish in the near future.

Consider the following:

– Neither GSE apparently offers cumulative preferred stock, meaning if they decide not to pay a preferred dividend it doesn’t sit as booked debt to be paid later. A missed preferred dividend is just that: missed, forever.

– Some of the GSE preferreds are variable-rate. Much is tied to the London Interbank Rate and, additionally, the moon’s phases. Few can decipher what the GSE’s accountants have wrought.

– Many GSE preferreds can be redeemed at a fixed price, presently an extremely attractive figure, should Freddie or Fannie so desire. There’s not one chance in 1,000 of this happening now but …

– The government has changed its implicit backing of Freddie and Fannie to ironclad explicit, meaning the GSE’s won’t ever be allowed to fail.

– Many GSE preferreds pay 10+ percent. There’s an excellent chance the subprime debacle’s demise will see these issues climb to reflect prevailing interest rates. This could mean enormous profits. Unfortunately, no one knows when, or if, this will occur.

– Market volatility among the usually staid financials and banks is fearsome. On many days, the preferreds (and commons) of the GSEs move a point or more in either direction. This means opportunity for both bulls and bears, if they have the stomach and bankroll.

– Check Fannie and Freddie’s options if you’re really stout-hearted.

‘If bullish, you might eye the Fannie Mae (FNMpH) 5.81 percent ‘H’ series preferreds. If bearish, a short position or puts may be your path to a sumptuous Hamptons home.

‘No matter which direction you favor you could be correct. Visit Fannie and Freddie on the web and research the numerous preferreds each offers. You’ve at least 37 choices, each with slightly differing terms. You’ll need to be an accountant with a magnifying glass to decipher each one’s pros and cons. Be sure enough shares are outstanding ‘ at least three million ‘ to assure market liquidity. Whether you win or lose a GSE bet, and that’s close to what it would be, you might need to move quickly!’ To contact Zane via e-mail, click here and we’ll forward your message to him.