Opinion

Felix Salmon

The Frannie gamble

By Felix Salmon
May 29, 2013

fnma.tiff

This is a three-year chart of Fannie Mae’s common stock, which fell almost 30% today; it’s now at a level not seen since Friday afternoon. You can think of this as shares “getting destroyed” if you want — but really what we’re seeing here is little more than a game of chicken between traders who find it easier to day-trade from their desks than to jet to the 32nd floor of the Galaxy Macau casino for the weekend.

Every so often the financial markets throw up a security which doesn’t make any sense from an intrinsic-value perspective but which traders love to trade anyway. A large amount of cocktail chatter than springs up around the question of whether this is all just a game, where traders try to second-guess each others’ moves, or whether there might actually be some value buried in there somewhere.

Examples are easy to find: AIG stock circa January 2010, for instance, or credit default swaps on the USA a year earlier. For people who have internalized the efficient markets hypothesis, the fact that such things have value means that there has to be a credible story explaining where that value might lie. And sometimes there is: AIG is now a genuinely valuable company, and shares which were trading at a silly $29 in January 2010 are now trading at a pretty sensible $45.

The Frannie trade is interesting because it’s basically a bet on the US government taking pity on various different classes of shareholder. The common stock is pure gamble, but there’s real money being invested in the preferred stock, which is being held by the likes of John Paulson and Jim Millstein, the man who managed to unlock the value in AIG. Millstein explained the bull case to Nick Timiraos:

At some point over the next year, “the government is going to get all of its money back. So the questions for the government are what will, and what can, they do with the excess?” said Mr. Millstein.

Fannie and Freddie, which took around $188 billion from the U.S., will have paid the government about $132 billion in dividends by next month. Investors betting on the preferred shares are taking heart in those improved fortunes.

The problem is that while the government might well get its money back, in nominal terms, from Fannie and Freddie, the $188 billion in debt is still outstanding: the $132 billion in dividends has not paid down a penny of the debt. Since the debt is first in line for any payout from the companies, there’s no particular reason to believe that the preferred stockholders, who are next in line, or the equity holders, who are even more junior, are ever going to see any money at all. The government can keep on dividending out as much money as it likes from Frannie, and still hold onto 188 billion reasons why no one else should ever get anything.

Of course, if the government wanted to recapitalize Frannie and give the companies back to their current shareholders, it always could. But that doesn’t seem likely — especially given how fiscally conscious most of Congress is, these days. And certainly there’s been nothing in recent weeks to justify the massive run-up in the prices of the preferred and the common shares. Rather, what we’re seeing is textbook speculation: people buying shares just because they think a greater fool will be willing to jump onto the momentum trade in the future. If you time it well, you can make a lot of money with that strategy.

There’s another trade here, too, though, which is more distasteful. Timiraos reports that “small investors also have begun to pile in” to Frannie preferreds, and I can’t help but think that they’re doing so for much the same reason that their counterparts a few years ago invested with Bernie Madoff. Back then, it was thought that Madoff was managing to front-run the market, and that his investors were reaping the benefit; now, it is thought that well-connected Washington types like Millstein have inside information about what the government is going to do, and/or are likely to influence the outcome, and that the smart trade is to just follow the insider money.

But that trade — following the smart money — almost never works for retail investors, since the smart money never advertises its exits. If you were lucky enough to be in on this trade a few weeks ago, then you’re sitting on a very nice profit right now. But my guess is that it’s over now, and that if the stock has peaked, the Frannie preferreds aren’t going to stay at their current elevated levels much longer.

Comments
3 comments so far | RSS Comments RSS

” The government can keep on dividending out as much money as it likes from Frannie, and still hold onto 188 billion reasons why no one else should ever get anything.”

Well that’s the government’s position. It’s interesting that the government never used the bankruptcy process with the GSE’s the way they did with GM. They never pushed the exchanges to delist the stock.

To be honest the preferred looks like a pretty good bet to me. I hold no position and don’t intend to hold a position but the government doesn’t want this in the courts.

I think as soon as the government gets their money back they will abandon the existing GSE’s and just start a new agency under a different name which performs the same function. They could probably even house it all within the Federal Reserve and have the government keep the full spread the way they do with student loans.

Posted by y2kurtus | Report as abusive
 

@y2kurtus wrote: “It’s interesting that the government never used the bankruptcy process with the GSE’s the way they did with GM.”

Isn’t that because of the “officially denied, implicitly believed, then semi-explicit” status of the GSE’s debt as backed by the full faith and credit of the United States Government?

A GM bond default was viewed as MUCH different than a Frannie bond default, by the markets and by the Fed.

And I seem to recall that China had about a trillion dollars in Frannie debt in 2008, so the Fed certainly had some pressure to find a non-bankruptcy solution to Frannie’s situation (I have vague memories of reading that the USG even explicitly promising to China that their Frannie holdings were safe).

“abandon the existing GSE’s and just start a new agency under a different name which performs the same function.”

From reporting, it sure seems that the current Congress, both sides, are very interested in winding down the government’s almost-exclusive role in housing finance. A new agency will be created, to be sure, but with strong mandates that will try to limit its market share. Frannie will be wound down, hopefully killed and carved up to form the core of the new entity, but perhaps re-privatized with a clear understanding that it is now truly and completely private with no possibility of government backstopping any new debt.

Posted by SteveHamlin | Report as abusive
 

The run-up in the common this week was pure momentum players. It had to end badly.

- IF – there is any value in the Agencies, it will be in the pref, not the common. The end result would have to be a conversion of the pref to new common. That would dilute the existing common shares by 5Xs.

Felix points to the Fannie S pref. A better benchmark is the Fannie T, last at $8.

Posted by Krasting | Report as abusive
 

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