Market Madness: Freddie Mac edition ($FRE)

by PlanMaestro

The bailout companies are back on the news and this time they are not at bottom of the pile. The appreciation of AIG, Citibank, Fannie Mae and Freddie Mac stock is leaving people scratching their heads. Were not these companies bankrupt?

I was of the same opinion until I read Bronte Capital’s in-depth analysis of Freddie Mac and could only say wow. He conservatively estimates that the government is only going to be $56 billion in the hole. Well, maybe only is not the right word but every pundit is talking of loses beyond our imagination while this order of magnitude is within this Frankenstein’s cash flow capability. It could well be alive.

To see why, a quick reminder of the equity structure of Freddie Mac at its $73 stock price high in December 31, 2004.

  • Preferred: $14.1 billion
  • Common Equity: $47.9 billion
  • Equity Value: 62 billion

And that begs the rhetorical question: would not be some value left for the preferred and common stock after all this ends? That sure would be a variant perception and a profit opportunity. Considering the obvious political uncertainty, where I have no particular insights, I decided to play some ketchup finance and see if at least the market was pricing these securities correctly on a relative basis.

In all the following scenarios I will suppose that the preferred stock eventually gets its dividend reestablished, so it trades at par. The reason is that the preferred is the fulcrum security after the subordinates were bailed out . The preferred unexpectedly is priced 6 cents on the dollar, so before the equity gets anything the preferred has to appreciate more than 16x (!). The following is a top down analysis to see if the common justifies its August 30 $2.4 price per share .

Scenario A: FM pays back the principal of the government senior preferred over five years, the equity stays at current prices over this period and the preferred is made whole (remember 16x performance)

  • Preferred: $14.1 billion
  • Common Equity: $1.6 billion
  • Government Warrants: $6.4 billion
  • Government Senior Preferred: $56 billion
  • Equity Value: $78.1 billion

Clearly it does not look reasonable: it is a much higher valuation than Freddie Mac’s peak and the performance is 16x the preferred versus 1x on the equity. There must be something else the market is expecting.

Scenario B: Let’s try to think a positive scenario for the common. Let’s say the government pardons the warrants but Freddie Mac still has to pay the senior preferred to keep receiving financial support from the federal government. That is huge handoff, no 80% dilution.

  • Preferred: $14.1 billion
  • Current Common Market Value: $1.6 billion
  • Government Senior Preferred: 56 billion
  • Equity Value: 71.7

That gives another above peak valuation and another substandard performance versus the preferred. Could the market be betting on a government pardon of the warrants and some more?

Scenario C: So let’s see what would be the scenario to justify the current disparity between common and preferred. A scenario where equity has the same 16x performance and we will keep the condition that the warrants are pardoned

  • Preferred: $14.1 billion
  • In-your-dreams Common Market Value: $25.6 billion
  • Government Senior Preferred: 56 billion
  • Equity Value: 95.7

No comments.

Conclusion: Only extreme scenarios could justify the current relative price of Freddie Mac’s preferred and common. I imagine the situation is similar with Fannie Mae.

This is market madness it looks like two-quart bottles of ketchup are selling for less than twice the price of one-quart bottles. I let you decide if there is a relative arbitrage situation. I made my bet already.

Disclosure: Long FRE prefs, Short FRE common