Description

Freddie Mac--- FRE, long July 55 calls, short 10 year FRE debt against long comparable maturity treasuries.

I have resisted writing up this idea because it is unclear that I have much value to add in terms of analysis on the company or industry. However, it is a large investment for us, one in which I have conviction, and I believe that events in the next 6 months will drive substantial price movement in FRE securities, securities that are currently mispriced. As such, I have decided to dive in.

I recommend buying the Freddie Mac July 55 calls, currently $6.40 offered, a $2.42 premium of the stock which is at $58.98. I also recommend shorting any of the non-callable FRE longish term (say 10-year paper) which is priced at roughly 50 basis points over the curve (long 10 year treasury hedge to interest rate risk suggested). I am not sure whether the debt or the equity is mispriced or both. I actually think they both are, but I don’t think that they are both correctly priced.

FRE has been a front page. The problems have been well reported. I am happy to respond to specific questions about the problems. The web site, in particular, the Baker Botts report details the problems. In a nutshell, among many problems, the major problem leading to the restatement is that company did not properly mark certain derivatives to market. Of course, he problem with the GAAP approach now is that is marks some assets to market (certain derivatives) while not marking others to market (eg other assets and liabilities). So at the end of the day, one has to try to make an assessment of this company’s economic earnings potential. This company really did not earn $5.01, $4.23, and $14.18 in 2000, 2001, and 2002.

Let’s address a couple of issues right now. In practice, what benefit does the government confer on FRE and FNM. In practice, none. There is no explicit guarantee. (Or course, foreigners that own lots of the GSE paper are kind of backing on it, and it practice, these companies may be too big to fail). If that perception changes, bonds will get killed compared to the stock. The line of credit that the company has is tiny ($2.5bn) in relation to is funding needs.

As for the short bond part of the trade, 50 basis points is not a lot of extra yield. This company has roughly $1.5 trillion of exposure, supported by roughly $30bn of capital including preferred equity. This company doesn’t have much “margin of safety”. It won’t take much to get people scared and blow the spread out. Certainly, there must be some non-meaningful probability of this happening. While not priced to perfection, the downside on this trade is 50 basis points of capital a year. And in return, one has created a low-cost put on FRE being a disaster. If there is a real housing bubble, then the debt will get killed. If FRE has credit quality or derivative problems, the debt will get killed. If interest rates back up a lot, 50 basis points of pick-up will seem less important and will force spreads wider (in essence, this trade creates a put on bonds). This paper is held in huge amounts by overseas governments and agencies. If the dollar keeps getting killed, the pressure on these securities will only increase. Additionally, this paper seems a great disaster hedge for an overall portfolio. Hard to see the US going into the tank and FRE/FNM coming out smelling like a rose. So with controlled downside, this paper seems to provides many ways to win. By itself, I think the trade is a terrific investment for any portfolio.

But I actually think the stock has a high probability of doing well in the first 6 months of this year. And I think the call options are a perfect way to play it. By buying the $55’s in particular, one is paying only a 3.4% premium to own the stock, thereby gaining securing much of the upside while bearing only modest downside.

The elements of the bullish case in the next period of time are as follows. 1) The stock is not expensive, which I will detail below. 2) Results for 2003 and Q1 2004 will be released by the end of June. This has been one of the three huge overhangs on the stock, and getting it out of the way will be a huge relief (assuming the news is not bad). 3) The new CEO, Richard Syron is known for picking good people. His hiring removed one of the overhangs; while I think people were hoping with a “bigger name”, there should be some hiring announcements which will help the stock. 4) As important as the releasing of the results, one should hope that the political uncertainties, the last overhang, will be resolved in the first half of this year. As noted above, the government does not confer any tangible substantial benefit on FRE and FNM. So there is not much to take away. As for oversight, it is hard to imagine how at the end of the day, more oversight will hurt too much. The Administration has been vocal against the GSE’s. There are indeed some hardliners in the administration who are vocal against FRE and FNM. But most important, in an election year, hard to see the administration doing anything dramatic. There is only downside to a big shake-up. Things are working in the mortgage market right now; there is much more risk than upside to the administration to trying to do something big. My assessment is that the administration wants to be on record as talking tough so that if there is a problem, they can say I told you so without taking the chance of causing a problem. FRE/FNM are well liked on capital hill so I don’t see much danger here. Something will happen that will increase and perhaps change oversight; there will be noise; at the end of the day though , the key is to get the issue over and done with. FRE is underowned enough by big funds focused on the S&P 500 that if it starts to move, it could really move. Although I own the calls to protect downside and because I think there could be a big upside move, the financial and economic environment seems calm enough that one could own the stock outright.

With these overhangs out of the way, the stock should be able to lift, particularly because it seems inexpensive by any metric. In 2002, the last reported year, FRE created economic value of $6.13 a share. Economic earnings continue to grow as the retained portfolio (mortgages owned) and guarantee portfolio grew a combined roughly 10% in 2003. This stock is less than 10x earnings. Fair value capital at the end of 2003 (book value after preferred equity) should be about $32, $35 by mid-year. So mid-year, if the stock is here, it will be at 1.7x book. This is too cheap, if one believes that the earnings are recurring. And frankly, given its leverage, this company should be at least a 20% ROE company, just to justify the risk. The company also buys back stock with its free cash flow and pays a $1.04 annual dividend for a 1.76% yield (obviously not received as an option holder). One other thought worth considering about the mortgage market (note: I have not pontificated on the mortgage market/housing bubble). Even if houses are overvalued, people do not like being kicked out of their houses. People do everything they can to pay their mortgages.

Bottom line, if the company’s debt is correctly priced at 50 basis points over, the equity just seems too inexpensive. And if this is a single digit PE multiple company because of the risk, then 50 basis points over the treasury curve seems insufficient to. Justify the risk perceived by the equity market. The company also buys back stock with its free cash flow and pays a $1.04 annual dividend for a 1.76% yield (obviously not received as an option holder).

In terms of the theoretical economic model, in brief, Freddie and FNM have historically earned roughly on average 00bp on the retained portfolio. FRE’s portfolio at the end of Nov was $645bn. The guarantee fee has gone down to roughly 20basis points. FRE’s guarantee was $750bn at the end of November. Credit costs are 1 basis point a year (no typo) on $1.5 trillion. Overhead is about $1.5bn. Tax rate is roughly 32%.

Spread Income of 1% on $645mm: $6.4bn
Guarantee Income of 20bp on $750mm: $1.5bn
Credit Costs: -$150mm
Other costs: -$1.5bn
Pre-tax income: $6.25bn
After-tax Income: $4.2bn
EPS (695mm shares) $6.00+/share

Why FRE vs. FNM. 1) FRE is less expensive than FNM by about 1 multiple point of economic earnings, 2) It has already scrubbed…. Or at least it is substantially in process, 3) FRE is trading at a lower multiple of fair-value capital 4) FRE is less levered (which is kind of a joke to phrase it that way) meaning if there is a need to raise capital, FRE holders will suffer less dilution, and 4) there is greater company specific fear in Freddie. Note: this trade works well shorting FNM paper as well, but I think it better to be short the FRE credit if involved in the FRE stock. If not, I think short debt of both companies makes sense.

The dangers of the investment include the following scenarios. 1) Stock and bonds just sit still as the tug-of war between bulls who argue stock is cheap on any valuation metric and bears who will never get over the risk of the inevitable 50 year flood at some point killing this company (a la Long Term Capital) cause any long premium strategies (which my recommendation is) to essentially bleed. Company needs to raise capital which hurts stock and helps bonds. 2) Big bear market hurts stock without helping bonds. 3) There is also pricing competition between FRE and FNM, which FRE is initiating to try to regain market share. As these two companies have become such a big piece of the market, growth is going to be harder to come by, increasing the risk of continued price contribution. 4) Economic earnings power ends up at low-single digit ROE which the market believes to be sustainable. Stock doesn’t move (or goes down) and bond spread tightens. But I don’t believe that this company at a single digit ROE deserves to be at a 50 basis point spread at this degree of leverage. And if the bond spread is determined to be right, the stock is pricing too much of a risk premium at its single digit PE multiple.

Net-net, with all the events coming up, we believe the long-call strategy to have an excellent risk-reward in the next 6 months while the short debt-long treasury strategy is an excellent hedge as well as stand-along investment.

Catalyst

financial restatement completed in first half of year, political problems addressed, new hirings..... blow-up (read on)