Description

I recommend going long Freddie Mac common shares, currently trading at 0.59 per share.  Although certainly fraught with risk, the idea is that a massively favorable risk/reward can be had as a result of the structure of the recent bailout.  Also note that the same logic applies to Fannie, and I have not chosen Freddie over Fannie for any particular reason.

The bailout essentially gives the government 80% of Freddie’s equity (in the form of warrants with a nominal strike price) in exchange for, among other valuable things, up to $100 billion of fresh capital in the form of preferred stock.  The current structure of the bailout implies that:

1)      The government does not intend to liquidate Freddie or force it into bankruptcy.

2)      The government, after scrubbing the books, believes that the $100 billion lifeline and other measures should be (more than) sufficient to see Freddie through the crisis (although of course it is unclear what assumptions were made in this analysis).

3)      The government does not want to fully privatize Freddie and prefers to see it remain a publicly traded company.

So what do we have?  We have a company with $810 billion in debt as of their latest 10-Q (not including $14 billion of perpetual preferred stock, up to $100 billion of senior preferred stock to be issued to the government, or the inherent leverage of the massive amount of mortgage guarantees issued by Freddie), an equity market cap (after adjusting for warrant issuance to the government) of around $1.9 billion, and massive government support designed to prevent insolvency.  I suggest that at some point in the next five years or so, the equity value should reach a minimum of 5% of the enterprise value, which would equate to over $12 per share (after adjustment for warrant issuance) or approximately 20x the current valuation.  If my logic is correct, and the current structure remains in place, this could be the mother of all stub stocks (massive leverage, tiny equity sliver (around 0.2% of enterprise value), and government backing).  The investment thesis boils down to:  If Freddie doesn't go bankrupt, the equity is worth something, and if the equity is worth something, it is likely worth a lot more than 0.2% of the enterprise value.

What are the risks?

1)      The government may decide to change the structure of the bailout in ways detrimental to the common shareholders (possibly including a full privatization).

2)      Additional dilution of the common if the housing crisis last longer than expected or a stronger capital ratio is mandated in the future, and more investment (government or private) is required.

It appears to me that based upon the risk/reward ratio, this is a very attractive investment despite all of the uncertainties.  In order to gain true conviction in this idea, I think that additional resources (primarily legal and regulatory counsel to which I don’t have easy access) would be very helpful in answering the following questions:

1)      In Freddie’s current “conservatorship” status, what rights do the common stockholders have?

2)      Review of terms of perpetual preferred securities junior to newly issued government preferred but senior to common. 

3)      Which scenarios could result in bankruptcy?

4)      Why has the government chosen to take only 80% (actually 79.9%) of the company?  Does the 80% threshold relate to accounting or other issues?

5)      What are the most likely long-term structures for Freddie (in either an Obama or McCain administration)?  (Could include privatization, breakup, etc.).

What am I missing?  I look forward to thoughts on this idea.

Catalyst