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Fannie and Freddie: Smart Money Sticks to GSE Preferred Shares

NEW YORK ( TheStreet) -- The more than 200% rise in common shares of Fannie Mae (FNMA) and Freddie Mac (FMCC) in the past four trading days is "just insane," according to a hedge fund investor who bought the preferred shares of both companies just a few months after they were taken over by the government, and has hung on ever since.

That investor would be John Hempton, an Australian hedge fund manager and blogger, and one of a small number of savvy investors who have gone public in discussing their investments in preferred shares of the government-sponsored enterprises (GSEs).

If you don't know what preferred stock is, and you have either been buying or considering buying common stock of Fannie and Freddie, you really need to keep reading.

In my occasional reporting on the preferred shares of Fannie and Freddie over the past two-plus years, I have interviewed four different hedge fund investors and one analyst, as far as I can recall. None of them appeared to have any interest in the common shares, though I'm not sure I asked all of them.

I didn't ask them in part because the preferred shares are already a long shot offering a huge potential reward if they pay off. Talking about an even longer shot, then, seems silly, especially when the reward is about the same.

Bear with me while I explain the difference between common and preferred stock. Common stock is what most people think of when they think of stock. It is a stake in a company. Preferred stock, on the other hand, is a misnomer, since it actually has much more in common with debt.

Common stockholders of Fannie and Freddie aren't entitled to a penny of the companies' profits until the preferred shareholders (i.e., the lenders) are paid in full, and that looks to be a long way from happening.

While it is true that you can double your money if you buy Fannie Mae common shares at $1 today and sell them at $2 tomorrow, it is also true that that rally would be based on pure speculation: the idea that one day the preferred shareholders will be paid in full and there will be profits left over for common shareholders. The foundation on which that idea is based could crumble very quickly, and you're back at 30 cents a share.

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