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Sell Fannie and Freddie Common, Buy the Preferred (Update 3)

The face value of Freddie Mac's junior preferred shares is $14 billion, with a market value of about $1.4 billion. The market value of the company's common shares at Wednesday's market close, including warrants, was $3.5 billion.

So the combined market cap of the common shares exceeds the trading value of the preferred shares, even though the preferreds are in line to get paid ahead of the common stock in the event that Fannie and Freddie are wound-down.

Fannie and Freddie cannot simply disappear. The companies have a combined $5.2 trillion in assets. Considering the face value of the junior preferred as compared to total assets, it is clear that the preferred shares can gain tremendous value with incremental operating improvements at the GSEs.

The professional investor we interviewed said "there is starting to be a change in the tempo, attitude and behavior in the discussion," in Washington on the future role of Fannie Mae and Freddie Mac. "It was easy to bash them when they were not profitable. But they are set to be wildly profitable as home prices continue to rise," he says.

Some readers have been asking why the government conservatorship of Fannie Mae and Freddie Mac is different from the bailout of American International Group (AIG), which famously ended in a fat profit for the U.S. government. The biggest difference is that government-held preferred shares in AIG were converted to common shares. This helped AIG by eliminating the dividend on the government-held preferred.

Through asset sales, AIG was then able to pay back loans from the Federal Reserve, and make several repurchases of common shares from the government, at ever increasing prices. The government also sold some of its common shares in the open market, after riding them up to a profit.

The likelihood of the government's preferred shares in Fannie and Freddie being converted to common shares is next to nil. However, if it were to happen, the market value of the junior preferred shares would likely jump immediately to par value, according to the investor we interviewed.

"The reality is, from a trading perspective today, the preferreds are trading massively cheaper than the common equity. You should be selling the common and buying the preferred," he said.

GSE reform has already waited for five years, following the height of the credit crisis, and is likely to take many more years. In the meantime, with the DTA recapture and the prospect of "pretty substantial net income" for Fannie and Freddie, according the investor we interviewed, the preferred shares are the best GSE investment play for investors.

-- Written by Philip van Doorn in Jupiter, Fla.

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Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for TheStreet.com Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.
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