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Why Fannie and Freddie Differ From AIG

Stocks in this article: FNMA FMCC AIG

Of course such a move would have to be within reason. If they used the profits to double the pay of every member of Congress, it would be a huge scandal. But let's say they used the profits to reduce the principal on underwater mortgages. That would be controversial, but it seems less far fetched.

Regardless, whatever government officials decide to do with those excess profits, making sure there is enough money left over to benefit investors in penny stocks is likely to be pretty far down on the list.

Maybe the courts will get involved, as hedge fund investor John Hempton of Bronte Capital argues. There are lots of potential variables. That's why if I were going to speculate, I'd rather be first in line with a chance to make eight times my money, as preferred shareholders currently are, before the common shareholders earn a cent. That's especially true when the common shareholders, in the rosiest of outcomes, won't get a much better return than that.

Fannie Mae has 16 preferred issues outstanding, while Freddie has 24, according to a report published Wednesday by CRT Capital Group. Most of these trade at roughly 12 cents on the dollar. In other words, if you buy them today and they recover their initial value, you can make more than eight times your money.

Unless they recover all of their initial value, common shareholders get zero. Preferred shareholders must be paid in full before common shareholders see a penny.

Bronte Capital's Hempton argues that Fannie and Freddie traded at about $50 each per share in good times, which equates to $10 today since the government owns 80% of them. That's about nine times the $1.08 price where they closed on Wednesday. So even if you believe that Fannie and Freddie will return to their pre-crisis level of profitability, which seems like a rather large leap, you make nine times your money. That's just a little bit better than the preferred, with considerably more risk.

Fannie and Freddie have been political footballs throughout much of their exisence, and that status isn't likely to change any time soon. As long as it doesn't, the risk to investors remains high.

-- Written by Dan Freed in New York.

Disclosure: TheStreet's editorial policy prohibits staff editors, reporters and analysts from holding positions in any individual stocks.
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