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

Updated from 3:14 p.m. ET with market close information.

NEW YORK ( TheStreet) -- It's been quite a ride for common shares of Fannie Mae ( FNMA) and Freddie Mac ( FMCC) over the past two days.

But the preferred shares are the better deal.

Fannie Mae's common shares were down 28% to close at 78 cents, after rising 80% over the previous two days. Freddie Mac's common shares also sank 28% to close at 78 cents, following a gain of 71% over the previous two trading sessions.

Meanwhile, the action in Fannie Mae's preferred shares intensified. Fannie's preferred series E (FNMFM) shares were up 60% to close at $11.20, after rising as high as $17 late Thursday morning. The preferred Series E shares had risen 34% on Tuesday. The Fannie Mae preferred series E shares have a coupon of 5.10% and a par value of $50.00.

Freddie Mac's preferred series Z (FMCKJ) shares, with a coupon of 5.375% and a par value of $25, pulled back 1% to close at $3.16, after rising 6% on Tuesday.

Both mortgage giants were taken under government conservatorship by the Federal Housing Finance Agency in September 2008. At that point, common and preferred shares of Fannie Mae and Freddie Mac were pretty much given up for dead, with little prospect the companies would resume operating as private companies and very little prospect for the payment of dividends on existing preferred stock.

The fun began early Tuesday when the Wall Street Journal brought attention to Fannie Mae's plan to delay filing its annual 10-K report to the Securities and Exchange Commission. Fannie said it would need extra time to analyze whether or not it could recapture some of its $61.5 billion valuation allowance for deferred tax assets (DTA), as of Sept. 30.

That's a very big deal, because the money could go quite a long way in helping the company redeem $116.1 billion in preferred stock held by the U.S. Treasury, for bailout assistance since September 2008.

Freddie Mac was able to file its 10-K on time, saying that the company's DTA valuation allowance was $31.7 billion as of Dec. 31. The government holds $72.2 billion in Freddie Mac preferred shares.

The common shares of both companies have soared on the obvious hopeful prospect that since both are now profitable and both may get a "head start" on repaying the government if the DTA are recaptured, the shares will have real value.

Daytraders have obviously been looking to make quick killings on the common shares. For the preferred shares, the story is very interesting, because the future of the GSEs hasn't yet been determined. Fannie and Freddie together back roughly 90% of newly originated mortgage loans in the U.S. Please see TheStreet's previous coverage of Fannie Mae and Freddie Mac for detailed discussions on what Congress and President Obama may have in store for the future of the GSEs.

Fannie and Freddie are still with us for a very obvious reason. The credit crisis was no time for a radical redesign of the mortgage finance structure in the U.S. The economic recovery following the crisis has been slow and fragile and the federal government still isn't keen to reinvent the wheel when so much is at stake.

Depending on what Congress and the president ultimately agree on as a way forward for Freddie and Fannie, if the GSEs fully repay the government and go on operating, there is hope for eventual payment of dividends on preferred shares not held by the government. Please see Dan Freed's article on TheStreet for a discussion on legal aspects supporting some private investors' decisions to continue holding Fannie and Freddie preferred stock.

Going back to our preferred stock examples, it's obvious that new investors can make quick gains if the shares go up, but what about the income? If the dividend were resumed on Fannie Mae's preferred series E shares, investors would receive annual income of $2.55 a share. That would be a pretty fat yield 36.48% for investors who went in Wednesday at $6.99 a share.

If Freddie Mac was able to resume the dividend on its preferred series Z shares, the annual income would be $1.34 a share. That would make for a lovely yield of 41.99%, for investors who purchased the shares at the closing price of $3.20 on Wednesday.

One professional investor says the preferred shares are a much better play for investors than the common shares. For starters, preferred shareholders are always ahead of common shareholders if the companies are ultimately wound down. And with Fannie and Freddie set to book huge profits as housing prices continue to recover and with credit recoveries similar to Fannie's huge settlement with Bank of America ( BAC) in January, the GSEs may be in solid shape far sooner than anyone expected when they were bailed out.

GSE Preferred Over Common, by the Numbers

The numbers make the case for the preferred shares being worth much more than the common shares.

The face value of Fannie Mae's junior preferred shares -- that is, shares not held by the U.S. Treasury -- is $19 billion. That's just 0.6% of Fannie's total assets. The market value of Fannie's junior preferred shares was roughly $1.9 billion at Wednesday's market close. The market value of Fannie's common shares -- including warrants held by the government -- was $6.2 billion.

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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