Fannie and Freddie: Buy the Debt, Skip the Stock

DESPITE THEIR INCREASINGLY dire straits, and the dizzying plunge in their stock prices, Fannie Mae (FMN) and Freddie Mac (FRE) still seem to exert a strong lure for investors. I've already warned investors to stay far away from the stocks of these awkward quasi-governmental lenders, but obviously some trades and speculators are making — and losing — big money on the wild gyrations in their stock prices. For the rest of us, I stand by my earlier advice: Stay away.

But what about the massive amounts of Fannie and Freddie debt and preferred stock offerings? Lately I've been hearing from commentators touting FNM and FRE's bonds and even their high-yielding preferred shares for long-term investors. How risky can they be, especially after the government said it would guarantee the debt? Just ask J.P. Morgan Chase (JPM), which disclosed this week that it owned $1.2 billion in preferred shares of Fannie and Freddie, and was writing down the value by half. Plenty of other banks are expected to write down the value of their holdings.

There's no doubt that these companies' preferred shares offer eye-popping yields. There's quite an array of these, such as FMN.T, which was issued at $25 per share and now trades at $12, with a yield of 17%. Of course the high yield is a function of the sharp fall in price, which is why banks like Morgan are taking such a hit.

Over the years I've learned to be very wary of yields of 15% and higher, which nearly always signal that investors expect a dividend cut. Despite government pronouncements intended to shore up investor confidence in the mortgage companies, the fate of the preferred shareholders as well as the holders of rest of the companies' subordinated debt (which is basically everything other than the standard-issue bonds) remains unclear. Uncertainty increases risk, which boosts yields, hence the huge yields.

In recent weeks I've done quite a bit of reading on this netherworld between common shareholders, widely expected to be wiped out or severely diluted by any government bailout, and bondholders, who have the government's assurance the debt is secure. (This includes an informative column by Gretchen Morgenson in last Sunday's New York Times.) But unless you find yourself terminally bored this upcoming Labor Day weekend, let me save you the time with some simple advice: Don't be tempted by the yields. The preferred shares are likely to be as toxic as the common. Not only are dividend payments likely to be suspended in the event of a government bailout, but they may well be suspended even before that, if the companies' capital levels fall below certain minimums.

There is a camp that believes that will be the time to buy — when the dividends have been suspended — on the theory that eventually the government will find a way to compensate the preferred holders, if for no other reason that so many owners are the nation's big banks, which can't absorb another blow to their balance sheets. But that's sheer speculation. Whether anything like that happens may well turn on the outcome of this fall's election and will in any event take years to resolve. That's more than I want to worry about.

At the other end of the risk spectrum are all the Fannie and Freddie bonds, and there are a lot of them. (The full, dizzying array is on display at the FINRA web site.) Despite the U.S. government guarantee, recent auctions have pushed up the yields, at one point this month to 212 basis points above comparable 30-year Treasurys. The 30-year Fannie Mae bond was recently yielding 6.04%, near its all-time high reached in March, just before the bailout of Bear Stearns, and before the government was forced to issue the explicit guarantee.

In my view, this is indeed an opportunity for fixed-income investors. The government's guarantee has effectively rendered these bonds as safe as U.S. Treasurys, no matter what happens to the big mortgage companies themselves. Even Russia has said it is still buying them, the recent flare-up with the U.S. over Georgia notwithstanding. So I see no reason for investors who would otherwise be buying Treasurys not to go for the extra yield. Bear in mind, however, that the prices of all bonds, no matter how safe, fluctuate with interest rate changes. The shorter maturity, the lower the risk of rising interest rates.

Also See:
Stewart: Sell Fannie, Freddie While You Can
Stewart: Investors Should Hold Off on Investing in Russia
Stewart: ARPS Scandal: Banks Must Rebuild Investors' Trust