Fannie And Freddie: Low-Probability, Speculative Gambling – Seeking Alpha

(source)

Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) are low-probability binary bets, and the market's steep discounts to the stocks reflects the tiny likelihood of a shareholder favorable outcome.

Regarding the bullish coverage of Fannie and Freddie, one would be justified assuming the long thesis a slam dunk before the recent court decision proved it otherwise. For almost two years, a narrative suggesting the U.S government 'unfairly' stole private property prevailed. And while the analysis has been sound - it has been undeniably colored by bias.

Free market efficiency exists in everything, and when counterbalance is impeded, securities (or any other variable affected by dissenting factors) become mispriced. In the case of the GSEs, there is a lack of bearish voices to counterbalance the bullish thesis that has mislead investors for so long - not because it was a bad thesis, but because it was allowed to run without opposition.

The GSE court case argument to go long Frannie was based on a biased interpretation of a binary event just as the current bullish thesis rests on an even more unlikely binary event.

The Weak Case for Government Intervention

The bullish legal case for the GSEs has failed, and now investors turn to the Trump administration's Steve Mnuchin for salvation - analyzing every word he says for clues about his intentions. Regardless of the speculation, there is quantifiable evidence that the likelihood of a shareholder-favorable outcome to the GSE situation is a low-probability binary event.

As per the efficient markets theory, the likelihood of GSE privatization can be estimated by the valuations of the stocks themselves. For this example, we can use Fannie Mae:

Fannie Mae posts TTM revenue of almost $20 billion on a market cap of $3.38 billion. This translates to a P/S ratio of 0.16. The average industry P/S ratio is around 3-5, and if Fannie Mae were valued at its 2005 P/S of 3.75, the market cap would be around $75 billion - over 2000% upside from the current price.

FNMA Market Cap data by YCharts

We could say the market is discounting the stocks by 95.5% due to doubts about the possibility of privatization and other concerns - put another way, their risk-adjusted value is only 4.5% of fair value. This suggest the market assigns an extremely low probability of privatization in the GSEs. If the efficient market believed there was a substantial chance of GSE cash eventually going to investors, it would afford the GSEs a higher multiple on sales.

The Efficient Market

(Source)

Remember, the market is more rational than any specific investor or analyst, and so 5% should be assumed to be the likelihood of privatization in light of all the available evidence. Investors who are still not convinced should take a look at the financial situations of Fanny and Freddie: Giving these firms to private investors represents a serious economic risk because of their capital structure.

Fannie Mae, for example, is expected to pay $5.5 billion to the treasury this month. The size of this dividend is determined by taking the company's net worth (total assets less liabilities) of $6.1 billion and subtracting this number by the capital reserve of $600 million. This will be done for every quarter of 2017, and in 2018 the capital reserve will drop to zero as per the requirements stipulated in the amended conservatorship agreement.

With a capital reserve requirement of $600 million, Fannie is already very risky (without government support) considering the fact that it provided $635 billion in mortgages financing in 2016 and is the largest risk holder in the sector. Now, and especially when the capital reserve drops to zero, the viability of giving the GSEs to private investors represents a serious risk to the American economy. The firms still need government support because their capital reserves are too small to survive serious economic challenges without tax payer money.

What is the Trump administrations incentive to give the GSEs to private investors? Altruism?

Conclusion

The investing community has an incorrect perception about the nature of investing in the GSEs. Fannie and Freddie are not traditional investments but rather low-probability binary speculations that will likely end in disappointment. Investing in Fannie and Freddie is like gambling.

The low probability of success is reflected in the market's pessimistic valuation of these stocks. With a RAV of only 4.5% fair value - as determined by a P/S multiple of 3.75 - this is much like betting; the lower the probability of success, the greater the potential payout. Frannie's deep discount is not a bullish factor; it should be seen as a grave warning. Investors should only invest in Fannie and Freddie with money they are willing to lose.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

See the original post:

Fannie And Freddie: Low-Probability, Speculative Gambling - Seeking Alpha