By Martin Hutchinson
Contributing Editor

The bailout of mortgage giants Fannie Mae (FNM) and Freddie Mac (FRE) is extremely confusing to holders of their debt and equity securities, because it’s very difficult to figure out what the final outcome of the “rescue” might be, and if so, who benefits.

However, as a service to Money Morning readers who are unfortunate enough to have been holding Fannie or Freddie paper, or to the venturesome few who wonder whether there is any among the debris, I thought I’d peer through the fog of uncertainty and try to figure out what the different classes of Fannie and Freddie securities may be worth.

Tread Lightly and Bury a Big Debt

Let’s start – gingerly – with the politics. It would be politically impossible to allow $5 trillion of mortgage debt to default, particularly since its purchasers had been told that it was “just as good as” U.S. government paper. The economically logical course would be to take Fannie and Freddie fully into government ownership, sweeping all their debt onto Uncle Sam’s balance sheet (thus roughly doubling its reported debt/gross domestic product (GDP) and debt/export ratios), and then winding down Fannie and Freddie’s operations, since neither entity serves a useful purpose in a proper free market.

That won’t happen, for two reasons:

• First, it would make U.S. debt ratios look bad, possibly increasing the nation’s cost of borrowing from foreign central banks. In not formally accounting for the liability, Uncle Sam is basically pulling the same scam the banks did when they shoved all their worst mortgage assets into Structured Investment Vehicles (SIVs), but so what? Do you actually expect the government to follow the same rules of honest accounting as the private sector?

• Second, Fannie and Freddie top management are politically plugged in – in the biggest ways possible – and won’t allow themselves to be “demoted” from cushy slots as big shots earning $12 million a year and transformed into lowly GS-15 government wage slaves (civil servants who will top out at $155,000) simply because the companies they ran were “nationalized.”

Therefore, Fannie and Freddie will remain members of the private sector, but will be given taxpayer handouts to keep them in business. In return for those handouts, they may be forced to raise extra capital from the market, or in an extreme case their existing capital may be wiped out and replaced by government loans or equity injections. Holders of Fannie and Freddie debt will probably be protected; holders of their shares probably won’t.

Given the outlook for Fannie and Freddie, what’s the outlook for their holders of particular securities? Let’s look at individual securities.

• Direct Agency Debt: These are obligations of Fannie and Freddie directly, generally with ordinary fixed-term maturities. They are currently trading very close to government paper, within 0.05% of it in yield, much closer than they were before the bailout. There’s a tiny risk you will lose money on these, but if you do, you will lose most of it because Fannie and Freddie’s assets may not be worth much. Buying Treasury bonds directly looks to be a much better bet.

• Mortgage-Backed Securities (MBS): These have a final maturity of 30 years, but their average maturities are much less than that, depending upon the repayments on the underlying mortgages. If interest rates were to drop, they would mature quite quickly; if interest rates were to shoot up, they would behave like a 30-year bond, as nobody would refinance the cheap mortgages. They trade at yields around 1% above long-term Treasuries. Here you should ignore the Fannie and Freddie guarantee altogether and try to find out when the MBS you are buying was originated. If it dates from before 2003 or so, it will contain mortgages on houses that later appreciated substantially in price – so may still have a cushion above the mortgage value. MBS originated in 2006, on the other hand – no matter how fine their initial quality – today will be suffering from the housing-price decline, which will have lowered the potential sale prices of many of the houses below the value of their mortgages. Among older mortgage-backed securities, however, there will be bargains that will very likely never use the Fannie/Freddie guarantee.

• Common Stock: No matter how cheap it may look, I’d avoid stock altogether. First, the government may insist on it being wiped out as a condition of a bailout. Second, both Fannie and Freddie are talking about raising $10 billon or more of new capital – but their market capitalizations are below that figure, so these stock offerings would be hugely dilutive to existing shareholders. If Fannie and Freddie issued preferred stock, the dividends would be huge, wiping out the possibility of dividends on the common stock for several years.

• Preferred Stock: This is the most interesting flotsam among the debris. In order to bolster their capital, Fannie and Freddie are each talking about issuing $5 billion to $10 billion worth of preferred stock. To get sold, that preferred stock would have to carry a very high dividend yield – people are talking of 13%, although I’d say 11%-12% is more realistic. If the preferred stock is genuine “equity preferred” – in which the dividends are not tax-deductible for Fannie and Freddie (which it would have to in order to be counted as capital) – then its dividends would be taxable at 15%, just like common-stock dividends. While there’s obviously a possibility that Fannie and Freddie could make large preferred stock issues and then declare bankruptcy, it’s fairly unlikely given the announced bailout – investors in a new preferred issue could reasonably sue the government for seducing them into investing with promises of a bailout that didn’t materialize. So, these issues would offer a reasonably secure yield of say 11%-12%, taxable at 15% (provided a newly elected U.S. President Barack Obama doesn’t remove the dividend-tax break, an move that’s not near the top of his list). That looks pretty attractive.

Cautious investors should probably avoid Fannie and Freddie securities altogether, selling any they have left to be on the safe side. More-adventurous investors may find Fannie and Freddie-backed MBS attractive, providing they’re old enough, and any new issues of preferred stock extremely tempting. Even the most hardened thrill-seeker should probably avoid the common stock; the odds appear stacked against it.

[Editor’s Note: With each successive financial mess that appears in the U.S. securities markets, the odds of the much-feared “SuperCrash" become greater and greater. But those who fear the SuperCrash do so only because they know nothing of the once-in-a-lifetime profit plays that will emanate from the this cataclysmic event. For a report on these profit plays - an offer that includes a free copy of New York Times bestseller "Crash Proof: How to Profit from the Coming Economic Collapse" - please click here.]

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