Which Fannie Mae and Freddie Mac Investment Is Better -- Common Shares or Preferred?

By Markets Fool.com

Government-sponsored enterprises (GSEs)Fannie Mae and Freddie Mac are two of the most polarizing investments on the market today. But within the framework of investing in these companies, there are two main ways to invest in Fannie and Freddie: common shares and preferred shares.

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With prominent investors coming down on each side of the issue, I'll take a look at the pros and cons of each type of Fannie and Freddie security.

A quick background
Fannie Mae and Freddie Mac occupy a unique place in today's markets as companies that are generating significant profits but none are going back to shareholders. This stems from the bailout of the GSEs whereby the Treasury received $187 billion in senior preferred stock between the two companies and later changed the terms of the senior preferred shares to receive all of the GSEs' profits.

The change to preferred stock purchase agreement is currently being challenged by such investors as Bill Ackman, Richard Perry, and Bruce Berkowitz who allege the change violated the law. Potential investors need to consider that these lawsuits are almost the only way that they could see value in the future.

But even with this in mind, there are other considerations for the common and preferred shares.

Preferred shares
In terms of how much value they are seeing out of Fannie and Freddie's profits, the preferred shares are in the same boat as the common shares. They are known as the junior preferred since they are behind the senior preferred owned by the Treasury in line for payment. Since the senior preferred collect all the profits of the GSEs, there is currently nothing left over and the junior preferred receive no dividends.

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Most series of preferred trade for 1/4 of liquidation value or less representing upside of 300% in an ideal scenario. Unlike the common shares, the preferred shares have a fixed liquidation value protecting them from potential share dilution that could result from several possible reasons discussed further in this article.

All series are noncumulative, meaning the GSEs will not have to make up for the dividend payments that stopped being paid in 2008.But, like most preferred stocks, they are ahead of the common for any future dividends, should there be any.

The preferred shares are also ahead of the common shares in the event of a liquidation of Fannie Mae and Freddie Mac. In the Johnson-Crapo bill that would have wound down the GSEs, the junior preferred holders would have been next in line to be repaid after the government's claims were satisfied. It's important to note that had this bill passed, the junior preferred holders may still not have received any payment due to the size of the senior preferred stake; however, the position in line during liquidation is still something to keep in mind.

Junior preferred shareholders will still require an end to the net worth sweep of the GSEs to see full value for their investments but they are ahead in line for proceeds if the GSEs are liquidated; at least under previously proposed legislation. In addition, they have fixed liquidation values protecting them from dilution that poses a risk to the common shares.

Common shares
For investors with a greater tolerance for risk, common shares of Fannie and Freddie could provide even more upside than the preferred shares. Currently trading for around $3 each, the outcomes for the common shares vary widely compared to the preferred.

Right now, the Treasury holds warrants to purchase 79.9% of Fannie Mae and Freddie Mac's common shares for $0.00001 that, if exercised, would dilute current shareholders to ownership of 20.1% of outstanding stock. Some investors have challenged the legality of the warrants in court; however, since the warrants were part of the 2008 bailout and separate from the net worth sweep, voiding the warrants will be more difficult.

For the investment case presented by Bill Ackman, he has assumed that the warrants will be exercised which, at this point, seems more likely than not. But even under these circumstances, there is still significant potential upside for the common shares.

In his base case, Ackman figures for $16 billion in total earnings from the GSEs with $10 billion coming from Fannie Mae and $6 billion from Freddie Mac. In its most recent earnings report, Fannie Mae announced $14.2 billion in 2014 earnings but expects future earnings to be "substantially lower". If these "substantially lower" earnings are around $10 billion, per Ackman's estimates, they would come in around $1.70 per share factoring in the dilution from warrants.

In this situation, the share value would come down to the multiple the market places on the stock. If released from conservatorship, Ackman figures shares to be worth $23 at leastwhile Dick Bove values them at $18 each. Either way, in a case where earnings fall lower from current levels and the warrants are exercised, common shares have over 500% potential upside.

But there are other factors at play here. The common shares could be diluted more than through the warrants if the GSEs have to raise new capital or if the senior preferred is converted into common shares as was done with American International Group and Citigroup during their government bailouts. Such dilution would negatively impact earnings per share and reduce upside potential, possibly eliminating upside if dilution is severe enough.

As Ackman mentioned in his presentation, Fannie and Freddie could increase their profits further by raising their guarantee fees. This opens up the potential for further earnings growth which Ackman has estimated could push shares as high as $47 each. If the GSEs are released to private shareholders again, this move becomes a possibility as the GSEs could be run for shareholder profit and could create further upside for Fannie and Freddie.

Which should you choose?
For investors willing to accept the high degree of risk that comes with Fannie Mae and Freddie Mac, common shares and preferred shares are the available options each with their own unique risks and potential rewards.

Personally, I have chosen to own some of each, leaning more heavily toward the common as I see the Fannie and Freddie investment as a fairly binary outcome and the common shares have more potential upside. However, I also own some of the preferred so I can still profit from the investment if the common is heavily diluted or earnings per share for the common decline.

Overall, there is not a clear winner between the common shares and preferred shares and even the big investors don't agree. Berkowitz has about seven times as much preferred as common and Ackman has taken the side of the common through investments and agreements that give him exposure to about 11% of each GSE.

Investors need to review the numbers and decide for themselves and, after that, only invest money they can afford to lose.

The article Which Fannie Mae and Freddie Mac Investment Is Better -- Common Shares or Preferred? originally appeared on Fool.com.

Alexander MacLennan owns common shares of Fannie Mae and Freddie Mac. He also owns American International Group warrants and Fannie Mae preferred shares. The Motley Fool recommends American International Group. The Motley Fool owns shares of American International Group and Citigroup Inc and has the following options: long January 2016 $30 calls on American International Group. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.