Be careful of Fannie, Freddie ‘bargains’

If you’re thinking the stocks of Fannie Mae and Freddie Mac are bargains that may regain their highs of the glory days – be very careful. You may not win this bet.

I’ve seen it before, the stock of a troubled but venerable public company that once traded for good money drops to penny stock territory. Investors, gambling that the shares will rise from the ashes like the mythical Phoenix, go on a buying binge.

But for the average individual investor, this is a place where only the well heeled, or experienced, should go.

Fannie Mae and Freddie Mac were taken over by the federal government on Sept. 7 in an effort to rescue the companies from further financial disaster. The two companies were chartered by the government to help increase homeownership in this country by buying mortgage loans.

The entities were also publicly traded companies that sold shares of common stock. In the last year, the stock has suffered significantly. Fannie Mae’s stock declined from a 52-week high of $68.60 to a close of just 73 cents on Sept. 8, the day after the Treasury Department announced the takeover. Freddie Mac went from a 52-week high of $65.88 to 88 cents.

What many common shareholders fail to realize is that as the owners of a company, they are last in line for claims on any assets. So if the company enters bankruptcy protection or conservatorship, as Fannie Mae and Freddie Mac have, there’s a good chance your shares will become worthless.

“One would be speculating if they were to buy the stock now in hopes that it would increase in value,” said Fred Joseph, Colorado securities commissioner and the president-elect of the North American Securities Administrators Association, which represents state securities regulators.

Fannie Mae and Freddie Mac are not under bankruptcy protection. I just want to make that clear. Instead, the companies are under conservatorship, which is the legal process in which a person or entity is appointed to establish control and oversight of a company to put it in a sound and solvent condition.

In this case, the newly formed Federal Housing Finance Agency (FHFA) has been appointed as conservator of the two companies.

Here’s where it gets interesting, if you own or are thinking about buying the stock. As part of the takeover, the Treasury and FHFA have established “preferred stock purchase agreements.” These instruments essentially put the government in a preferred position. The action was taken to ensure that each company maintains a positive net worth, said Jim Lockhart, director of the new independent regulator.

The agreements were also necessary to provide security and clarity to debt holders – senior and subordinated, Lockhart said in a statement.

“Under the terms of the agreement, common and preferred shareholders bear losses ahead of the new government senior preferred shares,” he said.

That means there is no guarantee that current shares of the company will be worth anything when or if Fannie Mae and Freddie Mac come out from under the conservatorship.

“Market discipline is best served when shareholders bear both the risk and the reward of their investment,” Lockhart said. “While conservatorship does not eliminate the common stock, it does place common shareholders last in terms of claims on the assets of the enterprise.”

If taxpayers end up significantly bailing out the companies, it’s not likely there will be any value left for shareholders.

“This is so unique,” Joseph said. “It’s hard to tell what will happen to the stock or the stockholders.”

We certainly know what happens in many corporate bankruptcy cases. For example, last year American Home Mortgage Investment of Melville, N.Y., once a major mortgage lender, filed for Chapter 11.

Its stock closed in over-the-counter trading at 28 cents. That was down from a 52-week high of $36.40.

In its press release, included in a Securities and Exchange Commission filing, American Home Mortgage said that realistically, there would be no shareholder equity value remaining.

Nonetheless, more than 1.8 million shares traded after the bankruptcy announcement. Now some of that activity was probably shareholders trying to lock in their losses for tax purposes. But no doubt some was done by investors bargain-basement shopping.

Individual investors who bought the pre-bankruptcy stock of Kmart felt cheated when the shares ended up worthless.

Kmart made retail history in 2002 when it became the largest merchant ever to seek bankruptcy protection. In its SEC filings, the company made it clear that the old stock would be canceled and that buying it was highly risky. And yet the day Kmart and its U.S. subsidiaries and affiliates emerged from Chapter 11, 91 million shares changed hands before trading was canceled.

“A lot of people see a buying opportunity at the bottom but you have to be real cautious,” Joseph said.

Consider yourself warned.