Ney Torres September 11, 2019

A Different view on Fannie Mae (FNMA) and Freddie Mac (FMCC) “Optionality has value”!

A Different view on  Fannie Mae (FNMA) and Freddie Mac (FMCC), an issue is rather complex. 
Here I may refer to both institutions as “government-sponsored entities” or (“GSEs”).

But YOU as an investor should focus on what’s knowable and controllable.
Here is what the market is missing an my variant perspective: “Optionality has value”!

Here is my invitation to you investor: see Fannie Mae and Freddie Mac at current price as an option, that could go to $0 or to $17.55 each. You would really be paying for the optionality.
You just bought an option, but not only that, this one doesn’t expire. 

how much would that option be worth?
for a “know nothing about the company” kind of investor using a Black an Scholes kind of formula works pretty well. Even though we don’t want to use it for prolonged periods of time, since the formula stops working basically.

Charlie Munger on Black Scholes Option Pricing Model (2003) –

we need some assumptions: –

Calculation results

Option price
Days to option expiry

That means you are getting $2.77 for free in the a $3.2 stock.

Now all of the reading, research, news, video calls, etc etc any work that you may put into understanding GSE’s will only affect the size of your position, due to your level of confidence (I use Kelly criterion calculator in binomial situations like this, where I think the value is either $38 or 0, I take about this later)

Let me summarize a very complex issue like this the best I can:

  • Under current conditions shareholders there WILL NOT be profits for shareholders ever, but shareholders have been pushing back with very good arguments, and now they are winning slowly.
  • Congress is almost 79.9% owner of the institutions though warrants 
  • Is in everybody’s interest to raise the price of the stock (remember the US holds a lot of warrants and needs to sell them)
  • GSE’s are out of riskier practices that caused their collapse and started making a lot of money.
  • GSE’s will make more income, because insurance for new loans are higher as time passes and old loans disappear.
  • Trump wants to capitalize the GSE before a recession.

The problem:

  • We don’t know how lawmakers are going to capitalize GSE again. In some hypothetical scenarios there could be significant dilution of current shareholders or even worst, that would mean you stock goes to $0 so fast that you won’t be able to exit your positions.

So what started moving the stock now?

Trump just came out with a plan to capitalize the company. And a lawsuit in favor of shareholders to put everything back on track. 
You see the Government has already been paid what they lend and then some, but they don’t want to let go. 

The extreme uncertainty on what is going on has the stock going up and down like a yoyo. 
Is going to be full of ups and downs, lot of drama in the news, etc etc.
But! the most likely scenario is not catastrophical for current shareholders.

How to think about this positions. Easy! use a Kelly criterion calculator and put in your numbers.

In a bad case scenario equity is going to be worth nothing, but in a good scenario stock could go over $38

At a $2.5 (when I bought writing this article) means that I have a 8% confidence it will go through amd could build up to 3% of your portfolio on this. But your confidence on this will be different than mine anyway, I like the odds.

Update: as I publish this prices are around ($3.40) that would mean your confidence is now 10% only.

Now I’m missing a lot of details but that as fast as somebody can explain the whole mess in 3 minutes.

You made it so far! now you are wondering… yeah all good, but why is $17 a strike price for this “hypothetical” option. Glad you asked.

This “banks” are kind of hard to value because they broke down so long ago, anything that usually correlates well like graham number methodology , etc etc, does not work any more. here is what I mean:—Fannie-Mae-corelations-to-price

This 2 GSE (yes, there are more than this 2) buy mortgages from lenders and either hold them or repackage them in the (now famous) mortgage-backed securities to be sold. 
The main difference between both banks is who they buy it for. but for a quick “back of the napkin valuation” we can treat them both as one institution that:

1) insurance of mortgages of mostly 30 year fixed income mortgages.
2) Investing the spread between the interest of this loans and rates they have to pay the government. They normally hedge interest rate fluctuation risk with derivatives. 

The best methodology I had found so far is this one by

Update: after I finish the article the stock jumped to $3.8 but now is at $3.25