How to Profit from the Fannie and Freddie Bailout

By: Money_Morning

Martin Hutchinson writes: The second of two parts analyzing the upside and downside of the Fannie Mae/Freddie Mac bailout. Part I appeared yesterday (Tuesday).]

Between the U.S. Treasury Department's weekend bailout of Government Sponsored Enterprises (GSEs) Fannie Mae ( FNM ) and Freddie Mac ( FRE ) – and Monday's bullish market reaction – you'd think the $5.4 trillion deal had no downside risk at all.

Regrettably – as the bearish market moves yesterday (Tuesday) showed us – that was far from the case.

U.S. stocks plunged Tuesday – with the Standard & Poor's 500 Index shedding 3.4% on the way to recording its worst day in a year and a half – after worries about the survival of investment bank Lehman Brothers Holdings Inc. ( LEH ) doused Monday's optimism. [For a related story about Lehman's prospects in today's issue of Money Morning , please click here .]

In the long run, the biggest loser will almost certainly be the U.S. taxpayer, but there are other losers, as well.

But here's the key: There are also a few winners, and we're going to detail them for you.

Six weeks ago, when Treasury Secretary Henry M. “Hank” Paulson Jr . asked Congress for the authority to bail out GSEs, I looked at Fannie and Freddie's securities and tried to make predictions about which would do well . I said their senior debt would do well, as it became completely guaranteed by the U.S. government, but told readers that the two companies' common shares should be avoided, as any bailout would involve massive dilution.

That turned out to be correct – the government has taken warrants to buy 79.9% of both entities at a nominal price, effectively reducing the stake of existing stockholders to 20%.

On their preferred stock, I was bullish – provided Fannie and Freddie were able to sell new preferred stock to institutions, as they were planning to do; I felt that the government would not destroy the value of something that had only recently been issued. However, Fannie and Freddie were unable to make their planned preferred stock issues, so there were no new issues for the government to worry about.

Now the dividends on Fannie and Freddie's preferred stocks have been cancelled, and the preferred stocks are consequently worth very little. That is bad news for preferred stockholders, which include a number of banks, mostly small regional banks such as Midwest Bank Holdings Inc. ( MBHI ), which has 23% of its capital in GSE preferred shares, according to Bloomberg data. 

Because of the bailout deal's size, it has important implications for other sectors. For one thing, it is likely to be expensive. The Treasury now has a commitment to put up to $100 billion into both Fannie Mae and Freddie Mac if necessary, but it also has a program of buying mortgage-backed securities . While that will prop up that the market, it also will lead to additional borrowing by the federal government.

Since the amounts of money involved are important, the effect on both the U.S. money supply and the federal budget deficit, both areas of current concern , are likely to be significant. That means the bailout will be doubly bad for the Treasury bond markets – both because of its inflationary implications and because of the government's greater borrowing requirement. It also doesn't help that, adding in Fannie Mae and Freddie Mac's mortgage-debt guarantees, Uncle Sam's total indebtedness has almost doubled.

Theoretically, the GSE bailout should be good for housing and for financial institutions. For one thing, since Fannie and Freddie are now fully government-backed institutions, the spreads on their debt above Treasury bonds should narrow, reducing mortgage costs somewhat.

However, in the overall scheme of things, that's not likely to be a very important effect. Housing prices are still declining – although more slowly than before – and the question about what the U.S. Federal Reserve is going to do about inflation is acting as an increasing black cloud overhanging the U.S. housing market.

Either the United States has a recession deep enough to tame inflation – and that recession would have to be a pretty deep one at this stage – or the Fed will have to raise interest rates enough to attack inflation.

As for U.S. financial institutions, the losses that will be borne by holders of GSE preferred stock will dent their balance sheets yet again, and may suggest to investors that even the largest banks will be bailed out at the expense of existing shareholders.

However, European banks and other financial institutions may benefit a little – if they did not participate in the mortgage market directly, but only through their holdings of GSE paper. These foreign institutions may see some gains that can be written back through the income statement and boost short-term earnings.

Therefore, there are two strategic investments that clearly benefit from the bailout:

• The Rydex Juno Fund ( RYJCX ): This is a fund designed to move inversely to Treasury bonds; it has been a terrible investment recently, as T-bond yields have trended steadily down as prices rose. But because Treasury bonds will likely be hit both by higher inflation and greater government borrowing, this fund should benefit accordingly.

• Gold : The StreetTracks Gold Trust shares ( GLD ) may be the most efficient way of getting a pure gold play. At just above $800 an ounce, gold looks cheap, particularly as the bailout has provided yet another boost to world liquidity. In 1980, the last great inflationary episode, gold hit about $2,200 in today's money; a move towards $1,500 seems increasingly likely in the not-too-distant future.

[ Editor's Note : In Part I of this two-part series, Money Morning Investment Director Keith Fitz-Gerald took an in-depth look at how the bailout of Fannie and Freddie would adversely affect the U.S. taxpayer. Please click here to read Part I. If the whipsaw markets we're experiencing lead to the so-called market “Super Crash” that many analysts fear, shrewd investors won't have to worry. The reason: They will be able to capitalize on the once-in-a-lifetime profit plays that we detail in a new report. For a copy of that report – which includes a free copy of CNBC analyst Peter D. Schiff's New York Times best-seller, " Crash Proof: How to Profit from the Coming Economic Collapse " – please click here .]

News and Related Story Links:

• Money Morning Bailout Plan Analysis (Part I of II): Bailout Blues: Beware of the Unseen Fallout From the Fannie/Freddie “Rescue” Plan . Money Morning Financial Analysis: Fishing for Profits in the Fannie/Freddie Flotsam .
• Radio New Zealand : Lehman Fears Send Markets Into Skid .
• Wikipedia : Henry M. “Hank” Paulson Jr .
• IOUSA : Documentary Web Site

By Martin Hutchinson
Contributing Editor

Money Morning/The Money Map Report

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