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I submitted a write-up on May 14^th explaining the case for selling short Fannie Mae Fixed-to-Floating Rate Non-cumulative Preferred Stock, Series S.  It was then trading slightly above par, at $25.04, a price that severely limited upside to investors because it is callable at $25 on December 31, 2010.  The downside was real, however, as subsequent events revealed the fragility of what was essentially “a $12 billion fund (its self-reported fair value) that has written puts on $3 trillion of mortgages, $51 billion of which are subprime and $ 345 billion of which are Alt-A, achieving 250:1 leverage,” funding short-term, requiring approximately $1.5 trillion annually.  With Fannie Mae now in conservatorship, Series S trades for $0.95, its dividends eliminated until further notice by the Treasury Department.

Fannie Mae is a case study in buying “cheap options,” positioning to profit from extreme outcomes.  At par the Series S investor earned a small premium as long as Fannie Mae remained solvent and lost everything if it became insolvent.  I thought of the investor as having sold puts on Fannie Mae’s equity (and Treasury as having sold puts against its debt).  The short seller, by contrast, was buying the put.  At $0.95, Series S is again a cheap option, only now it is a call option, with the potential to benefit from an extreme event few have discussed:  the need for Treasury to cause all GSE preferred securities to increase in value as a means of recapitalizing the banking and insurance systems.

I was surprised when Treasury made its investment senior to the preferred shareholders and suspended dividends, not because there was value at the preferred level, but because I thought Treasury would not want to exacerbate solvency concerns at the regional banks and insurance companies that held the preferred stock.  At $0.95, I am positioned to benefit from the potential for Treasury to reverse its decision, at least in part.  Think of it this way:  if Treasury were simply to announce that it would consider reinstating Fannie Mae and Freddie Mac dividends during the conservatorship, the preferred securities would increase in value so dramatically that it would be tantamount to injecting tens of billions of dollars into the banking and insurance industries without needing Congressional approval.  The current cash cost in the form of dividends would be modest by comparison.

Absent this policy decision, the preferred securities still have some option value provided that the GSEs are not liquidated during the next several years.  Valuing the preferred stock is difficult because of Fannie Mae’s extraordinary leverage and because the GSEs’ future form is uncertain.  Treasury has three options:  (i) privatize, (ii) liquidate and move the US to a covered bond model, and (iii) nationalize the GSEs, bringing them back into the federal government, from which they were privatized only to serve budgetary manipulation.  There are many variations on each theme.  For example, the GSEs could be privatized as two entities or as ten; the GSEs could be privatized with an explicit guarantee or with an FDIC-like guarantee for which they would pay an insurance premium; the GSEs could be brought back into the federal government without or with public shareholders (this would preserve the inherent conflict of the dual mandate, but could serve as a check on government missteps).  Bernanke has pointed out that there is no buyer of last resort in the covered bond model, and that this is important should the US face another housing crisis.  When Congress is made aware of the dramatic fall in covered bond volume in the UK, it is hard to see them supporting such a strictly market-based approach.  Congress’ solution, then, is likely to increase the time to expiration of this call option.

Another thought is that Treasury will be under some pressure to make sure their senior preferred stock investment is "money good."  They are likely to want to overshoot rather than undershoot, which also increases the probability of a successful outcome.  By the way, Fannie Mae's market capitalization is now over $3 billion, which is absurd (and doubly absurd relative to the preferreds), but I have not sold the common stock short as a hedge.

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