Freddie Mac: A Strong Trump Trade Candidate

seekingalpha11-08

Freddie Mac is a GSE that provides mortgage financing to the American real estate market.FMCC shares surged 39% after Trump's re-election, as investors bet on a potential privatization of the company....

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One prominent 'Trump trade' that has been bandied about by hedge funds is the Federal Home Loan Mortgage Corporation (OTCQB:FMCC), more commonly known as 'Freddie Mac'. For sure, Freddie Mac had a tremendous one-day response to President Trump's re-election, rallying 39% on the day after the election (Figure 1). Figure 1 - FMCC was a huge beneficiary of the Trump election win (Seeking Alpha) However, after such a strong rally, is there still any upside left for investors buying at today's prices? I believe there should still be upside potential for speculators since the shareholder's equity of Freddie Mac is potentially very valuable. However, the unknowns are 1) whether Freddie Mac will be privatized, 2) the timing, and 3) the dilution to shareholders. I rate FMCC a speculative buy, but would recommend investors only bet with money they can afford to lose. Company Overview The Federal Home Loan Mortgage Corporation ('Freddie Mac') is a government-sponsored enterprise (\"GSE\") chartered by the U.S. Congress in 1970 to provide financing and support to the U.S. housing finance system and to help ensure reliable and affordable access to mortgage financing across the country. Freddie Mac's primary business is buying loans that meet their lending standards (i.e. conforming loans) from banks and other approved lenders (Figure 2). Figure 2 - Illustrative business model of FMCC (FMCC 10K report) Once it has accumulated a pool of mortgages, Freddie Mac then packages the mortgages into mortgage-backed securities (\"MBS\") that it sells to investors interested in the interest rate, prepayment, and liquidity risks of the pool of mortgage loans. Freddie Mac primarily earns net interest income (\"NII\") on its mortgage loans and non-interest income from investment gains and fees on providing credit guarantees on multifamily securitizations (Figure 3). Figure 3 - FMCC financial summary (FMCC 10K report) In 2023, Freddie Mac earned $18.5 billion in NII, $2.7 billion in non-interest income, and $10.5 billion in net income, making Freddie Mac one of the biggest players in the American real estate markets. Nationalized During Great Financial Crisis With a business gushing ~$10 billion+ in net income a year, it is hard to imagine why Freddie Mac is owned by the U.S. government. The reason stems from the 2008 Great Financial Crisis and the government's near $200 billion bailout of Freddie Mac and Fannie Mae, its GSE sibling. Heading into the Great Financial Crisis, the American real estate markets saw a tremendous boom from lower interest rates and a belief that residential real estate prices could only go up. The boom was partly fueled by a shift towards non-traditional mortgage financial products such as adjustable-rate mortgages (\"ARM\") and mortgages to subprime borrowers. Investors were also shifting away from GSE securitizations (i.e. Freddie and Fannie) towards private-label securitizations (\"PLS\"). In order to maintain market share and deliver consistent earnings growth, the GSEs' private shareholders forced the GSEs to lower their underwriting standards and compete with the PLS. Ultimately, we all know how the story ended. The American real estate bubble popped in 2008 and the U.S. government had to step in to bail out Freddie Mac with up to $100 billion in capital each (Freddie Mac drew $71 billion in capital) to prevent a disorderly bankruptcy. In exchange, Freddie Mac issued $1 billion of senior preferred stock to the U.S. Treasury Department plus 20-year warrants to purchase 79.9% of the company for a nominal price. As part of its conservatorship, Freddie Mac also has to pay all of its net profits to the U.S. Treasury Department as a dividend on its preferred share ownership. Through September 2019, Freddie Mac has paid nearly $120 billion in dividends to the U.S. Treasury, and the company paid $10.7 billion in dividends in 2023 (Figure 4). Figure 4 - FMCC Income statement (FMCC 10K report) With all of its profits being diverted to the U.S. Treasury, the shares of Freddie Mac became virtually worthless and fell to ~$1/share (Figure 5). Figure 5 - FMCC share price (Seeking Alpha) What Is The Opportunity? Coming back to the main point of this article, the opportunity for investors is that one of the earliest decisions of the President-elect will be to name a new head of the Federal Home Finance Agency, which oversees Freddie Mac and Fannie Mae. In his prior administration, President Trump had sought to privatize Freddie Mac and Fannie Mae, both as a way of raising money to fill depleted government coffers, and also as a potential reward for long-time loyalists (hedge fund managers John Paulson and Bill Ackman, both vocal Trump supporters, have been long-time investors in preferred shares and common shares of Freddie and Fannie). If the government can privatize Freddie Mac, the now virtually worthless shares could be worth a pretty penny. For example, the largest American banks like JPMorgan and Bank of America trade at 13-20x trailing P/E ratios (Figure 6). Figure 6 - Money center bank valuations (Seeking Alpha) Assuming Freddie Mac can achieve a 15x P/E multiple for its equity and a trailing net income of $11.6 billion (Figure 7), Freddie Mac's equity could be worth $174 billion. Figure 7 - FMCC earned $11.6 billion in the trailing 12 months (tikr.com) After deducting the government's 79.9% control of the common equity (through their 20-year warrants), the remaining 20.1% could still be worth $35 billion, or multiples of what the shares are currently trading for in the public markets (Figure 8). Figure 8 - FMCC only has a $5 billion market cap (Seeking Alpha) Hold Your Horses In theory, the upside on FMCC shares is huge, provided the government recapitalizes Freddie Mac and refloats the company. The problem is, everybody knows the shares are valuable. The government will likely demand a fair market price for their ownership, and institutional investors who will participate in the recapitalization of Freddie Mac will likely demand equity warrants, similar to the government's. So ultimately, the question is, what is the dilution to existing FMCC shareholders in a recapitalization scenario? Typically, in a corporate insolvency/recapitalization, existing shareholders are wiped out, or receive only a tiny sliver of the resulting company. For example, a company I had written about previously, National CineMedia (NCMI), went through a Chapter 11 bankruptcy in 2023 and restructured its debts. As part of its restructuring, existing shareholders were diluted through a 1-for-10 reverse stock split and debt holders ended up with an 86% equity ownership of the resulting company. Technical Picture Positive For now, speculative hype will likely propel FMCC shares higher, at least until there is clarity on the privatization plans and the capital structure of Freddie Mac if it were to be privatized. The last time President Trump was in office, Freddie Mac shares rallied to over $4/share based on speculative hype, so there is definitely still upside at current levels (Figure 9). Figure 9 - FMCC had rallied to over $4 during prior Trump administration (stockcharts.com) But Only Bet With Money You Can Lose However, I strongly encourage investors to only bet/speculate with money they are prepared to lose, since there are still lots of unknowns with the privatization story. Moreover, bear in mind that you are competing with John Paulson (famous for making billions shorting the housing market during the Great Financial Crisis) and Bill Ackman, one of the sharpest hedge fund managers currently. They will have access to analysis and information that you will not have, and will likely be able to exit the trade at far more favorable terms than retail investors. Conclusion One of the best performing 'Trump trade' in the last few days has been shares of the Federal Home Loan Mortgage Corporation, more commonly known as 'Freddie Mac'. Freddie Mac was nationalized during the Great Financial Crisis, and there is a belief that President Trump will look for ways to privatize Freddie Mac once he assumes office in January. On the upside, shares of Freddie Mac could be worth multiples of where they are currently if privatization is approved and if the dilution to existing shareholders is not extreme. Overall, I think this is a good speculative bet. However, I would caution against betting too heavily on this trade, as there are still lots of unknowns. I rate FMCC a speculative buy.  Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. 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