Federal National Mortgage Association (OTC:FNMA) and Federal Home Loan Mortgage Corp (OTC:FMCC) investors got some good news this week when the Treasury Department and the Federal Housing Finance Agency announced that Fannie Mae and Freddie Mac will be allowed to retain $3 billion of income each in Q4 to start building up a capital cushion.

Now that capital retention is confirmed, Height Securities analyst Edwin Groshans says potential upside for Fannie and Freddie investors hinges on the details of the housing finance reform bill that is expected out in January.

Devil's In The Details

“GSE capital retention and a legislative vehicle that leads to privatization are positive developments for Fannie Mae and Freddie Mac; however, the potential upside for junior preferred shareholders will be determined by the value allocated to the class in the transition plan, which we expect Treasury and FHFA to develop,” Groshans wrote Friday.

He recently sat down and crunched the numbers on how much upside Fannie and Freddie junior preferred shares could deliver if they're converted to common shares at par value of $50 and $25 at conversion rates of 100 percent, 75 percent and 50 percent.

Path To Upside

To arrive at his estimates, Groshans divided the par value of the preferred shares by the closing price of the common shares as of Dec. 21 ($2.83 for Fannie Mae and $2.67 for Freddie Mac). Groshans then estimated that the value of those common shares will decline by 35 percent after the conversion process.

If the preferred shares are converted at a 100 percent rate, Height estimates 130 percent average upside for Freddie preferred shares and 117 percent average upside for Fannie preferred shares. Even at a 50 percent conversion rate, Groshans sees an average of 15 percent upside for Feddie preferreds and 8 percent upside for Fannie preferreds.

How To Play It

Groshans sees the most potential upside for Freddie Mac variable rate series B, G, L, M, and N preferred shares, which he estimates could each more than triple in value if converted at a 100 percent rate. Among Fannie Mae preferred shares, Groshans estimates the most potential upside (at least 160 percent) for series E, M, and G shares.

Here is a rundown of the tickers of the junior preferred shares mentioned above:

FED HOME LOAN MTG (OTC:FMCCI)
FED HOME LOAN MTG (OTC:FMCCG)
FED HOME LOAN MTG (OTC:FMCCL)
FED HOME LOAN MTG (OTC:FMCCM)
FED HOME LOAN MTG (OTC:FMCCN)
FED NATL MORT ASSC (OTC:FNMFM)
FED NATL MORT ASSC (OTC:FNMAL)
FED NATL MORT ASSC (OTC:FNMAO)

Why Fannie And Freddie Have A Path To Survival

Image Credit: Carol M. Highsmith [Public domain], via Wikimedia Commons

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