Freddie Mac FRE PRZ S
February 10, 2010 - 8:30pm EST by
2010 2011
Price: 1.04 EPS $0.00 $0.00
Shares Out. (in M): 0 P/E 0.0x 0.0x
Market Cap (in $M): 0 P/FCF 0.0x 0.0x
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT 0.0x 0.0x
Borrow Cost: NA

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I am recommending an arbitrage trade within the preferred stock of Freddie Mac with a long position in the FRE PRN and a short position in the FRE PRZ with a ratio of 1.7 shares short for each share long. These are pari passu issues with the only substantial difference between the two the par value of the preferred. The Series N preferred has a $50 par value and the Series Z has a $25 par value.

Despite having 2x the par value of the Series Z, the Series N trades at only a 26% premium to the Series Z. As a result of this disconnect, it is possible to create an arbitrage where you can profit regardless of what the ultimate outcome to the preferred stock is so long as the relative par values are respected by the government. For instance, if the government chooses to cancel all the pref stock, you would make about $0.45 on each share of pref N (or about 34%). Alternatively, if the pref stock is reinstated or rolled over into a new entity, etc, you would make about $7.20 on each share of Pref N if both issues go back to par. The way you lose a lot of money is if the government decides to just give everyone something like $5 or $10 for each pref share and not to base this on the relative par values (i.e. you get the same amount of new consideration regardless of whether you own the $50 or $25 preferred). Even for this administration's view of property rights (see Chrysler), I think that is unlikely.

While the cost to borrow the Series Z is low, the amount of borrow is limited and both series are rather illiquid. Accordingly, this trade is probably only good for your PA.

I think this is a timely idea because members of both the executive branch (mostly treasury) as well as Barney Frank have publicly stated that a working solution to Fannie and Freddie is a priority for the beginning part of this year. I'm not holding my breath for a politician to act, but a 1%-ish annual cost to borrow on the Pref Z means I can wait if needed. This is the end of this idea.


Frankly I think that these issues of preferred stock have been puked by institutional investors and have become the playthings of retail investors trading 100 shares at a time for a quick high in between completely incoherent Oxycontin spells. Accordingly, the primary emphasis has been on the absolute cost per share rather than the cost per share as a percent of par value and hence the opportunity. You can profit from this inefficiency and hopefully the current inept administration keeps to their timing that dealing with Fannie and Freddie is a priority for the first part of this year.

(Disclaimer: I don't like any politicians - nothing specific to this administration)

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