John Hempton writes,

Pre-tax, pre-provision operating profits of Freddie Mac are running at over $15 billion. If the government were not demanding 10 percent on its preference shares the companies would be sufficiently well capitalised to repay their interest in 4 years. With the drag of having to pay the government $5 billion per annum it will take a bit over five years. Either way the operating profits of Freddie Mac are big enough to ensure the government gets its money back. If you do the same analysis for Fannie Mae its is even better. However Fannie has less aggressively marked private label securities to market so it has less chance of recoveries from their current marks.

He goes on to advocate speculating in Freddie and Fannie preferred stock. Actually, months ago, I heard a similar case made by an ex-Freddie Mac employee with good financial smarts. “Keep your eye on NIM,” he said. That’s net interest margin, which Hempton talks about here. My friend said you should only speculate with money you are prepared to lose entirely. I think that’s right. If Hempton’s scenario plays out, you could do really well. But there are economic and political scenarios in which your investment goes to zero.

My personal concern would be whether Freddie and Fannie are doing enough to hedge their interest-rate risk. As I’ve said before, it seems to me that they are making mortgage loans at interest rates that seem ridiculously low. I worry that they will be tempted to use short-term funding to try to get quick profits, leaving themselves exposed down the road. Hempton’s on top of that issue, but not really. He talks about Freddie having timed the market well at the time of his post. But risk management is not the same as market timing. In fact, it’s the opposite–it’s constructing a portfolio that allows you to sleep soundly whatever the market might do. I have no inside information about what Freddie is up to, but Hempton’s analysis leaves wide open the possibility that it is trying to fund too many long-term mortgages with too little long-term debt.

If you could ignore political risk, you could hedge a purchase of Freddie or Fannie shares by buying deep out-of-the-money put options on Treasuries. Which is what Freddie and Fannie ought to be doing for themselves (again, I have no information one way or the other on whether they are doing it).