Former Blue Chips Are Now Penny Stocks

| October 3, 2008 | 0 Comments

Just this morning I was in line at Starbuck’s.  I’d gotten there before the usual morning crowd.  It was quiet and peaceful.  Still half asleep, I listened to the soothing jazz music.  I was really looking forward to that cup of coffee.

All of a sudden these two guys barged through the door.

Their voices were loud, their tones excited.  (Clearly they’d already had a cup of coffee – or three).  Their hands were gesturing in all directions.  I could tell they were talking about the financial crisis.

One of them exclaimed, “Fannie Mae and Freddie Mac are the buys of the century!”

I couldn’t believe my ears . . . and I couldn’t help but listen in.

He kept talking, listing reasons for buying shares of both Fannie and Freddie.

“At these prices there’s nothing but upside.”

“Your risk of a total loss is small.  The government’s not going to let these companies fail.”

“It’ll take a few years, but eventually these stocks will be worth 20 or 30 times today’s prices.”

I couldn’t believe what I was hearing.  Right now, Fannie and Freddie are penny stocks.  At least one guy thinks of them as great bargains.  I began to wonder how many others were thinking the same thing.

Some of you might even be thinking, “What’s wrong with buying Fannie and Freddie at these prices?”

I have hundreds of reasons.  But let me give you three easy ones.

Government’s bad for shareholders.

Fannie and Freddie will be managed by a government agency. Government is concerned with protecting the public, not making money.

Call me crazy, but I want management focused on issues important to shareholders.  Increasing revenues.  Cutting costs.  And making money. These are the things that grow shareholder value and push stock prices higher.

Shareholders are at a huge disadvantage.

The government gets 80% of Fannie and Freddie in the form of senior preferred shares and warrants.  This takes priority over all other equity shares.  So, common shareholders are at the bottom of the ladder when it comes to profits.

Who knows what’s going to happen in the future.  Fannie and Freddie might be turned into public utilities whose rates are regulated by the government.  Or they might be converted into government agencies.  A third possibility is that they will be broken up into smaller public companies.

Each of these paths out of conservatorship carries significant risk.  None of these offer much upside potential for shareholders.

But that’s not all.

Shareholder interests are being diluted.

Every time the government injects capital into Fannie and Freddie, they’ll take more senior preferred shares and warrants.  Each new preferred share and warrant reduces the value of the existing shares.  This is called dilution.

What’s dilution and why is it bad for shareholders?

I’m glad you asked.

Let’s say a company has 100 shares of stock outstanding and you own 10 shares for a 10% interest.  Then the company issues another 100 shares of stock to a private investor, say – the government.  Your ownership interest is now 10 shares out of 200 shares outstanding or 5%.

By doubling the shares outstanding, the company has just cut your ownership interest in half.  This is what’s happening at Fannie and Freddie.

What happens if they need more cash?

The government’s pledged $100 billion dollars each for Fannie and Freddie.  For each dollar received, the companies will issue more equity to the government.  Every new share dilutes the interests of existing shareholders.

I think you’ll agree 100 billion dollars makes for a lot of dilution.

These are just a few of many reasons to avoid being sucked into Fannie and Freddie.  At first blush they might look attractive, but they’re what professional traders call “value traps” – pure and simple.  At best, these shares are dead money for several years.  At worst, they’re dead money for several years and then ultimately worthless.

If you’re tempted to take a flier on Fannie and Freddie, understand the risks and be prepared to lose your money.  Personally, I think you get better odds at a craps table.

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Category: Penny Stocks

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The Dynamic Wealth Report works with a number of staff writers and guest experts who specialize in everything from penny stocks to ETFs to options trading. These guest analysts post under the 'staff writer' moniker for ease of use.

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