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Investors buy 'Lotto ticket' with bet on Fannie and Freddie

Wednesday, 10 Jul 2013 | 1:53 PM ET
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Regular investors are rolling the dice on the common stock of Fannie Mae and Freddie Mac in a big way, making a risky bet that Congress and the Obama administration won't get their way in doing away with the government-controlled entities. A move that would leave the shares worthless.

The pair of mortgage finance companies, which now trade over the counter after their delisting from the NYSE, were among the most actively traded shares by the retail investor in June, according to TD Ameritrade's analysis of its 6 million funded accounts. They are right up there in popularity with the high-flying momentum stock Tesla.

This raises many questions. Does the retail investor know exactly what they are betting on? Do they know that these are not the preferred shares that pay a dividend and are owned by many hedge funds? Do they know that these shares are last in line in the capital structure and therefore last to get paid?

"I don't think the retail trader knows what they're doing," said Stephen Weiss of Short Hills Capital Partners. "They are looking to buy a lotto ticket and not realizing they could lose 100 percent of their capital in these things."

One of the rare bipartisan views shared by many lawmakers are that these enablers of the housing crisis five years ago should be totally nationalized. This is essentially what would happen under the bipartisan bill proposed by Sens. Bob Corker and Mark Warner that would wind down Fannie and Freddie, send most—if not all—their profits into U.S. coffers, and replace them with a government-run reinsurer.

(Read More: Hedge Funds vs. Treasury on Fannie Mae)

Fannie, Freddie Sued by Hedge Fund
CNBC's Kate Kelly reports Perry Capital is suing the Treasury Department over its handling of the government-controlled entities. And the FMHR traders have the play on banks ahead of second quarter earnings.

But some investors are taking exception to this bill, as well as the existing setup of the government's conservatorship that has paid the government $130 billion in dividends so far. This amount was buffeted by a change in the rules of the conservatorship by the Treasury last year to sweep all the dividends back to the government.

Riding the housing recovery, Fannie and Freddie over the next five years will pay back much more than the almost $200 billion injected by the government to rescue the entities during the financial crisis. Investors—both Wall Street and Main Street alike—believe those profits should go to preferred and common shareholders in the form of a payout.

"Congress keeps misunderstanding this issue," said Larry McDonald, a trader and political risk analyst. "Retail investors are heavily invested in Fannie and Freddie. Many still own their 2008 shares when they were told by Bernanke and political leaders that Fannie and Freddie were well capitalized."

(Read More: Another Fund Sues Over Fannie, Freddie)

This week, two firms that purchased the preferred shares—hedge fund Perry Capital and mutual fund manager Fairholme Capital Management—filed lawsuits alleging that the government was changing the rules on the fly and have a fiduciary duty to pay out at least some of these profits.

The kicker is that since the government owns 80 percent of the shares, it would be hurting itself if it decides not to pay out enough money to trickle down to the preferred shareholders and then, the common shareholders.

The ideal scenario would be to allow the firms to recapitalize and the government to sell its stake back in the open market after the taxpayer gets paid back in full. Future dividends would then go to equity holders and the government could still have stronger oversight of the entities than before the crisis by creating some sort of FDIC-type insurance body for the mortgages originated by the firms.

But this would go against the current sentiment in Washington.

So while the common stock of Fannie and Freddie are up 500 percent this year alone, investors should be very careful before buying the shares (both priced under $2) and certainly realize the risk remains of losing all their money.

—By CNBC's John Melloy. Follow him on Twitter @CNBCMelloy.

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