On Friday, news that Bank of China has significantly reduced its exposure of Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE) spooked investors and triggered a drop in Fannie and Freddie shares.

It’s only the latest in a long series of bad news stories concerning the stricken giants.

However, Andrew Gordon says preferred shares in Fannie and Freddie still represent some of the best value to be had in the market right now.

This from Andrew in today’s Investor’s Daily Edge:

Last Thursday, Richard – my colleague and the person I turn to whenever I have a question about the bond market – called me.

He wanted to talk corporate bonds. And he knew I’d be interested.

“I just had a client on the phone. He wanted to buy GMAC bonds. I asked him why. He said if GM fails, the government will bail them out. What could be safer than that?” Richard said.

I had talked to Richard a week before about GSE (Government-Sponsored Entity) bonds. So I knew where this conversation was headed.

“Would you be interested in a bond-like instrument with similar ratings but with double the yield?’ I asked him. Plus the government is going to save this company before GM.”

“By the end of the conversation, he was sold on Freddie and Fannie preferred shares,” said Richard.

This was the same Freddie and Fannie whose shares have been nose-diving. I told him that I found it surprising that he was recommending them.

“I know. You’re either going to be a hero or a bum. But the downside isn’t nearly as bad as you’d think. And the yield is unbeatable.”

Before I go on, let me explain to you that there are three ways to invest in F&F – and each way has a very different risk exposure.

Most exposed are the common shareholders. If F&F goes under or is taken over by the government and restructured, they’re on the bottom of the totem pole for getting any money back.

On the top of the totem pole are the bond holders. Any cash that F&F are holding – and/or any asset sales (like their mortgage paper) that generate cash – go to the bond holders first.

And anything left over after the bondholders get their share goes to the owners of preferred shares.

While they’re called “shares” they are actually much safer than common shares and behave more like bonds. They also come with yields that can go higher or lower (depending on the share price). And they can be bought and sold at discounts (and premiums).

Preferred shares also come with a coupon. The coupon states the interest that the shares will give. It’s equivalent to a legal contract. A company cannot arbitrarily decide to make good on it, not like it does on dividends paid to shareholders. It has to pay up. And it has to pay preferred shareholders before common shareholders.

Okay, now back to my conversation with PR. He told me the F&F Preferreds are selling at around a 60 percent discount. So for every $100 of these shares, you only pay about $40.

If F&F doesn’t have enough money to buy back the entire value of your preferred shares but has some money left, you still end up with a better deal than if GM went broke, for example.

Here’s an example of how that works. Let’s say F&F can only pay you back a quarter on the dollar. That’s $25 for every $100 worth of shares. But since you paid only $40 for these shares, the $25 gets you over 60 percent of your money back.

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Mind you, this is one of the worst-case scenarios that is being discussed and PR thinks the alarm and panic on Wall Street on what could happen to F&F if the Treasury decides to “bail” it out is way overdone.

“Investors have been selling on all this speculation about what the government may do. But the Treasury Department isn’t giving out any details. So that’s all it is. Speculation.  But the selling is driving the price down. And that just feeds on itself. Investors see the price dropping and that encourages more selling.”

Richard says, “I’m buying.”

As you know by now, I’m not a big fan of Freddie and Fannie. As private-sector companies with government-mandated missions and sponsorships, I called them mutts in this space a couple of weeks ago

I was insulting them or at least trying to. A reader wrote in complaining that I insulted his dogs instead – how dare I compare F&F to his beloved dogs. Hmmm… sorry about that.

I’m not interested in hurling insults at F&F. I’m more interested in making money off them.

And the government has created a wonderful opportunity for you to do so.

The government won’t let Freddie and Fannie fail. That much is clear. That should have strengthened F&F in the eyes of investors. But it did the opposite. At least at first.

But investors are once again warming up to Freddie and Fannie. They went into the market in the past two weeks and raised a combined three billion dollars from the bonds they issued.

Investor demand was strong, so they were easily sold.

And the share prices of both companies – having dropped over 90 percent – have staged a mini-rally over the past week. Take a look:

While preferred shareholders are still vulnerable, the basic fact about them is this: they represent a highly protected class of shareholders in a company that has the implicit backing of the U.S. government.

This is all new territory for everybody. And it may be weeks or months before this all plays out. But the biggest secret of making big money is to invest in hated assets. I love this investment despite Wall Street’s nervousness over F&F.  In fact, I love it because of Wall Street’s nervousness.

I believe that Wall Street has got this issue wrong.

For gosh sake, Paulson comes from Wall Street. He knows what’s at stake. He’s going to give F&F every chance to get back on their feet. And if he has to act, he will act to save the value of these GSEs – not kill it. If Wall Street wasn’t so quick to scare – God bless them – they’d have figured this out.

With preferred shares you get double-digit interest yield on an investment which also has the backing of the U.S. government – and that backing is much more explicit than it used to be.

Sounds pretty good, doesn’t it?  On top of that, you get to buy these shares at over a 50 percent discount.

The bailout may never happen.  I do know that Mr. Paulson – the Secretary of the Treasury Department – gave the Treasury these bailout powers (he called them his “bazooka”) in the hope that just having them (as opposed to using them) would calm the markets. It took a while but the markets finally began to cooperate last week.

The risk-reward for preferred shares of F&F beat most anything else available on the market right now. They’re worth looking into.

A few facts: preferred shares are bought and sold on the major exchanges. They’re usually issued at $25 per share but F&F’s go for $50. As I said, they’re now being traded at huge discounts.

Source: The Best Buy in the Market? That Would be Freddie and Fannie.