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Fannie Mae Preferred Shares: Financial Winners

An example of a major credit recovery was the $10.3 billion settlement in January by Bank of America (BAC - Get Report) of a long simmering mortgage putback from Fannie Mae. Bank of America agreed to pay Fannie $3.6 billion in cash and pay roughly $6.75 billion to repurchase about 30,000 mortgage loans.

Fannie reported a third-quarter profit of $1.8 billion, which was the company's third consecutive profit. Earnings for the first three quarters of 2012 were $9.7 billion, compared to a net loss of $14.4 billion during the first three quarters of 2011. The company was also able to pay its third-quarter dividend of $2.9 billion in the Treasury's preferred shares, without resorting to further government borrowings.

Freddie Mac filed its 2012 10-K on time, saying its valuation allowance for deferred tax assets (DTA) was $31.7 billion, as of Dec. 31. The government held $72.2 billion in Freddie Mac preferred shares at the end of 2012. Freddie earned $11 billion during 2012, swinging from a loss of $11 billion in 2011. The company paid $7.2 billion in dividends to the Treasury during 2012, for a total of $23.8 billion in dividends paid since the company was taken under conservatorship.

While the GSEs are now required to pay all profits in excess of certain capital buffers directly to the Treasury, the expected continued profit improvement, along with a possible massive DTA recapture, could put them on a solid path to escaping the bailout faster than most investors expected back in September 2008. That points to a possible massive payday ahead for long-term investors, although there's plenty of political risk as the GSEs' fate is eventually decided.

There is also the prospect of a lawsuit by preferred shareholders against the FHFA. After all, if Fannie and Freddie are able to recover sufficiently to repay the government, which shouldn't other preferred shareholders -- who are ahead of the common shareholders in line -- get paid too?

The above examples show the obvious potential for very large gains for long-term investors, if the preferred shares of Fannie and Freddie rise to par, and if the companies continue to improve, that is a possibility if the dividends are restored, because those yields are quite attractive in such a low-rate environment.
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