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Killing GSEs Could Kill Fixed-Rate Mortgage Loans, Says Bove

Stocks in this article: FNMA FMCC AIG

NEW YORK (TheStreet) -- Politicians of all political stripes love to bash Fannie Mae (FNMA) and Freddie Mac (FMCC). However, unwinding the government sponsored enterprises (GSEs) could be very dangerous for the U.S economy, according to Rafferty Capital Markets analyst Richard Bove.

"Historians will relate that the reason that the nation has 20 and 30 year fixed rate mortgages is because the GSEs buy them," Bove wrote in a note to clients on Friday.  The analyst went on to say that "If the GSEs are gone so will be these mortgages. Banks might make 15 year self-amortizing mortgages but it is very unlikely that they will carry fixed rates. The standard mortgage in the United States is like to be a 10-year, self-amortizing, adjustable-rate mortgage."

What Bove is talking about is the possible consequences of plans being bandied about in Washington to do away with Fanne Mae and Freddie Mac, which together purchase the great majority of the mortgage loans being originated in the United States.

Fannie Mae and Freddie Mac were taken under government conservatorship at the height of the credit crisis in September 2008. The U.S. Treasury holds $117.1 billion in senior preferred Fannie Mae shares and $72.3 billion in senior preferred Freddie Mac shares. Under their modified bailout agreements, the GSEs must pay all earnings to the government in excess of minimal capital cushions of $3 billion apiece.

Following their next dividend payments in December, the government will have received $185.3 billion in dividends from Fannie and Freddie, for a five-year investment of $189.4 billion. But there's no mechanism in place for either GSE to repurchase any government-held preferred shares.

This means that common shareholders of Fannie and Freddie, along with their junior preferred shareholders, are to remain out in the cold. Fairholme Capital and other institutional investors holding common and/or junior shares of Fannie and Freddie have filed multiple lawsuits against the government, saying the modified conservatorship was an illegal seizure of their property.  Many institutional investors -- including Bill Ackman's Pershing Square -- see a chance for huge gains on the common and/or junior preferred shares, depending on how the battle for the future of the GSEs works out.  There's no denying that the government's return on the GSE bailout is turning out to be a hefty one. 

Fairholme Capital founder Bruce Berkowitz on Nov. 13 proposed that his mutual fund management firm and a group of private equity investors take over the operating assets of Fannie and Freddie, with his firm and other institutional investors providing $17.3 billion in capital.  Under Berkowitz's plan, the lawsuits would be dropped, the bulk of the GSE's balance sheets would continue to be run down by the government and two new companies would be formed to take over the GSEs leading role in the U.S. secondary mortgage market. The proposal also calls for private investors to receive $34.6 billion from Fannie and Freddie in exchange for their preferred shares in the GSEs.

Based on comments from the Obama administration and members of Congress, "killing Fannie and Fannie" is still quite a popular notion in Washington. However, the political reaction to Berkowit'z offer was quite negative

So what does the future hold for Fannie and Freddie?  The investors placing bets on the constitutional question over the government's modified bailout plan, under which Uncle Sam gets huge dividend payouts from the GSEs while allowing no repurchase of government-held preferred shares, may see a huge payday somewhere down the line.  But the GSEs could still wind up being shuttered.

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