Wall Street Journal Misses Fannie Preferred Point

NEW YORK ( TheStreet) -- The government is going to make a lot of money on its investments in Fannie Mae ( FNMA) and Freddie Mac ( FMCC) and junior preferred shareholders may eventually get in on the gravy.

In a Heard on the Street article Wednesday, the Wall Street Journal rightly said, "there is no plan, or mechanism, in place" for the company to repurchase $117.1 billion in preferred shares held by the government. But the Journal misses the point that investors in junior preferred shares of Fannie and Freddie may be see a huge payoff over the long term.

Fannie Mae on Tuesday reported record profits for the fourth quarter and for all of 2012, and said it could see a potential $58.9 billion windfall from the recapture of its valuation allowance for deferred tax assets (DTA), as early as the first quarter.

Fannie Mae's shares rose 13% on the news, closing at 90 cents on Tuesday. Sister mortgage giant Freddie Mac saw its shares rise 14% to close at 87 cents. Both Fannie and Freddie -- collectively known as the government sponsored mortgage enterprises -- were taken under government conservatorship at the height of the real estate crisis in September 2008.

Under its initial agreement with its regulator, the Federal Housing Finance Agency and the U.S. Treasury, Fannie Mae agreed to pay quarterly dividends at an annual rate of 10%, even if it failed to turn a profit, which forced the insolvent company to make multiple draws from the Treasury in order to continue operating and cover the dividends. Then in August 2012, after Fannie posted profits for the first and second quarters, the agreement with the Treasury was amended so that beginning in 2013, the company would no longer pay a 10% dividend on the government-held preferred, but instead would pay an amount based on the company's "net worth as of the end of the immediately preceding fiscal quarter."

Fannie Mae is now, essentially, paying all of its profits to the Treasury, while maintaining a "capital reserve" of $3 billion, which declines by $600 million a year, until it reaches zero in in 2018.

If and when the company recaptures some or all of the $58.9 billion DTA, that amount will be added to the previous quarter's profit, less the capital cushion, for a large dividend payment to the government.

Fannie Mae spokesman Andrew Wilson confirms there is no mechanism in place for Fannie Mae to repurchase any of the senior preferred shares held by the Treasury, no matter how high the dividend gets. He also says, "it is right and appropriate that our profits go to the taxpayers."

It certainly makes sense for Wilson to say that, but some quick back-of-the-envelope calculations show that the government may soon be looking at a shockingly high yield on its preferred investment in Fannie Mae.

Fannie Mae's second-quarter dividend to the government will be based on its first-quarter results. If the company were to recapture the full DTA, while also paying the same $4.2 billion dividend it did for the previous quarter, the total first-quarter dividend would be $63.1 billion. If we add that to the $35.6 billion in dividends already paid, we potentially have $98.7 billion in dividends paid to Uncle Sam through the second quarter.

That is a mighty hefty return for an investment of less than five years. Based on the full $117.1 billion in preferred shares, the dividend would make for an annual yield of 17% over a full five-year period. Of course, with the actual period being less than five years, and the government's investment slowing building up to the $117.1 billion, the actual yield would be higher.

And even if this all happens through the second quarter, there is no end in sight, since Fannie Mae's agreement with the Treasury has no expiration date.

Freddie Mac is in a similar position, owing the federal government $72.2 billion as of Dec. 31, with a DTA valuation allowance of $31.7 billion. Freddie reported net income of $4.5 billion for the fourth quarter and $11 billion for all of 2012. The company paid the U.S. Treasury dividends totaling $23.8 billion in dividends from 2008 through 2012.

Even though dividends on junior preferred shares in Fannie and Freddie have been suspended since the companies were taken under government conservatorship, and even though there is no end in sight for the Treasury preferred, some investors see value in the junior preferred shares.

For example, Fannie's preferred series E (FNMFM) shares, with a par value of $50.00 and a coupon of 5.10%, rose 23% on Tuesday to close at $8.00. The shares were flat in late morning trading on Wednesday.

Freddie Mac's preferred series Z (FMCKJ) shares, with a coupon of 5.375% and a par value of $25, rose 15% on Tuesday to close at $3.88. The shares were up 4% in late morning trading on Wednesday, to $4.02.

The Treasury holds a warrant to purchase up to 79.9% of Fannie's common shares, at an exercise price of just $0.00001 per share. That makes a long-term investment in the common shares a rather dubious proposition.

But for the junior preferred shares, the story is different. For one thing, the government is looking at a potential political time bomb, as it feasts on Fannie Mae's dividends. Numerous voices will be asking why the Treasury doesn't want its preferred investment -- the taxpayer bailout -- to be repaid. Fannie is now a profitable company with $3.2 trillion in total assets as of Dec. 31. It's not simply going to disappear, despite what we hear from various politicians.

There is also a possibility of the junior preferred shareholders filing a lawsuit against the government.

Australian hedge fund manager John Hempton, said in an interview with TheStreet on March 21 that the government's windfall on Fannie and Freddie could cause an "enterprising lawyer to take the case all the way to the Supreme Court and win."

Hampton said the August deal for Fannie Mae and Freddie Mac to effectively pay unlimited dividends to the government violated the Fifth Amendment of the U.S. Constitution, which requires "just compensation" to be given if the government seizes private property for public use.

Over the long haul, the government's potential for an outrageous yield on its preferred stake in Fannie and Freddie may constitute just the sort of "public use" that will end up with a big payout to junior preferred shareholders.

-- Written by Philip van Doorn in Jupiter, Fla.

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Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for TheStreet.com Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.

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