Fannie and Freddie Keep Tumbling: Financial Losers (Update 1)

Updated from 2:27 p.m. ET with market close information and additional comments on Thursday from Michael Kao of Akanthos Capital Management.

NEW YORK ( TheStreet) Fannie Mae ( FNMA) and Freddie Mac ( FMCC) continued their epic slide on Thursday, following their change of course on Wednesday.

Shares of Fannie Mae dropped 40% to close at $1.73. The shares had declined 29% to $2.90 on Wednesday, following an increase of 140% the preceding week through Tuesday when the stock closed at $4.08.

Freddie Mac's shares were down 39% to close at $1.60. The shares had fallen 30% on Wednesday to close at $2.61, after seeing a one-week return of 150% through Tuesday's close at $3.75.

Fannie and Freddie together are known as the government-sponsored enterprises, or GSEs, and were taken under government conservatorship in September 2008. The GSEs together hold roughly $5.2 trillion in mortgage loans and mortgage-backed securities, and remain critical to the U.S housing market, as they purchase roughly 90% of newly originated mortgage loans in the United States

After the GSEs were placed under conservatorship their common shares plunged, as investors had no confidence the common shareholders could ever see a decent return, because of the size of the government bailout and the GSEs' uncertain future.

Common shares of both companies traded for just 26 cents at the end of 2012.

GSE shares were strong all last week, and Ralph Nader on Friday wrote in an explosive op-ed piece in the Wall Street Journal that , saying the two companies' common shareholders should fight against the federal government's "great Fannie and Freddie rip-off."

As part of its bailout agreements with Fannie and Freddie, the GSEs granted the government warrants to purchase just under 80% of the common shares of the two GSEs at a strike price of $0.00001 per share.

"The zombie common shareholders have no rights or remedies against Fannie and Freddie, both operationally active companies, or their regulator -- the Federal Housing Finance Agency," Nader wrote on Friday. "FHFA ordered the Fannie and Freddie boards and executives to suspend communications with shareholders and abolish the annual stockholders meeting."

President Obama and Congress are expected soon to negotiate over the future of the U.S. mortgage finance market, which will include a way forward for Fannie and Freddie, or possibly the long-term dissolution of the GSEs

Nader wrote that "the common shareholders of Fannie and Freddie need to organize and make their voices heard in Washington. Clearly, they should have a say in how Fannie and Freddie are managed -- in the board room and in Congress -- from here onward."

A Massive, Profitable Bailout

The U.S. Treasury holds $117.1 billion in Fannie Mae senior preferred shares and $72.3 billion in Freddie Mac senior preferred shares, for the multiyear bailout. Fannie Mae announced on May 9 that it would pay the Treasury a second-quarter dividend of $59.5 billion, after the GSE determined it could recapture most of its valuation allowance for deferred tax assets (DTA) at the end of the first quarter.

Freddie Mac announced on May 8 that it would pay a dividend of $7 billion to the Treasury in June.

Following the June dividend payments from Fannie and Freddie, the government will have received dividends totaling $131.6 billion on its combined GSE preferred investment of $189.4 billion.

A major factor holding GSE common and junior preferred shares back through the end of last year was, was the lack of a mechanism allowing either GSE to repurchase any government-held preferred stock. That hasn't changed, despite the much brighter earnings outlook for Fannie and Freddie.

Junior Preferred Shares

Dividend payments on junior preferred shares of Fannie and Freddie were suspended in September 2008 when the two companies were taken under conservatorship.

With junior preferred shareholders having preference ahead of common shareholders for any possible reward from Fannie and Freddie, the market action for the junior preferred was strong for several sessions through Tuesday's close. But they were down on Wednesday and continued to decline on Thursday.

Fannie's preferred Series E shares, with a face value of $50, plunged 32% to close at $10.26, following a 24.5% decline on Wednesday. The shares trade under the symbol FNMFM.

Freddie Mac's preferred Series Z shares, with a face value of $25, ppulled back 3% to close at $6.45, after declining slightly on Wednesday to close at $6.66.

A high-profile institutional investor has disclosed major investment in GSE preferred shares, possibly signaling a large commitment by other big investors, which could provide a solid "floor" for the junior preferred shares.

CNBC on Wednesday reported that Bruce Berkowitz's Fairholme Capital Management had taken a roughly $500 million position in GSE preferred shares.

Berkowitz, in a note to CNBC, wrote "taxpayer dollars expended by the government during a time of national crisis will be fully repaid," adding that "equitable treatment of taxpaying shareholders, including community banks and insurance companies, must be restored.

"The government's ability to fully recoup its investment and restoring value to shareholders are not mutually exclusive," Berkowitz wrote.

When asked about the weakness in GSE common shares on Wednesday, Michael Kao, head of Los Angeles-based hedge fund Akanthos Capital Management, said in an email exchange that "the furor that took the common stock to a $40 billion combined market cap seemed overdone when the preferreds have continued to languish at an $8 billion capitalization."

Kao on Thursday said in an interview with Bloomberg TV that there might be a future for the GSE's government-sponsored business model. "It was really a failure of oversight, as opposed to a failure of the public/private model," that led to the GSE bailouts, he said.

"If you go ahead and dismantle these guys cold turkey and don't guarantee the legacy book $5 trillion in obligations, you can throw the MBS markets into complete chaos," he said.

If Fannie and Freddie were to be fully nationalized, Kao said "there will be no political will to re-attract private entrance to the marketplace."

Other Financial Services News

The broad indices were all up 1% in afternoon trading, and the KBW Bank Index ( I:BKX) 1% to 62.90, after two slightly disappointing economic reports gave pause to investor fears that the Federal Reserve might soon curtail its monetary stimulus.

The Bureau of Economic Analysis reported that its second estimate on U.S. first-quarter GDP showed an annual growth rate of 2.4%, which was down from the first estimate of 2.5%. U.S. GDP grew at an annual rate of just 0.4% during the fourth quarter, in part because of the effect of Superstorm Sandy on the Northeast. The consensus estimate among economists polled by Thomson Reuters was for the first-quarter GDP growth rate estimate to remain at 2.5%.

The Department of Labor said that initial unemployment claims for the week ended May 25 increased by 10,000 to 354,000, which was above the consensus estimate of 340,000. The four-week moving average for initial jobless claims was 347,250, an increase of 6,750 from the previous week's average of 340,500.

Shares of CIT Group ( CIT) were up 6.5% to $47.37 in afternoon trading, after the lender announced that the Federal Reserve Bank of New York had lifted a consent order placed in August 2009. The order required CIT to submit all plans for capital deployment to the New York Fed for approval.

BTIG analyst Mark Palmer in a note to clients on Thursday wrote that as investors grew tired of waiting for the order to be removed, they chose "to focus on investment opportunities in which the timeframe for potential catalysts was more easily defined."

The removal of the regulatory order "is also critical insofar as we believe it likely presages another announcement long awaited by investors in the company's shares: that the capital plan it had submitted to the Fed has been approved, and that CIT will finally begin returning part of its ample capital to shareholders," Palmer added.

CIT has already announced that any return of capital to investors this year will be modest, but according to Palmer, the company has "sufficiency of capital to support share buybacks and/or the initiation of a dividend is clearly not an issue as the company's Tier 1 and Total Capital ratios as of Mar. 31 were enormous at 16.3% and 17.1%, respectively."

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

>Contact by Email.

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.

More from Investing

McDonald's Criticized for Not Doing More in Wake of Sexual Harassment Claims

McDonald's Criticized for Not Doing More in Wake of Sexual Harassment Claims

Finding Stocks Right for You: Cramer's 'Mad Money' Recap (Friday 8/25/18)

Finding Stocks Right for You: Cramer's 'Mad Money' Recap (Friday 8/25/18)

Jim Cramer: The 10-Year Yield Could Go to 2.75%

Jim Cramer: The 10-Year Yield Could Go to 2.75%

Bitcoin Today: Prices Continue to Slump Heading Into Weekend

Bitcoin Today: Prices Continue to Slump Heading Into Weekend

Week Ahead: Wall Street Looks to Jobs Report as North Korea Meeting Less Certain

Week Ahead: Wall Street Looks to Jobs Report as North Korea Meeting Less Certain