Fannie, Freddie Still Have Enormous Potential

NEW YORK ( TheStreet) -- There's no doubt that the extreme volatility will continue for shares of Fannie Mae ( FNMA) and Freddie Mac ( FMCC), but despite the run-up this year, investors still see the potential for enormous additional gains.

Fannie Mae's common shares closed at $2.53 Monday, gaining 873% from their closing price of 26 cents at the end of 2012. Freddie Mac's common shares closed at $2.45 Monday and were up 842% from the end of last year when they also closed at 26 cents.

Junior preferred shares of Fannie and Freddie have also risen considerably this year, and since they have a potential to rise to par value if investors become convinced the dividends will be reinstated, they have been seen as a safer play. The junior preferreds are indeed the more conservative play for investors, based on the potential dividends and preference over the common shareholder in the event the GSEs were "broken up" by the government.

But the eventual gains on the preferred shares are limited by their (hopefully reinstated) dividend yields relative to the market. The common shares are more risky but also appear to have more potential for investors, based on a very low valuation to operating earnings.

Background

Fannie and Freddie, known as the government-sponsored enterprises, or GSEs, together hold roughly $5.2 trillion in mortgage loans and mortgage-backed securities, and remain crucial to the U.S housing market, as they purchase about 90% of newly originated mortgage loans in the United States.

The two companies were taken under government conservatorship at the height of the financial crisis in 2008.

The U.S. Treasury holds $117.1 billion in Fannie Mae senior preferred shares and $72.3 billion in Freddie Mac senior preferred shares, in lieu of bailout funds provided to the GSEs. Both GSEs returned to profitability last year, and have been making very significant dividend payments on the senior preferred shares, while dividends on junior preferred shares have remained suspended since September 2008.

Per their amended bailout agreements, Fannie and Freddie are required to pay dividends to the government equal to all of their earnings, less $3 billion apiece in retained earnings to provide a minimal equity buffer.

As a further sweetener, the government holds warrants to purchase common shares in Fannie and Freddie in sufficient quantities to give the Treasury a 79.9% stake in each GSE, at a very low price of $0.00001 a share.

Fannie Mae announced on May 9 it would pay the Treasury a second-quarter dividend of $59.5 billion, after determining 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. That is quite a solid return to U.S. taxpayers, especially considering that a few years ago, the GSEs were all but given up for dead.

But no matter how much Fannie and Freddie can now earn, there is no mechanism in place allowing either Fannie or Freddie to repurchase any government-held preferred stock.

High-Profile Investors Fight for Private Shareholders

Two recent statements by high-profile investors in Fannie Mae and Freddie Mac have huge political significance.

Ralph Nader in an op-ed piece published in the Wall Street Journal on May 24 said he was a shareholder in both GSEs and that common shareholders of Fannie and Freddie should fight against the federal government's "great Fannie and Freddie rip-off."

"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, adding that "FHFA ordered the Fannie and Freddie boards and executives to suspend communications with shareholders and abolish the annual stockholders meeting."

Despite the continued cries to "break up Fannie and Freddie" from some politicians and pundits, President Obama and Congress have been in no hurry to come to an agreement on a way forward for home financing in the U.S. During an economic recovery that has included a slow increase in employment, there has been understandable hesitation to radically transform the largest segment of the economy.

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