Fannie and Freddie Shareholders Will Get Nothing: KBW

NEW YORK ( TheStreet) -- While investors have become much more comfortable with the prospects for Fannie Mae ( FNMA) and Freddie Mac ( FMCC), KBW analyst Bose George still says that when all is said and done, common and junior preferred shareholders will get nothing.

"While both companies could have significant value, we continue to believe that residual value, if any, will go to the government and not to private shareholders," George wrote in a report on Sunday.

KBW has "underperform" ratings for both Fannie Mae and Freddie Mac, with price targets of zero, underlining the firm's negative view of prospects for private shareholders.

Common shares of Fannie Mae closed at $1.98 Friday, returning 662% since the end of 2012, when the shares closed at 26 cents. Freddie Mac's shares closed at $1.86 Friday, returning 615% since the end of last year, when they also closed at 26 cents. The most liquid junior preferred GSE shares have also risen considerably this year, trading for roughly 22 cents to par value on Friday, increasing from 7 cents to par, at the end of last year.

Fannie and Freddie -- together known as the government-sponsored enterprises, or GSEs -- were taken under government conservatorship in September 2008. The U.S. Treasury holds $189.4 billion in senior preferred share of the GSEs, for bailout assistance, and dividends on all other share classes have been suspended since September 2008.

The GSEs continue to play their crucial role in U.S. mortgage finance, holding roughly $5.2 trillion in mortgage loans and mortgage backed securities as of March 31, and purchasing roughly 90% of newly originated mortgage loans in the United States.

High profile investors, including Ralph Nader and Bruce Berkowitz's Fairholme Capital Management have made public statements saying that when President Obama and Congress finally agree on a way forward for the U.S. mortgage market, the property rights of the GSEs' common and junior preferred shareholders should be respected. A draft bill expected to be introduced in the Senate has also given hope to private investors.

But according to George, neither the numbers nor the legal factors make it likely for the private shareholders to see any reward from a political settlement for Fannie and Freddie. "We believe that the longer-term value of the common and preferred shares will be driven by political actions and not by operating fundamentals," he wrote. "So our expectation remains unchanged that the shares are likely to have no value."

"Earnings Should Remain Strong"

Fannie Mae reported a record first-quarter operating profit of $8.1 billion, and also announced on May 9 that it would pay the Treasury a second-quarter dividend of $59.5 billion, after recapturing most of its valuation allowance for deferred tax assets (DTA).

Freddie Mac reported first-quarter operating earnings of $4.5 billion and announced a second-quarter dividend of $7 billion to the Treasury.

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.

Under the modified bailout agreements, Fannie and Freddie are required to pay all earnings in dividends to the government, above a $3 billion capital buffer for each company. There is no mechanism in place for either company to repurchase any of the government-held preferred shares. "While it appears likely that the Treasury will recoup its investment (in nominal terms) by the end of 2013 or early 2014, these payments do not reduce the principal amount of the preferred investment."

KBW introduced earnings estimates for the GSEs on Sunday. Factoring in the runoff of loan portfolios, "we still think both companies can generate normalized annual EPS of around $2," George wrote.

A Differing Opinion on Legal Prospects for Private Shareholders

Nader's comments, as well as a statement from Fairholme Capital, imply that common and junior preferred shareholders of Fannie and Freddie could take their claims to court, with the idea that the federal government has illegally seized private property, in denying dividends to share classes other than the government's senior preferred. The basis for this argument is the GSEs' return to profitability.

"If the GSEs were normal companies, we think this argument might be more persuasive," George wrote. "Instead, the companies are specifically chartered by the federal government and we think the courts will give the government far more deference in determining whether or not to pay a dividend to preferred shareholders even if the companies have paid back the taxpayers."

Fairholme Capital Management's statement also implies a way forward for Fannie and Freddie that could prove very lucrative to private shareholders, depending on the eventual political settlement.

"On behalf of the hundreds of thousands of Fairholme Funds shareholders who helped to rebuild American International Group ( AIG), Bank of America ( BAC), CIT Group ( CIT), General Growth Properties ( GGP), MBIA Inc. ( MBI), and others after the Great Recession - we stand ready to do our part," the statement reads.

This means that Fairholme, along with "thousands" of shareholders (voters) would be quite pleased to see the government's senior preferred shares in Fannie and Freddie converted to common shares. A similar action was taken for AIG, enabling the insurer to move past its bailout, the government and the Federal Reserve both claiming significant profits.

George isn't buying this argument either: "The GSE dividend sweep has helped improve the federal budget situation and money being paid to the Treasury is helping to fund government operations," he wrote. "At a time of sequestration, it would be politically difficult to stop the sweep and dividends while the government is cutting spending on some popular programs and furloughing some government employees."

The analyst also sees the scenario of Fannie and Freddie simply continuing to operate following a conversion of government preferred shares to common shares, as "politically unpopular."

"The political objection would be that hedge fund managers should not benefit to the detriment of taxpayers, the government, and government programs for the poor," he wrote. "Congress, especially Democrats, would find it difficult to explain to constituents why the government has to raise taxes or cut spending on programs like food stamps or Medicare while institutional investors are benefiting from the rescue of Fannie and Freddie."

-- 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 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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