Fannie and Freddie: A Chart and a Friend

Updated from 8:50 a.m. ET with volatile morning market action and additional comment from Rafferty Capital Markets analyst Richard Bove.

NEW YORK (TheStreet) -- Investors can expect another day of extreme volatility for shares of Fannie Mae (FNMA) and Freddie Mac (FMCC), amid mixed signals from Washington.

Fannie Mae's common shares on Tuesday dropped 30.8% to close at $4.03, while Freddie Mac's common shares were down 26.8% to close at $4.04, after Senate Banking Committee Chairman Tim Johnson (D., S.D.) Senator and Mike Crapo (R., Idaho), the ranking member of the committee, announced they had come to an agreement on a bi-partisan proposal to wind-down the mortgage giants.

Fannie's shares were down another 10% in early trading Wednesday to $3.63, while Freddie's common shares were down aother 13.4% to $3.50.

GSE junior preferred shares also also hit hard.  Fannie Mae's preferred Series S shares (FNMAS) were down 7.6% to $10.95, after pulling back 3.3% on Tuesday.  Freddie's preferred Series Z shares were down 7.8% to $11.30, after a 3.9% decline on Tuesday. Both issues have face values of $25, with investors hoping the junior preferreds will trade up to par if their dividends are restored.

Fannie and Freddie -- together known as the government-sponsored mortgage enterprises, or GSEs -- were taken under government conservatorship at the height of the U.S. housing market meltdown in September 2008. The GSEs' common and preferred stocks remained publicly traded, but values plunged because dividends to non-government shareholders were suspended, and because it appeared highly unlikely at the time at the GSEs would eventually return to being highly profitable.

Over the past year, many institutional and retail investors have ridden common and junior preferred shares of the GSEs to huge gains on what they consider to be a unique investment opportunity, during a long legal battle over government's treatment of private investors.

The government's original bailout agreement with the GSEs required Fannie and Freddie to pay the U.S. Treasury 10% annual dividends on the government-held senior preferred shares. However, in August 2012, after the GSEs had returned to profitability and after they had stopped increasing their borrowings from the government, the bailout agreement was changed so that all GSE profits were paid to the government, in excess of minimal capital cushions.

Following their March dividend payments, Fannie and Freddie will have paid total dividends of $199 billion on $189.4 billion in senior preferred shares held by the Treasury. Factoring in warrants that were handed to the government to acquire up to 79.9% of the GSEs common shares, Rafferty Capital Markets analyst Richard Bove on last week estimated the government's return on its investment in Fannie and Freddie was $238 billion.

There's no mechanism in place allowing either Fannie or Freddie to repurchase any of the senior preferred shares held by the government. Despite all the talk in Washington since 2008 of doing away with Fannie and Freddie, nothing has happened. A major reason for no action in Congress or by President Obama is fear of disrupting the U.S. economic recovery. Another reason for the Obama administration to leave the GSEs' status unchanged for as long as possible is the significant lowering of the federal budget deficit from the dividends being paid the government.

There was no mention in the statement from Sen. Johnson and Sen. Crapo of any consideration for private investors, but the senators did say that their bill would "start with" the provisions laid out in last year's GSE reform bill from Senate Banking Committee members Bob Corker (R., Tenn.) and Mark Warner (D., Va.) which would replace Fannie and Freddie with a new Federal Mortgage Insurance Corp., funded by private investors and the mortgage industry. The Corker-Warner bill provided nothing to common and junior preferred shareholders of Fannie and Freddie.

A Letter to the Treasury Secretary

But Fannie and Freddie's private investors have at least one friend on the Senate Banking Committee, Pat Toomey (R., Penn.).

Here's the entire text of a Question for the Record (QFR) letter sent to Treasury Secretary Jack Lew by Sen. Toomey on Friday:

To: The Honorable Jacob Lew

Community banks, retirement funds and other investors have all reached out to me to express their concern - and even outrage - about the unprecedented "sweep" that takes all of the GSEs' profits and gives them to the government.

Mr. Secretary, you have emphasized repeatedly the importance of returning private sector capital to the housing finance market. However, the government's actions with respect to the GSEs' profits raise serious concerns, including whether these actions lawfully respect the rights and interests of all Americans. As we can both agree, our nation is the most attractive place in the world to invest partly because of our commitment to the rule of law.

While I strongly support GSE reform that protects taxpayers, such efforts should also be mindful of investors in addition to other considerations. Taxpayers should be fully compensated, but once they are, investors, such as the York County pension fund in Pennsylvania, should not be denied their fair share of any remaining value.

What comfort can you give to private sector investors considering investing in the future of the housing finance system when they believe that the government arbitrarily changed the rules of the game mid-stream with the Third Amendment?

Based on the terms of the conservatorship, Treasury's stake in Fannie and Freddie is 79.9 percent. Has Treasury done any analysis of the value of its 80 percent equity stake in the absence of a Third Amendment? Did it value its stake prior to adopting the Third Amendment?

Do you believe that Treasury owns a 100 percent economic interest in the GSEs? If that is Treasury's view, why have Fannie and Freddie not been consolidated on the Federal balance sheet?

Secretary Lew may respond with similar arguments to those made by the government when it sought to have a lawsuit by institutional shareholders of the GSEs, including Bruce Berkowitz's Fairholme Funds, thrown out.

That argument failed to impress Judge Margaret Sweeney in the U.S. Court of Federal Claims, and the lawsuit is moving to the discovery phase. This means key witnesses for the government will be required to answer questions from the plaintiffs' lawyers.

One such witness will be Mario Ugoletti, who has the unique distinction of having served as the U.S. Treasury's director of the Office of Financial Institutions Policy, participating in the drawing up of the government's agreement to bail out Fannie and Freddie, while later serving as a special adviser to former acting Federal Housing Finance Agency Director Edward Demarco and helping draw up the subsequent agreement through which nearly all of the government sponsored enterprises' profits are being swept to the government. Ugoletti now serves as a special adviser to FHFA Director Mel Watt, who assumed his post in January.

It is most unlikely that the Senate will be able to pass any bill on GSE reform this year. Meanwhile, the battle over Fannie and Freddie is likely to drag on in the courts for years. 

Bove  in a client note on Wednesday wrote that "Congress cannot proceed without a clear statement from the courts as to what is legal and what is not in the actions taken by the Treasury to date."  But he is still alarmed by the attitude of so many senators, writing in a separate note: "Since Fannie and Freddie are the only entities in the country willing to purchase 20 and 30 year fixed rate mortgages, their elimination would have meaningful impacts on the mortgage markets. The monthly cost of owning a home would rise and the size of the market itself would shrink."

Bove sees a long-term strategic concern for Wells Fargo (WFC), the nation's leading mortgage lender.  If Fannie and Freddie were to be completed wound-down, and if 20-year and 30-year fixed-rate mortgage loans were no longer being offered by mortgage lenders, would not only hurt the bank's lending and mortgage servicing business, it would through its investment strategy into disarray, because "residential mortgage backed securities are estimated to be just under 50% of the bank's securities portfolio."

Tuesday was a painful day for GSE shareholders; however, this chart showing the common stocks' amazing run over the past year puts that drop into perspective:

FNMA Chart data by YCharts

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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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