Have you looked at the stocks of the Federal National Mortgage Association (OBB:FNMA), better known as Fannie Mae, and the Federal Home Loan Mortgage Corporation (OBB:FMCC), better known as Freddie Mac, recently?
They’re far from a pretty picture.
Yet for those who’ve followed Fannie and Freddie’s stories from the financial crisis to today, the common and preferred stocks of these firms may actually be a ”Buy.”
Here’s a quick refresher: Fannie Mae and Freddie Mac, while government-sponsored enterprises (GSEs), are still private companies. And as separate companies, they compete with one another.
They also have the same business model, wherein they buy mortgages on the secondary mortgage market, pool those loans, and then sell them to investors as mortgage-backed securities in the open market.
The main difference between Fannie and Freddie is that Fannie Mae mostly buys mortgage loans from commercial banks, while Freddie Mac mostly buys them from smaller banks, often called “thrifts.”
Here’s the issue, though: If interest rates are still very low (they started the year below 4%) and housing is thriving in many parts of the United States, why are the stocks of these enterprises so depressed?
The Artificial “Bailout”
The problem boils down to this: Fannie and Freddie were never really in trouble during and after the financial crisis.
Rather, they were seized by the government in order to provide a backdoor bailout to truly vulnerable large banks and simultaneously restore confidence to the traumatized financial markets.
The stocks of Fannie and Freddie declined rapidly in 2007-08 along with the rest of the panicked market. The government, nevertheless, allowed and actually encouraged their widespread naked short selling.
In doing so, the government provided additional ammunition for its argument that it was necessary for them to “rescue” Fannie and Freddie.
According to Gary Hindes, CEO and Managing Member of the private equity fund Delaware Bay Company LLC, “Despite the ‘Big Lie’ still being put forth even today by the anti-GSE zealots, the nationwide collapse in home prices was not caused by Fannie and Freddie (or, for that matter, by Clinton and Bush Administration decisions to expand homeownership) – it was caused by the too-big-too-fail (TBTF) banks in their unending greed to earn fees and pay large bonuses to their executives.”
In fact, the twins had returned to profitability in the summer of 2012, just four years after the financial crisis.
Yet in the bailout, the Obama Administration had agreed to unilaterally change the rules at the finish line and begin confiscating 100% of Fannie’s and Freddie’s profits in perpetuity, instead of the 10% dividend that was previously agreed upon.
This highly objectionable action – also known as the “Third Amendment sweep” – led, not surprisingly, to a series of law suits.
On January 18, the plaintiffs will file their response to the government’s motion to dismiss in the U.S. District Court in Delaware.
The case falls under the Delaware General Corporation Law, which means that no majority shareholder of a corporation (in this case, the U.S. Treasury) can force that corporation to issue a class of stock that, to the detriment of all other shareholders, takes 100% of a company’s economic value for itself.
In another case, Perry Capital v. Lew, a coalition of investors called Investors Unite filed an amicus curiae, or friend of the court brief, claiming that the “Third Amendment sweep” violates the Housing and Economic Recovery Act (HERA) of 2008.
Final briefs are due on March 8, after which oral arguments will be scheduled, with a decision expected mid- to late summer.
In layman’s terms, the government’s actions may have been illegal. But caveat emptor, if the shareholders lose, the value of the stocks will likely go to zero.
Keep a Close Eye
Take note that recent headlines point favorably to a Fannie and Freddie recovery. For example, The Wall Street Journal noted that Freddie Mac became the top multifamily lender in 2015, with $47.3 billion in volume.
Additionally, for the do-good investor, Freddie Mac has extended disaster relief to eligible borrowers in Mississippi and has announced alliances to help mortgage bankers build stronger businesses in 2016.
Finally, it was announced on Tuesday that captive insurance companies are losing Federal Home Loan Bank Membership.
This is actually good news in that these mortgage investors had been using a loophole to access low-cost, government-backed financing, coupled with the fact that captives insure the risk of the companies that own them.
So consider the twins (common and preferred) in 2016 – but keep your eye on the courts.
Good investing,