Don't Buy Fannie Mae Or Freddie Mac

| About: Fannie Mae (FNMA)

New rules by the Fed in March 2013 force all profit made by Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) to be swept into the U.S. Treasury as dividend payment and not used in the repayment of the bailout loans. Both GSEs made huge profits first quarter of 2013, but the government is netting all the profits, legally, through the agreement they created during the bailout.

Fannie Mae assessed it would be able to recapture most of its valuation allowance for deferred tax assets [DTA] at the end of the first quarter of 2013. Fannie Mae announced on May 9 that it would pay the Treasury a second-quarter dividend of $59.5 billion. Freddie Mac announced on May 8 that it would pay a dividend of $7 billion to the Treasury in June. In both of these cases, neither was able to pay any amount against the repayment of their loans.

As part of the massive bailout of the Government Sponsored Enterprises (GSEs), the bailout agreements with Fannie and Freddie, the government acquired warrants to purchase just under 79.9% of the common shares of the two GSEs at a strike price of $0.00001 per share.

As part two of the 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. All preferred shares' dividends must be paid before any dividend can be returned to the common stock holders.

Fannie Mae's preferred series E shares are supposed to pay annual dividends of $2.25 a share. Freddie Mac's preferred series Z shares are supposed to pay annual dividends of $1.34 a share.

Rules established during the bailout stated a 10% dividend forced a payment even if the GSEs failed to make a profit; they just borrowed money from the government to make the payment. The Fed's new rules in March 2013 allows the Fed to sweep all profits into the U.S. Treasury, effectively preventing any profit to be used as repayment of the bailout money. The GSEs paid a dividend of $65.2 billion, which counted as a return on the government's investment.

Under the bailout's terms, there's no mechanism for the GSEs to exit conservatorship. Neither Fannie Mae nor Freddie Mac can build capital, because Treasury takes virtually all of their quarterly profits as dividend payment.

There are three possibilities we see at this time, and Congress and the Fed are the decision makers. The first option is the government leaves everything the way it is and Fannie Mae and Freddie Mac remain cash cows providing billions of dollars each fiscal quarter into the government's general fund for Congress to spend freely.

Two, there are attempts on-going from Lobbyists to encourage Congress to reestablish the GSEs by conducting a buyout of the government's position to a profit estimated between $100 - $200 billion dollars. This number seems impressive, however, if the government continues to tighten fiscal restrictions on the big 6 financial institutions and maintain the massive ownership of both GSEs, the lobbyists will not be successful in the near term. The sale of the GSE stocks, both preferred and common, would provide a quick increase in income, but fail to provide the long term cash flow the government desires.

The third possibility is for the government to stop taking the dividends from the GSEs and allow them to pay off their debt. Investors on the free market would be able to purchase shares from the government at an extreme profit to the government. Remember the strike price was $0.00001 per share (1,000 shares for one penny) for both GSEs. Once again, this creates a large one-time cash infusion for the Fed of billions or trillions of dollars, but does not quench the thirst that our government is looking for in a large stream of income for an indefinite period of time.

The government could liquidate the GSEs, which would be a bad move for the economy. This could lead to another housing crisis with the effects on the security of loans and lack of private investment capital to support the market needs. Approximately 90% of all loans are covered by the GSEs. We do not consider this an option at this time, because it provides no source of income for the government.

Currently, there is no plan in place to allow either of the GSEs to repurchase the government's stake and return to their private forms. The U.S. budget deficit in 2013 is projected to shrink faster than earlier thought, thanks in large part to the dividend payments of Fannie Mae and Freddie Mac. The Congressional Budget Office reported the budget deficit will shrink to an estimated $642 billion in 2013. The projection was $203 billion smaller than the $845 billion shortfall forecast by CBO in February. These one-time dividend payments to the U.S. Treasury were so significant, Treasury Secretary Jack Lew said it would delay the deadline to raise the debt limit to at least Labor Day. Future dividends from the GSEs will likely be smaller, but the fact is that the government is earning a handsome yield on its investment.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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