On May 31, 2013, the U.S. Treasury and HUD released a paper that provided three options that would likely reduce or eliminate both Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC). I reiterate my position to steer clear of both of these Government Sponsored Enterprises (GSEs). The Fed's latest action was to sweep all of the profits from first-quarter 2013 from both Fannie and Freddie into the U.S. Treasury without recourse for the common stock holders.
Reuters News Service reported on June 4. 2013, that draft legislation from a bipartisan group of U.S. senators would plan to liquidate Fannie Mae and Freddie Mac within five years and be replaced by another entity offering government reinsurance for mortgage-backed debt. Although this is a long way from becoming law, there is substantial support for eliminating the Government Sponsored Enterprises (GSEs) as we know them today.
The draft bill, first reported by Bloomberg on May 31, said revenues from a liquidation of the two companies would first be used to repay the government for its stake in the companies, with any remaining funds going to junior preferred shareholders and finally common shareholders.
Most analysts said it was unlikely any funds would remain beyond what would be needed to repay the government.
Fannie Mae and Freddie Mac secured almost $190 billion in taxpayer aid and have paid the Treasury about $132 billion in dividends. The terms of the bailout do not allow them to buy back the government's stake, which means they will keep making dividend payments as long as they are profitable without ever recovering the loan amount.
The government has an 80 percent stake in each firm, with the U.S. Treasury holding about $117.1 billion in Fannie Mae senior preferred shares and $72.3 billion in Freddie Mac senior preferred shares. It also has warrants to purchase common stock.
Investors, including some hedge funds, have been buying up both common and junior preferred shares of Fannie Mae and Freddie Mac in the hopes lawmakers will draft legislation that does not wipe out current shareholders.
The Treasury/HUD white paper published in May 2013, identifies three proposals to dramatically reduce, and most likely eliminate, Fannie Mae and Freddie Mac over a period of time.
Option 1: Privatized system of housing finance with the government insurance role limited to FHA, USDA and Department of Veteran's Affairs' assistance for narrowly targeted groups of borrowers.
- Dramatically reduces the government's role in insuring or guaranteeing mortgages to only FHA and other programs targeted towards creditworthy lower- and moderate-income borrowers.
- Allows more capital into other areas of the economy, hopefully leading to more long-run, and diversified, economic growth.
- Less easy access to mortgage capital may reduce inflationary pressure on housing costs.
- Direct taxpayer exposure to private losses in the mortgage market would be limited to losses on loans guaranteed by FHA and other narrowly focused government loan programs, rather than on guarantees covering most of the nation's mortgages.
- Acute costs due to the potential impact on access to housing credit for many Americans because the cost of credit for those not qualifying for FHA-insured loans, representing the majority of borrowers, would increase.
- More difficult for many Americans to afford a traditional 30-year, fixed-rate mortgage.
- Smaller lenders and community banks may have a difficult time competing for non-FHA mortgage business, which could impact those banks and their customers significantly.
- The government's ability to effectively step in to ensure access to capital during a crisis could be hampered significantly, and lacking the government's support during another credit crisis, even more severe economic downturns could occur, resulting in even greater risks to taxpayers.
Option 2: Privatized system of housing finance with assistance from FHA, USDA and Department of Veterans' Affairs for narrowly targeted groups of borrowers and a guarantee mechanism to scale up during times of crises.
- Same as in Option 1.
- As in Option 1, FHA and other narrowly targeted programs would provide access to mortgage credit for low- and moderate-income borrowers, but the government would also develop a "backstop mechanism" to ensure access to housing credit in the event of a housing crisis.
- Addresses one of the primary concerns with Option 1, namely the government's inability to ease credit contraction during a crisis, without assuming all the costs associated with a broad government guarantee during normal times.
- Same as in Option 1.
- It may prove difficult to design and manage a government organization that is able to remain small during normal economic times, but which can quickly assume broader authority, responsibility, and capacity during times of economic crisis.
Option 3: Privatized system of housing finance with FHA, USDA and Department of Veteran's Affairs assistance for low- and moderate-income borrowers and catastrophic reinsurance behind significant private capital.
- As with Options 1 and 2, non-FHA mortgage markets and other federal agency guarantee programs would rely on the private investment market, with private capital assuming the primary credit risk. However, to increase liquidity and access to mortgage capital for creditworthy borrowers, the government would offer reinsurance for the securities of a targeted range of mortgages.
- Provides the access to mortgage credit at the lowest cost of the three options. Though mortgage rates would increase because of the cost of the reinsurance premium and the additional risk of loss, the reinsurance may attract a larger pool of investors to the mortgage market which would increase liquidity.
- Provides a more competitive environment for small lenders and community banks, allowing them to better serve their customers and communities.
- As was the case in the years leading up to the current housing market crisis, the increased flow of capital to the mortgage market in this option may attract capital away from other areas of the economy and could result in artificial inflation of housing costs again.
- The government's reinsurance of private sector lending activity once again exposes added risks to the taxpayer similar to those found in the current system.
Neither the U.S. Treasury nor HUD provided a recommended course of action. Congress is not close to passing any legislation that would provide a way ahead and as long as the GSEs remain profitable, the Treasury will continue to sweep the profits into the U.S. Treasury. In this case, no action is a positive cash flow for the government.
There is no light at the end of this tunnel for Fannie Mae and Freddie Mac stock holders. I recommend investors stay clear in the near term.
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.
Additional disclosure: Information collected from news reports from Reuters News Service, Bloomberg and U.S. Treasury website.