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Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) are government sponsored entities owned by private shareholders and are tasked with providing essential liquidity to the secondary mortgage market. After the $187.5 billion bailout of these two publicly traded companies in 2008/09 they were placed under conservatorship of the Federal Housing Finance Agency. Subsequently, a sweep agreement was installed, which required Fannie and Freddie to turn all their profits over to the Treasury. Crucial: The net sweep won't affect the bailout balance although profits at Fannie and Freddie surged as a result of a recovering housing market. Fannie Mae alone handed over nearly $60 billion to the government in June 2013. Several firms including Fairholme Funds and Perry Capital are suing for a court to throw out the net sweep agreement and have the dividend payments for the preferred stock reinstated.

Lawsuits

Law 360 summarized the recent developments about the impending suits:

A group of shareholders who hold Series S and Series T preferred stock - which is behind the senior, controlling stock the Treasury holds following Fannie Mae's 2008 bailout, but ahead of the junior preferred stockholders who also sued the government recently and common stockholders - have accused the Treasury of usurping their rights with changes it made to its control of Fannie Mae in August 2012.

"Rather than seeking to return Fannie Mae to a safe and solvent condition and recover the taxpayers' investment, the FHFA and the Treasury are using it as a cash cow until such time as they can wind it down entirely," the complaint said.

In response to the filed lawsuits the Treasury stated:

We are reviewing these lawsuits carefully, but it is important to remember that U.S. taxpayers provided over $187 billion in exceptional support to these two entities to maintain their solvency, protect the broader economy and support continued access to mortgage credit for millions of American families.

While it is certainly important to remember that the taxpayer provided exceptional support in times of crisis, it is also important to remember, given the return to profitability of Fannie and Freddie, that the extended financial assistance will get paid back in full and taxpayers will likely make a profit; very similar to the case of American International Group (NYSE:AIG). I cannot imagine a court to allow expropriation of property and I consider the lawsuits to have very good chances of success. The filed suits basically relate to the preferred stock, which have seniority over the common. The common itself, technically, is worth little. But this could change dramatically once a court repeals the net sweep agreement. Correspondingly, Fannie Mae common stock has the largest upside potential. Now that the Treasury sweeps away all of Fannie's profits the common stock hovers in bargain territory at around $1-1.50 waiting for impulses of what's going to happen next.

If the suit with regard to the preferred stock is successful it is very likely that the common also gains in value. I predict the court ruling will make it easy for the market to conclude a reasonable price for the preferred and the common stock. Besides thinking that the suit has good chances of succeeding, I think that the institutional dysfunction of Washington will prevent a solution that is focused on restructuring the mortgage finance market.

Institutional market structure unlikely to change

Like it or not, but besides the 2005-2008 bubble period, the Fannie Mae and Freddie Mac-based mortgage finance system actually worked. And it worked well with millions of Americans able to purchase houses that were otherwise not affordable or accessible. Mortgage securitizations allowed mortgages to be traded quickly making home loans cheaper for lower-income Americans and raising homeownership levels across the country. If, at the same time, underwriting standards were not watered down, Fannie and Freddie very likely would not have been placed under conservatorship preserving substantial wealth of private shareholders.

Given the current state of dysfunction in Washington, I cannot even imagine an alternative scenario of how the mortgage market could be structured. What are the alternatives to Fannie Mae and Freddie Mac, which are responsible for $3.7 trillion in mortgage debt? Expropriating existing shareholders and turning Fannie and Freddie into government owned enterprises? This would hardly find the support of Republicans plus a tsunami of suits would hit the courts, which is neither economically nor politically sensible. Many Fannie Mae and Freddie Mac investors still belong to the retail base. The idea to wind down Fannie and Freddie and establish a new entity makes no sense at all. The probable outcome is that Fannie and Freddie will continue to operate just as they are doing now. Operationally, there are no changes whatsoever. Fannie and Freddie provide credit to the mortgage market every single day. The only difference is that the profits are kept by the government while the shareholders still absorb the risk for which they aren't compensated. As a result, Fannie Mae's and Freddie Mac's common stocks incorporate immense risk premiums, which could turn into substantial gains once uncertainty about the future institutional market structure (read: the same structure as now) abates.

Conclusion

The common stock offers an asymmetric bet on a status-quo secondary mortgage market structure. In terms of risk/reward ratio I would put Fannie Mae into the same basket as American International Group, MGIC (NYSE:MTG) and Radian (NYSE:RDN): All of them were pronounced dead but they just defied the odds and made staggering comebacks. Investors purchasing the common stock bet that the sweep agreement will be repealed and both preferred and common stocks gain in instant value. Until the courts have made their decisions with respect to the preferred stock, the common stock is likely to fluctuate erratically. As long as the sweep agreement is in place, I would not recommend speculating on specific earnings announcements. So far, the market has accepted that earnings will be swept over and aren't value accretive to either the preferred or the common. The court's ruling on the preferreds and political inaction are the determining catalysts for Fannie Mae's common stock.

Source: Fannie Mae Common Stock: A Once In A Lifetime Asymmetric Bet On Washington's Dysfunction