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Fannie Mae (OTCQB:FNMA) common stock has returned to volatility. Over the last week shareholders have once again gotten used to wild daily swings of +/-10% in the value of the common stock. The recent volatility in the stock can be attributed to a federal jury in Manhattan finding Countrywide liable for selling rotten mortgage loans to Fannie Mae and Freddie Mac (OTCQB:FMCC). Former Countrywide executive Rebecca Mairone was also found liable for defrauding those entities: A rare but significant win for the government and the GSEs. The US government is seeking a penalty of $848 million equal to the gross losses experienced by the two entities.

While it remains uncertain how much money the GSEs will finally receive, it is certain that the money will go straight to the Treasury. The existing Net Sweep Agreement entitles the US Treasury to receive all profits (including settlement or restitution payments) from Fannie Mae and Freddie Mac. A few preferred shareholders are currently suing the US challenging the Sweep Agreement and demanding the resumption of dividend payments.

Volatility

In May 2013 it was made public that Bruce Berkowitz has initiated a substantial position in Fannie Mae. With a par value of $2.4 billion of Fannie Mae and Freddie Mac Preferred Stock Berkowitz has made a substantial bet on the recovery of those companies. Berkowitz is a long-term oriented investor who follows his thesis through. American International Group (NYSE:AIG) is another investment he wants to keep for the long-term (Insightful CNBC interview about his GSE stake here).

Fannie Mae common stock prices shot up hundreds of percent in May/June 2013 on the news that Berkowitz initiated his stake. The bubble, created by short-term oriented speculators, subsequently deflated and the stock fell back to the $1 level after hitting a High of $5.44 at the end of May. The stock then traded for about three month between $1-1.50 before breaking out of its narrow trading range after the jury found Countrywide liable just last week. The common stock gained massive momentum shooting up to $2.69 during a trading session but was unable to hold this level. The stock now quotes at $2.21 and further short-term correction potential is likely considering the force with which Fannie Mae exploded higher. I think the market currently overreacts to any positive news related to Fannie Mae and Freddie Mac and the common stock still remains in overbought territory.

(click to enlarge)

Catalysts

The ultimate catalyst for common stockholders is going to be a judicial victory that declares the existing Net Sweep Agreement null and void. In the meantime I expect the stock to be extremely volatile even though the underlying value of the stock is unlikely to change. I would also advise against speculating on earnings announcements; a theme that has repeatedly been suggested by investors. Higher profits for Fannie and Freddie won't accrue to common shareholders as long as the Sweep Agreement is in place and the market has come to terms with that new reality. Higher profits also do not affect the odds to win the court battle against the government. For now, as bad as it is, we lose and don't get to bite in the juicy apple.

Another point I'd like to raise which could have a substantial impact on the price of the common stock relates to the Federal Housing Finance Agency which is the regulator and conservator of both Fannie Mae and Freddie Mac. Conservatorship alone doesn't absolve the FHFA from its fiduciary duty to shareholders of those companies. The notion of a breach of fiduciary duty on the site of the conservator could further increase chances that the Net Sweep won't stand its ground in court.

The Net Sweep in essence resembles expropriation. Property rights are essential for the functioning of markets. I assume that the US government is going to have serious trouble in court justifying the expropriation of shareholders. The role of the conservator and his breach of fiduciary duty could add further strength to the plaintiffs' suit.

Conclusion

My advice to long-term oriented investors is to keep the eye on the ball and see past short-term volatility. The best turnaround stories take time. I'd rather put up with volatility than leave this asymmetric bet with a hugely attractive pay-off profile. The ultimately goal is to have the Net Sweep agreement overturned and dividend payments to the preferreds resumed. A court victory would be the distinguishing catalyst for Fannie Mae's common stock. Earnings results are likely to be without impact on the stock price as long as profits are diverted to the Treasury and away from stockholders. I would advise against earnings speculation in the short-term.

Disclosure: I am long OTCQB:FNMA, AIG. 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.

Source: Fannie Mae: What Is Happening Here?