F&F Earn Billions In Dividends, Swept To Treasury

| About: Fannie Mae (FNMA)

Since last quarter when Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) reported billions in profits and were swept into the Federal Treasury. From the August 17, 2012 memo "Treasury Department Announces Further Steps to Expedite Wind Down of Fannie Mae and Freddie Mac", that states: "The agreements will replace the 10 percent dividend payments made to Treasury on its preferred stock investments in Fannie Mae and Freddie Mac with a quarterly sweep of every dollar of profit that each firm earns going forward."

90 days later, on August 7, 2013 Fannie Mae and Freddie Mac will once again reported their profits in the billions of dollars Fannie - $10.2 billion dollars, and Freddie - $4.4 billion dollars, and the Federal Treasury will once again sweep the dividends into the Federal spending pot. Those in Washington are thankful for the extra spending money. The investors in F&F have legal action pending, but we know how fast Washington moves when they want to delay any action that will negatively affect their funding sources.

Fannie Mae released a statement on October 10, 2013 on the agreement with SunTrust. The numbers have not yet been released, but another settlement expected in the millions.

The latest news last week was JPMorgan's (NYSE:JPM) settlement with the Federal Housing Finance Agency. In total, JPMorgan will pay $5.1 billion in its settlement and crucially, the firm will not be forced to admit wrongdoing in the settlement. Approximately $2.74 billion to Freddie Mac and $1.26 billion to Fannie Mae to resolve claims tied to mortgage securities the bank and its acquired subsidiaries, Bear Stearns and Washington Mutual, who sold to the FHFA between 2005 and 2007. The bank will also pay $670 million to Fannie Mae and $480 million to Freddie Mac to resolve representation and warranty claims related to single-family mortgages purchased by the two companies.

Bank of America (NYSE: BAC) and Wells Fargo (NYSE: WFC) have not yet settled with FHFA and BAC had the highest defaulted loans with the mortgage companies they consumed during the financial crisis in 2007-08. If both settle this quarter we could expect another healthy dividend pay out by F&F next quarter as well.

Regardless if these settlements are reported third quarter or next, these billions of dollars will be added to the profit statements of F&F and be swept into the U.S. Treasury per law.

This quarter neither F&F claimed increased deferred tax assets to bump their profits higher, based on the recovering housing market and financial stability. This was a possibility, to increase the dividend claimed and paid to the government. The deferred tax assets will be carried forward and available in the future.

Legal Action Investors hope that the law suits filed by the Berkowitz Group in federal court in the District of Columbia and names the Federal Housing Finance Agency, which regulates Fannie and Freddie, as a defendant in addition to the U.S. Treasury Department. Berkowitz is among a group of professional investors who have been betting on the junior preferred shares of the housing giants on the theory that since the government-sponsored enterprises are profitable, will one day repay the government, with money left over to pay dividends on junior preferred.

In June 2013, the Police Retirement System of Austin, Texas, and a bank from the state of Washington, sued the government over its takeover of Fannie Mae and Freddie Mac, seeking billions of dollars in damages.

In July 2013, Perry Capital, one of the largest U.S. hedge funds, sued the U.S. Treasury over the terms of large dividend payments it has been receiving from Fannie Mae and Freddie Mac, the mortgage companies taken over by the government during the depths of the housing crisis in 2008. The hedge fund, which has invested in Fannie Mae and Freddie Mac, alleges the Treasury violated the rules associated with its control of the companies in 2012 when it created the Sweep Amendment that allows the U.S. Treasury to sweep all profits into the U.S. Treasury without paying off the loans associated with the bailout. Perry Capital is asking the U.S. Treasury to use the dividend money to pay off its loans in the government-sponsored enterprises.

The suits from Berkowitz and Perry, however, do not challenge the takeover but the 2012 amendment, arguing that it violates the principles of conservatorship. This is key to understanding they do not want the government to dismantle, but allow them to pay off their loans and return control back to the investors.

There has been no reported movement on any of the legal actions and with the government tied up in the budget and deficit debates, little time is available for action on a program. Washing see F&F currently operating satisfactorily by supporting the financial/mortgage markets and providing income to the government.

Refresher As part of the massive bailout of the 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 scheduled to pay annual dividends of $2.25 a share. Freddie Mac's preferred series Z shares are scheduled 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 rule in August 2012, 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.

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. There has been no action taken to date.

On the Fannie Mae website, FNMA states they are under conservatorship from the FHFA. I agree with many investors who claim FHFA is not acting in the best interest of the company and stock holders. The actions of the FHFA are directly benefiting the federal government, not properly representing the GSEs. However, the actions of FHFA are within legal steps of the law, as passed by the current administration.

If the law suits get their day in court, the opportunity for a win is subject to a lot of conditions. F&F are GSEs, and as such, Congress may be willing to dismantle rather than letting the stockholder regain financial control. Congress may disband the agencies and replace it with another government entity of different structure. If the government loses, the courts would demand payment for all lost income and full repayment of the loan, and repurchase of the stock at a market price, which would be much higher than the original purchase price by the government. In layman's terms, I believe the company would be stripped of all value prior to being resold to the share holders.

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. There are many other investments that provide a 10% or better return on your investment. If you chose to hold on, expect a long road ahead and still very unclear reward if the law suits do win.

Disclosure: I am long C, BAC. 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: If you are invested in FNMA or FMCC, watch the reports on the law suits closely. Watch for Congressional action to disband and create new agency.