Fannie Mae: Gold Mine Or Death Trap?

Mar.13.14 | About: Fannie Mae (FNMA)


Recent volatility offers a good entry point for a long position in Fannie Mae.

Common shareholders of Fannie Mae and Freddie Mac have legitimate claims against the government for confiscated profits.

The winding down of Fannie Mae and Freddie Mac would constitute a taking of property, requiring the government to compensate shareholders as required by the Fifth Amendment to the Constitution.

Over the past few years, the federal government has created a great deal of controversy as the majority shareholder and conservator of Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC). These two government-sponsored enterprises (GSEs), which became insolvent and were left for dead during the Panic of 2008, have been doing better recently. Better to the tune of more $100billion in profits over the last two years.

While it is reasonable to attribute the post-crisis success of Fannie and Freddie less to fundamental changes in their business models and more to the purchase of trillions of dollars of mortgage back securities by the Federal Reserve, success is still success. And, any rational person would expect the federal government, and its incumbent administration, to bask in the reflected glory attributing their success to TARP and the 2009 stimulus bill. But that 's not what's happening.

Instead of heralding the success of the GSEs, the administration has, in no uncertain terms, vowed to dissolve them in favor of some new regulatory scheme. To that end, the government has done everything possible to undermine the interests of common shareholders and discourage investment in the two companies. In its most controversial move to date, the Federal Housing Finance Agency (FHFA), the bureaucracy charged with overseeing Fannie and Freddie, decided in 2012 to confiscate all of the GSEs' new found earnings and forward the largess to the United States Treasury Department.

Of course, that didn't go over well with common stockholders and it spawned a large body of litigation. The potential rewards of that litigation, together with the return to profitability of the GSEs, resulted in a spike in their stock prices over the past twelve months. Unfortunately, just when these weary equity warriors began to see a flickering light at the end of the tunnel, another of the dysfunctional branches of our federal government joined the fray and blew out the candle.

Although both houses of Congress have, for some time, been actively discussing plans to shut down the GSEs, panic selling of Fannie and Freddie shares reached a fevered pitch earlier this week when Senators Tim Johnson and Mike Crapo announced plans to introduce a bill in the Senate which would require winding down the two companies. Since then, both stocks are down almost 50% from their recent highs.

While these events haven't really changed anything from a fundamental standpoint, they were very effective at polarizing investors into two camps with diametrically opposed valuations of Fannie and Freddie. One side sees ten-fold returns in the GSEs while the other views the companies as worthless. Certainly, there is a great deal of risk associated with the two companies and extreme price volatility will continue. Yet, for more aggressive investors I think the potential reward justifies the risk.

From a political perspective, I agree the GSEs should be shut down. There is no doubt that the GSEs, together with the other fiscal, monetary and political policies of the federal government, caused the Panic of 2008 as well as the resulting Great Recession. Nevertheless, the government is, in my opinion, without the ability to shut the GSEs down from both a political and a legal perspective. At least not without compensating equity owners.

From a political perspective, the federal government is currently so dysfunctional there is no conceivable way Congress and the administration could reach an agreement to reform one of the largest and most important parts of the economy. It simply isn't possible in the current political environment and probably wouldn't be possible even if one party controlled both houses of congress and the white house. These companies are so large and so deeply ingrained in our economy, it could easily take two decades or more to wind them down without causing a major economic calamity. Moreover, even if a political agreement to deal with the GSE problem could be reached, it is highly unlikely that Fannie and Freddie would cease to exist. In such a situation, it is more than likely the GSEs would survive in some form as a private company with much greater bureaucratic oversight similar to other aspects of the financial industry. Again, these companies are simply too large to be closed down.

From a legal perspective, there is even greater protection for common stockholders. At the height of the 2008 Financial Panic, when Fannie Mae and Freddie Mac became insolvent, the federal government clamored for ways to rescue them. With more than $5 Trillion in guaranteed mortgages on their books, Fannie and Freddie were the ultimate examples of "Too Big To Fail." Their demise would have directly or indirectly affected almost every financial institution in the world and could have triggered a domino effect leading to the failure of virtually the entire global financial system.

The government's response took shape with the enactment of the Housing and Economic Recovery Act of 2008 (the "Recovery Act") which created the Federal Housing Finance Agency (FHFA) to oversee the GSEs and vested new, wide-ranging regulatory powers in the new agency. Prior to the passage of the Recovery Act, the government could force the GSEs into conservatorship if they failed to meet certain capital requirements. The government did not, however, possess the legislative authority to liquidate GSEs in receivership. The Recovery Act changed that and authorized FHFA to appoint itself as a conservator or a receiver for the GSEs if certain conditions were met. See 12 U.S.C. § 4617.

On September 7, 2008, the FHFA exercised its authority under the Recovery Act and placed Fannie and Freddie in conservatorship. Immediately thereafter, the FHFA dismissed the officers and directors of both Fannie and Freddie. Furthermore, the FHFA signed agreements on behalf of the GSEs whereby, in exchanged for capital infusions, each GSE issued $100 billion of senior preferred stock with a 10% coupon to the Treasury together with warrants permitting the government to purchase 80% of the outstanding common stock of each company with an exercise price of less than a penny per share.

In the current debate, most people assume that the government has the absolute authority to do as it wishes with the GSEs and few people question the authority of the FHFA to enter the agreement it made with the Treasury Department in 2008. The FHFA is, however, clearly limited in its authority. Specifically, the Recovery Act, which created the FHFA and authorized the appointment of itself as conservator, also sets forth the powers which it may exercise as conservator. The Recovery Act states, in relevant part, as follows:

The Agency may, as conservator, take such action as may be-

(I) necessary to put the regulated entity in a sound and solvent condition; and

(ii) appropriate to carry on the business of the regulated entity and preserve and conserve the assets and property of the regulated entity.

See 12 U.S.C. § 4617(b)(2)(D). At its essence, the statute requires that the actions of the conservator be necessary to keep the GSE solvent, carry on its business and conserve its assets. Any actions taken by the FHFA which do not meet these requirements exceed the scope of its powers.

While one might argue as to whether the FHFA negotiated the best deal possible when it entered the 2008 agreement with the Treasury Department, it would be hard for any reasonable person to deny the agreement was necessary to keep the GSEs solvent, carry on their business and conserve their assets. On the other hand, the 2012 agreement, whereby the FHFA agreed to transfer all GSE profits to the Treasury as dividends on its preferred shares, clearly meets none of the statutory requirements. In fact, the latter decision flies in the face of the statute as the payment of unnecessary dividends undermines the solvency of the GSEs, interferes with their ability to carry on their business and, rather than preserving their assets, gives the assets away.

These actions, by the FHFA, clearly give rise to causes of actions on the part of the common stockholders of Fannie and Freddie to recover the dividends paid to the government in excess of the 10% to which the government was entitled. And the amount of the overpayment is substantial. Under the terms of the original agreement, the government was entitled to approximately $40 billion in dividends from the GSEs since 2008. As a result of the 2012 agreement, however, the government has been paid more than $100 billion and that figure continues to rise. Based on these numbers, the government has, to date, been overpaid to the tune of about $60 billion which is approximately 12 times the entire market cap of Fannie Mae.

Fannie and Freddie also clearly have value as going concerns. For example, at the end of its last reporting period, Fannie Mae showed $10 billion in book value, had $30 billion in operating income and generated free cash flow of $81 billion. While the government could try to shut down the GSEs, such action would clearly constitute a taking of property from the common stockholders for which the government would be required to provide just compensation in accordance with the Takings Clause of the Fifth Amendment to the United States Constitution.

Disclosure: I am long FNMA. Since November of last year, I have held a modest long equity position in it. I used the recent drop in the stock's price to buy more. I intend to continue adding to my position until it reaches around 3% of the total value of my portfolio.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.