Fannie And Freddie Poised To Break Out

Includes: FMCC, FNMA
by: David Sims


Fannie Mae and Freddie Mac are poised to break out.

The GSEs helped millions of households avoid foreclosure.

Retaining Earnings is the best protection for taxpayers.

Systemic Importance

In 2008, the United States was on the verge of stepping over and into a financial precipice so deep that the impacts on the world economy would have been devastating. This is something that has become common knowledge. Less known and somewhat unbelievable was the fact that some leaders on the international stage were rooting for the calamity to strike and strike hard. Hank Paulson, then Treasury Secretary in 2008, wrote about an encounter with a Chinese diplomat at the 2008 Beijing Olympics. He said that he was informed of a plot by the Russians to dump massive quantities of U.S.-backed bonds on the market. This action would have started the chain reaction that lead to the 2008 financial crisis. These bonds were implicitly guaranteed through Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC).

Through a series of laws passed by Congress, the implicit backing of the GSE mortgage bonds became explicit. A housing bubble burst and many banks failed. Congress passed the TARP program. Weakness in the housing market prompted the creation of the Home Affordable Refinance Program (HARP) and Home Affordable Modification Program (HAMP).

HAMP and HARP Figures

In 2008, 7.5 million families were underwater on their homes. By 2009, this number rose to 10.7 million. Home values were quickly dropping. Foreclosures were rising. The expected losses grew and grew, along with unemployment.

The Obama Administration's HAMP and HARP programs were created in 2009 as a means to stop the crisis. Fannie Mae and Freddie Mac were the prime candidates to implement this new public policy. By November 2013, there were 432,256 permanent HAMP modifications and through the end of 2013, 3.06 million homes refinanced through HARP. According to Fannie Mae, every refinance saved homeowners $223 per month on their mortgage payment. The annualized savings on these refinanced loans is approximately $8.2 billion. The effect of modifying 432,256 mortgages through HAMP is more difficult to calculate, however consider the fact that the GSEs had been increasing their loss reserves for these, in the event they went into foreclosure. Those reserves are reversing now, which is boosting profitability and making them the two most profitable companies in the world.

Acting as public utilities, Fannie Mae and Freddie Mac gave up 70 years of profitability to the crisis. They increased their market share and did what no other institution could do. Without their efforts the U.S. economy would have been much worse off.

Importance of Housing in the Domestic Economy

Housing's impact on the domestic economy cannot be downplayed. Roughly 18% of GDP can be directly attributed to the housing market. It is one of the few industries that can exist solely through domestic building and services. You cannot outsource or import residential construction, home improvement, real estate brokerage, or lending services.

Additionally, household debt totals $11.52 trillion in the United States. Mortgage indebtedness stands at $8.05 trillion and Fannie Mae and Freddie Mac have a combined $5.23 trillion in housing-related assets on their balance sheets. If you could pick any two institutions with the same level importance to the economy, it would be a difficult task. Of the $20 trillion or more of securities traded on the NYSE and NASDAQ, none are guaranteed by the exchanges or the Federal Government. But GSE Mortgage Backed Securities count with a special risk-weighting under Basel III standards, meaning the world's largest banks will load up on them. They are the bedrock of the world's banking balance sheets along with Treasuries.

But what value does this bring for the common stock of the GSEs?

Johnson-Crapo is More of the Same

Since last week's unveiling of the Johnson-Crapo Bill, shareholders have felt jittery with good reason. The Center for Individual Freedom puts it best:

...the proposal continues to disregard investors' rights - the community banks, pension funds and individuals that supported Fannie and Freddie, before, during and after the bailout. Under Crapo-Johnson, those investors remain left out in the cold, their savings and retirement in limbo. Meanwhile, taxpayers would remain on the hook because the full faith and credit of the U.S. government would backstop the newly-created entity under Crapo-Johnson.

Luckily, the bill appears to have as little as a 10% to 15% chance of passing and some have gone as far as to call it idiotic.

End the Net Worth Sweep

In accordance with all of these guarantees, intertwined interests, and domestic policy concerns are the quasi-private missions of the entities to pursue a profit. Profits and retained earnings are the mechanism for preserving the system. The system exists to build capital and improve wealth, the noblest of all American principles. In tough times, when losses begin to mount, retained earnings are the lifeblood that keeps a business running. So, this is why the current situation with a 100% sweep of the GSE's net worth is a shame. The United States is essentially riding the wave of a housing rebound with a naked guarantee backed by nothing but the goodwill of taxpayers. The GSEs should be allowed to retain capital. This will insulate taxpayers from the next crisis.

It's a known fact among those working in the halls of corporate America and gliding around the halls of Congress that the United States is the global leader in business. Somehow this belief also corresponds to a confidence in the global system. The fallacy of the thinking is the underlying belief that the global system would fail if the United States didn't exist as a leader in this realm. That flawed thinking has put leaders in a position to extend their interests overseas without considering the macro risks that over-extension can create.

In our global economy, we never know how long U.S. goodwill will last. You would be challenged to find one single geopolitical trend that has lasted more than a few hundred years. The current mantra of being backed by the full faith and credit of the United States of America is one of our defining exports. That too extends into our legal system, which means that the current state of Fannie and Freddie is a reflection on the entire country's status of being the dominant business and geopolitical power of the world.

A shareholder's right includes the right to own a private company, direct its board of directors, and to retain and reinvest capital. These are basic fundamentals of our system that we tout as examples of democracy in action. Denying the intent of the system is the same as handing it over to our enemies.

Quick Technical Analysis

Recent weakness in trading presents an opportunity to accumulate shares below trend lines. Unlike last year, the lawsuits are proceeding more quickly and discovery will begin March 20th. So, a near-term event could cause a spike in the share price.

If near-term events provide a catalyst, a cup and handle chart formation may appear, which is an indication that the stock may break out. A break-out would take this stock above its recent 52-week highs.

Disclosure: I am long FNMA, FMCC. 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.