Investors are struggling to determine if the common shares, junior, or senior shares of Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) have any value, and how much. Will the administration or Congress take action to settle the issue or will the courts have final say in the rightful ownership? These questions and forthcoming answers will unravel over the next weeks, months or years will determine which, if any, retain any value.
To answer these questions we must take a deep dive into the processes, purpose and motivation of the Congress, administration or the courts. The purpose is not to dissect the political aspect but to determine how we can see through the fog and find the value for the investor. The focus is to determine if there is value in holding any of the shares of stock and what the value may be.
As the current legal situation stands, the Federal government through the Federal Housing Finance Agency (FHFA) maintains operational control of the 2 GSEs and the current quarterly profits (dividends) are deposited in the federal Treasury.
There are at least 20 lawsuits that have been filed against the Treasury by investors seeking a seat at the table as the future of Fannie and Freddie is decided. Judge Margaret Sweeney in the U.S. Court of Federal Claims last month rejected the Treasury's motion to dismiss a high profile lawsuit by an investor group that includes Bruce Berkowitz's Fairholme Funds. By rejecting the motion to dismiss, the courts have now taken an active hand in the disposition of the GSEs. Of the 20, only a few will go forward with some merging, and others wait to see the outcomes of the initial cases.
The administration's fight with Congress over the debt ceiling and funding has been a political challenge for both sides, and the billions of dollars that the GSEs are paying each quarter to the Treasury is a cash cow neither party wants to stop. Both sides were talking about the issue, but neither wanted to commit to a course of action that could create a political football for the elections.
With the court ruling, the case will move to the discovery phase, enabling the plaintiffs' lawyers to question government witnesses. This now opens the FHFA, the administration and Congress into a defensive position to justify their actions and move toward some type of settlement. The FHFA will likely be the first to be grilled in court and depending on the outcome, several key leaders will provide the direction and speed of future actions.
One current response this week occurred when Senator Johnson and Senator Crapo laid out provisions for support in last year's GSE reform bill from Senate Banking Committee members Bob Corker and Mark Warner, which would replace Fannie and Freddie with a new Federal Mortgage Insurance Corp. This would be funded by private investors and the mortgage industry. The Corker-Warner bill provided nothing to common and junior preferred shareholders of Fannie and Freddie, and the statement from Senator Johnson and Senator Crapo on March 12, 2014 also made no mention of any consideration for private investors. The key point here is that this action would move the GSEs to a newly controlled entity under the government that the courts would no longer have access to, through these law suits.
One reason there has been no hurry over the winding-down Fannie and Freddie is the fear of a major disruption to the U.S. mortgage finance market. Fannie and Freddie purchase the great majority of newly originated fixed-rate mortgage loans in the United States.
A strong point of support for the GSEs and the mortgage markets, Fannie and Freddie are the only entities in the country willing to purchase 20 and 30 year fixed rate mortgages, their elimination would have meaningful impacts on the mortgage markets. The monthly cost of owning a home would rise and the size of the market itself would shrink.
The legal cases boils down to a simple question: Was the agreement to take over Fannie Mae and Freddie Mac the correct course of action, and second, was the "Sweep Amendment" done in good faith, with respect to all parties?
Mario Ugoletti served as the U.S. Treasury's director of the Office of Financial Institutions Policy and participated in the drawing up of the government's agreement to bail out Fannie and Freddie, while later serving as a special adviser to former acting Federal Housing Finance Agency Director Edward Demarco and helping draw up the subsequent agreement through which nearly all of the government sponsored enterprises' profits are being swept to the government, leaving private investors in the cold. Ugoletti now serves as a special adviser to FHFA Director Mel Watt, who assumed the post in January, 2014.
Mario Ugoletti's testimony will be key in determining the direction and process the courts react to the investors. If his testimony is perceived to be the correct actions based on the current recession during the 2007-08 crisis, then the FHFA may likely proceed and the administration and Congress could move forward with the wind-down and restructure under a new government program with no recourse for investors.
However, if the testimony opens new avenues for legal action the courts may direct the government to settle with investors, then the courts will have to determine if the warrants given to the government are legal and how to create a solution for this never-experienced tug-of-war with government agencies and hundreds of billions of dollars at stake.
In the last two years the common share stock price has increased from below $1.00 to a high of $6.35 on March 11, 2014, then the bottom dropped to an open on March 19 at $3.06 and $3.03 . Most investors are holding out, hoping for the payday when the law suits force the government to turn over the GSEs to the investors.
Likely courses of action:
COA 1 - The courts hold hearings on the many facets of the actions that the FHFA and administration have taken throughout the years. All these actions are reviewed for legal content, however, due to the first time many of these actions have occurred, the courts will be creating rulings on open law, not previous rulings. A split could occur here of two directions: First the court and administration can come to an agreement on a solution, which would give the administration control of determining the direction of the settlement. The second is the court can rule on parts or all of the case. It is highly likely it will direct some mediation to work toward an agreement. The administration's least favorite outcome is to allow the courts to rule on final settlement. This is the most likely outcome, but the results will be so varied that there is no definition to the resolution.
COA 2 - If the courts throw out the case(s), the administration and Congress will have full control of the GSEs and the creation of any new program. Investors are able to resubmit law suits, but this is shaping up as a one-time shot to push the government into a corner. Second most likely COA.
COA 3 - The government (Congress and the administration), in a timely manner, finds a process to stand up a new program that takes over the duties of the GSEs, and officially winds down Fannie and Freddie. This would attempt to remove the courts from the process. The accounting process would show no funds and costs the government would pay to prevent any payout to investors. This scenario is less likely due to the courts already involved and the law suits would continue and evolve through the restructuring process. Third most likely COA.
COA 4 - The investors win the law suits outright and the courts force the government to allow repayment (based on previously paid or new payments with interest), the opportunity for the GSEs to return to investor control. We would expect to see a wave on new legislation that would increase demands for capital and push all risk to investors. The government would tighten control on the purchase of mortgages from banks that would have a ripple effect across the markets. Least likely COA.
More questions for Investors include:
1. Regardless of the COAs listed above, how will the value of the GSEs be assessed between assets, liabilities, and final value?
2. Will the senior preferred notes and warrants agreed to during the crisis stand, or will they be annulled as illegal? If upheld, the government will hold enough stock to basically keep all the assets. If not upheld, how would the GSEs assets be assessed to provide for the senior preferred, junior preferred and common stock?
3. Will the GSEs still have to repay the loans they borrowed from the government, or has the amount repaid already cover the bill?
4. If the government creates a new program, would any of the stock holdings be rolled over as new owners, or will the government not recognize and force all new purchases with new money?
Our Assessment: Based on the current actions of the administration and Congress, the government does not demonstrate the desire to acknowledge the interest of the current common or junior shareholders. We believe the administration and Congress will continue to take action that will perpetuate the cash flow from the GSEs or the new program into the federal Treasury. In our evaluation of the possibilities of investors winning the law suits outright are low, but chances to win some battles through the process are high. In the end, we believe the government will strip all value from the company prior to releasing control back to the investors, whether it is the current GSEs or the new program under the FHFA. Any investor involvement will require the purchasing of new shares and include new regulations controlling the investment and oversight. Investors are not receiving any current dividends, and will not until the resolution of ownership and disposition of the GSEs. We do not believe the current common or junior share holders will regain any value from their current shares.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.