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Freddie and Fannie Shareholders: What This Means for You

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On Sept. 7, 2006, NYU economics professor Nouriel Roubini stood before a group of econ geeks and made some bold predictions about the future of credit markets. One of those predictions -- which was likely met with a few chuckles and sneers, and perhaps some sympathy applause -- was that Freddie Mac (NYSE: FRE  ) and Fannie Mae (NYSE: FNM  ) would eventually be crippled or destroyed by the fallout in the housing market.

Oh, how right he was.

Two years later to the day, Freddie and Fannie -- created by the government to provide liquidity to the mortgage market -- have been essentially taken over by the government to, well, provide liquidity to the mortgage market. The ironies abound.

What's all this mean for shareholders? I don't need to remind you that common shareholders drew the short straw of the deal -- shares of both companies are down around 80% as I write this. "But why?" I've heard many people ask. "The government didn't wipe out the shares, as many predicted, so we're out of the woods, right?"

Sadly, no.

The Treasury's deal didn't necessarily "wipe" shares out -- they're still trading -- but shareholders might have a tough time distinguishing between the two. Three terms of the deal leave common shareholders with little more than scraps of hope:

  • All dividends and voting rights have been stripped, for the time being.
  • The Treasury gets warrants to purchase 79.9% of the companies.
  • Common shares are now first in line for losses, last in line for profits.

These developments aren't bad. You'd have to cover them in sugar and wrap them in a bow to consider them "bad." They're downright terrible.

Most investors are focused on the second part -- the massive share dilution. Shareholders perked up yesterday when Reuters reported that "the government has no plans to exercise those warrants," but at the end of the day, it doesn't really matter. Warrants have to be carried on companies' books as fully diluting shares, so dilution essentially takes place regardless of the Treasury's desire to exercise them.

And if the Treasury didn't exercise them, what would that tell you? That common shares would be fundamentally worthless. The only situation where the Treasury would exercise the warrants is if shares held legitimate value. Hence, you get two outcomes: Either shares become worthless, or the Treasury actually exercises the warrants, and legitimate dilution takes place. Any way it gets spun, common shareholders are worse off than they were last week.

And keep in mind, this weekend's actions represent the first of what could be many moves. As time goes on and the housing market continues to wallow, it's entirely likely that Fred and Fan will require more capital injections, which would likely mean more dilution. Is it possible shares will be diluted to zero? Absolutely.

Going forward, many banks will benefit from this weekend's bailout. Annaly Capital (NYSE: NLY  ) , Wachovia (NYSE: WB  ) , and Bank of America (NYSE: BAC  ) , among others, surged on the news. Although diehards remain loyal, Freddie and Fannie's common shares will likely live out their remaining days at or around penny-stock land. Good riddance.

For related Foolishness:

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. Annaly Capital Management and Bank of America are Motley Fool Income Investor picks. The Fool has a disclosure policy.

Read/Post Comments (6) | Recommend This Article (37)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 08, 2008, at 4:41 PM, cnegrinelli wrote:

    How will this affect the banks that hold perferreds, such as GBTS? Are they out like the common shareholders or is still a little hope?

  • Report this Comment On September 08, 2008, at 5:13 PM, BDunn19 wrote:

    Are the bonds affected? What pecking order do they fall in?

  • Report this Comment On September 08, 2008, at 9:04 PM, GoNuke wrote:

    It has been evident for many years that Americans have been living beyond their means and that China has been propping up the US dollar by buying US debt instruments, not for the return, but to keep Chinese goods cheap. The US maintained unrealistically low interest rates that were lowered to bail out the speculators in the dot com boom. This lead to the housing bubble. The buck has to stop somewhere. The US clings to the mantra that regulation is bad as if it was a message from God. The housing bubble has been a comedy of errors that has only been possible because of a lack of banking regulation and due diligence. At each turn the US has chosen de-regulation followed by "unorothodox" measures to soften the blow of the excesses caused by the lack of regulation.

    Look at the Canadian model. We have big banks that have always been able to operate nationwide so money saved in one region could finance homebuilding in another. Our banks are regulated to the extent that they are not allowed to do some of the foolish things US banks did. Canadian banks continue to perform well, Canadian house prices are stable or rising, the Canadian economy is healthy, and it is very closely tied to the US economy.

    From the day I first learned of the existence of sub-prime mortgages I saw visions of the Tokyo real estate meltdown. I would have sold any shares I had in US companies dealing in mortgages. This disaster was almost unavoidable given US policy. It appears that all the lessons of the S&L fiasco were forgotten long ago.

    It is time for the USA to reconsider some of its economic dogma. The rigour of the SEC's regulations made the US a safe place for foreign capital. The same rigour needs to be applied to banking so that people will return to the notion that you get rich by working, saving, and investing; not by gambling as in betting on bubbles.

  • Report this Comment On September 08, 2008, at 9:41 PM, burneb43 wrote:

    "The US clings to the mantra that regulation is bad as if it was a message from God."

    This isn't a mantra from God, but a mantra from the Republican Party, which many in the US take as the same thing. In every major deregulation I can recall, such as the trucking industy, airlines, savings & loans, etc., disasters in that segment have followed within 3 years or less, due to greed and fraud leading to corner-cutting and over reaching.

    There are many to blame in the current mortgage crisis, but even The Economist ranks the current "regulation-adverse" US Administration about 40% responsible for dilution and lax enforcement of Federal regs.

    There really is NO excuse for issuing a no-doc, lier's loan, or NINJA mortgage. Clearly any such lender intends to mislead or defraud another party about the value of such a receivable.

    Not that most Fed regulations couldn't be judiciously trimmed or simplified, but industries never seem to have much collective judgement or restraint for long, and always lobby for the conditions of their own downfall.

  • Report this Comment On September 09, 2008, at 11:43 AM, cchin wrote:

    What also erks me is I hear the CEO's are going to be given a $14 million package upon their exit. For what? How many mortgages can be saved with $14 million? Greed. Greed is why we have these problems. These people who do a bad job that affects so many people, especially the middle and lower class that always seem to get the shaft, shouldn't get paid for that. What message are they sending? If you are a CEO and you don't do your job, hey at least you'll be set for life when you leave. So go, play golf, do as little as you can for the health of your company for which so many people depend on. People who don't see a dime if they are let go. They should be ashamed that they let so many people down, I guess here they get to be ashamed all the way to the bank. So sad.

  • Report this Comment On September 12, 2008, at 1:18 PM, richqw wrote:

    It's a crime that dividends were suspended on the preferred stock. Over 50% of the outstanding preferred stock was issued in 2007 and 2008. Some was even issued in May 2008. The preferred stock was supposed to be a safe, conservative investment.

    Not only did many banks hold the preferred stock, but it was also held by many investors looking for income.

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