How Fannie and Freddie Became the Greatest Stock Story of the Year

Something very strange has been happening. Housing, in all regards, is actually turning around. Home prices are up. Housing starts are improving. Granted, this improvement leaves the housing market looking up at the pre-crash peak, but in relative terms and compared to earlier recessionary lows, it's been more than enough for optimism.


Source: Federal Reserve Bank of St. Louis.

Plenty of housing stocks have reaped the rewards of this recovery, such as it is:

XHB Total Return Price Chart

XHB Total Return Price data by YCharts.

And this is just a small sample of the stocks you could have bought into during the great post-crash housing recovery. Investors have had no shortage of opportunities, from the materials going toward constructing and improving homes for sale, to homebuilders themselves, to the banks offering loans to prospective homeowners. However, one (well, two) of the most important links in the American housing chain remained locked to the ground, unmoving -- until this spring.

FNMA Total Return Price Chart

FNMA Total Return Price data by YCharts.

While the rest of the market was freaking out about solar stocks and electric cars, the common stocks of America's two most notable housing government-sponsored enterprises (GSEs) languished. Of course, this was almost certainly because both Fannie Mae (NASDAQOTCBB: FNMA  ) and Freddie Mac (NASDAQOTCBB: FMCC  ) were placed in conservatorship as the economy melted down in 2008, which has left common shareholders without a means of redress or indeed without any expectation of sharing in the fruits of recovery. But come March, the stocks began shooting up, and they've shot up again this month. What's going on?

The government owns about 80% of each GSE, which it obtained in 2008 in exchange for an influx of $187.5 billion in bailout funds. These two factors have kept the stocks depressed from the takeover until this spring, when Fannie Mae reported the expectation of "significant net income." That income turned out to be truly significant -- at more than $58 billion(most accrued through tax benefits), and Freddie Mac's $4.6 billion profit turned out to be the second-largest in its history as well. As a result of the great quarter, both GSEs are now closer than ever to bringing the government's net bailout cost down to zero:

GSE

Bailout 

Total Dividends Paid*

Net Bailout Cost

Fannie Mae

$116.2 billion

$95.0 billion

$21.2 billion

Freddie Mac

$71.3 billion

$36.6 billion

$35.0 billion

Total

$187.5 billion

$131.6 billion

$56.0 billion

Source: Reuters and Propublica.
*Includes announced second-quarter payments.

Make no mistake: This is still a hefty chunk of change. But it is far, far lower than the $128.4 billion net cost that Propublica reported earlier this year. Now that both Fannie and Freddie have been profitable for several consecutive quarters (and by all regards appear to be on track for more profitability), we can see roughly how long it'll be before these two GSEs provide the government a profit on the bailout -- an event that's sure to bring a righteous firestorm of investor lobbying to bear on returning shares to the public.

The latest quarter was deliberately left off this graph to present a clearer picture of how much each GSE returned to the Treasury under "normal" circumstances. And what exactly are "normal" circumstances now? Let's take a look at pre-tax profits over the same time frame, while including the most recent quarter for a picture of progress closer to the present:

The GSEs have been making solid progress, and a trend toward greater profitability is becoming clear. Since the start of 2012, Fannie and Freddie's average quarterly pre-tax profits have been $5.1 billion and $3.4 billion, respectively. Under these new "normal" circumstances, the GSEs have been paying out substantially all (about 90% in Fannie's case and over 100% in Freddie's case) of their profit to the Treasury, which is more or less how the new conservatorship structure works.

If these averages hold up (under 90% payouts), Fannie Mae would be able to pay approximately $4.6 billion per quarter from here on out, and Freddie would be able to pay $3.1 billion. Based on the current level of outstanding bailout debt, this rate would reduce Fannie's net bailout cost to zero in just five quarters, and Freddie's in 12 -- in either case, far faster than a reported 10-year timetablefor full repayment set by the Obama administration. That's even if you count a hoped-for $50 billion profit, which would take another seven quarters of repayment between the two GSEs.

It should therefore come as no surprise that a number of major hedge funds are now taking up positions in Fannie and Freddie's shares and are lobbying hard for the government to spin off its stake, again making Fannie and Freddie the publicly traded companies they once were. Even erstwhile presidential campaigner (and GSE stockholder) Ralph Nader is up in arms at the government's apparent dalliance over returning a cash cow to private ownership. With at least one writer now claiming that the Federal Housing Finance Agency (the GSEs' conservator) has breached its fiduciary dutyto shareholders, it seems likely that the Fannie and Freddie situation must be resolved far sooner than the government had hoped -- quite possibly in court, should Fannie and/or Freddie zero out their debts in the next two years or so.

Thanks to stricter lending requirements, higher fees, and a lack of real competition, Fannie and Freddie appear headed for record profitability, even when discounting the impact of tax charges. We're highly unlikely to see these two enterprises vanish from the American housing picture, considering that the vast majority of American mortgages now bear the Fannie or Freddie guarantee. If they do, there's a massive amount of assets (more than $5 trillion) to be wound down first and thus accrue to shareholders -- though preferred shareholders would get first crack -- another reason why institutional investors like the GSE story right now.

After an incredible rally, the remaining upside in Fannie and Freddie shares will depend largely on how effective large shareholders are in lobbying for the results they want. Fannie and Freddie didn't have the same strident voices in their favor as did the financial industry in 2008. Now they appear to. You might not like Wall Street, but do you really want to bet against it when it smells a good deal?

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Read/Post Comments (22) | Recommend This Article (9)

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 May 29, 2013, at 12:17 AM, kthor wrote:

    my only regret is i didn't buy enough of both this penny stocks ...;-(

  • Report this Comment On May 29, 2013, at 1:03 AM, JeffreySwim wrote:

    Not sure if this article is from Motley Fool or just someone blogging but it implies that taxpayers are on the verge of being "paid back" following which common shareholders are in the money. This simply is not true.

    Before anyone buys shares in FNMA please read the regulatory documents. The senior preferred stock gets all future income via dividends. It would require an act of Congress to renounce the preferred stock which has not been paid down as the Motley Fool post says.

  • Report this Comment On May 29, 2013, at 1:35 AM, minmartar wrote:

    Can someone please confirm if this article is endorsed by Motley Fool or this is just a blog that anybody can write anything they want?

    This FNMA stock is very hot and I want to call it pure speculation.

    But 130 millions a day?

    4 dollars a share?

    Hard to believe if this is just pure speculation.

    But Matt Koppenheffer repeatedly saying, this is pure speculation and don't buy.

    Whose suggestion do I go by?

  • Report this Comment On May 29, 2013, at 1:43 AM, TMFBiggles wrote:

    @ JeffreySwim -

    At no point here does it say that the liabilities have been paid down. What it says is that the -anticipation- of this event, on an accelerated timetable, is the driver of FNMA and FMCC stock gains so far this year. Following this event, legal and lobbying pressure in favor of reprivatization would be intense, to say the least.

    It's still essentially a bet on the ability of Wall Street to pull levers in Congress at some point down the line, rather than a standard sort of investment in corporate common stock. If you believe that possibility to be likely, then the argument for the price growth is compelling. If not, then you probably expect the shares to flop soon.

    - Alex

  • Report this Comment On May 29, 2013, at 1:57 AM, TMFBiggles wrote:

    @ minmartar -

    It is essentially a speculation on the future possibility of reprivatization. You might never see that happen, and it might happen in a year or two. Nobody can say for sure.

    There are reasons why this is a compelling idea, and of course there are reasons why it is not. This article focused on the compelling side, but it's up to you to decide which argument holds more weight. I do admit that it is significantly riskier to bet on growth now than it would have been two weeks ago, and the upside is certainly smaller.

    - Alex

  • Report this Comment On May 29, 2013, at 2:14 AM, Mega wrote:

    TMFBiggles

    You are doing TMF readers a tremendous disservice by claiming that the remaining liability has been reduced to $56B. The FHFA has made it clear that this is not true. The terms of the preferred shares state that dividends don't reduce the amount owed.

  • Report this Comment On May 29, 2013, at 2:59 AM, TMFBiggles wrote:

    @ MegaShort -

    The term "bailout liability" should probably be replaced by the term "net bailout cost," so I will put in for that change. However, the ongoing payments and the net bailout cost are still issues that will be raised against FHFA's ongoing conservatorship, should it become apparent that the conservatorship is actively preventing full GSE recovery. Here's a better legal perspective than mine, which explains why this matters:

    http://seekingalpha.com/article/1458171-the-fhfa-has-breache...

  • Report this Comment On May 29, 2013, at 6:38 AM, Ksalhab20 wrote:

    I think we all agree the person who wrote this article is a moron. Has no idea what is going on and if he did have any idea he would probably crap his pants wondering what he's investing his money in. If this guy who actually has clout to even write this article is this misinformed and he's an investor then I stand to make a lot of money in the stock market at his expense and at the expense of people like him.

  • Report this Comment On May 29, 2013, at 6:41 AM, Ksalhab20 wrote:

    The government will privatize them and do nothing else. They won't change or liquidate. Just privatize. You can't buy stock in town hall. This is now town hall

  • Report this Comment On May 29, 2013, at 7:05 AM, Pxerxes wrote:

    All buying of stocks is a gamble. I've lost good money buying great companies simply because if a few statements made by "pundits". Life is a gamble, and most times you gamble based on the information you have. I'd like to think that our government would like to do something to help the stock payers of this company. I'm in. At .42¢, at .82¢, and once again at $2. I've lost more money on better stock bets, and at those prices it looks too good. I feel more comfortable about this article than about buying my second house in 2008.

  • Report this Comment On May 29, 2013, at 7:20 AM, tshk527 wrote:

    Since they are still listed on pink sheets, the spread of bid and ask is unbelievably wide. As for FNMA, bid is only 40 cents, while ask is $5. Market makers' immediate profit is 92%, which means you can't win them now. Even if you buy it now for $5 a share by paying a 25% premium over the fair market value of $4, you still have to wait indefinitely until it gets out of the pink sheet and until the bid gets normal.

  • Report this Comment On May 29, 2013, at 9:55 AM, jargonific wrote:

    There are a lot of choices on Fannie... which one to choose? We bought FNMA.

    Will it ever look like this one? What's the diff between them all?

    FNMFO at 21,500.000!!!!

    And what about this story about their potential merger of Fannie and Freddie into a company re March 2013 items?

  • Report this Comment On May 29, 2013, at 11:44 AM, Mega wrote:

    If you look to a seekingalpha writer as a valid source for legal opinions, god help you.

    Bill Ackman publicly asked the FHFA conservator about this two years ago. They stated that they have no fiduciary duty to shareholders.

  • Report this Comment On May 29, 2013, at 11:48 AM, 6sandamo wrote:

    And now it's tanking!

  • Report this Comment On May 29, 2013, at 11:53 AM, Mega wrote:

    http://video.cnbc.com/gallery/?video=1786618239&play=1

    Bill Ackman (Pershing Square): Who are you a fiduciary for? The shareholders?

    Clayton Rose (Freddie Mac boardmember): Our fiduciary duties run strictly to the conservator.

    Ackman: So you can make decisions that are adverse to shareholders?

    Rose: Correct.

    Ackman: Yet there is no liability to you?

    Rose: Correct.

  • Report this Comment On May 29, 2013, at 1:48 PM, jargonific wrote:

    The manipulative web site Market Watch had a lot to do with today's market downturn and I would expect the sell off of FNMA too.

    They tend to sensationalize and exaggerate either way and today it was obvious from the abrupt turn of language that they had in 24 hrs moved from hyper excited and positive to 'worried about QE's emminent demise'... my words.

    By 1:30 (another magic market time) an actual person spoke, Boston Fed. Rep Rosengren, and he said it would be premature to stop asset purchases... he mentioned need for positive jobs reports and economic data before "tapering" easing.

    This game is helpful to hedge fund traders who move markets abruptly and make it seem like a site like MW is far more powerful than it is.

    The hedge fund managers will use anything. So. They are presently using Fannie Mae as a vehicle. That's the problem.

    Still holding FNMA hopefully. But we didn't buy because of privatization. We bought because of potential increase in share price.

  • Report this Comment On May 29, 2013, at 3:13 PM, Mega wrote:

    "The government owns about 80% of each GSE, which it obtained in 2008 in exchange for an influx of $187.5 billion in bailout funds"

    This is not an accurate description of the capital structure.

    True, Treasury owns warrants for 80% of the common equity. But much more significantly, they own 100% of the senior preferred shares. The preferred shares were issued for $187B, and the 80% common warrants (which are currently worthless and will likely never be exercised) were thrown in for free.

  • Report this Comment On May 29, 2013, at 5:20 PM, mylotus wrote:

    In my opinion, why not the government take over both

    GSE as well since it already owns 80% of each. I don't think both FNMA & FMCC have to do privatization. Under good control and management of the government, it shows a lot of profit and this is belongs to all us US citizens, why have to turn back to private enterprise and mess up everything and need bailing out again.

  • Report this Comment On May 29, 2013, at 5:26 PM, mylotus wrote:

    FNMA's historical price was ever $50+ in it's good time, so today's low price is pretty much worthy for investment. I hope the quote may go to $20 a share and I'll get all my money back been lost from other within these several years and retire.

  • Report this Comment On May 30, 2013, at 3:12 PM, jargonific wrote:

    This is a page showing FNMFO share price rising this year.

    http://investing.money.msn.com/investments/equity-historical...

    5/27/13 22,750 high recent

    6/11/2012 3,850 low a year ago.

  • Report this Comment On May 30, 2013, at 3:12 PM, jargonific wrote:

    CAN ANYONE explain the share price? What this is? Are these the old shares, essentially non trading ones?

  • Report this Comment On May 31, 2013, at 1:06 PM, Mega wrote:

    "CAN ANYONE explain the share price? What this is? Are these the old shares, essentially non trading ones?"

    If you can't figure out what they are worth on your own, obviously you shouldn't be investing in them. End of story.

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