The Bill Is In. Fannie Mae and Freddie Mac Investors Should Be Worried

The bill by the Senate Banking Committee has officially been released. Fannie Mae and Freddie Mac investors now have reason to fear.

Mar 17, 2014 at 1:00PM

Shares of Fannie Mae (NASDAQOTCBB:FNMA) and Freddie Mac (NASDAQOTCBB:FMCC) Mac tumbled more than 30% last week, but a recently revealed bill may indicate the companies have even further to fall.

Images Of Money

Source: Flickr / Images of Money.

Why they fell
After months of speculation, the shares of Fannie and Freddie plunged after the Senate Banking Committee released an overview of its plans to wind down the two government sponsored entities. The bi-partisan bill revealed Chairman Tim Johnson (D-SD) and Ranking Member Mike Crapo (R-ID) sought to protect taxpayers and the investment of the U.S. Treasury through the creation of the Federal Mortgage Insurance Corporation (FMIC) which would result in the gradual unwinding of the two companies at the heart of the $11 trillion mortgage market.

Yet many questioned exactly why the shares of the firms plummeted, as the press release outlining the bill gave no mention as to what exactly would be ahead for the preferred or common shareholders of the two firms. Billionaire Bruce Berkowitz -- who at last count had a $1.3 billion position in the firms through both preferred and common shares -- has even called for the ultimate unwinding of Fannie and Freddie, albeit in different ways.

By Eoz

Source: Flickr / Zoe Rudisill.

While his aim was a shift the firms into private hands, he nonetheless would likely be happy to see the words of Crapo which suggested "this agreement moves us closer to ending the five-year status quo and beginning the wind down of Fannie and Freddie while protecting taxpayers with strong private capital, building the components for a stable secondary market and avoiding repeating the mistakes of the past." Berkowitz  and the other shareholders of the firms also want an end of the status quo which currently guides Fannie and Freddie.

However, the 442 page bill outlining the changes was released in its entirety on Sunday, and it provides further explanation as to why current investors have reason to fear.

The reason for more fear
The word "shareholder," wasn't mentioned until page 229, and at first glance, an investor may think it's reason to celebrate. The bill hopes to create a new platform which will be used in the securitization process -- bundling up individual mortgages into bonds -- which will seek "maximum return to senior preferred shareholders of the enterprises." Indeed, such language certainly sounds appealing.

Fnma By Future Atlas

Source: Flickr / Future Atlas.

But it is critical to remember the senior preferred stock is that which is held by the U.S. Treasury. Fannie Mae itself notes the "the senior preferred stock purchase agreement and warrant contain covenants that significantly restrict our business activities and require the prior written consent of Treasury before we can take certain actions."

Those actions include common things used to provide returns to shareholders, like paying dividends or repurchasing shares, selling or leasing any new assets, issuing debt, or even increasing the compensation of its executives.

The senior preferred stock held by the Treasury is a part of the conservatorship of Fannie and Freddie, which now results in Fannie stating, "in conservatorship our business is no longer managed with a strategy to maximize shareholder returns while fulfilling our mission."

Many lawsuits have been brought in the past to challenge this arrangement and the broader terms of the reality of the two companies being deemed government sponsored entities. And although many have suggested such an agreement is unfair, the government is seemingly unwavering in its response.

While we are perhaps years away -- lawsuits and legislation don't move quickly -- from the final decision on where Fannie Mae and Freddie Mac will go, one has to think the two companies aren't headed the way which will delight shareholders.

One reason to celebrate
The shares of Fannie and Freddie have been on an incredible run, but that run may be over. However, there are other great stocks which could be poised for similar gains. The Motley Fool's chief investment officer has selected his No. 1 stock for 2014, and it's one of those stocks that could make you rich. You can find out which stock it is in the special free report "The Motley Fool's Top Stock for 2014." Just click here to access the report and find out the name of this under-the-radar company.

Patrick Morris has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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