Why Fannie and Freddie's Investors May Be In Trouble

Source: www.futureatlas.com

Fannie Mae (NASDAQOTCBB: FNMA  ) and Freddie Mac  (NASDAQOTCBB: FMCC  ) have been the topic of intense debate ever since the financial crisis, and it looks like some action may be taken this year that would drastically change the system. The details of the recently proposed bipartisan Senate bill overhauling these companies could have a huge impact on investors, as well as on the overall U.S. housing market.

The bill and what it would do
The most drastic effect of the legislation would be to wind down Fannie and Freddie over a period of five years. In their place would be a somewhat elaborate system of private sector firms and a federally backed but privately held agency that together would assure that 30-year fixed rate mortgages would remain available and affordable.

The bill also sets up a mortgage insurance fund to protect taxpayers from having to bear the costs of any future downturns in the real estate market, and also establishes stricter underwriting standards to fit the new definition of "qualified mortgage." Among other things, this raises the minimum down payment to 5% from the current 3.5% the FHA requires.

Most significantly, the bill is geared toward creating a more natural and competitive market for housing finance, while assuring the broad availability of credit for eligible borrowers.

What about the investors?
It is still a bit unclear just what will happen to holders of Fannie and Freddie's preferred and common stock, but it's probably not good. In fact, the common stock of both companies have lost about one third of their value over the last couple of weeks on the anticipation of this bill.

The largest investor in Fannie and Freddie is the government (specifically, U.S. taxpayers), and they are entitled to profits before any of the other equity holders.  There is currently a lawsuit against the U.S. by shareholders who feel that they should also benefit from the companies' financial turnaround.

The new bill could wipe out the equity holders, and Fannie and Freddie's assets would be sold off, with all proceeds going straight to the U.S. Treasury, not the shareholders. The holders of the preferred and common stock might see some money in the end, but there is an uphill battle even to get to that point.

What it could mean long-term
While investors in Fannie and Freddie may indeed get wiped out, in the long run the bill should be good for both the U.S. real estate market and its taxpayers.

Specifically, it should create a greater level of competition among government-guaranteed mortgage issuers, which should go a long way in ensuring that mortgages remain widely available and affordable. The provision of the bill that says the government insurance won't even kick in until private capital suffers losses should force lenders to maintain even higher standards than the government requires, as it forces them to put their own capital at risk first, before the government will step in and bail them out.

This could indeed cause the housing market to slow down at first, but in a good way. If less "marginally qualified" borrowers are buying homes, the foreclosure rate will drop over the long run, and this will encourage a healthier housing market.

Foolish final thoughts
A central cause of the financial crisis was the fact that lenders didn't feel like they were putting any of their own money on the line when making loans. This bill does an excellent job of addressing that problem through the requirement of private capital funding, which is the first money to be at risk, should a loan go bad.

While the bill is not perfect, especially for investors, it may be what is necessary to get the U.S. housing market on a sustainable and responsible path for the future. I think that investors will ultimately wind up getting some compensation, but the Treasury and the taxpayers in general will be the big winners here.

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Read/Post Comments (21) | Recommend This Article (5)

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 March 22, 2014, at 8:46 AM, bigjohn327 wrote:

    actually the bill would still have taxpayers on the hook for billions of dollars only the first 10 percent loss would be from private equity. so if we had the exact same meltdown the taxpayer would still have paid over 160 billion dollars. second there is no provision to sell the assets. third the government is not entitled to all of the profits. the government took all the profits by self dealing with a conservator that was appointed by the government. if enacted the new bill which is pretty much the same as the old bill will raise the cost of a mortgage without protecting the taxpayers. So that is a net negative in a weak housing market

  • Report this Comment On March 22, 2014, at 9:13 AM, infinitemf wrote:

    You have raised more questions than answers.

    Who has the authority to liquidate solvent shareholder owned private companies?

    Can congress/Fed Gov violate the laws without totally re-writing the laws governing

    incorporated companies?

    Will not this violate the constitutional authority of states to regulate incorporated companies?

    Is this not in the jurisdiction of shareholders and courts?

    FnF are still under the management of private entity (FHFA Conservatorship),

    with mandated duty to: (Ref:FHFA website)

    "to preserve and conserve the Company’s assets and property and to put the Company in a sound and solvent condition".

    How can Conservator act as liquidator of a solvent company without legal authority? As long as company is in c'ship, liquidation is ruled out.

    Once it comes out conservatorship, it will be solvent, profitable company.

    How can you put solvent, profitable company in receivership.

  • Report this Comment On March 22, 2014, at 9:17 AM, hongchang wrote:

    This fool did not have any new opinion other than the facts that we all know for years.

  • Report this Comment On March 22, 2014, at 9:55 AM, zachg wrote:

    Corker, Warner, Crapo, and Johnson, stop wasting tax payer's money to try and fix something that isn't broke.

    Keep Fannie and Freddie for another 75 years!

  • Report this Comment On March 22, 2014, at 10:02 AM, zachg wrote:

    Foolish comment: "the common stock of both companies have lost about one third of their value over the last couple of weeks"

    Do you even know what the pps was just over a year ago? .40 cents

  • Report this Comment On March 22, 2014, at 10:02 AM, AmyQrs2014 wrote:

    I have following comments about the proposed bills and recent news on FMCC and FNMA.

    1) From news onlined, I found some people do not understand purpose of setting up these 2 companies, and what kind of business they are involving. Some people do not understand why to package and sale the products that investors already invested to investors again. Many people think the government did not properly use tax payer’s money, when the government bailout these 2 companies.

    I think purpose of setting up these 2 companies is to provide liquidity to big FIs in mortgage business. They release some big FIs from mortgage lending. Then, these FIs can initiate or work on other new projects. FMCC and FNMA products can allow individuals and smaller companies to benefit from the return.

    But, I think these 2 companies probably should consider more strict credit police and improve their management to - only serve suitable projects and suitable companies at suitable prices when the market condition is proper.

    They should not avoid the role of being a market watcher and maintaining certain discipline in the market. They can treat the role as a CSR project or develop the role into their legal responsibility.

    They may consider to separate first tier and second tier mortgage projects, let other companies know that they will postpone some projects when the market condition is bad and reject bad quality projects. So that property developers, investors and lenders will take certain responsibilities of property investment and development, rather than just transfer all risk to these 2 companies.

    The public should understand their - Because of sufficient money supply and funding channels in recent years, many FIs tend to keep good mortgage projects, and only outsource bad projects. This makes these 2 companies more difficult to get a proper return, their projects and business more risky.

    In addition to their existing business, these 2 companies may consider to expand into other suitable business and product sectors.

    2) Some news also mentioned that some people suggest to Replace the FMCC and FNMA with Mortgage insurance company, and bailout only when investors’ loss is more than 10%.

    I think mortgage insurances have different function and purpose with existing FMCC and FNMA products. They are like peach and orange. The situation is like when people fall ill, after eating some bad peaches during bad weathers, they should not ask God to replace all peaches with oranges.

    The US government did not always bailout FMCC and FNMA. This probably is the first time to bailout FMCC and FNMA in 10 to 20 years, or since their establishment.

    It is not a good idea to benefit from the companies during their good years, and your rainy days. Kick them away, during their rainy days, but your good years.

    3) The companies were set up some years before. It is certainly a good idea to continually perfect and develop their business and operation. But it seems not a good idea to crackdown everything and start from zero.

    4) Big Bath accounting treatment.

    From accounting prospects, some company write off uncertainties in their financial statement in 1 year to have high quality financial statements in future. i.e. Revaluation surplus that accumulated during many good years, or slow debt collection. Many good blue chips companies do things in this way.

    If people do not understand why the company recorded serious loss, they should first ask the company’s Investors Relationship Department.

    5) People should first understand purpose of setting up the company, what benefits and real contributions does the company bring to the society.

    It is not a good idea to benefit from the companies during their good years, and your rainy days. Kick them away, during their rainy days, but your good years.

    Any feedback, pls email me: Amy_qrs@yahoo.com

  • Report this Comment On March 22, 2014, at 10:16 AM, AmyQrs2014 wrote:

    I have following comments about the proposed bills and recent news on FMCC and FNMA.

    1) From news onlined, I found some people do not understand purpose of setting up these 2 companies, and what kind of business they are involving. Some people do not understand why to package and sale the products that investors already invested to investors again. Many people think the government did not properly use tax payer’s money, when the government bailout these 2 companies.

    I think purpose of setting up these 2 companies is to provide liquidity to big FIs in mortgage business. They release some big FIs from mortgage lending. Then, these FIs can initiate or work on other new projects. FMCC and FNMA products can also allow individuals and smaller companies to benefit from the return of bigger projects.

    But, I think these 2 companies should consider more strict credit police and improve their management to - only serve suitable projects and suitable companies at suitable prices when the market condition is proper.

    They should not avoid the role of being a market watcher and maintaining certain discipline in the market. They can treat the role as a CSR project or develop the role into their legal responsibility.

    They may consider to separate first tier and second tier mortgage projects, let other companies know that they will postpone some projects when the market condition is bad and reject bad quality projects. So that property developers, investors and lenders will take certain responsibilities of property investment and development, rather than just transfer all risk to these 2 companies and other parties.

    The public should understand their - Because of sufficient money supply and funding channels in recent years, many FIs tend to keep good mortgage projects, and only outsource bad projects. This makes these 2 companies more difficult to get a proper return, their projects and business more risky.

    In addition to their existing business, these 2 companies may consider to expand into other suitable business and product sectors.

    2) Some news also mentioned that some people suggest to Replace the FMCC and FNMA with Mortgage insurance company, and bailout only when investors’ loss is more than 10%.

    I think mortgage insurances have different function and purpose with existing FMCC and FNMA products. They are like peach and orange. The situation is like when people fall ill, after eating some bad peaches during bad weathers, they should not ask God to replace all peaches with oranges.

    The US government did not always bailout FMCC and FNMA. This probably is the first time to bailout FMCC and FNMA in 10 to 20 years, or since their establishment.

    It is not a good idea to benefit from the companies during their good years, and your rainy days. Kick them away, during their rainy days, but your good years.

    3) The companies were set up some years before. It is certainly a good idea to continually perfect and develop their business and operation. But it seems not a good idea to crackdown everything and start from zero.

    4) Big Bath accounting treatment.

    From accounting prospects, some company write off uncertainties in their financial statement in 1 year to have high quality financial statements in future. i.e. Revaluation surplus that accumulated during many good years, or slow debt collection. Many good blue chips companies do things in this way.

    In addition, 2009 is a very special and bad year. In 2008 and 2009, economy, property and financial market in many major developed countries including US slumped, after conservative growth in 10 or 20 years.

    These may be the reasons for these 2 companies recorded serious loss in 2009.

    If people do not understand why the company recorded serious loss, they should first ask the company’s Investors Relationship Department.

    5) People should first understand purpose of setting up the company, what benefits and real contributions does the company bring to the society.

    It is not a good idea to benefit from the companies during their good years, and your rainy days. Kick them away, during their rainy days, but your good years.

    6) If the proposed bill is 500 pages, any counter-offer bill/improvement and development proposals about the companies and the system could be 1000, 1500 or 3000 pages.

    Therefore, it is too difficult to summarize all my comments here.

    Any feedback, pls email me: Amy_qrs@yahoo.com

  • Report this Comment On March 22, 2014, at 11:22 AM, BeReAlY wrote:

    Just another short side article with a veiw to help in their own trade MFool is worse than Seeking Alpha!

  • Report this Comment On March 22, 2014, at 1:02 PM, LucoBrazi wrote:

    Every time I read a MF article, I am expecting something with a little more edge, but I keep get the same old blah, blah, blah...... really disappointed.

  • Report this Comment On March 22, 2014, at 1:23 PM, maestrolindo wrote:

    Two senators from rural white farming states want to kill Fannie and Freddie. This will never fly in a state with an urban population.

    The FMIC will leave tax payers on the hook. Tell me again, who is the backstop here? All this bill does is get rid of two companies and create others to fill their void. If that isn't immediately obvious to you look at this illustration.

    http://blogs.wsj.com/economics/2014/03/15/what-can-take-the-...

    This is a fake bill

  • Report this Comment On March 22, 2014, at 1:42 PM, bigjohn327 wrote:

    how does housing remain affordable if the down payment goes from 3.5 to 5 percent. already some groups complaining about the less affordability.........and interest rates will be higher if the private sector is handling the mortgage business

  • Report this Comment On March 22, 2014, at 1:50 PM, bigjohn327 wrote:

    since you did not even discuss the legal action and whether the government will prevail it is clear that when you claim the treasury and taxpayers will do well it is obvious that you have no clue

  • Report this Comment On March 22, 2014, at 4:17 PM, maestrolindo wrote:
  • Report this Comment On March 22, 2014, at 5:25 PM, bena99 wrote:

    This Motely Fool reporter has not done his homework to understand the law. No one, I mean no one is above the law. Congress cannot pass laws that are unconstitutional and illegal and the Supreme Court will be compelled to execute the original letter of the law and constitution, that means that the 2012 congressional deal to sweep away 100% of FnF profits was indeed unconstitutional and illegal. Therefore, the shareholders will be entitled for compensation of this money illegally taken by the treasury dept. Mr. fool your are indeed a fool, next time you post your conclusions do your homework so us less informed can have a fair crack at the truth and not your biased opinion since you obviously have an underlying agenda by releasing such an article.

  • Report this Comment On March 22, 2014, at 6:12 PM, chessmoves wrote:

    There is a difference between being and idiot and a fool. In this case the writer happens to be both for he has neither the comprehension of the macro circumstances nor the understanding of the true legalities between the lines on this particular subject.

  • Report this Comment On March 22, 2014, at 8:03 PM, gagdump wrote:

    I add to the above comments - there is absolutely no news in this article. If MF had to do a spread on Fannie before closing time today, why not, at least, do some reporting on the Discovery motion in the federal court case now going on?

    This can only be another MF attempt to suppress the stock in the face of the Discovery that was supposed to be made public yesterday, and which would be favorable to FNMA. MF and Senate rumors are intended to "manage" FNMA now (and last May) so that its rise will be more dramatic into the summer and just before the midterm elections. Allowing FNMA to naturally rise as it would normally do may cause it to peak too early. FNMA will be played as a poster child for the demo party this November.

  • Report this Comment On March 22, 2014, at 8:15 PM, bigjohn327 wrote:

    freddy how is the new company any different than the old company?..the answer is it is not and if we had the same exact meltdown the taxpayers would be on the hook for over 160 billion bucks,,,that certainly sounds like it protects the taxpayers,,,,,not

  • Report this Comment On March 23, 2014, at 2:01 PM, truthwillsaveus wrote:

    I am unsubsrcibing to the stock advisor. I have been a fan of the fool for years but evidently they have sold out. The fact that the disaster of blowing up Fannie and Freddie is not forseen or understood by The Fool is disheartening at best.

    After listening to all the buy and hold long term investing talk!

    They have been made patsies by the noise machine after NO culpability in the crash.

    And now that they are profitable again you want to end one of the greatest contributors to the establishment of the middle class, the strongest economic engine, and greatest American institution in history?!!!

  • Report this Comment On March 23, 2014, at 3:16 PM, casahanson1 wrote:

    My fellow Fools, the pending lawsuits are in line first. The Courts have 100% Authority and Jurisdiction over and before any new legislation can decide anything....period!

  • Report this Comment On March 23, 2014, at 9:06 PM, smauney wrote:

    So US has spent $1.5 trillion on the F-35 fighter and it's 7 years behind schedule and $163 billion over budget. Are we going to wind down the military? Unlike the GSE's, no one is getting paid back for this mistake.

  • Report this Comment On March 24, 2014, at 9:24 AM, northforkfool wrote:

    My take on the MF and Kill the GSE's.

    1. MF knows more than they are telling and wants to warn us fools.

    2. MF is a mouthpiece for Corker.

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