Why Fannie and Freddie's Investors May Be In Trouble

The new bipartisan Senate bill would wind down Fannie and Freddie, quite possible leaving investors with nothing, but it may be necessary for the long-term health of the housing market.

Mar 22, 2014 at 8:00AM

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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