Senate and Stress Test: Another Week With Fannie Mae and Freddie Mac

Last week hosted two major events concerning Fannie Mae and Freddie Mac that investors should know about.

May 6, 2014 at 7:33AM

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Action (or in some cases, inaction) continues to surround GSEs Fannie Mae (NASDAQOTCBB:FNMA) and Freddie Mac (NASDAQOTCBB:FMCC) and the last week of April proved no exception. The widely expected Senate panel discussion of the Johnson-Crapo bill occurred as senators discussed the future of Fannie and Freddie. In the same week, stress tests were released for Fannie and Freddie with a number that looks alarming but could be fixed by taking relatively simple action.

Both events are big news for Fannie and Freddie shareholders, and we'll take a look at both.

Wind-down legislation
So far, most proponents of housing reform in Congress have focused on a perceived need to wind-down Fannie Mae and Freddie Mac. Although there is considerable debate as to what extent the GSEs are to blame for the crisis, Congressional proposals pretty much all have the intent to wind-down Fannie and Freddie.

The most recent legislation is the Johnson-Crapo bill, which shares many similarities to last year's Corker-Warner bill and went up for Senate panel discussion last week. Although there was a panel discussion, the actual vote has been delayed as the bill's backers try to build more support.

The delayed vote and continued disagreement is a major positive for Fannie and Freddie investors. If the bill were to pass, Fannie and Freddie would be wound down and shareholders left with little from the liquidation. Timing is also an important aspect: within the next few months, members of Congress will begin campaigning for the 2014 mid-term elections. So the longer Johnson-Crapo can be delayed, the less chance it has of passing.

Two amendments were also added to the bill. The first stated that companies that originate eligible mortgages cannot also cannot also be the guarantor for mortgage backed securities that carry a government guarantee. The other amendment noted the bill would not supersede the results of the ongoing lawsuits against the government concerning its handling of Fannie and Freddie. While it's good that Congress has acknowledged the wind-down legislation would not supersede court rulings, this amendment is probably not necessary since the lawsuits are based on a Constitutional issue and legislation passed by Congress can be struck down for Constitutional reasons -- whether or not Congress says so.

Stress tests
Like the systemically important financial institutions, Fannie Mae and Freddie Mac underwent stress tests to give estimates as to how they would perform in an economic and housing downturn. After the effects of the 2008 crisis, getting a picture for the GSEs potential losses is important, however, there is another part to these stress tests that many reports leave out.

The stress tests found potential losses of $190 billion in the event of a worst case scenario housing and economic crisis, and the Federal Housing Finance Agency (FHFA) said this would necessitate another bailout.

So why are Fannie Mae and Freddie Mac so undercapitalized? It's because they couldn't rebuild capital if they wanted to. The current structure of the preferred stock purchase agreement with the Treasury forces Fannie and Freddie to turn over virtually all of their profits without reducing the senior preferred stock stake owned by the Treasury. If the more than $200 billion paid under this agreement was instead applied under the original terms of the bailout agreement, the GSEs would have been able to repurchase almost all of the Treasury owned preferred stock and begin using their massive profits to rebuild capital.

Fannie and Freddie are in a position to require another bailout if another crisis hit tomorrow but not because they've failed to generate profits. Instead, the lack of capital exists because that capital has been going to the Treasury. So it's worth looking at what could happen to Fannie and Freddie during a crisis, but the claim of another $190 billion bailout requires additional context.

Eventful week
The delay in a panel vote for the Johnson-Crapo bill is a positive for Fannie Mae and Freddie Mac shareholders, as it further increases the likelihood that the bill will not pass before the mid-term elections. The bill also faces an uphill battle if it ever makes it to the House since the House is controlled by a republican majority with many members opposed to any government role in the housing market.

The stress tests results appear scary at first but looking at Fannie and Freddie's earnings power, and the fact that the $190 billion figure is a worst case scenario, the capital requirements are not nearly as daunting.

Investors should continue to follow political, financial, and legal happenings surroundings Fannie Mae and Freddie Mac. After all, all three matter to Fannie and Freddie investors.

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Alexander MacLennan owns common shares of Fannie Mae and Freddie Mac. This article is not an endorsement to buy or sell any security and does not constitute professional investment advice. Always do your own due diligence before buying or selling any security. 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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