A Purchase of Fannie Mae and Freddie Mac's Common Stock is Speculation, Not Investing

Source: Company

Fannie Mae (NASDAQOTCBB: FNMA  ) and Freddie Mac (NASDAQOTCBB: FMCC  ) shareholders continue to face massive uncertainty with respect to the underlying values of the common stocks of these two companies.

Buying the common stock of the two government-sponsored enterprises is a speculation on Washington's inaction with respect to fundamental reform of the U.S. housing finance market. In addition, investors bet that U.S. courts will overturn the net sweep agreement and strengthen shareholder rights.

Difference between investing and speculating
There is a vast difference between being an investor and being a speculator. Investors do their research and are pretty much backed up by solid fundamentals relating to an investment target's business or industry.

Speculators, on the other hand, often bet on a price movement, either short-term or prolonged, which is expected to be precipitated by some projected catalyst. Buying the government-sponsored enterprises Fannie Mae and Freddie Mac, most notably their common stocks, certainly should be classified as a speculative action, not as an investment based on financial due diligence.

The outcome of a long position in Fannie Mae and Freddie Mac largely hinges on the courts and the inability of both political parties to reach a compromise about housing finance market reform.

Background
After the government-sponsored enterprises ran into serious solvency issues during the financial crisis, Fannie Mae and Freddie Mac were placed into conservatorship of its immediate regulator, the Federal Housing Finance Agency, or FHFA.

Source: Company

Ultimately, because of extremely high mortgage losses, which threatened to push the two companies into bankruptcy, both GSEs received a capital infusion of $187 billion from the Treasury.

As a result, a 'net sweep agreement' was put in place, which requires both companies to transfer all of their (prospective) earnings to the Treasury.

The most important characteristic of the net sweep: The dividends swept over by Fannie Mae and Freddie Mac aren't applied against the bailout balance. In other words, though the GSEs keep on paying an ever increasing stream of dollars to the Treasury, the companies, technically, have not repaid their bailout funds.

High-profile investors involved
Some investors, most notably, Perry Capital, filed suit against the net sweep agreement and many investors including Bill Ackman from Pershing Square Capital Management, Bruce Berkowitz, Morningstar's mutual fund manager of the decade from Fairholme Funds and Carl Icahn from Icahn Enterprises have initiated contrarian, high-risk equity positions in the common stocks of Fannie Mae and Freddie Mac.

As you can imagine, investors easily got fired up by the involvement of highly successful investors -- many with extremely appealing activist records.

The common stock, said to be worthless because of the net sweep, kept soaring throughout much of 2013 and the first quarter 2014 until a Senate Banking Committee made its best effort yet in March of 2014 to wind down Fannie Mae and Freddie Mac.

Though the Johnson-Crapo bill, which aimed at reducing the role of the government-sponsored enterprises in the mortgage finance market, was largely expected to not have any chances at all to succeed, the discussion of the bill and vote on it in the Senate Banking Committee forcefully injected volatility into the common stock of the two GSEs.

Expect high volatility going forward
After some volatile trading days and investors coming to terms with the fact, that the Johnson-Crapo reform bill will go nowhere, shares of Fannie Mae and Freddie Mac have found a bottom around the $4 mark, while both common stocks eagerly wait for new impulses.

Just last week, Fairholme Funds achieved a minor victory in court as Judge Margaret Sweeney in the U.S. Court of Federal Claims sided with Bruce Berkowitz and ruled that the discovery process in Fairholme Funds' suit against the government could proceed.

The news was responsible for sending shares of Fannie Mae and Freddie Mac up 9% and 10% respectively, indicating just how volatile an 'investment' in the GSEs can be. Investors should continue to expect high volatility in either stock going forward.

The Foolish Bottom Line
The purchase of Fannie Mae's and Freddie Mac's common stock is a high-risk bet that reform attempts of the mortgage finance market will be unsuccessful in an election year as well as beyond 2014.

Further, investors bet, that the courts will side with shareholders and overturn the net sweep.

There is an important distinction to be made between investing and speculating. If you buy the common stock of the two GSEs, you are speculating and you should only allocate a small amount of your funds to such a risky bet.

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Read/Post Comments (16) | Recommend This Article (1)

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 July 21, 2014, at 10:58 AM, smauney wrote:

    copy / paste / print.

  • Report this Comment On July 21, 2014, at 11:28 AM, smauney wrote:

    Here's some speculation: When stock market makes upcoming big correction Washington will be begging the GSE's to stick around. Winding down GSE's while market is another 5 to 7 year recovery mode would truly spell, as judge Sweeney likes to say, "Doomsday".

  • Report this Comment On July 21, 2014, at 12:56 PM, truthwillsaveus wrote:

    I continue to be shocked and saddened by The Fool's unwillingness to take a principled look at the GSE situation. I resent the constant patronizing tone of your articles calling F&F risky bets. I have researched the history and status of their situation thoroughly and am invested not just with the hope of monetary gain but as a matter of principle.

    1.The stock in these companies is for sale. That means anyone can buy a piece of these companies. They are PRIVATELY OWNED.

    2.The companies have assets.

    3. They have paid back their bailout money and then some.

    4. They are profitable and have been working consistently to clean up the mess from the crisis.

    5. For 75 years they have provided for affordable 30 year mortgages helping create a strong middle class and having an immeasurable positive effect on our economy.

    6. Were demonized and blamed for the housing crisis when in reality the banks and mortgage companies responsible for the crisis have been held largely unaccountable and left F&F holding the bag.

    7. Conservatorship is not recievership or bankruptcy. The sweep is illegal. The government must uphold basic property rights.

    8. Attributing no stock value for Fannie and Freddie for whatever reason turns the whole principle of private corporate ownership upside down.

    Like the interstate highway system Fannie and Freddie have been taken for granted for so long but need a little repair. The reform bills I've seen so far (including the most recent) want to tear up the system and replace it with something which is likely to cause uncertainty, far more harm than good at best, and possibly dire economic consequences.

  • Report this Comment On July 21, 2014, at 1:43 PM, Retiree2 wrote:

    I invested in 2009, long before the government declared "The Robin Hood Act" of 2012.

    I believe in American, I invested in America.

    I'll be damned if I will let the government steal the only chance I have of a finically secure retirement.

    If I sell now, I would be OK for a few years.

    But just a few years ago, the government scared me into believing there would be no SS in a few years.

    Their advice was to invest in the stock market.

    I used my savings and took their advice.

    As I am too old to get a good paying job again, they are now going to steal my last twenty years on earth?

    NO!!!

  • Report this Comment On July 21, 2014, at 3:07 PM, PaulApp wrote:

    To idiot, it's a speculation!

    I've purchased Fannie and Freddie before 2008 and had continue to do so because I believe in America! Both of these companies have provide suitable housing market for many home buyers and investors. They have fulfill their goal to provide affordable housing to all Americans!

    Tell me any other companies that have done as much, then I will promise to remain quiet!

  • Report this Comment On July 21, 2014, at 3:23 PM, hongchang wrote:

    fools keep telling people the same story over and over again. Well, tell us investing in which company isn't speculation then, biotech, internet companies?

  • Report this Comment On July 21, 2014, at 5:58 PM, truthwillsaveus wrote:

    “If you tell a lie big enough and keep repeating it, people will eventually come to believe it. The lie can be maintained only for such time as the State can shield the people from the political, economic and/or military consequences of the lie. It thus becomes vitally important for the State to use all of its powers to repress dissent, for the truth is the mortal enemy of the lie, and thus by extension, the truth is the greatest enemy of the State.”

    Joseph Goebbels

    Of course these days "the State" is simply an extension of the highest bidder, whether it's big oil, coal and gas, big pharma, the military industrial, complex, the gun lobby, or big banks, etc.

    The big lies come from the corporatocracy now but the truth is there if you look hard enough. The necessary demise of Fannie and Freddie is a whopper that I'm surprised that The Fool buys into.

  • Report this Comment On July 21, 2014, at 10:47 PM, maestrolindo wrote:

    This sounds like an aritcle from 2012

  • Report this Comment On July 22, 2014, at 11:25 AM, smauney wrote:

    I think most writers for the Fool are trust-funders. I'm surprised the author/trust-funder of this article owns the following stocks: AAPL, O, AIG, BAC, JCP, BBY, BBRY, KPLUY, MOS, POT, FNMA, F. I guess you've learned that if you have nothing new, just resort to writing some bovine scatology to rile up investors. With so many interesting things to discuss I'm surprised this rehashing of old news is all you can come up with.

  • Report this Comment On July 22, 2014, at 2:53 PM, casahanson8 wrote:

    Bold Investment

  • Report this Comment On July 23, 2014, at 3:56 PM, flordels wrote:

    buying the stock at $4 in hopes of it going to $20 is a speculation and not an investment. buying it at $4 in hopes of it going up based on fundamentals is an absurdity. there is no equity value, no dividend, and no profitability based upon the current state of things. the current state is by definition the fundamentals of the entity in question. IFF the equity, dividend, and profitability are returned to the shareholder, then the stock will very likely blast its way to $20 and beyond. That is speculation.

    those who purchased at $.50, even with a long term mindset were speculating; speculating that it would be 5 years or more before anyone did anything about addressing the situation in any way shape or form. The news actually reported for months and months in 2008/2009 that the stock would no longer be traded. And it just kept trading and trading and some of us said, "even if its a mistake or oversight, the very fact of it continuing to trade would lead to a day of reckoning for the government. And it has, and treasury will have to relent at this point because to not relent would confirm the most evil of right wing conspiracy theorists (many of whom are acquiring FNMA by the boatload) that the liberal government is nothing but a socialist bureaucracy that does as it pleases with no regard for individual rights.

  • Report this Comment On July 23, 2014, at 5:41 PM, LucoBrazi wrote:

    Not necessarily true. Although the stock was d-listed from the NYSE to give the impression it should not be considered active, it was never reported by the news the stock "would no longer be traded".

  • Report this Comment On July 24, 2014, at 10:01 AM, smauney wrote:

    This sums it up: "Fannie Mae’s one-time dividend to the U.S. Treasury was so significant, Treasury Secretary Jack Lew said it would delay the deadline to raise the debt limit to at least Labor Day.

    Future dividends from the GSEs will likely be smaller, but the fact is that the government is earning a handsome yield on its investment. " INFORMATION FROM: The Street May 21st, 2013

  • Report this Comment On August 12, 2014, at 4:43 PM, pete163 wrote:

    It's time the 30 year went away and for good reason. It would bring housing back to a time that people got what they paid for not this overpriced trash they have today. The GSE needs to be closed and take bill with them.

  • Report this Comment On August 14, 2014, at 11:53 AM, usesomesense wrote:

    the government and conservator for Fannie Mae have argued in their own defense that fannie is a private entity. so, what gives the government the right to take any gains away from shareholders

    On April 30, the U.S. District Court for the District of Columbia held in an employment case that Fannie Mae is not a government entity and therefore the plaintiff could not sustain her Bivens claim. Herron v. Fannie Mae, No. 10-943, 2012 WL 1476051 (D.D.C. Apr. 30, 2012). The plaintiff, a former Fannie Mae employee and outside contractor to the institution, claimed that Fannie Mae is a government actor and improperly terminated her employment. She asserted a First Amendment claim under Bivens v. Six Unknown Named Agents of the Federal Bureau of Narcotics, 403 U.S. 388 (1971), and, in the alternative, brought claims against Fannie Mae as a private employer. Fannie Mae and its government conservator, the Federal Housing Finance Agency, which was granted intervenor status, moved to dismiss the Bivens claim on the grounds that Fannie Mae is not a government actor. The district court dismissed the Bivens claim, holding that the imposition of FHFA conservatorship did not transform Fannie Mae into a government actor. Instead, Fannie Mae was a private entity before conservatorship; FHFA stepped into that private role when it became conservator.

  • Report this Comment On August 19, 2014, at 10:19 AM, pete163 wrote:

    Fannie and Freddie are chance speculative, remember both companies are bankrupt. You do know the term bankrupt. Anyone that is that stupid to pour their own money into companies that could vanish overnight is a fool. These fatcats that are buying Fannie and Freddie on speculative margin are not using their money. They are using someone else's money. They are not that stupid. For the past 20 years. Fannie and Freddie have been supporting people of foreign government being that called illegals.

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