Many people and companies were hurt by the recent government shutdown and threat of default. But as Congressional dysfunction continues to become entrenched as the norm, mortgage giants Fannie Mae (NASDAQOTH:FNMA) and Freddie Mac (NASDAQOTH:FMCC) are being put in a better position to realize value for their common and junior preferred stockholders. In fact, if Congress were to act in a cooperative, bipartisan basis, the GSEs could find their continuing existence very difficult.
Shares of Fannie and Freddie were temporarily hit last summer when a bill with bipartisan support rose to headlines in the Senate. The bill called for the dismantling of the GSEs and their assets to be liquidated in a way that would make recovery for common and junior preferred shareholders highly unlikely. This was combined with President Obama's noting his support for a bill to wind down Fannie and Freddie.
Now, it may sound as if the GSEs are doomed. But we have to remember what the real value of bipartisan and presidential support is. We saw bipartisan and presidential support for the gun control bill crafted in the wake of the Newtown tragedy and similar support for comprehensive immigration reform. Both issues have grabbed much more national attention than GSE reform, yet the support of members of both parties, the president, and the majority of the public were still not enough to pass either one.
While both Congressional Democrats and Republicans generally agree on a wind-down of Fannie and Freddie, the issue is far from resolved in Congress, and looking at current trends, GSE reform is not near the top of the list.
A speculative bet
Fannie Mae and Freddie Mac were originally taken over in a conservatorship-style approach, where the government would inject funds in exchange for 10% yielding senior preferred stock. Shares of the GSEs traded around $0.30 a piece, as most investors saw them as perpetual money pits that could never pay back their bailout funds, eventually requiring the GSEs to be wound down in some way.
However, Fannie and Freddie managed to show signs of life again, after some analysts began to see the potential for profits. But around the same time, the Sweep Amendment was introduced to sweep all of the profits of the GSEs (not just those necessary for the senior preferred stock interest payments) into the Treasury.
With this set-up, it would be impossible for the GSEs to ever emerge from government control, since the payments didn't go toward buying back the senior preferred stock held by the Treasury.
Fannie and Freddie's only hopes now come from the lawsuits filed by various private investors challenging the government's involvement in the GSEs. Among the plaintiffs are Perry Capital and Bruce Berkowitz, the contrarian investor known for taking a huge stake in American International Group, along with major banks.
If they're successful in their lawsuits, shares of both the common stock and the junior preferred stock (where the dividend is currently suspended) could surge in value. With Fannie Mae Series S preferred shares (NASDAQOTH:FNMAS) trading at less than 27 cents on the dollar, the upside potential is quite high and serves as a primary reason the plaintiffs are suing the government.
A game of delay
The current state of Fannie and Freddie provides no shareholder value for common or preferred stockholders. For these shareholders to realize value, the policies around the GSEs need to change.
If done by Congressional action, it's unlikely that non-government shareholders would receive much of anything. If resolved through litigation, there is a chance the Sweep Amendment could be thrown out and the GSEs would be able to begin buying back the government's senior preferred stock, eventually emerging as highly profitable, privately owned entities.
However, litigation takes time and could last multiple years. In the meantime, common and junior preferred shareholders must continue to hope that Congress remains as divided and uncooperative as it has shown itself to be. Only that way do these stakeholders have a chance of seeing significant returns.
Until there is a resolution to the current uncertainty, Fannie Mae and Freddie Mac remain highly speculative investments with the potential for multibagger gains and total losses.
Alexander MacLennan has no position in any stocks mentioned. 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 recommends, owns shares of, and has options on AIG. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.