Fannie Mae (NASDAQOTH:FNMA) and Freddie Mac (NASDAQOTH:FMCC) shareholders don't receive a penny in profit from their investment, no matter how well the companies perform. However, that could change this fall if shareholders get their way in court. Whichever way the judge's ruling goes, this fall is likely to be when Fannie's and Freddie's shareholders finally get some answers.
The Fannie Mae and Freddie Mac saga: The 2-minute version
Put simply, the government takes all of Fannie and Freddie's profits -- which have totaled hundreds of billions over the past few years -- and shareholders get nothing. Understandably, the shareholders have a problem with this arrangement.
It started in 2008, when Fannie and Freddie received bailouts of $187.4 billion and the agencies were put into conservatorship with the aim of ensuring that, whatever happened in the future, they would never again operate in such a way that investors made all the profits while taxpayers took all the risk. Sounds reasonable, right?
Well, at the time, almost nobody thought the agencies would return to profitability anytime soon. Even Treasury secretaries Hank Paulson and Timothy Geithner have testified that they never thought Fannie and Freddie would be in a position to fully repay the bailout.
However, in 2012, the agencies did return to profitability, producing billions of dollars in income every quarter. And, coincidentally or not, that's the same year the government decided it would begin to sweep 100% of the agencies' profits directly into the Treasury. As of the most recent quarterly reports, Fannie and Freddie have sent $230.8 billion to the Treasury -- $43.4 billion more than they received. So it would seem the bailout has been paid back and then some.
However, these payments to the Treasury are considered "dividends" and not a repayment of the principal. So, no matter how much Fannie and Freddie give the Treasury, they cannot escape government control. It's no wonder shareholders -- many of whom took a gamble by holding their shares while the agencies were left for dead -- are angry about this state of affairs.
The trial is set to begin this fall
Shareholders, led by several prominent hedge funds, are suing to change the arrangement. And while one judge tossed out a handful Fannie/Freddie lawsuits last year, he did say that such a use of government power may "raise eyebrows or even engender a feeling of discomfort." The remaining lawsuits are being presided over by Judge Margaret Sweeney, who seems to be a little more sympathetic to the shareholders' case and who is likely to have the final word in the saga when the trial commences this fall.
Earlier in 2015, Sweeney refused to dismiss the shareholders' lawsuits and agreed to give the hedge funds' lawyers access to memos and emails of the government officials involved in the case. And while the lawsuits' demand of an immediate end to the profit sweep and up to $100 billion in profits returned to shareholders may be a tad ambitious, Sweeney seems to dislike the idea that the government intends to leave the companies in conservatorship indefinitely.
On the other side, the government argues that the profit sweep is completely legal, and according to one expert, Fannie and Freddie would be unable to operate independently, as they would need to raise hundreds of billions in new capital to become self-sufficient. And there's an argument to be made that the agencies wouldn't be profitable at all without the government's guarantee of mortgages, which an independent Fannie and Freddie could have to pay a premium for.
The odds aren't great for Fannie and Freddie fans
Pershing Square's Bill Ackman referred to Fannie and Freddie as the most interesting investment in the capital markets from a risk-reward standpoint, and I tend to agree.
In a presentation, Ackman made the case that Fannie's and Freddie's common shares could be worth between $23 and $47 apiece if the agencies were allowed to recapitalize, and that's including the dilutive effect of the government's 80% stake. So on the low end, that's a value of about 10 times the current share price, plus the possibility of the return of some profits.
I'm the first to admit that the odds are definitely in the government's favor, especially considering the government is likely reluctant to do anything that could be seen as a "bailout" for shareholders. However, given the strength of the shareholders' argument and Sweeney's refusal to dismiss the lawsuits, I won't rule anything out.
To sum it up, an investment in Fannie and Freddie is still a lottery ticket. I, for one, will be sitting on the sidelines -- and this will definitely be an exciting match.
Matthew Frankel has no position in any stocks mentioned. 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.