Why Fannie Mae And Freddie Mac's Common Shares Are Lottery Ticket Trades

Shares of Federal National Mortgage Assctn Fnni Me FNMA and Federal Home Loan Mortgage Corp FMCC are up more than 30 percent each over the past two days following commentary from President-elect Donald Trump’s Treasury Secretary nominee Steven Mnuchin.

Mnuchin said the administration will make sure Fannie Mae and Freddie Mac are no longer owned by the government.

On the surface, Mnuchin’s comments seem like good news for Fannie and Freddie. However, before traders rush into the OTC-traded stocks, it’s important to understand the risks of doing so. The bar for good news for the two government-sponsored enterprises (GSEs) is extremely low.

The Path To Worthlessness

During the mortgage crisis, Fannie and Freddie got caught with $1.5 trillion in mortgage debt on their books and required a $185 billion bailout from the government. As part of the bailout deal, the GSEs were placed under conservatorship. The U.S. Treasury was issued warrants to purchase 79.9 percent of Fannie and Freddie’s common shares for a “nominal” price of $0.00001 per share.

The two GSEs also issued the Treasury $1 billion in preferred shares with an annual dividend yield of 10 percent. Neither were profitable from 2008 to 2011, so they were forced to issue even more preferred shares to the Treasury to pay their dividends. Fannie and Freddie finally returned to profitability in 2012 and were able to pay dividends out of their own income for the first time.

Unfortunately for Fannie and Freddie common stock shareholders, the Treasury made an amendment to the terms of the agreement shortly thereafter.

Starting in 2012, Fannie and Freddie were forced to pay 100 percent of their net income to the Treasury in what was called a “net-worth sweep,” leaving the two GSEs' common shares essentially worthless.

The net-worth sweep is still in effect to this day. However, at over $4 per share, the common stocks certainly aren’t worthless. Why?

No Longer Worthless

A number of Fannie and Freddie investors have sued the U.S. government in recent years claiming that the net-worth sweep is illegal. While several of the claims have been dismissed, a handful are still outstanding. Prior to Mnuchin’s statements, Fannie and Freddie common shareholders’ only hope was that one of the judges in the outstanding court cases would rule in their favor.

Now, shareholders have a new reason for hope. Mnuchin could step in and voluntarily do what shareholders have been trying to force the Treasury to do — return profits back to shareholders.

Unfortunately, Mnuchin didn’t provide any details or clarifications about his plan for Fannie and Freddie other than getting them off the Treasury’s books.

“We will make sure that when they are restructured, they are absolutely safe and don’t get taken over again,” Mnuchin said. “But we’ve got to get them out of government control.”

Seasoned investors understand that “restructuring” is rarely good news for shareholders, and the possibility of a favorable outcome seems slim. At this point, Fannie and Freddie common shares seem like a lottery ticket trade that hinges on favorable court rulings and/or generous treatment from the Trump administration.