Trouble Ahead For Fannie Mae / Federal National Mortgage Association (OTCBB:FNMA) Shareholders. Despite becoming one of the most highly capitalised penny stocks on the US markets earlier this year, the Federal National Mortgage Solution (FNMA) AKA Fannie Mae has taken a hammering on government plans to privatise the institution. Understandably, shareholders, many of which were already hit hard during the 2008 bailout are waiting anxiously to see how the proposed bill will fare in the senate.

Fannie Mae

Fannie Mae – A National Institution

Founded during the Great Depression as part of the New Deal domestic economy reforms, the original purpose of Fannie Mae / Federal National Mortgage Association (OTCBB:FNMA) was to expand the secondary mortgage market by securitising mortgages in the form of mortgage backed securities. However, during the 70s. Fannie Mae was allowed to purchase private mortgages leading to the formation of Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC), affectionately known as Freddy Mac.

Some might argue that it was in 1999, when Fannie Mae came under pressure from the Clinton administration to expand into the subprime market, that its troubles began. At the time, the New York Times commented that although the move might not pose difficulties during ‘boom’ times, an economic downturn could cause problems and even prompt a government rescue plan.

Troubled Times

That prophecy was realized during the mortgage crisis of 2007 when many borrowers struggled to make their repayments, especially those in the subprime sector. Despite action by the government to bolster confidence in Fannie Mae / Federal National Mortgage Association (OTCBB:FNMA), share prices tumbled more than 90%. Ever since, there has been talk of the government taking control of the lender.

The collapse of the organization would mean a big headache for the government. Fannie Mae and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) own, or guarantee, half of the US mortgage market. Somewhere in the region of $6 trillion in bonds are owned by individuals and bodies throughout the world. Even the Chinese government has a stake. If Fannie Mae goes bankrupt, there would be huge global ramifications.

As a result, the government decided to take conservator-ship of the banks. In what was labelled ‘one of the most sweeping government interventions in private financial markets in decades’, CEOs and boards of directors were summarily dismissed. Share prices plummeted, investors lost $41 billion and the stocks were eventually delisted from the NYSE.

Is this the end of the line for Fanny Mae?

Fannie Mae / Federal National Mortgage Association (OTCBB:FNMA) continued to trade as a penny stock and enjoyed a spectacular run between March and May of this year. Now, however, that has come to an abrupt end with the bill presented by Bob Corker, a Tennessee Republican and Mark Warner, a Virginia Democrat proposing to wind down both entities over a five-year period:

‘It’s time to end this failed model,’ commented Sen. Bob Corker.

Clearly, this raises the distinct possibility that equity owners will be wiped out. So shareholders have filed a complaint stating that when the entities were placed in conservator-ship back in 2008, the government did not abide by the requirements for conservator-ship established by HERA. The plaintiffs argue that the three amendments to the Preferred Stock Purchase Agreements forced the GSEs to ‘completely and fully transfer any remaining economic value from their shareholders to the treasury guaranteeing that shareholders are left with nothing’.

For the greater good?

If the bill goes through, the result will be higher lending standards and higher mortgage rates. Private mortgage insurers will have assume the credit risk. That is, of course, if they are willing to step up to the plate. The mortgage market will be transformed. Good for the country – maybe, but certainly not good for common shareholders at the bottom of the pile.

There is hope. Bruce Berkowitz, the famed value investor from Fairholme Capital Management has a $2.4 billion stake in the preferred shares of Freddie and Fannie, Berkowitz argues that the institutions should be restructured instead of wound down:

‘Privately-owned Fannie Mae and Freddie Mac are critical to our nation’s economic security, lowering the cost and increasing the availability of home ownership. There are no substitutes.’

The problem for shareholders is that, ultimately, conservator-ship was the right decision for the country, it just wasn’t the right decision for investors. And this time again, it will take more than the voice of Berkowitz to sway the court’s decision.