As had been expected the U.S. Treasury Department released its report on the government-sponsored enterprises on Friday. The good news is that the proposals offer something for everyone. However, the bad news is that Fannie Mae and Freddie Mac shareholders won’t be getting as much as they expected to get.

Treasury report is good news for the GSEs

Bank analyst Dick Bove issued a pair of notes on the Treasury report soon after it was released. He explained that the Treasury report states that the GSEs need more capital and better regulation and that they “remain critical to the functioning” of the housing finance system. The report also states that the Treasury Department would support legislation authorizing a government-backed guarantee for qualifying mortgages, which Bove said certifies that Fannie Mae and Freddie Bac will continue to exist.

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The Treasury report also calls for both GSEs to be recapitalized and released from conservatorship. It also calls for a secondary mortgage market to be created in such a way that Fannie and Freddie could operate in a similar fashion to how they did before they were placed in conservatorship. However, for that to happen, the embattled junior preferred shares must be paid off.

Confusion over GSEs

Bove believes the report indicates that preferred share holders "are about to make a great deal of money" and that Wall Street "may be about to raise the largest amount of money in its history for what would now be private companies." Additionally, he believes if Congress agrees with the Treasury report, then it will have the right to set up secondary mortgage companies to compete with Fannie and Freddie.

Based on his interpretation of the report, he sees taxpayers, the U.S. economy, the housing industry, holders of preferred shares and possibly even common shareholders making money on the proposals.

One of his concerns has been whether the Treasury would keep the government guarantee on the 30-year fixed-rate mortgage, and the report does indicate that it will remain. Although it's clear that competitors for the GSEs will be created, Fannie Mae and Freddie Mac will continue to be the foundation of the secondary market. It also may take decades for new competitors to gain a significant share od the market.

About that net worth sweep…

Holders of Fannie's and Freddie's preferred shares have been locked in a number of legal battles with the government over their dividend payments and the so-called "net worth sweep." The Treasury report never actually says the net worth sweep will be eliminated, although before it was released, an executive order eliminating the sweep was widely expected.

Despite the lack of an order calling for the elimination, Bove explained that the Treasury's call for a total recapitalization of the GSEs implies that the net worth sweep and the senior preferred shares will be eliminated. He said recapitalizing the two GSEs would include using both preferred and convertible bonds and require both companies to regain control over their profits.

The Treasury also suggested leaving the $200 million draw facility in place, although the hope is that it would not be needed after Fannie and Freddie are recapitalized. Taxpayers would be protected by keeping it in place, however.

Surprise at Fannie's and Freddie's reactions

The Treasury report also did not explicitly say that holders of Fannie's and Freddie's junior preferred shares would receive any payments, but Bove believes payments to them are implied in the Treasury's report. He noted that Federal Housing Finance Agency head Mark Calabria has written something to the effect that the government is obligated to protect the rights of investors who hold preferred shares.

"More importantly, in order to raise well over $150 billion to recapitalize these companies the government would be forced [to] re-establish credibility with investors," Bove wrote. "To do this the junior preferreds must be paid."

After the Treasury report was released, preferred shares of Fannie Mae and Freddie Mac started to slide. Bove said the decline was due to the lack of a direct statement about the elimination of the net worth sweep and the lack of an order for a payout on junior preferred shares. He said the issue was expectations going into the report.

Bove expressed surprise at how Fannie and Freddie's preferred shares reacted because he had never expected a definitive statement on the preferred shares or an executive order eliminating the net worth sweep. He has long expected there would be a two-step process for releasing the GSEs from conservatorship. Calabria is now expected to release his own plan this month or next.

"What is being overlooked in the Treasury report is a major philosophical switch by the Republican spokespeople," Bove wrote. "For the whole existence of the GSEs, the Republicans argued that they should be eliminated. Moreover, the Republican position on government guarantees was also hard set. The party was against them."

Treasury Report Conclusion

However, the Treasury report demonstrates that Republican views on the GSEs have completely changed. The report states that the finance industry needs Fannie and Freddie, and the Republican administration agrees to guarantees on 30-year mortgages. Bove added that these major changes provide a basis for "creating agreements with the Democrats who are strong believers in the GSEs and the guarantee of the 30-year fixed rate mortgage."

"The wave of selling in these securities [Fannie and Freddie preferred shares] is likely to abate when those buyers with high expectation depart," Bove said. "I would rather be a buyer here than a seller. The Senate hearings next Tuesday will be very illuminating in this regard."

This article first appeared on ValueWalk Premium