Fannie Mae, Freddie Mac Crash on Shutdown Plan - Analyst Blog

Shares of two government sponsored enterprises (GSEs) – Fannie Mae FNMA and Freddie Mac FMCC – tanked on Tuesday following the release of a new bipartisan plan to shut them. Fannie Mae plunged 30.8% from the previous day's closing price to $4.03 while Freddie Mac was down 26.8% to $4.04.

The announcement of the new reform plan, framed by Republican senator Mike Crapo and his Democratic colleague Tim Johnson, did not disclose the timeline for the proposed closure of Fannie Mae and Freddie Mac. However, the draft of the legislation will expectedly be revealed soon.

Moreover, the bill requires approval from both Houses to be made into law. However, chances of the bill being passed before mid-term elections in November appear to be dim.

Further, the legislation will likely face opposition as majority of Democrats and a few other community groups favor government backing to mortgage loans for stabilizing the housing market. However, the Republicans want to end government involvement and allow the private sector to dominate the market.

In spite of the considerable time which the plan might take to get implemented, retail investors started fleeing from the stocks on Tuesday.

The main purpose of the reform plan is to ensure that taxpayers' money is not at risk in case Fannie Mae and Freddie Mac require a bailout again. In Sep 2008, the government had taken over these two GSEs in the wake of the housing market collapse. The companies were infused with around $188 billion of tax-payers money.

Under the terms of the bailout, the U.S. Treasury suspended dividend payments by Fannie Mae and Freddie Mac to non-government stakeholders. Though shares of these two companies continued to be publicly traded, the stocks lost much of the value as investors doubted whether the GSEs would turn profitable again.

Nevertheless, Fannie Mae and Freddie Mac turned profitable, thanks to recovery in the housing sector. With the payment of dividends later this month, these two would have paid nearly $199 billion as dividends to the U.S. government.

Despite turning profitable and aiding lower the federal deficit (through significant dividend payments), Fannie Mae and Freddie Mac are considered a risk to the government. Hence, the reform plan aims to shift the mortgage financing risk to the private sector.

The idea is to create a new system of federally insured mortgage securities similar to the Federal Deposit Insurance Corporation (FDIC). The Federal Mortgage Insurance Corporation will build a mortgage insurance fund that will protect taxpayers from future bailouts. Additionally, private insurers will bear the initial impact in case of losses, before the government guarantee is triggered.

Other than senators, many other non-government stakeholders might not want Fannie Mae and Freddie Mac to be closed. Many hedge funds including Pershing Square, Perry Capital and Fairholme Funds have made significant investments in these two to reap huge returns.

Further, some of the non-government investors have joined hands and filed lawsuits challenging the bailout terms that require all profits from Fannie Mae and Freddie Mac to be paid as dividends to the Treasury. They are demanding a share of Fannie Mae and Freddie Mac's significantly improved fortune.

So we believe that the fall in share prices on Tuesday will not likely be repeated again as shutting down Fannie Mae and Freddie Mac will be a long, drawn-out process. There are many issues to be considered before any final decision is taken.

Currently, both Fannie Mae and Freddie Mac carry a Zacks Rank #3 (Hold). Some better-ranked stocks in the finance sector include Home Loan Servicing Solutions, Ltd. HLSS and Fifth Third Bancorp FITB. Both of these have a Zacks Rank #2 (Buy).