Federal National Mortgage Assctn Fnni Me (OTCMKTS:FNMA) and Federal Home Loan Mortgage Corp (OTCMKTS:FMCC) shares plummeted on Tuesday following an unfavorable court ruling. The ruling blocked a major legal path forward for shareholders.
The situation for Fannie Mae and Freddie Mac investors is complicated to say the least.
While the ruling was certainly a blow to the bull case for investors, it wasn’t quite the death knell. The bull case for FNMA and FMCC is certainly still alive.
Fannie Mae and Freddie Mac Need Something to Change
As it stands today, FNMA stock and FMCC stock are utterly worthless. The only reason the two stocks aren’t trading at $0 is because investors believe that the companies’ situation will soon change.
Fannie Mae and Freddie Mac earned a combined net income of nearly $10 billion in Q4. Unfortunately, under the terms of the two companies’ bailout agreement, every dime of Fannie and Freddie’s profits go to the Treasury. Even if Fannie Mae and Freddie Mac made $1 trillion in profits, shareholders don’t get even a whiff of any of those earnings.
Shareholders believe the terms of the Fannie Mae and Freddie Mac “net-worth sweep” are illegal and have challenged it in court. However, back in 2014, a judge threw out shareholders’ case against the net-worth sweep. Hopeful investors were counting on an appeals court to overturn that decision.
Unfortunately, the appeals court upheld the judge’s decision this week, sending FNMA and FMCC shares into a tailspin.
Fannie Mae and Freddie Mac Investors Still Have a Legal Path
Now that the bad news is out of the way, let’s get to the good stuff. The legal window of opportunity for Fannie Mae and Freddie Mac shareholders may have closed a bit this week. Fortunately, it’s the window is not shut. At this point, shareholders still have two options in the courtroom. First, they can continue to appeal. This route involves either asking for a rehearing from the full appeals court or taking the case up to the Supreme Court. Of course, this path would involve overturning the decisions of two previous courts.
The other legal option may be a bit more realistic at this point. The appeals court threw out the case against the government. But it also ruled that shareholders were free to pursue breach-of-contract claims.
“It remanded contract claims regarding liquidation preferences and dividend rights to the lower court for further proceedings (i.e., certain shareholders can sue for damages),” Height Securities explained in a new research note.
If FMCC and FNMA shareholders qualify for the class action lawsuit, they may be entitled to damages. It’s important to remember, shareholders of preferred classes such as FED HOME LOAN MTG 5.79% PRF PERP USD50 (OTCMKTS:FMCCK) and FED MATL MORT ASSC 7.625% PRF NON-CUM SER’R’ (OTCMKTS:FNMAJ) are higher up on the priority list when it comes to liquidation claims than FMCC and FNMA shareholders.
Fannie Mae and Freddie Mac Still Have a Policy Path
Perhaps the most convincing bull case for Fannie Mae and Freddie Mac doesn’t even involve the courts. Back in November, newly appointed Treasury Secretary Steven Mnuchin said Fannie Mae and Freddie Mac shouldn’t continue under government control.
“We will make sure that when they are restructured, they are absolutely safe and don’t get taken over again,” he said. Throughout his confirmation hearings, Mnuchin stayed vague about the plans for Fannie Mae and Freddie Mac. Shareholders are hoping the plan involves recapitalizing the two entities and turning control back over to shareholders.
This may be the best-case scenario for FMCC stock and FNMA stock in the long-term. But it would still be an uphill climb. Height Securities believes it would take up to a decade to get Fannie Mae and Freddie Mac fully capitalized.
However, the firm believes Mnuchin has roughly a two-year window to begin that process. Congress has plenty of high-priority issues to tackle ahead of the 2018 midterm elections other than housing finance reform.
President Donald Trump and Treasury Secretary Mnuchin just need to decide they want Fannie Mae and Freddie Mac back in the hands of shareholders. In that scenario, both FMCC stock and FNMA stock could easily deliver explosive upside from their current levels. Investors won’t even need the courts.
As of this writing, Wayne Duggan did not hold a position in any of the aforementioned securities.