Freddie Mac Hits Its X-Date

 | Nov 08, 2013 | 4:00 PM EST
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Freddie Mac announced that it will send the government $30.4 billion yesterday after reporting similar net third-quarter income and reversing deferred tax allowances.

Symbolically, Freddie has now repaid taxpayers on a cash basis, even though the controversial terms of its Preferred Share Purchase Agreements (PSPA) with the Treasury don't allow repayment of $71.3 billion in principal drawn from the government.

After similarly reversing DTA allowances earlier in the year, Fannie Mae (FNMA) reported an $8.7 billion profit, which it also largely transferred to the Treasury (after sweeping all profits above a minimum net worth of $3 billion per the PSPAs). Having remitted $114 billion of $117.1 billion borrowed from the feds, Fannie Mae is poised to also hit x-date, or the point at which it has technically repaid taxpayers, next March.

Elsewhere, preferred shares of both (FNMAS and FMCKJ) hovered above $8, still a 2/3 discount to par but up 300% since March. All this came while the Senate Banking Committee, at its eighth reform hearing, continued to encounter minimal dissent against its goal of forging a bipartisan bill to phase out and replace the GSEs.

I see a disconnect. But what's it mean?

I'd say that the Fannie-Freddie preferred investment remains speculative, but is more rational than consensus readings of Washington's toxic GSE politics might suggest. Meanwhile, shareholders' success or failure in an initial court decision landing as early as next spring could have big implications for the reform debate just ramping up on Capitol Hill.

Freddie's long awaited arrival at x-date seemed to win a more respectful-than-previously accounting from top industry news reporters. The Wall Street Journal's Nick Timiraos, for instance, cited nine reasons for how and why the GSEs have become such cash cows for the government, noting that "a few years ago, the conventional wisdom in Washington said that FNMA and Freddie Mac wouldn't ever be able to make taxpayers whole for (their) 2008 bailouts."

He also observed that home prices are up sharply, fewer homeowners are defaulting, and (my favorite): "(s)ome of the eye-popping profits have been driven by the same accounting rules that required the companies to take eye-popping writedowns five years ago."

The curing of the GSEs' collective book and balance sheets, and the still-solid prospect for nothing done in Washington, hasn't been lost on some investors, of course, as shares of Fannie and Freddie preferreds have reached four-bagger status since March.

Nevertheless, the x-date milestone went unremarked in the Senate Banking Committee, where Chairman Tim Johnson (D-S.D.), Ranking Member Mike Crapo (R-Idaho) and an interested/determined subsection of the panel's 22 members held their eighth hearing on GSE reform since mid-July.

Treasury and the Obama administration have been running Fannie and Freddie flat out as virtual wards of the state to sustain the mortgage and housing markets during and since the Great Recession  and also to keep from having to inflate the federal balance sheet with trillions of dollars in additional debt obligations.

Yet (via the PSPA sweeps) they are also now holding the two companies down, so to speak, giving Congress time to consider legislation to replace them.

As Timiraos wrote, "(i)f it sounds like Fannie and Freddie are making interest payments on a loan that can't ever be repaid, that's because they are."

But, of course, the dynamic could transform yet again. Nothing done this Congress might indeed only add to restiveness as the two companies continue to return cash with their lack of capital neglected. And even that latter point could change if the government loses its defense in court against the lawsuits filed by Perry Capital and other investment firms that have challenged the August 2012 sweep amendments to the PSPAs as unconstitutional.

According to a mid-September agreement  by the presiding judge and opposing counsel, Treasury and FHFA have already been compelled to post "administrative record" filings, as of Oct. 28, and additional motions will be due between now and Jan. 31, in support of a summary judgment motion by Feb. 28.

I have assumed this might yield a decision in the case by as early as 2Q 2014, which not only might have key implications for Fannie-Freddie shareholders, but the political/legislative debate as well. 

I offer no odds on plaintiffs' prospects. Nevertheless, I'd guess that an initial setback could deflate sentiment, but not end investors' quests.

Meanwhile, reinstatement of GSEs ability to retain profits, boost capital and resume paying shareholder dividends would do more than just reward shareholders. It would also test the ability of reformers to quickly respond with legislation to forge a new regime after all. And by that point, should that day ever come, voices in support of a retained role for a reformed/more-utility-like Fannie and Freddie might finally speak louder.

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