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Fannie Mae: What To Do After Yesterday's Massacre

Oct. 2, 2014 9:21 AM ET | 10 comments | About: Fannie Mae (FNMA), FMCC



Disclosure: The author is long FNMA. (More...)






Summary
•A U.S. judge has thrown out two Fannie Mae/Freddie Mac lawsuits and dealt investors a blow.
•Shares of Fannie Mae and Freddie Mac collapsed as a result.
•Is it still worth it clinging to the long investment thesis after this week's court ruling?

What a day yesterday. Shares of government-sponsored entities Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) got slaughtered in yesterday's trading session after a U.S. court dealt a massive blow to investors who were banking on the U.S. justice system to throw out the 'net sweep agreement'. The sweep agreement in question basically stipulates that both Fannie Mae and Freddie Mac have to fork over all (future) earnings indefinitely, while at the same time dividends won't be applied against Fannie Mae's and Freddie Mac's debt balance at Uncle Sam.

Some shareholders like Perry Capital or Bruce Berkowitz's Fairholme Capital Management brought suits against the government questioning the legality of the net sweep arrangement. Though many high-profile investors like Bill Ackman from Pershing Square Capital Management and Carl Icahn of Icahn Enterprises have jumped on board -- which lend even more credibility to the GSE investment thesis --, a common stock position in either Fannie Mae and Freddie Mac was of high risk nonetheless.

As has previously been noted by me as well as other contributors on Seeking Alpha, the investment thesis in Fannie Mae and Freddie Mac was pretty much characterized by a binary event: Either a judge would strike down the net sweep agreement, or uphold it. In either case, significant upside and downside volatility would ensue. And investors certainly got a taste of it yesterday.

Bloomberg reported yesterday on the uppercut delivered to Fannie Mae and Freddie Mac investors:

“
Fannie Mae and Freddie Mac plunged in New York trading after investors including Bruce Berkowitz's Fairholme Capital Management LLC lost a legal bid yesterday to force the bailed-out companies to share profits with private shareholders.

The investors sued for breach of contract over allegedly promised dividends and liquidation preferences, and what they called an illegal "taking" under the U.S. Constitution. U.S. District Judge Royce Lamberth rejected their claims, finding that the government is allowed under a 2012 amendment to the companies' bailout agreements to sweep "nearly all" profits from Fannie Mae and Freddie Mac to the U.S. Treasury.

Investors have claimed they've been unfairly barred from participating in post-bailout profits earned by Washington-based Fannie Mae and Freddie Mac. At least $33 billion -- the face value of potentially worthless preferred shares in the companies -- is at stake in the cases, as well as shareholders' efforts to win congressional support for the idea of reviving Fannie Mae and McLean, Virginia-based Freddie Mac.

Hedge-fund manager Bill Ackman's Pershing Square Capital Management LP filed a separate suit in August in the U.S. Court of Federal Claims in Washington, claiming the government's diversion of profits violates the Constitution's Fifth Amendment, which prohibits the taking of private property for public use without just compensation. Fairholme also has a case in that court that is now in pretrial exchange of information.

"Although litigation is a lengthy process, shareholder-owned Fannie Mae and Freddie Mac remain vitally important and increasingly valuable to all constituents," Berkowitz's firm said in a statement through Sard Verbinnen & Co. "On behalf of hundreds of thousands of Fairholme Funds shareholders, we will vigorously pursue the enforcement of existing contractual claims and our inalienable rights of property ownership as guaranteed by the U.S. Constitution."

The court ruling certainly is a massive blow for shareholders in the government-sponsored enterprises. However, other courts are still involved in the lawsuit, and especially the big guys are going to fight the court's ruling and make their way through the justice system as far and as aggressive as they possibly can: Just too much money is at stake.

However, one has to admit: The odds have clearly worsened with respect to a successful shareholder lawsuit, and the judge's adverse court ruling rightly affected the share price of the two companies.

Chart picture
As you can easily imagine, investors completely lost it yesterday and panicked after news about the court ruling made the headlines: Fannie Mae lost 37% in yesterday's trading session, and shares of sister company Freddie Mac declined 29%.

Both Fannie Mae and Freddie Mac now trade at levels not seen since the end of October 2013.
Freddie Mac's share chart similarly depicts a yawning gap as a result of yesterday's extreme volatility.

(click to enlarge)


Source: StockCharts.com

Bottom line
There is no denying here: The long investment thesis has been dealt a serious blow by this week's court ruling against Fannie Mae and Freddie Mac shareholders. Throwing out the lawsuits that intended to stop the fund flows into the coffers of the Treasury on the basis of the net sweep agreement, also had a massive psychological impact on investors -- as the share charts above highlight.

From a technical perspective, there might be a long trading opportunity emerging after both share charts depict two yawning gaps. From an investing perspective, I believe the odds have turned against shareholders, and I would advise against an investment in Fannie Mae's or Freddie Mac's common shares after yesterday's brutal sell-off. Avoid.


Editor's Note: This article discusses one or more securities that do not trade on a major exchange. Please be aware of the risks associated with these stocks


http://seekingalpha.com/article/2536245-fannie-mae-what-to-do-after-yesterdays-massacre

(click to enlarge)