Rafferty Capital Markets’ Richard X. Bove comments on the latest news from Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC), contending that it’s time to step back and asses the situation from an objective perspective.

Time to Actually Think

The promised Johnson/Crapo Bill to restructure the housing finance industry has not appeared at the time that this is being written although it is likely to surface soon. There are a few items worth discussing as we await this legislation. First is the legal issue. Second is the concept of shuffling the insurance function of Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) to the private sector. Both raise serious questions as to whether this legislation has any chance of passage. Also, wipe away any thoughts that this bill has bi-partisan, or even partisan, support. This concept is being sold by a press to lazy or uncaring to actually investigate before it speaks.

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Fannie Mae, Freddie Mac: The Legal Issue

In numerous interviews on television and in the press, Senator Crapo (R., ID) along with his colleagues have indicated that the legislation being proposed must take into account the court cases against the U.S. Treasury related to Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) (together GSE or the Company). Thus, it is important to have some grasp of these cases.

The Law

The Housing and Economic Recovery Act of 2008 (HERA) deals with the status of Fannie Mae and Freddie Mac. It creates the basis for putting the two companies into conservatorship. In this Act, there is a segment entitled Title I – Reform of Regulation of Enterprises: Subtitle B – Regulated Capital Levels for Regulated Entities, Special Enforcement Powers, and Reviews of Assets and Liabilities. By inclusion the Act restates Sec 1369E from the Federal Housing Enterprises Financial Safety and Soundness Act of 1992. The applicable section states:

“The Director shall, by regulation, establish criteria governing the portfolio holdings of the enterprises, to ensure that the holdings are backed by sufficient capital and consistent with the mission and the safe and sound operations of the enterprises.”

Further down in the Act under the included section 1361, it states:

“The Director shall, by regulation, establish risk-based capital requirements for the enterprises to ensure that the enterprises operate in a safe and sound manner, maintain sufficient capital and reserves to support the risks that arise in the operations and management of the enterprises.”

In a statement released on September 7, 2008, at the time Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) were placed into a conservatorship, James B. Lockhart, the Director of the newly formed Federal Housing and Finance Agency (FHFA) stated:

“During the conservatorship period, FHFA will continue to work expeditiously on the many regulations needed to improve the new law. Some of the key regulations will be minimum capital standards, prudential safety and soundness standards and portfolio limits. It is critical to complete these regulations so that any new investor will understand the investment proposition.”

This statement was accompanied by a fact sheet entitled Questions and Answers on Conservatorship. A few points in this fact sheet are worth mentioning:

“The purpose of appointing the Conservator is to preserve and conserve the Company’s assets and property and to put the Company in a sound and solvent condition.”

“The FHFA, as Conservator, may take all actions necessary and appropriate to (1) put the Company in a sound and solvent condition and (2) carry on the Company’s business and preserve and conserve the assets and property of the Company.”

“Upon the Director’s determination that the Conservator’s plan to restore the Company to a safe and solvent condition has been completed successfully, the Director will issue an order terminating the conservatorship.”

“During the conservatorship, the Company’s stock will continue to trade.”

“There are no plans to liquidate the Company.”

There are a few points to be made from a review of HERA and the statements and fact sheet of the FHFA:

The capital of Fannie Mae and Freddie Mac must be maintained to insure their safety and soundness.

The companies must be brought back to health and returned to the private sector shareholders.

The stocks were/are allowed to trade so that the private shareholder position was/is not removed.

While the FHFA could put the companies into receivership, it had no intention to do so. The clear intent was to return these companies to their shareholders.

Variable Liquidation Preference Senior Preferred Stock , Series 2008-2 (Preferred A)

In the description of the Preferred A under Section 2 (c) entitled Dividends, it states:

“Dividend Rate” means 10.0%; provided, however, that if at any time the Company shall have for any reason failed to pay dividends in cash in a timely manner as required by this Certificate, then immediately following such failure and for all Dividend Periods thereafter until the Dividend Period following the date on which the Company shall have paid in cash full cumulative dividends (including any unpaid dividends added to the Liquidation Preference pursuant to Section 8), the “Dividend Rate” shall mean 12.0%.”

And in section 2 (f):

“If and whenever dividends, having been declared, shall not have been paid in full, as aforesaid, on shares of the Senior Preferred Stock, all such dividends that have been declared on shares of the Senior Preferred Stock shall be paid to the holders pro rata on the aggregate Liquidation Preference of the shares of Senior Preferred Stock by each holder, and any amounts due but not paid in cash shall be added to the Liquidation Preference pursuant to Section 8.”

There are two point here other than the government uses words like the “aforesaid.” They are:

• The dividend rate on the Preferred A is 10% and in certain cases 12%.

• If the dividend is not available to be paid in cash it can be paid in stock.

Third Amendment

On August 17, 2012, it appears that the United States government changed its mind about all of the above – the laws and the indenture to the Preferred A stock. It states in in Section 3 that it is amending Section 2 (c) as quoted above. From January 1, 2013 to January 1 2018:

“… the “Dividend Amount” for a Dividend Period means the amount, if any, by which the Net Worth Amount at the end of the immediately preceding fiscal quarter, less the Applicable Capital Reserve Amount, exceeds zero. … from January 1, 2018 the Applicable Capital Reserve amount shall be zero.”

There is a great deal of aforesaid type language in this Section but simply stated it means two things:

First, 100% of the earnings of Fannie Mae and Freddie Mac will be paid to the U.S. Treasury after January 1, 2013 and that has, in fact, been the case.

By January 1, 2018, the net worth of Fannie Mae and Freddie Mac will be zero.

Thus, we have the basis for a series of lawsuits against the government. The Third Amendment reverses the demands of HERA that Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) be well capitalized to protect their safety and soundness. In essence, the Third Amendment disobeys the law as passed by Congress and signed by the President. It completely reverses the comments made by Director Lockhart in 2008 when he placed Fannie Mae and Freddie Mac into a conservatorship. It completely ignores the Fact Sheet which indicated that there was no intention to liquidate the Fannie Mae and Freddie Mac.

Second, the Third Amendment changes the dividend on the Preferred A from 10% to 12% of par value to 100% of earnings. In so doing, the Third Amendment eliminates any possibility of the junior preferred shareholders receiving any dividends. The financial statements suggest that there are hundreds of billions of dollars that are available to pay the junior preferred shareholders and the common shareholders, as well. Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) have already paid over $200 billion to the U.S. Treasury under the Third Amendment.

Fannie Mae, Freddie Mac: Initial Conclusion

The FHFA’s decision to adopt the Third Amendment is also of interest. In the negotiation, the U.S. Treasury Department represented itself