Mnuchin Wants Fannie (FNMA)/Freddie (FMCC) Out of Government Hands, But Stocks Grossly Overvalued - Keefe, Bruyette & Woods

December 2, 2016 11:51 AM EST
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The incoming Treasury Secretary, Steven Mnuchin, recently made it known that the new administration wants to get the GSEs out of government hands. Shares of Fannie Mae (OTC: FNMA) and Freddie Mac (OTC: FMCC) have rallied sharply following the comments. Keefe, Bruyette & Woods (KBW) believes that the movement in the shares of the two companies has been based on unrealistic earnings expectations because there has not been enough focus on the lack of capital at the GSEs.

Keefe, Bruyette & Woods analyst Bose George commented, "Shares of Fannie Mae (FNMA) and Freddie Mac (FMCC) have rallied sharply over the past two days following comments from Steven Mnuchin, the incoming Treasury Secretary, stating that the new administration wants to get the GSEs out of government hands. He also noted that resolving the GSE issue was a top 10 priority for the new administration. While it remains unclear how any privatization would work, we believe that even in the best case scenario, where the shares are privatized with a 2.5% capital requirement, the capital need will meaningfully dilute the value of the common shares, suggesting little upside from current levels. We continue to believe that the most likely scenario is one in which the common shares have no value. We reiterate our Underperform ratings and $1 price targets for both companies."

There are several ongoing shareholder lawsuits and all of them are challenging the Third Amendment of the Preferred Stock Purchase Agreement (PSPA). The third amendment eliminated the 10% dividend and replaced it with a dividend sweep which swept all earnings from the GSEs to Treasury. KBW believes that even in the best case scenario, the shares are already trading at around 10x pro forma earnings. Even if the plaintiffs win the litigation overturning the Third Amendment, the GSEs will have no capital.

However, KBW believes that if the Third Amendment were to be overturned, the GSEs could replace the sweep with a periodic commitment fee. A commitment fee similar in size to the fee charged to Sallie Mae in the 1990s (30 bp) would reduce GSEs earnings and the longer term value of the companies by about two-thirds.

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