Why Fannie Mae and Freddie Mac Stock Jumped 11% Today

What happened

Shares of Fannie Mae (NASDAQOTH: FNMA) and Freddie Mac (NASDAQOTH: FMCC) are up by more than 11% as of 3:10 p.m. EDT, after six Democratic senators wrote a letter to Treasury Secretary Steven Mnuchin and Federal Housing Finance Agency Director Mel Watt, asking them to address Fannie and Freddie's low levels of capital. The senators wrote to ask that the officials consider allowing Fannie Mae and Freddie Mac to retain some of their earnings as a buffer against future losses, while leaving the door open for allowing the government-sponsored enterprises (GSEs) to exit conservatorship.

So what

The letter addresses the Preferred Stock Purchase Agreements between Fannie Mae, Freddie Mac, and the Treasury Department. Specifically, the letter details the senators' shared concern that Fannie Mae and Freddie Mac, which insure trillions of dollars of residential mortgages, will soon operate without any cushion against losses due to these agreements.

Under the agreements, Fannie Mae and Freddie Mac send all of their income to the Treasury Department, ultimately "leaving two entities that back more than $5 trillion in mortgage debt with zero retained capital reserves beginning on January 1, 2018," according to the letter.

A little backstory may be helpful here. The U.S. government put Fannie Mae and Freddie Mac into conservatorship during the financial crisis of 2008. Initially, the U.S. Treasury injected capital into Fannie and Freddie via preferred stock, which would reward the U.S. Treasury for its investment with a regular fixed dividend.

That all changed in August 2012, when the terms of the investment were amended. Rather than pay a fixed rate of return on the U.S. Treasury's preferred stock, Fannie and Freddie would be required to pay dividends based on their net worth. In effect, the new "net worth sweep" sent all the profits of Fannie and Freddie to the U.S. government.

The net worth sweep has made Fannie Mae and Freddie Mac incredibly profitable for the U.S. government, but since all the earnings are swept from the companies with regularity, Fannie Mae and Freddie Mac have little or no cushion should mortgage insurance profits turn into mortgage insurance losses. The mortgage insurance business is very much a "feast or famine" industry: Long periods of profits are earned when housing prices rise in a slow and steady pace, followed by massive losses when housing prices fall.

Right now, it's more feast than famine, and the U.S. Treasury is taking all the profits out of Fannie and Freddie. However, it's quite likely that at some point the fortunes of the industry, and the flow of money, will have to reverse, at which point the Treasury will have to send cash back to Fannie and Freddie to cover any losses. The senators characterize the future reversal of cash flows as a risk to taxpayers.

In some ways, this letter seemingly politicizes a relatively unimportant accounting issue. It essentially argues that if the government takes less money from the GSEs today, it won't have to pony up as much capital in the future for losses. That's kind of obvious, and it isn't immediately clear to me why the senators think taking $3 now is so much better for taxpayers than taking $10 now with the knowledge you may have to return $7 at a later date, but that seems to be exactly what they're arguing.

Now what

The senators write rather plainly that they only want Fannie and Freddie to be able to build up adequate reserves for losses, not to exit conservatorship. For shares of Fannie and Freddie to be worth anything at all, they would have to be allowed to exit conservatorship, something the government has largely opposed because...well, frankly, it really likes the profits that the GSEs are generating right now.

"We are simply requesting that the GSEs be permitted to build capital. We do not believe they should be released from conservatorship absent reform," the senators wrote in their letter.

Of course, if you're a Fannie Mae and Freddie Mac bull, you might take notice that the senators aren't leaving out the possibility of privatizing Fannie or Freddie, since they say they oppose releasing the GSEs from conservatorship "absent reform." This implies that they may support letting the GSEs exit conservatorship if they are reformed. But who knows what "reforms" might be necessary for them to support putting Fannie Mae and Freddie Mac back in private hands?

However, as has been the case in the past, when a government official leaves the door open (or even slightly cracked) to letting Fannie and Freddie out of conservatorship, shares of both go wild. Add today as yet another example.

10 stocks we like better than Fannie MaeWhen investing geniuses David and Tom Gardner have a stock tip, it can pay to listen. After all, the newsletter they have run for over a decade, Motley Fool Stock Advisor, has tripled the market.*

David and Tom just revealed what they believe are the 10 best stocks for investors to buy right now... and Fannie Mae wasn't one of them! That's right -- they think these 10 stocks are even better buys.

Click here to learn about these picks!

*Stock Advisor returns as of September 5, 2017

Jordan Wathen has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.