Citigroup Ponies up $968 Million to Fannie Mae, What’s Next?

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Citigroup (NYSE: C) announced another multi-million dollar settlement with Fannie Mae (NASDAQOTCBB: FNMA) over ongoing mortgage claims.

The too big to fail banking behemoth will fork over $968 million to cover pre-existing loans and any potential future claims on loans originated and sold to Fannie Mae between 2000 and 2012.

Head honcho of CitiMortgage, Jane Frazier reportedly said, “We have a strong and productive relationship with Fannie Mae.”

The Art of the Deal

The settlement between Citi and Fannie involves 3.7 million mortgage loans already gone astray as well as others that may tank. Fannie Mae will continue to service the loans. The agreement is centered on so-called “legacy repurchase issues” and will also compensate taxpayers who financed the government takeover of Fannie Mae in 2008.

This agreement is separate from a previous deal earlier this year with Citi and other money center banks. While this payoff was apparently covered by the bank’s existing mortgage repurchase reserves, Citi will add another $245 million in the second quarter to that cash pile.

In other words, this deal will take a bite out of the bank’s profits. A small bite perhaps, but this is another serving to go along with other settlement agreements that have hit the bank in the pocket book. While fundamentals are a key for investors in the financial sector, these ongoing settlements are also important to consider, so caveat emptor.

What Settlement With Citi Means for Fannie Mae.

In general this deal allows Fannie Mae to cover another $1 billion or so in mortgage losses and shore up its balance sheet in the process. Moreover, the government-owned lender is currently negotiating other deals with the usual suspects involved in the mortgage market meltdown that triggered the financial crisis in 2008.

Citigroup and other big banks sold millions in mortgages to Fannie and Freddie Mac (NASDAQOTCBB: FMCC). The lenders then bundled the paper into tainted mortgage-backed securities. And this caused huge losses that ultimately were paid for by taxpayers.

In sum, this deal is good news for Fannie Mae as it continues to recover from the housing market collapse. Moreover this could be an opportunity for buyers interested in both common and preferred shares of both lenders.

Effect of Other Developments on Fannie and Freddie

As has previously been reported, the Federal Housing Finance Agency (FHFA) announced in the spring that it intends to consolidate the operations of Fannie Mae and Freddie Mac. FHFA is the federal regulator tasked with overseeing Fannie and Freddie.

The Agency plans to form a new corporate entity to combine certain operations of the two housing finance giants. The goal is to build a new securitization platform. And this will be the cornerstone of a new company that will eventually replace Fannie Mae and Freddie Mac. But this scheme will take years to implement. In the meantime, common shares of both lenders could offer investors a buying opportunity.

However, when this spin-off actually happens, preferred shareholders will be paid off first. So investing in common shares is not a long term play. That said, there is also the possibility of the preferred class being converted to common.

The Bottom Line

Fannie and Freddie made profits in 2012 for the first time in about seven years. But they still owe the government about $180 billion. At the same time each has revenues of about $100 billion. Some analysts note paying back the government bailout debt will take another five years.

In the meantime, the housing giants will be refinancing this debt by selling bonds at lower interest rates in order to repurchase their higher interest rate offerings. And these refinancings should boost the share price of Fannie and Freddie.

It is unclear what the valuation of these outfits will be in the long run. Fannie is presently trading at about $1.70 per share. This is far above the 52-week low of nine cents and off the high of $5.44. Fannies’ price earnings ratio is 12.20 -  below the S&P 500 PE of 17.70. As for Freddie, it is hovering at $1.60 share.

Combining these fundamentals with clear indicators the housing market is on the mend means the mortgage market will also improve. So there might be profits on the horizon for both lenders. In any case, for those investors with nerves capable of coping with a bumpy ride, a small slice of the Fannie and Freddie pie may be worth a second look.

Ultimately as long as Fannie and Freddie remain in a Treasury Department conservatorship they continue to be backed by the Federal government. And until the housing finance giants are eventually replaced by a surviving entity, they are needed to keep the mortgage securitization market afloat.

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Kyle Colona has no position in any stocks mentioned. The Motley Fool owns shares of Citigroup Inc . Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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