The trade looks very risky. Savvy hedge funds and unsophisticated retail investors alike have piled into the common and junior preferred shares of Fannie Mae and Freddie Mac, betting that the government-sponsored enterprises will be returned to the private sector. They are wagering that the shares they purchased for pennies on the dollar will produce values not seen since before the financial crisis.
The political odds are against this outcome, however. Given the $187.5 billion cost of the bailout of the two mortgage giants, Washington political opinion across the ideological spectrum has coalesced around the idea of winding them down after a period of five years.
Investors in depressed shares of the two firms are blind to these political realities, according to Edward Mills, financial policy analyst at FBR Capital in Arlington, Virginia. At the end of the day, there is no real political support to allow Fannie and Freddie to come out of conservatorship and reconstitute themselves as publicly traded companies, he says.
Indeed, sentiment runs in the opposite direction. There is a strong desire in GSE reform on Capitol Hill to end Fannie and Freddie, Hill says. The House position is to completely get rid of them. The Senate position is to transform them into something that is not a publicly traded company. In those kinds of scenarios, we have a hard time seeing how the existing shareholders are going to be compensated.
You would think that the political brick wall blocking the way to a big upside would dampen investor enthusiasm for Fannie Mae and Freddie Mac. But even after President Obama publicly supported a wind-down of the two GSEs in early August, a key investor announced he was doubling down on an earlier bet. On August 15, Bruce Berkowitz, founder and chief investment officer of Fairholme Capital Management of Miami, said he was going to reopen the Fairholme Fund to new investors and would consider buying up more shares of Fannie Mae and Freddie Mac. The Fairholme Fund already owns junior preferred stock shares in both companies that have a redemption value of $2.4 billion, according to the firm. And the funds existing position of GSE shares represented $566 million, or 6.9 percent of its portfolio, as of May 31, according to a company source.
Berkowitz remains convinced his investment will pay off. I believe Freddie and Fannie preferred shares represent a compelling opportunity because they are priced at huge discounts that imply both companies are near death, and that makes no sense to me, he says. Without Fannie and Freddie, there would be no middle-class housing and no 30-year mortgage. They are not just part of our housing finance system. They are the system.
Fairholme, along with several insurance companies, filed two lawsuits in the U.S. Court of Federal Claims in July. One suit demands just compensation from the U.S. government for taking away dividends on junior preferred shareholders. That occurred in 2012, when Treasury changed the terms of its agreement with Fannie and Freddie and required them to pay virtually all their earnings to Treasury instead of into 10 percent dividends, as originally agreed to in September 2008. The two GSEs had just resumed being profitable, and the junior preferred shareholders were looking to see their dividends restored. The second suit, against Treasury and the Federal Housing Finance Agency, asks the court to set aside the 2012 decision to take all profits and reinstate the 10 percent dividend.
Berkowitz contends that the GSEs are so profitable making a combined $40 billion a year that they can afford to pay back the government and taxpayers and still make whole all the shareholders in the companies ownership structures.
Fairholme is not alone. Other major hedge funds have made long trades on the GSEs, including Paulson & Co.; Claren Road Asset Management, owned by the Carlyle Group; and Perry Capital. They all have a preference for preferred shares at the two GSEs although they decline to reveal how much they have invested. Despite a pullback in June, the subsequent movement in prices for Fannie and Freddie common and preferred shares suggests investor sentiment remains strong. People view it as an attractive risk-reward opportunity, says Mills, by which they can acquire something trading pennies on the dollar and see it return to par value in the case of the preferreds.
So far this year its been a wild roller-coaster ride for Fannie and Freddie share prices, swept first by euphoria, then hit by nagging doubts that values might fall, perhaps to near zero. In what could be the rally of the year, Fannie Mae common shares rose from 29 cents March 12 to an intraday high of $5.44 on May 29 before settling between $1.25 to $1.75 levels four to six times higher than those that prevailed before the run-up. Freddie Macs shares have followed a similar path.
Investor demand also sent Fannie Maes junior preferred shares sharply higher. Preferred stock, which has less risk than the common, is likely to attract more sophisticated and institutional investors. The largest junior preferred issue, Series S, rose from $1.90 on March 12 to an intraday high $6.85 May 29 and settled back into a range of $4.65 to $5.25 two and one half times higher than the price before the run-up. Full recovery could bring prices closer to the $25 redemption value for junior preferreds, plus a resumption of dividends with coupons ranging from 7.75 percent to 8.38 percent.
Investors like Berkowitz point to strong financial performance at both Fannie and Freddie as a persuasive argument for privatization. That performance has allowed the two GSEs to pay back in dividends a sum close to the original Treasury bailout outlay. In the second quarter, Fannie Mae earned $10.1 billion while Freddie Mac earned $5 billion, nearly all of which was paid to Treasury as dividends. Second-quarter earnings will bring total dividends to $146.2 billion, leaving only $41.3 billion of the bailout still uncompensated. If earnings continue at their current pace, it would only require a few more quarters before the GSEs will have paid Treasury dividends equal to the bailout funds. Then, investors contend, the ongoing viability of two now profitable mortgage companies will make the case for privatization irresistible.
There is only one problem with this scenario: Under terms of the bailout, dividends are not counted against paying down the principal.
Nonetheless, some investors are pressing their case in Washington. Ralph Nader, an investor in the two GSEs prior to the crisis, has for years called on Treasury to honor shareholder rights and give investors a role in deciding how Fannie and Freddie are treated. Paulson & Co. is lobbying vigorously for hedge funds that have taken long positions on the GSEs.
Other investors have turned to the courts. The City of Austin Police Retirement System and Washington Federal bank of Seattle filed a $41 billion lawsuit in June in the U.S. Court of Federal Claims asserting that the Federal Housing Finance Agency and Treasury improperly coerced the boards of the two companies into accepting conservatorship in September 2008. In July Perry Capital also filed a complaint in federal court claiming the federal government in 2012 improperly changed the terms governing senior preferred shares issued to Treasury by the GSEs.
Investors see an attractive precedent in Treasurys decision to sell the government stake in AIG and return the insurer to shareholders. Indeed, former Treasury official Jim Millstein, who oversaw the AIG restructuring, wrote a 63-page white paper two years ago that called on the government to end dividend payments and allow Fannie and Freddie to recapitalize. Once that is achieved, he called for the government to convert its preferred shares to common shares to be sold off over time. Plus, Treasury could exercise its warrants to buy 79.9 percent of shares in each of the GSEs at a nominal price. All told, Treasury would then own 85 percent of the two GSEs, a stake Millstein values at $150 billion. He also proposed setting up a new U.S. agency, the Federal Mortgage Insurance Corp., to reinsure mortgages to be securitized by a privatized Fannie and Freddie. This idea is now incorporated in legislation sponsored by Senators Bob Corker (R-Tenn.) and Mark Warner (D-Va.).
Neither the lawsuits nor the lobbying is likely to influence the policy debate on Capitol Hill, Mills believes. From his talks with members of Congress, he expects Congress to be inclined to get something done that doesnt allow for speculative bets to be paid.
The AIG precedent may be an interesting story but it is not entirely persuasive, he argues. Before the financial crisis, AIG didnt have much political baggage, while Fannie and Freddie are the two corporations with perhaps the most political baggage in the entire history of United States government for publicly traded companies. Theres yet another political obstacle. Washington has to figure out the shape of future housing policy before dealing with the two mortgage companies. That makes it completely different from AIG, says Mills.
The political weakness of Fannie Mae and Freddie Mac is a startling reversal of fortune, of course. They were once so powerful that they could reward friends, punish foes and shut down congressional debates over reform. Their former sway now works against them. Its even more of a reason not to return them to their former political selves, says Mills. Moreover, he adds, some of the fiercest critics of the GSEs in their heyday are now in positions of power, such as Rep. Scott Garrett (R-N.J.), chairman of the House Subcommittee on Capital Markets and Government-Sponsored Enterprises.
Despite the daunting odds, there is a scenario in which the path of least resistance may favor investors if no GSE reform bill emerges from Congress, says Mills. Then, because the GSEs have been profitable and we have come out of the housing crisis, the government decides it would like to monetize its stake in senior preferreds or get some value on the warrants for the common stock it took. Under this scenario, the government might move to recapitalize the two companies, require better underwriting and allow them to re-establish themselves as publicly traded companies outside of conservatorship. Then we all move on with our lives, because they figure that doing anything through a GSE reform bill is just too hard, Mills says.
In the end, should Congress pass GSE reform legislation that winds down Fannie Mae and Freddie Mac, it is not clear whether shares of common and junior preferred will become essentially worthless. The junior preferreds are more likely than the common to retain residual value, according to Mills. It will depend on how Congress does GSE reform, what decisions are made about legacy systems and the legacy books of business, as well as whether or not there is a change in the senior preferred stock purchase agreement that allows the GSEs to start paying off the principal they owe the government.
There are plenty of wild cards here, he adds. But from a policy perspective, I just see things stacked up against this trade.
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