(Idea) Fannie Mae Preferred (Part 2)
Wilson’s Note: Jon is an amazing writer and he can get wordy, but the Fannie Mae preferred series has been an excellent one and I think it deserves your attention. Please be sure to read part 1 of this report. Here’s the lengthy part 2 report that will be divided into 2 sections.
Capital Requirements For A Successful Privatization
Since I published my article on the GSEs next week, the pushback from well-informed observers has been more or less that “this trade has tripped up some of the smartest investors on the planet. Why should I jump in after they’ve lost?”
I’ll be the first to admit that this is a valid point.
For more than a decade, some of the most sophisticated financial sector investors—such as Bill Ackman, John Paulson, and Bruce Berkowitz—have recognized the value in GSE equity. Each purchased the common, preferreds, or both, only to be frustrated by the lack of progress in resolving the GSE conservatorship. In hindsight, these investors were far too early in their timing, as each one invested during a time when the GSEs’ financial, legal, and political unknowns loomed larger in the picture.
Since 2014, the crux of Bill Ackman’s thesis has been that GSE equity represents a perpetual option on the end of conservatorship, with low expectations with regard to timing.
Bruce Berkowitz began buying in 2013. By 2017, GSE equities made up more than 10% of his Fairholme Fund. Berkowitz’s thesis rested on a perceived margin of safety that if all else failed, he could sue the government and win damages stemming from the purported illegal seizure of property represented by the net worth sweep. Unfortunately, his lawsuits proved unsuccessful, and he ended up selling all of Fariholme’s holdings.
John Paulson’s thesis is more geared to the politics of the situation than those of Ackman and Berkowitz. Since Trump’s first term, he has been betting on a recap-and-release. Presumably, he views that outcome as more likely in Trump’s second term.
Each of these investors was early in their timing. Those who didn't sell had to persevere through the opportunity cost of holding underperforming GSE securities, the imposition of a net worth sweep, numerous legal challenges, and unexpected regulatory changes for many years before realizing value for their efforts.
Why the Time is Right to Buy
It’s fair to say that “this time is different.” Now is the best time to buy Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) common and preferred stocks since they entered conservatorship in 2008. I want to reiterate this so that investors appreciate the opportunity:
The timing is right for the following reasons:
Privatization remains the most sensible long-term option for taxpayers and the mortgage market. The alternative to ending conservatorship is to put the GSEs into receivership, wind them down, and replace them with an alternative entity or entities that serve a similar purpose. A receivership would be complicated and drawn out. It would involve years of litigation in which the government could face defeat on multiple counts. The process would be fraught with controversial asset transfers and competing demands from special interest groups. The intrigue surrounding the process could disrupt the mortgage market. A severe market malfunction would risk sending mortgage rates higher and home values lower, which is not an outcome either political party would willingly embrace.
The Administration is now in control of the GSEs’ regulator, the Federal Housing Finance Agency (FHFA). President Biden replaced Trump’s FHFA Director as soon as the Collins v. Yellen Supreme Court ruling allowed him to do so. Trump can just as easily appoint his own FHFA Director and alter GSE oversight the way he sees fit.
Trump has clearly stated his intention to privatize the GSEs. The power of the President to appoint a new Director reduces the need for legislation to recapitalize the GSEs and release them into private hands.
Trump is leading in the polls and betting markets. His odds for victory at this point are better than they’ve ever been throughout 2024. In fact, they’re even better than they were at this time in 2016.
Court cases have already been fought, regulations have been challenged, and verdicts have been delivered in nearly every facet of GSE oversight and governance. The GSEs’ legal standing and the legitimacy of their shareholders’ claims are no longer under dispute as they had been in previous years.
The GSEs are building capital at a rapid pace. Insofar as conservatorship is intended to rehabilitate them with the intention of eventually releasing them, its usefulness has run its course. The GSEs have repaid more than what the government invested in them after the financial crisis. The funds received by the Treasury through its ownership of the senior preferreds represent a healthy return on investment to taxpayers.
The other options available to the U.S. government are simply not as attractive as recap-and-release. For instance, the government could opt to continue the conservatorship. But in that scenario, the GSEs would remain wards of the state with no private capital to absorb losses in a downturn. Taxpayers would remain exposed to significant loss in perpetuity.
Alternatives to recap-and-release raise the risk that the GSEs’ assets and liabilities end up as part of the government’s balance sheet. Under the current setup, the government’s 79.9% warrants are just below the 80% threshold for consolidation. However, the Congressional Budget Office’s accounting—which is more reflective of economic reality—considers the GSEs’ liabilities to be obligations of the U.S. government. As such, they will remain at risk of forcing a bailout and widening the budget deficit amid a crisis. Also, GSE mismanagement will be pinned on the government, which could deliver a black eye to any Administration.
Having established that recap-and-release makes sense, we have to determine whether it can be executed with realistic and effective capital requirements.