Should You Buy Fannie Mae and Freddie Mac?
Should You Buy Fannie Mae and Freddie Mac?
Just a few years ago, most investors and many members of the public had written off government sponsored entities Fannie Mae (NASDAQOTCBB: FNMA ) and Freddie Mac (NASDAQOTCBB: FMCC ) as dead.
But now the futures of Fannie and Freddie are far from certain.
Big name investors are talking up their investments in these companies, politicians are squaring off in a fight that has both sides in agreement and disagreement at the same time, and a series of lawsuits have been filed alleging unconstitutional actions at the highest government levels.
But I'm writing this article for the ordinary investor who looks at this and just wants to know in plain English what happened in the past, what's happening now, and what's the future holds for Fannie and Freddie investors.
I will do the best I can to give a complete picture with this five part series where Part 1 contains background information, Part 2 covers the current events in Congress, Part 3 covers the lawsuits and the big money investors, Part 4 evaluates the preferred stock, and Part 5 evaluates the common stock.
Part 1: The History
In writing background information on Fannie Mae and Freddie Mac, I first acknowledge that I cannot include every detail of what happened at these companies as such information would fill multiple books and indeed, already has.
Instead, I am noting the key facts and details investors should know and condensing them into one background section to preface the rest of this article.
Fannie Mae and Freddie Mac traces their roots back to 1938 and 1970, respectively, and were eventually tasked with both delivering profits for their shareholders and promoting affordable housing.
Fannie Mae was part of FDR's New Deal.
They each built massive operations around guaranteeing mortgages and when most people pay their mortgages on time (and the GSEs only guarantee the highest quality mortgages to begin with), this is a relatively stable and profitable operation.
However, the mortgage bubble and subsequent meltdown brought the perfect storm to bleed the GSEs of billions of dollars.
Not only were more mortgages going into foreclosure but, in the years prior to the actual meltdown, the GSEs started buying and guaranteeing more lower quality sub-prime mortgages the increased default rates even higher.
The cause of Fannie and Freddie's lower quality portfolios remains quite the subject of political debate today with one side arguing the GSEs were pressured into taking these risks by the government while the other side blames poor lending practices at major banks and their strategy of shifting low quality loans off onto the GSEs.
Either way, Fannie and Freddie bled cash like you would expect companies living at the center of a mortgage meltdown to do.
A plan was put together to put the GSEs into conservatorship, with the Federal Housing Finance Agency (FHFA) as the conservator. In exchange for government bailout money, the Treasury obtained warrants to purchase 79.9% of each GSE's common stock and a deal whereby the GSEs would issue senior preferred stock yielding 10% to the Treasury in exchange for cash.
This arrangement continued until early 2012 at which point Fannie and Freddie had issued a combined $189 billion in 10% yielding senior preferred stock in exchange for cash.
But in 2012, the bleeding stopped and the GSEs even returned to a slight profit.
However, in August of that year, an amendment was added to the senior preferred stock purchase agreement whereby instead of the GSEs paying a 10% interest rate on the outstanding senior preferred stock, virtually all the profits of Fannie and Freddie would be paid to the Treasury on a quarterly basis.
The payments would not go toward reducing the outstanding senior preferred stock and would continue indefinitely.
As this agreement remained in place, Fannie and Freddie continued to grow their profits all the while shipping them to the Treasury per the terms of the amendment.
But as profits rose into the billions and then into the tens of billions, speculators began to take an interest in the common shares driving them from their lows around $0.30 up above the $1.00 level and drove preferred stock from trading as low as two cents on the dollar to around 10 cents on the dollar.
Further profit growth and the movements by large investors (I will explain further in Part 3) pushed common shares into the $3 to $4 range today and preferred shares to trade at around thirty to forty cents on the dollar varying by series.
Where they are todayFannie Mae and Freddie Mac suffered extensive financial damage from their involvements in higher risk mortgages and this culminated in a government bailout that rose to a peak of $189 billion.
But since the, Fannie and Freddie have turned profitable again, but all those profits go to the Treasury under the terms of a new amendment added to the senior preferred stock purchase agreement in Aug. 2012.
With the government in control of Fannie and Freddie, the GSEs have only two ways out of limbo: Congress and the courts.
Part 2: The Politics
It's not often that both sides of Congress agree on something, but in this case, there is a general consensus agreement to wind down Fannie and Freddie.
But we're approaching six years since the bailout and this has not happened because, while Democrats and Republicans can agree on a desire to wind down Fannie and Freddie, they can't agree on what to replace them with.
As of now, it looks difficult for a housing reform bill to pass based on the layout of each house. Although the Senate has a reasonable chance that with enough negotiating, it could pass a bipartisan bill, such legislation would likely be dead on arrival in the House which is controlled by the Republicans taking a firm stance against government involvement in the housing market.
Presidential opinionSince it would be difficult to pass housing reform legislation in the first place, let alone override a presidential veto, housing reform legislation will need the support of the President to become law. In his last State of the Union address, President Obama mentioned housing reform among the things he would like to see accomplished and previous comments indicate he is favorable to something resembling the Corker-Warner bill.
From Corker-Warner to Johnson-CrapoLast year, Congress attempted to make its first major attempt at housing reform legislation with the Corker-Warner bill. Under the bill's guidelines, Fannie Mae and Freddie Mac would be wound down and replaced by a Federal Mortgage Insurance Corporation (FMIC) operating on a similar model to the FDIC that protects deposits of up to $250,000 in bank accounts.
Mark Warner and Bob Corker.
Fannie and Freddie's private investors would likely see little if any of the proceeds from the wind-down as the government's $189 billion senior preferred stock stake is ahead of them in line. Fortunately for Fannie and Freddie investors, the Corker-Warner bill never became law.
However, the next housing reform bill is the Johnson-Crapo bill which looks almost exactly like the Corker-Warner bill. Like Corker-Warner, Johnson-Crapo would wind down Fannie and Freddie and distribute proceeds to the government first before giving any leftovers to private investors.
Countdown to electionsAfter the Senate panel vote was delayed in late April, passage of Johnson-Crapo became even more difficult as Congress in now in a race against the clock. Now, with the vote delayed and six key Democrats opposed to the bill's passage is becoming even more difficult.
In just a few months, members of Congress will be leaving to campaign for the 2014 midterms so the bill would need the ultimate financial fast-tracking to move through Congress this year. And with legislation as large and controversial as Johnson-Crapo, the bill is highly unlikely to receive fast-track treatment.
What are the chances?With the exception of some sort of miraculous bipartisan agreement, Johnson-Crapo is highly unlikely to be passed before Congress begins leaving for 2014 campaigning.
Most likely another Congress will take up the issue again but that will again take more time and we may ultimately be left with the same disagreement we have now.
But what's the endgame for Fannie Mae and Freddie Mac investors? If the only thing Congress can agree on is winding down Fannie and Freddie, how can private investors hope to see value in their investments?
Part 3: The Big Money Investors and the Courts
The most important developments for Fannie and Freddie shareholders will likely come from the courts where some of the most prominent investors today are challenging the current allocation of the GSEs' profits.
What's at stake?As already mentioned, the amendment made to the senior preferred stock purchase agreement whereby the GSEs would no longer pay 10% interest on the senior preferred stock but would instead pay all of their profits to the Treasury.
Although this wasn't seen as that big a deal at the time when Fannie and Freddie were only slightly profitable and shares traded around $0.30, with the GSEs making billions in quarterly profits today, investors are challenging the legality of this amendment.
The plaintiffsBruce Berkowitz, manager of Fairholme Funds, and Richard Perry, manager of Perry Capital are among those suing the government over its handling of Fannie Mae and Freddie Mac.
Both plaintiffs' cases are argued with a basis of seeking compensation under the Fifth Amendment to the U.S. Constitution.
They argue the net worth sweep of Fannie and Freddie constitutes an unjust taking without compensation and the plaintiffs seek to end the net worth sweep and obtain compensation.
Big investors want their day in court. Photo: Wally Gobetz
The casesThese will no doubt be major cases as nothing less than tens of billions of dollars in annual profits is at stake.
If the plaintiffs lose, it becomes tough to see how the preferred or common stock would have anything more than negligible value.
However, both preferred and common shares could more than double if the plaintiffs win.
Right now, Fairholme Funds v. United States of America is in the discovery phase as plaintiffs seek key pieces of information from various parts of the government concerning Fannie Mae and Freddie Mac. With discovery being one of the earliest phases of a trial, investors should not expect a near term ruling on this issue.
OutcomesWith the amount of money at stake and the determination of each party to obtain it, this case could be one that heads all the way to the Supreme Court.
But for investors, the final ruling is critical to determining the value of their investment.
Part 4: The Preferred Shares
Before the crisis, preferred stock in Fannie Mae and Freddie Mac was seen as a safe income security.
As such, conservative investors and small banks purchased it. But when the GSEs melted down and required a bailout, preferred stock dividend payments were suspended and have yet to be resumed.
Since the preferred stock available to private investors is junior to the senior preferred stock owned by the government, the junior preferred stock is in a similar situation as the common stock in that it provides no dividend and is not directly benefiting from the rebound in profits.
Most series of Fannie Mae and Freddie Mac preferred stock have liquidation values of $25 or $50 and trade at between $0.30 and $0.40 per dollar of liquidation value. Much of the difference in current value has to do with the original dividend rate on the series despite the dividend being suspended and non-cumulative.
Risks and potential returnIf the plaintiffs lose their cases against the government as we've discussed, then the preferred stock is unlikely to have much value.
We know most politicians favor a wind down of the GSEs leaving preferred shareholders in line after the massive senior preferred stock stake from the government, and until the current situation changes, the preferred stock pays no dividend and the GSEs would not be able to reinstate one.
But if the plaintiffs can succeed in ending the net worth sweep, returns for the preferred stock would be significant. All series would move back toward liquidation value since Fannie and Freddie themselves are solvent although some lingering market fears may cause a slight discount to liquidation value to occur.
The preferred shares quickly became a hot piece of paper.
As with other preferred stocks and income investments, preferred stock series with a higher yield would trade at a higher multiple to liquidation than lower yielding series.
Although I own the common stock and not the preferred stock of Fannie Mae and Freddie Mac, I understand the possibility of significant upside, coupled with major risks, to owning the preferred.
With the liquidation value defined, the preferred stock has a fairly well established upper value. Additionally, if the GSEs can begin returning profits to private investors, the preferred stocks should begin paying the dividends defined in their prospectuses.
The fate of the preferred stockholders is largely correlated with that of the common stockholders but the preferred stockholders do have two key advantages in a liquidation or wind down.
One is that they are ahead of the common stockholders in line for payment. This means anything left over from a wind down or liquidation, after the government's stake is repaid, will go to the preferred stockholders.
The second advantage is that the liquidation value clearly defines what the preferred stock should receive.
So if the GSEs have been dismantled by the time of a final ruling in favor of the plaintiffs, it would be easier for the court to determine what value the preferred stockholders should receive while the common shareholder value would require other formulas to be used leaving it more up in the air.
While upside of 100% to 200% is still very good, the common stock still has greater potential upside. This is because preferred stockholders are only entitled to liquidation value plus dividends while the common stockholders can share the remainder of the profits which, in the case of Fannie and Freddie, are quite large.
Is it really safe?Preferred stock is generally seen as a safer income investment but Fannie Mae and Freddie Mac preferred stock is far from a safe income investment. Although it's still a lower risk investment than the common stock, the preferred stock currently has no dividend and its investors are relying on favorable legal or political developments to see any value at all.
If you do choose to go with the preferred stock, you'd be in good company. Bruce Berkowitz's Fairholme Funds owns preferred and common stock and Perry Capital owns the preferred stock as well.
There are also many series of preferreds at both Fannie and Freddie and each has its own liquidation value, yield, and daily trading volume. If you are considering the preferred stock, it is definitely worth the time to go through and pick out the series that best fits with your investment strategy.
Part 5: The Common Shares
Until solid profits started to show at Fannie and Freddie, the common stock was priced for liquidation trading at around $0.30.
But even as the profits started to appear, big investors like Fairholme Funds and Perry Capital purchased the preferred stock.
It was only late last year that the common stock received major interest from a major investor when Bill Ackman bought nearly 10% of the outstanding shares of each GSE.
The potentialTrading in the $4 range, shares of Fannie and Freddie have a lot of potential upside if the net worth sweep of the GSEs was removed.
Ackman. Photo: Insider Monkey
In a recent presentation, Ackman gives long-term values of $23 to $47 to shares of Fannie and Freddie. In his calculations, Ackman factors in the exercise of the Treasury's 79.9% warrant stake and the dilution that would come along with it.
Ackman argues the GSEs have long-term earnings power of around $11 billion for Fannie Mae and $6 billion for Freddie Mac. These calculations are done at current fee levels and assume a 35% tax rate.
Although these estimates are lower than what Fannie and Freddie reported in 2013, last year's earnings were helped by one time events such as the recognition of deferred tax assets and legal settlements with major banks. Because of this, investors should not expect a repeat of the 2013 level of earnings.
In translating the earnings to a share price estimate, Ackman uses a price to earnings level of 14 times at the low end and 16 times at the high end, both levels being in line with the broader market.
As an owner of the common stock, it would make sense that Ackman would hold a bullish stance on the GSE shares. While his estimates are generally reasonable, they should still be considered the bull case for the common stock.
The risksNo analysis of Fannie and Freddie common stock would be complete without discussing the risks.
Of course the biggest risk is that the plaintiffs lose their lawsuits and the net worth sweep continues. If the sweep is given the legal go-ahead, the common stock would be worth essentially nothing as it would receive none of the profits and be last in line to receive any assets.
Additionally, if the plaintiffs lose their case and the GSEs are wound down, the common shareholders are last in line to receive proceeds. Due to the large amount of government owned senior preferred stock and concerns that even the junior preferred stock will take a hit, there is little chance for common shareholders to see any return in a liquidation scenario.
But even with the net worth sweep gone, other risks do remain. Ackman estimates the GSEs can repay the Treasury in three years if the net worth sweep is undone and the old 10% dividend rate reestablished. He also estimates that Fannie and Freddie can rebuild necessary capital in 7 years by retaining earnings.
However, the government may want its money back faster or may pressure the GSEs to raise necessary capital sooner.
Either of these events may result in the conversion of the remaining senior preferred stock stake (which would be around $60 billion using the old 10% agreement) into common shares similar to what the Treasury did with its preferred stock stake in Citigroup.
The conversion of the Citigroup stake temporarily flooded the market with new shares and resulted in significant share dilution. This caused Citigroup common shares to actually drop even as the government exited its stake in the bank.
While such a conversion would cause dilution to Fannie and Freddie shares, ending the net worth sweep should more than make up for this dilution.
However, any dilution that occurs would likely lower the value of Fannie and Freddie shares from Ackman's $23 to $47 bullish estimate.
High risk, high potential rewardAfter researching Fannie Mae and Freddie Mac, I have established positions in the common shares of each based upon the significant upside potential and the reasonable chance of the plaintiffs winning their lawsuits to end the net worth sweep.
Significant legal, political, and economic risks do remain so this is definitely not an investment for conservative investors.
But for those willing to assume a large amount of risk for large potential returns, I believe Fannie Mae and Freddie Mac are some of the best investments on the market today.
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