Why Bill Ackman Is Bullish on Fannie, Freddie

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• NICK TIMIRAOS
 
• CONNECT

Bloomberg News

Bill Ackman detailed his bullish bet on Fannie Mae and Freddie Mac. It boils down to this: The companies that were too big to fail are now too important to replace.

Mr. Ackman’s Pershing Square Capital Management disclosed last November that it had taken 10% stakes in the common stock of Fannie and Freddie. On Monday, he spoke in greater detail at the Sohn Investment Conference in New York. on his investment thesis.

Fannie and Freddie, whose shares both trade over the counter at around $4, are worth $23 on a conservative basis, he said, and could be worth as much as $47. Here are a few frequently asked questions:

Doesn’t the government own Fannie and Freddie? It’s complicated, but the answer is no. The U.S. took over the companies in 2008 through a legal process known as conservatorship. The firms’ common and preferred shares plunged (and Mr. Ackman, who had shorted the companies, made out handsomely). But the U.S. didn’t acquire the companies entirely because that would have forced the Treasury to consolidate some $5 trillion in mortgage obligations onto the government’s books.

Instead, the government said the U.S. would inject vast sums of aid to keep the companies solvent and mortgage markets running smoothly. The Treasury took a new class of “senior preferred” stock in exchange, along with unexercised warrants to acquire nearly 80% of the firms’ common stock. Those senior preferred shares initially paid a 10% dividend.

In 2012, as concerns mounted within Treasury that Fannie and Freddie might exhaust the amount of aid the government had pledged in order for the company to make those dividend payments, the Treasury revamped those terms. Beginning last year, Fannie and Freddie don’t have to pay dividends when they lose money, but they have to send all of their profits to the Treasury as dividends in a so-called “profit sweep.” This means they can’t build capital.

The Obama administration has said it wants to wind down and replace the firms. Why would anyone bet on companies that can’t recapitalize themselves and are being wound down? Investors are betting that it won’t happen.

Shareholders have sued the government to challenge the profit sweep, and courts could rule later this year on whether the Treasury breached its authority to take all of the profits of a company when it has rights to just 80% of them. Rulings in favor of plaintiffs, which include the hedge-fund firm Perry Capital LLC and mutual-fund company Fairhome Capital Management, would constrain the government’s ability to take the profits of Fannie and Freddie. This means that even if the companies are liquidated, the preferred shares and possibly the common stock, could be in the money.

Mr. Ackman is essentially saying to Congress and the White House: you aren’t going to get rid of these companies, and replacing them with some untested set-up is going to be too difficult. Bruce Berkowitz of Fairholme has said the same. Lawmakers, the thinking goes, will conclude that getting rid of the companies could do unnecessary damage to the mortgage market and that any desired market overhaul could be accomplished by restructuring rather than replacing the companies.

Messrs. Ackman and Berkowitz are betting at some point down the road, once the government has lost its court case and once Congress has tried—and failed—to put together a coalition to replace the companies  that the government will sit down at the table to negotiate a settlement.

But isn’t there a bipartisan bill in Congress to overhaul Fannie and Freddie?Yes, but the Senate bill is struggling to gain traction because an array of interest groups—some backed by shareholder campaigns—are opposed to the proposed fixes. Conservatives worry that the bill, which provides for a continued government backstop of the mortgage-bond market, is too expansive. Liberals worry that the bill doesn’t do enough to limit potential rate increases for homeowners.

The legislation would replace Fannie and Freddie with a new system in which the government would guarantee certain mortgage-backed securities in which private investors have insured against heavy initial losses. Mr. Ackman on Monday suggested that there wasn’t enough private capital to fill the void required by the bill.

Lawmakers postponed last week a committee vote on the bill as they seek to garner a stronger majority, which many believe would be needed to compel a Senate floor vote this spring. If the bill doesn’t get out of the committee, it would be a clear sign that the support for replacing the companies isn’t as strong as the Obama administration and other longtime critics imagined it was.

Mr. Ackman said Monday that the companies are “essential to preserving the housing market.” Other countries don’t have Fannie and Freddie, and yet people still buy homes. What is he talking about? Key to the trade is understanding just how central Fannie and Freddie remain to the nation’s $10 trillion mortgage market, which is unique among industrialized nations because it is one of the only where the 30-year, fixed-rate mortgage is a dominant product.

Fannie and Freddie don’t make loans but instead buy them from lenders who package them into securities. They provide guarantees to investors when those loans default, and investors have treated those bonds like near-sovereign debt. That, in turn, has built deep and liquid markets for those bonds, enabling broad access to the popular 30-year, fixed-rate mortgage.

Rather than get rid of Fannie and Freddie, investors are betting that the companies will be shorn of their large investment portfolios that were a key source of systemic risk, and that their mortgage-guarantee businesses will be restructured and spun back out to private investors.

Mr. Ackman also said that private investors were unlikely to invest in any hybrid replacements of Fannie and Freddie. Is that true? This is a common line among investors, who have argued that Wall Street isn’t likely to invest in any new setup if investors are treated capriciously by the Treasury’s profit sweep. Given the rule change, “we don’t think there’s an investor in the world of any consequence that will invest in the new version of Fannie and Freddie,” Mr. Ackman said Monday.

It’s not really clear if that’s the case. For one, Messrs. Ackman and Berkowitz began investing in Fannie and Freddie after the government had already put the profit sweep in place. So while other investors may have been whipsawed by the change in terms, these funds knew what they were getting into—and with the shares up strongly over the past year, they’ve made handsome profits.

Moreover, in an interview with Bloomberg TV last month, Warren Buffett said that while he didn’t see any role for Berkshire Hathaway Inc. in Fannie or Freddie as presently constructed, he left the door open to investing in any successors. “There could be some [role for Berkshire] in some housing arrangement that gets worked out in the future,” he said.

Where does this all go from here? Keep an eye on what happens to the investor lawsuits. That will determine what Congress and the Obama administration can do with profits of Fannie and Freddie.

Next, keep an eye on Congress. If it can’t forge consensus around the proposed replacement of Fannie and Freddie, then legislation could idle for years, raising the prospect of the restructuring fix favored by Mr. Ackman.

Finally, watch the firms’ regulator, the Federal Housing Finance Agency, which has new leadership. Until January, the agency was headed by Edward DeMarco, an acting director who strongly believed that only Congress had the power to end the conservatorship and that the firms shouldn’t be restored. But the new director, Mel Watt, hasn’t said anything publicly yet about how the government conservatorship should be run.

Mr. Watt has broad powers to transform the companies and end the conservatorship, though only the Treasury Department can unwind its funding arrangement. If legislation falters, Mr. Watt could become the most important player on this issue.