Fannie Mae Preferred S (FNMAS)

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What a court ruling on raisins might mean for Fannie and Freddie
Ben McLannahan

Investors prepare for court battle with US government over stock dividend changes
A Freddie Mac sign stands outside the company's headquarters in McLean, Virginia, U.S., on Tuesday, April 8, 2014. Senator Sherrod Brown, an Ohio Democrat and a member of the Senate Banking Committee, said a bipartisan bill to replace Fannie Mae and Freddie Mac is too complicated and doesn't do enough to address too-big-to-fail concerns or provide assistance for affordable housing. The panel will consider the measure on April 29. Photographer: Andrew Harrer/Bloomberg©Bloomberg

Imagine you are a champion raisin farmer. Every year you produce the ripest, plumpest raisins. Then every so often the government comes along and takes almost half of your harvest for less than the cost of production, harking back to a 1940s price-stabilisation programme born out of the Great Depression. You’d be mad, wouldn’t you?

Marvin Horne certainly was — and after a 13-year fight he got even. In June the US Supreme Court ruled that the Fresno, California-based farmer was entitled to “just compensation” whenever the state came knocking.

The way a group of fund managers see it, there is a similar injustice in the way the US government has treated Fannie Mae and Freddie Mac, the home loan giants it bailed out in 2008 by buying common and preferred shares. The rescue was fair enough, the investors say: both government-sponsored enterprises faced huge losses as they were leveraged like hedge funds. Their business model consisted of issuing vast amounts of debt to fund purchases of US mortgages. That meant each $75 in total assets was effectively backed by only $1 of equity.

But in 2012 the Treasury Department changed the terms of its preferred stock dividend from 10 per cent to a 100 per cent sweep of all profits. That was “an egregious and unlawful action”, says Daniel Schmerin, Miami-based director of investment research at Fairholme Capital Management.
Fairholme and Perry Capital are the most outspoken plaintiffs in the two big Fannie Mae suits against the government. Bill Ackman of Pershing Square, which is also suing, told investors in his funds this week that Fannie remained his single best bet for outsized returns. He is a big investor in the common stock, which is still trading about 97 per cent lower than its pre-crisis peak.

The government just needs to follow the rule of law, says Tim Pagliara, director of a retail-shareholder group based in Franklin, Tennessee. He notes that the 2008 act under which the pair were put into conservatorship — a kind of temporary

freeze before rehabilitation or liquidation — said the state was supposed to “preserve and conserve” the companies’ assets.

“If you don’t [follow the law], you’re no different than Chávez in Venezuela, and other dictators who have taken it upon themselves to confiscate property,” he says.
Comparisons to Caracas are not entirely far-fetched. Since Fannie and Freddie became wards of the state the government has tightened its grip on America’s $9.9tn home loan market. Its total share of new mortgages has risen to 71 per cent — if you include loans insured by the Federal Housing Administration — from about 32 per cent 10 years ago.
Analysts say private lenders just cannot compete. A bank looking to originate a mortgage to sell into a securitisation might be paying 3 per cent a year for its senior debt and 12 per cent for its equity, for example, for a weighted average of about 4 per cent. So it needs to make at least that return after losses and prepayments — against a government that does not need to make any money at all.

Fannie and Freddie’s regulator, the Federal Housing Finance Agency, has tried to involve the private sector more through risk-sharing schemes. Traditionally, the government-

sponsored enterprises assumed all the credit risk by guaranteeing the timely payment of principal and interest on securities backed by loans meeting their underwriting guidelines. In these new deals, begun two years ago, the GSEs offload a portion of the risk of default to private investors, while maintaining the guarantees.

But many say that more radical action is needed. Congress should agree on a target for the optimal level of public sector support for mortgages, then cut the GSEs to size, says one senior banker.

The prospects for imminent reform seem slim. Several proposals have already come and gone in Congress, and with the presidential elections looming, no candidate wants to back any measure that could push up the price of a loan.
Besides, the government has grown fond of the GSE profits. Just three companies paid more in tax last year than Fannie and Freddie did in dividends: Exxon, Chevron and Apple.
Conservatorship — normally a two- to three-year deal — will last at least 10 years, reckons Laurie Goodman, director of the Housing Policy Centre at the Urban Institute, a Washington-based think-tank.

Whatever happens to the hedgies, Fannie and Freddie will remain the great piece of unfinished business from the crisis. The US likes to laugh at the EU for “kicking the can” over Greece, says Mr Pagliara. “But we can kick a can as well as anyone.”

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