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Hedge Funds' Bets on Fannie and Freddie Cause Pain
Mentioned: FMCC FNMA
By Juliet Chung and Andrew Ackerman
The end of the Trump administration is the end of the best hope for hedge-fund investors in a long and painful trade: Betting that Fannie Mae and Freddie Mac would one day be returned to private hands.
A long list of investors has bet that policy makers would eventually privatize the companies, and that once that path became clear, the value of the shares in these companies would increase dramatically. Most hedge funds hold preferred shares that carry a dividend. These shares are junior to the government's stake and thus don't get paid dividends until after the government is paid. So their value is greatly diminished by the large stake the government retains.
In one scenario where hedge funds would profit, Fannie and Freddie would raise fresh capital, junior preferred shares would be converted to common stock, and the government would write down or eliminate its senior preferred shares.
Investors including John Paulson, Anchorage Capital Group, Discovery Capital Management LLC, Blackstone Credit, Perry Capital, Bill Ackman's Pershing Square Capital Management LP and PointState Capital LP have been involved in the trade. Many funds are now expected to have lost money on the investment, though some early buyers and active traders profited.
It was a risky bet. But other complex, long-shot trades, including the subprime bet that the housing market would collapse, resulted in big paydays for some funds.
The trade seemed likely to pay off four years ago, when Treasury Secretary Steven Mnuchin stated his goal was to move the companies out of government control. But as the months passed, the likelihood declined significantly. Last week, Mr. Mnuchin said it wasn't happening on his watch. The most commonly traded class of Fannie's preferred shares have now fallen more than 40% from mid-November, to near $6. Common shares of Fannie have fallen from $3 at the end of November to $1.87 at Wednesday's close.
"We're back to square one in terms of getting them out of conservatorship," said David Barrosse of Washington, D.C.-based policy-analysis firm Capstone LLC, which counts hedge funds as its clients. "Investors are severely disappointed that more wasn't done before the end of the Trump administration."
The Trump administration's deferral of key decisions narrows investors' paths to victory, though some remain hopeful.
These investors cite the expectation that the Supreme Court will weigh in on legal issues stemming from the government's 2012 decision to channel nearly all of Fannie and Freddie's profits to the Treasury, or of a settlement after a ruling.
Some legal experts said the likelihood of a broadly favorable ruling for shareholders is remote. A ruling to reverse the profit sweep could trigger additional litigation, a Cowen Washington Research Group note said last week.
Greg Dowling, of Cincinnati-based investment consulting firm Fund Evaluation Group, said a Supreme Court victory was plausible but that trades involving politics, regulation and litigation are difficult to navigate.
"For every big short," he said, referencing the subprime trade, "there are thousands of other trades that sound so plausible but just never pan out."
Traders said some hedge funds fatigued by the trade or worried about a negative Supreme Court ruling have been trimming their shares in recent weeks. Still, giant mutual-fund complex Capitol Group Cos. has been a buyer, said people familiar with the firm.
The back-and-forth has gone on so long that it has outlived some of the early players in this trade; Mr. Paulson's firm and Perry Capital have effectively turned into family offices or shut down. Others, like Anchorage and Blackstone Credit, formerly known as GSO Capital Partners, are largely or entirely out of the trade. Both Anchorage and Blackstone Credit, which exited the trade in 2020, have made money on the trade, said people familiar with the matter.
But the length of the investment means that even for funds that made money, their internal rate of return is generally low, investors said.
Perry is likely one of the biggest winners to date, booking at least hundreds of millions of dollars in profit, investors said. Perry, one of the earliest to get involved, began snapping up shares of the companies for pennies on the dollar in 2010.
Fannie and Freddie are central players in the mortgage market, buying mortgages from lenders and packaging them for issuance as securities. The government effectively nationalized them in 2008 in a bid to stabilize the housing market as mortgage defaults mounted.
In return for injecting about $190 billion into the firms, the government created a new class of stock -- senior preferred shares -- that paid an annual 10% dividend, along with warrants to acquire nearly 80% of the firms' common stock.
Political and legal developments have sent Fannie and Freddie shares on a wild ride since hedge funds began buying in after the financial crisis.
The Treasury revamped its bailout agreement in 2012 to require nearly all the firms' profits be swept away to the government as dividend payments on its preferred shares, upending hedge funds' bets. Investors filed suit over the change. Fannie and Freddie have returned about $300 billion to the government. A recapitalization of Fannie and Freddie was viewed as a nonstarter by officials in the Obama administration.
The Trump administration breathed new life into the wager. Mr. Mnuchin, a former Trump-campaign finance director who had run the mortgage-trading desk at Goldman Sachs Group Inc., said overhauling Fannie and Freddie was a priority. Close ties between John Paulson and Mr. Mnuchin, who with Mr. Trump was an investor in Mr. Paulson's hedge funds in 2016, were another reason hedge funds were bullish.
The Trump administration in September 2019 said it would work with federal agencies to shrink the government's role in housing and return the mortgage companies to private hands. Fannie and Freddie along with their regulator, the Federal Housing Finance Agency, hired financial advisers and outside attorneys in 2020 as they sought help on future stock offerings.
Advisers close to President Biden have said he would be in no hurry to privatize the companies, which guarantee roughly half of the $11 trillion U.S. mortgage market.
Write to Juliet Chung at juliet.chung@wsj.com and Andrew Ackerman at andrew.ackerman@wsj.com
(END) Dow Jones Newswires
January 21, 2021 07:00 ET (12:00 GMT)
Copyright (c) 2021 Dow Jones & Company, Inc.
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