The Light Is Near For Fannie Mae And Freddie Mac
Jan. 23, 2017 12:03 PM ET| Anthony Bonsignore
..... Summary .....
-- There is no alternative to Fannie Mae and Freddie Mac and ultimately the original conservatorship bargain will be upheld.
-- The net worth sweep is highly favorable to end in 2017 to prevent the risk of an avoidable draw of taxpayer funds that could occur starting in 2018.
-- Fannie Mae and Freddie Mac with a focus on their core business represent the perfect foundation for a new housing policy.
-- A reform, recap and release is a win for everyone. The government can reap hundreds of billions in proceeds for taxpayers, housing would be stronger and shareholders would be compensated.
Multi-bagger upside potential from current prices in both common and preferred shares.[/color]
Executive Summary
Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC), two of the most important companies in the United States are not only the best investment idea for 2017, they are the most important economic situation facing every single person in America. Fannie Mae and Freddie Mac effectively control the availability of financing for homeownership in America and since housing equates to roughly 20% of GDP it is one of the most important parts of the economy.
In September of 2008, the U.S. Treasury with the Federal Housing Finance Agency (FHFA) placed Fannie Mae and Freddie Mac into conservatorship "in response to a substantial deterioration in the housing markets that severely damaged Fannie Mae and Freddie Mac's financial condition and left them unable to fulfill their mission without government intervention." Essentially the motive for conservtorship was a "bailout". Hank Paulson (the Secretary of Treasury at the time) and Jim Lockhart (the director of FHFA) both made it very clear that conservatorship was a temporary situation. The companies would be returned to shareholder control when the markets stabilized and profitability returned for both entities.
From 2008 to 2012 Fannie Mae and Freddie Mac would borrow 187 billion from Treasury; however by the end of 2014 they had repaid every cent of the 187 billion. Today both companies remain under conservatorship. The Treasury Department is currently funneling all profits from the companies into their general fund to help pay down the governments debt. To date, the companies have paid a combined 247 billion dollars to the U.S. Government; 60 billion more than what was originally borrowed. What was suppose to be a temporary situation to ensure the continued operations of these two enterprises has turned into the nationalization of the secondary mortgage market and two privately shareholder owned fortune 100 companies. At the same time the government has put taxpayers and mortgage lending liquidity at more risk than ever before.
Thanks to the incoming presidential administration Fannie Mae and Freddie Mac investors may finally be made whole. The new Secretary of Treasury appointee Steve Mnuchin has already came out publicly for supporting Fannie and Freddie and removing them from government control. As a result the upside is huge from today's current prices and becomes more and more favorable with each passing day.
Beginnings
In 1938 President Roosevelt and Congress created the government sponsored enterprise (G.S.E.) Fannie Mae as part of the New Deal. Fannie Mae was created to purchase mortgages from banks which in turn would allow banks to free up capital and increase borrowing and growth. In 1968, it was completely privatized as a 100% publicly traded shareholder owned company under Delaware law. During the 1970s, Freddie Mac was developed with the same mission as competition for Fannie Mae. In 1989 Freddie Mac became a 100% publicly traded shareholder owned company as well. Over time both entities grew and became extremely profitable with tremendous value to the housing industry. In simple terms the GSEs buy 30-year pre-payable fixed rate mortgages from banks, securitize them, and sell them to investors. Essentially their role in the secondary mortgage market is the ability to convert long term, illiquid mortgages (the 30yr mortgages they bought from banks) into highly liquid "Mortgage Backed Securities" (MBS). The key part of Fannie and Freddie's business is they provide insurance on the credit risk of the underlying mortgages. This is what separates Fannie and Freddie from any other privately owned company in the secondary mortgage market, the ability to provide credit insurance on the timely payment and interest to investors.
Conservatorship
In July of 2008, the government though HERA (Housing and Economic Recovery Act) created the Federal Housing Finance Agency (FHFA) to help supervise banks and regulated entities. FHFA would also become the new policy maker for Fannie and Freddie. As the summer progressed economic and financial conditions were deteriorating and the housing crash was beginning to take shape. On September 7th, 2008 FHFA assumed total control over Fannie Mae and Freddie Mac and their business operations. The boards and managements were fired. FHFA director Jim Lockhart stated conservatorship was designed to stabilize the institutions with an objective of returning them to normal business operations. With the two companies under conservatorship FHFA "is authorized to take such action as may be: necessary to put the regulated entity in a sound and solvent condition; and (ii) appropriate to carry on the business of the regulated entity and preserve and conserve the assets and property of the regulated entity." Plainly speaking, conservatorship was designed to stabilize the enterprise, preserve and conserve the assets and return them to shareholders.
The terms for conservatorship were as follows; Fannie and Freddie would grant Treasury senior preferred stock with a 10% cash dividend or a 12% paid-in-kind rate for all taxpayer funds and would receive warrants for 79.9% of the outstanding common stock of each company with an exercise price of .00001 per share. Both companies would be forced to draw taxpayer funds by the use of an accounting measure known as "Net Assets". (more on that shortly)
By 2012 both companies borrowed a combined 187 billion in taxpayer money. As the halfway point of 2012 rolled around Fannie Mae through the first two quarters produced 8 billion in net income and Freddie Mac 4 billion. Both companies had been paying the 10% cash dividend as Treasury required. On August 9th, 2012, Fannie Mae CFO Susan McFarland had a meeting with multiple Treasury officials regarding the financial outlook of Fannie Mae. She stated to Treasury officials "the company was, in fact now in sustainable profitability, that we would be able to deliver sustainable profits over time." At the same time the housing industry was stable and recovering providing a favorable market place for the two enterprises. All the factors were now a reality for Fannie and Freddie to begin building capital and return them to private sector like the Treasury Department and FHFA said would happen. Instead, eight days later after that meeting with the CFO, on August 17th, 2012, Treasury amended the original deal with Fannie and Freddie regarding the dividend payment. Treasury revised the deal with FHFA and demanded the entire net worth from both companies be swept into the Treasury's general fund after every quarter starting on January 1st, 2013. "Net worth" refers to the difference between assets and liabilities and refers to all profits the companies would make going further (equity). The stated reason for the amendment was Treasury did not feel the companies were going to be able to afford the 10% cash dividend and "were in a death spiral and taxpayers needed protection from future losses." Don't forget, the companies could have paid-in-kind at 12%, but apparently Treasury decided that wasn't good either.
To recap: Treasury had a meeting with Fannie Mae's CFO who directly told them of sustained future profitability and a week later Treasury claimed Fannie and Freddie were in a "death spiral", were not going to be able to afford the 10% cash dividend anymore and to protect taxpayers from future losses were going to take all the profits even though they didn't think there would be any. Weird huh? What happened next, wasn't completely surprising. The first quarter of 2013 Fannie Mae posted record profits of 59 billion in net income and would post a total of 84 billion of profit in 2013. Eighty-four billion dollars of profit in one year. Freddie Mac would post a total of 50 billion in profit for 2013. All of it would go straight to the government to help pay down the debt ceiling. See figure 1 below for more detail.
Figure 1
How could Fannie and Freddie produce such enormous profits, especially at a time when the government publicly claimed the companies were in a death spiral? When Treasury and FHFA took over the companies, between 2008 and 2011 they wrote down hundreds of billions in non-cash losses and reserve assumptions which forced Fannie and Freddie to draw taxpayer funding. Since "net assets" was the trigger, the write down of billions in non-cash losses and reserves forced net assets to become negative thus requiring the companies to draw taxpayer money even though they were unrealized and did not affect cash. Such non-cash losses include deferred tax assets and loan loss reserves. Between 2007 and 2011 Fannie and Freddie were forced to write down 244 billion in total net losses, however, only 102 billion would end up being realized losses. FHFA and Treasury not only overbooked losses, but they overstated by more than 50%. The majority of the 102 billion in losses came from guarantees on subprime and alt-a loans as well as a side business both companies were involved in, known as fixed income arbitrage. This business invovled the "GSEs issuing government subsidized debt to finance the purchase of mortgage assets and earn a profit from the small spread between the yield on their long-term assets and shorter-term debt." This was a business the GSEs first developed in the mid-1990s on their own that served no viable purpose to housing. It was simply a way for Fannie and Freddie to provide another source of income. Since conservatorship they have been in the process of winding down this part of their business and focusing primarily on their guarantee business; which involves very little risk and is essential to the affordability and availability of the 30-year-pre-payable fixed rate mortgage.
So what happened with the 142 billion in non-cash losses that were never realized and overbooked thanks to the tricky accounting and reserve assumptions of FHFA and Treasury? After Treasury implemented the net worth sweep FHFA decided to recognize and reverse tens of billions of the deferred tax assets and loan loss reserves that were written off and overbooked allowing huge amounts of profits (84 billion for Fannie in 2013, 50 billion for Freddie in 2013) to funnel into the government and keep the companies from building up capital. This is the most illegal act ever committed by the U.S. government. The government can not take 100% of the profits forever from a private corporation and there is no way this will stand from a legal perspective. They effectively nationalized two fortune 100 companies without any just compensation for shareholders and stole the profits that should have stayed within the company. Such profits would have bought value back to the outstanding preferred shares held by the private sector. What is interesting to note is this announcement of the net worth sweep happened right around the debt ceiling crisis; which is by no means a coincidence. Tens of lawsuits have been filed by shareholders against this action and the legal process is years into adjudication.
2017
Why is all this important and how does it relate to making Fannie Mae and Freddie Mac the best investment idea for 2017? With over 5 trillion dollars in outstanding mortgages between the two enterprises (roughly 50% of the total mortgage debt market) Fannie and Freddie have become the biggest and most important players in the mortgage industry. The core Fannie and Freddie system has worked for over 70 years. American citizens can enter into an affordable mortgage loan with reasonable rates and have the ability to refinance if interest rates were to decline. Banks are able to free up capital by selling those mortgages to Fannie and Freddie and in return make more mortgages. Fannie and Freddie take those mortgages, package them into MBS and sell them to investors around the world with credit insurance. Owning a home and having the ability to pay it down over a period of time at a low rate while improving your equity with each payment provides for the majority net worth of the middle class. (See figure 2)
Figure 2
Without Fannie and Freddie there is no low rate 30 year pre-payable fixed rate mortgage that accounts for more than 90% of the mortgages in America.(See figure 3)
Figure 3
What has actually happened since the start of conservatorship and the net worth sweep has been nothing but multiple attempts to reform (eliminate) both companies. A complete and direct opposite result of what conservatorship was supposed to be. One recently discussed in the middle of 2016 by politicians was to:
wind down Fannie Mae and Freddie Mac and replace them with a government-owned company dubbed the National Mortgage Reinsurance Corporation
The authors of this new proposal want to eliminate both companies and transfer all their assets into a single new corporation. On top of that, it would require private investors to sink over 100 billion dollars to provide capital for the new corporation. Currently the S&P 500 has roughly 40 companies with a market cap larger then 100 billion... Such companies include MasterCard (118B) and 3M (107B). So the plan from these politicians is to create the market cap of MasterCard or 3M overnight from private investors to supply capital for the new entity. First off, the conservatorship was not designed to eliminate both companies, and if the government chooses to do so the 5th amendment states:
Nor shall private property be taken for public use, without just compensation
Not one shareholder has been compensated. Second, no one in their right mind would invest a single dollar into a new government sponsored Fannie or Freddie when the last shareholders got taken to the woodshed and lost everything.
There are two main factors that make Fannie and Freddie have enormous upside for 2017. One is when Treasury implemented the net worth sweep they allowed 3 billion of capital to remain in each company starting January 1st, 2013 as a cushion. But the cushion would decrease to 0 by the start of 2018. Meaning, when Fannie and Freddie report Q1 earnings in 2018 they will have literally zero capital and if there is a loss, a draw will be forced against taxpayer funds thanks to the irresponsible actions taken by Treasury. The possibility of this occurring makes the implementation of the net worth sweep more than likely to be amended in 2017 to avoid an unnecessary draw of taxpayer money that could have been easily avoided.
The second is with Donald Trump's incoming administration taking control, his Secretary of Treasury appointee Steve Mnuchin has already addressed the Fannie and Freddie situation. He had this to say on Fox News in November:
We've got to get Fannie and Freddie out of government ownership. It makes no sense that these are owned by the government and have been controlled by the government for as long as they have in many cases this displaces private lending in the mortgage markets and we need these entities that will be safe. So let me just be clear- we"ll make sure that when they're restructured they're absolutely safe and they don't get taken over again. But we gotta get them out of government control.
As you can see the future Secretary of Treasury appears to have concluded what must be done with Fannie and Freddie and it's a very favorable comment for GSE investors. When one looks at the core business of the two enterprises, what they were originally set up to do; to buy qualified, prime first lien single family mortgages from banks, package and sell MBS to investors and guarantee the timely payment and interest, it's a proven successful low-risk business model. Fannie and Freddie have been winding down their riskier fixed income business while under conservatorship which serves no vital purpose to housing. The best and only reasonable outcome will be to reform and regulate Fannie and Freddie like utility companies with a focus on their guarantee business. With that, Fannie and Freddie present an excellent foundation for a new and stronger housing policy.
When the companies begin the process of being recapitalized and released from government control it will bring par value back to the preferred shares providing multiple 100% plus gains from current prices. The upside is tremendous. Such shares include but are not limited to FNMAS, FMCKJ, FMCKP, FMCKO, FNMFN, FMCCT, FMCCH, FNMFO, FMCKI, FMCCS, FMCCP, FMCCK, FNMAJ, FNMAM, FNMAH. For example, FMCKP currently trades at $12.00 but has a par value of $50. The common shares will also receive multiple 100% plus gains as well. Since the government owns warrants for 79.9% of the common stock in each company at an exercise price of 0.00001 they could obtain hundreds of billions in profits for taxpayers from selling their stake. Hedge-fund titan Bill Ackman estimates a reasonable value per common share of $23-$47. Well above the $3.78 where Fannie Mae's current common stock stands at, as well as Freddie Mac's current common stock price at $3.63. With this scenario everyone can benefit and win. The government upholds the original bargain made with shareholders. They reverse the illegal net worth sweep, begin recapping the entities and then reform them to be built like utilities with lots of cash on hand. The government then sells their stake over time bringing hundreds of billions in proceeds for taxpayers and at the same time shareholders are made whole from the agreements in 2008. This is the only logical scenario and will begin happening in 2017 under the Trump Administration with Secretary of Treasury appointee Steve Mnuchin at the helm. Preserve Fannie and Freddie and the original deal, preserve the 30-year pre-payable fixed rate mortgage and preserve housing.
Disclosure: I am/we are long FNMA, FMCC, FNMAS, FMCKP, FMCKJ, FNMAT.
