Fannie Mae and Freddie Mac seem much more likely to remain operational as governmental regulators have indicated that they have no superior alternative.
The Fannie Mae and Freddie Mac investor lawsuit against the Treasury Department is already strong and seems even more promising as it attracts national attention and rallies prominent lawyers, activist.
Self-learning algorithm has a strong bullish signal for Fannie Mae and Freddie Mac in the 3-month and 1-year time horizon.
Their diminishing risk and huge potential make Fannie Mae and Freddie Mac attractive investments.
Up until a year and half ago it would have been unthinkable to invest in Fannie Mae (OTCMKTS:OTCQB:FNMA) and Freddie Mac(OTCMKTS:OTCQB:FMCC), the two government-sponsored enterprises (GSEs) that were forced into government conservatorship in 2008 after suffering heavy losses from the bursting real estate bubble. The Treasury Department seemed intent on dismantling them and commandeering all their profits for itself, while shareholders seemed to have no promising way to fight back. However, investing in these GSEs has recently become much more attractive as Congress appears more willing to leave the GSEs intact and as a shareholder lawsuit against the government's illegal seizure of assets is gaining steam.
When Fannie Mae's stock rose nearly 200% in March 2013, Steven Davidoff of the New York Times wrote: "When zombie stocks show signs of life, you know you are in trouble" and joked that the only reason to invest in these two worthless companies was in anticipation of the "greater fool." In fact, he made a very strong argument: The Obama administration had declared that it wanted both GSEs wound down, it eliminated shareholder and voting rights, and retained the right to take nearly all their profits indefinitely. Moreover, Fannie Mae's management expressly said, "The future of our company is uncertain" and "instead of being run for the benefit of shareholders, our company is managed in the overall interest of taxpayers, which is consistent with the substantial public investment in us."
However, when Fannie Mae announced in March 2013 that it expected "to report significant net income" for the previous year due to the recovering domestic real estate market, and when it became evident that Congress didn't intend to propose any serious financial reforms for the secondary mortgage market, investors began to take interest. Then in May 2013, when Fannie Mae reported that it would repay the U.S. Treasury $59.4 billion, the GSEs showed even greater promise and their stocks gained billion dollar valuations, leaving penny-stock territory.
In July 2013, the hedge fund, Perry Capital sued the Treasury Department for overstepping its conservator rights when it seized profits it was not legally entitled to. Many other hedge funds and activist investors including Bill Ackman, Bruce Berkowitz, and Carl Icahn have since invested in Fannie Mae and Freddie Mac, presumably demonstrating their shared belief that there is merit in Perry Capital's lawsuit and that there is much unrealized value in the GSEs. Bill Ackman believes that if properly and fairly managed, Fannie Mae should be worth $23 to $47 a share, representing an approximate 10-fold increase from current prices. Of course this tremendous upside depends heavily on a shareholder legal victory against the Treasury Department. Having big name allies such as former Solicitor General Theodore Olson and consumer rights advocate Ralph Nader to advocate for shareholders should increase the lawsuit's chance for success.
Of course there is much risk in investing in Fannie Mae and Freddie Mac as they are currently being operated to maximize government revenue and minimize shareholder value. However, that risk seems to be diminishing given the regulatory impasse in Congress and recent indications from the director of the Federal Housing Finance Committee's (FHFC), Melvin Watt, that he plans to expand Fannie Mae and Freddie Mac, reversing previous efforts to wind them down. If Fannie Mae and Freddie Mac do in fact maintain their past and current importance in the secondary mortgage market and continue to post impressive profits, it will be highly unlikely that the government will be able to get away with depriving shareholders of their stake in the companies. Along those lines, the financial analysis firm, I Know First predicts that the two companies are becoming increasingly attractive investments in the short, medium, and long-term time horizons. Although investing in Fannie Mae and Freddie Mac may have once been precarious, I believe they've become much safer investments now that their futures look more certain.
The Risk
Stockholders of Fannie Mae and Freddie Mac face two major risks: a government decision to wind down the two companies and replace them with an industry-financed agency and a court verdict ruling that the government's seizure of the entirety of the two companies' profits is in fact legal. If the either of these scenarios occur Fannie Mae and Freddie Mac stocks should become nearly worthless. These risks were much greater a year ago when Congressional financial mortgage reform seemed likely and the lawsuit against the Treasury Department had few supporters. However, recently the odds seem to be shifting toward the shareholders' favor as both of these scenarios seem ever less likely.
The Potential Value
Fannie Mae and Freddie Mac have played a crucial role in expanding the available credit for American homebuyers, thus making home ownership more affordable for the middle class. With the implicit guarantee of the U.S. government, these GSEs securitize mortgages in the secondary mortgage market and resell these mortgage-backed securities (MBS) to lenders to increase the liquidity and stability of the American mortgage market. In the four decades of their existence, they have played an increasingly important role in guaranteeing mortgages and their market share has been increasing dramatically even in the wake of the recent real estate crisis.
Fannie Mae and Freddie Mac have lowered American mortgage interest rates by converting illiquid, long-term mortgages into MBSs, thus tapping into the global capital markets for new mortgage funding. In 2010 MBSs still funded nearly 60% of American mortgages, enabling a robust domestic real estate recovery.
In a March 5th presentation at the Ira Sohn Conference, a representative from Bill Ackman's Pershing Square Capital Management hedge fund explained the essential role that the GSEs play in providing Americans access to 30-year, fixed rate mortgages. These loans allow for lower, uniform monthly payments and protect against volatile interest rates, thus facilitating lower and middle-income families to purchase primary homes. Collectively, Fannie Mae and Freddie Mac guarantee approximately $5 trillion worth of high-quality, low-risk mortgages, thereby supporting the American mortgage market. These routine mortgage guarantees carry little risk and are very profitable on a large scale. If it weren't for the unreasonable pressure from the government to guarantee loans to low-income borrowers from companies such as Countywide that were fraudulently "passing off unsatisfactory loans as prime loans," it is likely that Fannie Mae and Freddie Mac would have been able to weather the 2008 downturn in real estate prices. In the wake of the financial crisis, both GSEs have written down their losses on their subprime mortgages and have since returned their guarantee businesses to profitability. In fact their credit losses from their guarantee businesses are reaching record lows and many of their anticipated credit losses from the credit crisis have failed to materialize.
Although both Fannie Mae and Freddie Mac experienced significant losses during the financial crisis, those losses were in fact 58% less than they had originally calculated. The GSEs have also taken steps to wind down their riskier fixed-income arbitrage businesses, insolating them from volatile interest rates. Additionally, the two GSEs have been increasing their profits in new MBSs as the government has forced them to charge higher guarantee-fees to allow other companies to become competitive. This will probably dent their market shares slightly, but their vast size and years of experience will likely ensure that they remain the major players in the industry.
The Current Situation
Congress has been looking for alternatives to replace Fannie Mae and Freddie Mac ever since it put them under conservatorship in 2008, but it hasn't yet been able to approve any meaningful legislation. Although the Senate Banking committee still intends to wind down Fannie Mae and replace it with an industry-financed agency with a last resort government guarantee, its bill has little support among Democrats or Republicans. In response to the Congressional inaction on mortgage finance reform, the GSEs' regulator, the Federal Housing Finance Agency (FHFA), has decided to increase its ability to aid the flagging domestic real estate market. FHFA director Melvin Watt asserted, "I don't think it's the FHFA's role to contract the footprint of Fannie and Freddie" and "our overriding objective is to ensure that there is broad liquidity in the housing-finance market and to do so in a way that is safe and sound." Many liberal nonprofit housing corporations have also advocated for maintaining the GSEs so as to continue facilitating mortgages for low-income housing. Pershing Square has written an extensive report outlining the many flaws of the Senate banking committee's proposal and has recommended various plans to decrease risk and limit taxpayer liability.
If the status quo is maintained, Fannie Mae and Freddie Mac are expected to increase their own profits dramatically while keeping mortgage prices low. They will benefit from higher guaranteeing fees, historically low credit default rates, and the sale of risky assets. They will also continue to benefit from the low borrowing rates they receive due to their implicit government guarantee. Pershing Square estimates that the two GSEs stock prices should increase 6 to 12 times if the companies are properly reformed and capitalized.
The Lawsuit
When it became clear in September 2008 that Fannie Mae and Freddie Mac would sustain huge credit losses from an increased number of mortgage defaults, the government infused them with $188 billion to prevent further chaos in the financial markets. In exchange for the bailout, the Treasury Department received 79.9% of the GSEs' preferred equity and the right to claim 10% dividends. Even though these terms were deemed incredibly strict and arguably unreasonable, the Treasury went even further last August when it issued the "sweep amendment" that allows it to claim all of the GSEs' profits. The hedge fund Perry Capital is teaming up with nonprofit housing organizations and consumer advocates to form Shareholder Respect to defend the rights of shareholders who they believe were misled and cheated by the government. Their lead lawyer is former Solicitor General Theodore Olson and their chief organizer is the consumer rights advocate, Ralph Nader.
The plaintiffs argue that the government has been overreaching its legal rights as a "debt collector" and warn that if the government were allowed to essentially nationalize the GSEs, it would set a chilling precedent for future property seizures. Not only should the government be responsible for adhering to the Fair Debt Collection Practices Act, the Housing and Economic Recovery Act, and the Fifth Amendment to the Constitution, but it should also be held accountable for misleading shareholders. The government put the GSEs under conservatorship to "preserve and conserve the assets and property;" however, an internal memo from 2010 demonstrates that the government's intention was to "ensure existing common equity holders will not have access to any positive earnings from the G.S.E.'s in the future." This is a blatant example of corporate governance misleading its shareholders and keeping them hopeful that they may be entitled to future profits even when it had no intention of ever sharing those profits.
According to Olson, it has become "the official position of the government to deprive shareholders of all gains," essentially legalizing governmental theft of private assets. He argues that the government not only violated many of the original stipulation of conservatorship, but has also issued many illegal addendums afterwards including the controversial "sweep amendment." Additionally, the government has already recouped more than its initial investment as it has already taken $213.1 billion in dividends. Even if it does own 79.9% of the preferred stock, it should still be obligated to compensate the other shareholders fairly.
The Algorithm
I Know First is a financial startup that provides daily investment foresight based on an advanced self-learning algorithm. The financial algorithm, which is based on artificial intelligence and machine learning, analyzes the structure and trends of the market, finds predicable patterns, and recommends trades based upon its machine-derived forecasts. The chart below shows the bullish algorithmic predictions for Fannie Mae and Freddie Mac in the short, medium, and long-term time horizons, as indicated by the dark green hues. The positive number in the middle of the box labeled FNMA/FMCC is the stock's signal that represents the direction and magnitude the algorithm believes the stock will move. The decimal number on the bottom of that box is the stock's predictability quotient, a relative indicator of how likely the stock will move in the predicted direction. When analyzing a stock's signal and predictability it is important to compare its present signal and predictability to its own historical signals and predictabilities and then track their daily changes.
(click to enlarge)
Conclusion
Fannie Mae and Freddie Mac have become much more attractive investments in the past year. There is no longer enough support in Congress to dismantle them as there are currently no practical alternatives and the FHFC has actually indicated that it wants to expand their role in sustaining the mortgage market. Additionally, the stockholder lawsuit seems to be gaining momentum and broader support as the full extent of the government's misuse of power comes to light. Although Fannie Mae and Freddie Mac remain relatively risky investments, their potential upside is huge and the chances of investors realizing these gains seem ever more likely. I believe the expected value of investing in the GSEs is strongly positive as the potential benefits multiplied by the chance of realizing those benefits outweighs the potential losses multiplied by the chance of realizing those losses. This, I think, makes investing in Fannie Mae and Freddie Mac a risk worth taking.
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