Hedge Funds Wagering on Fannie Reincarnation: Mortgages
Investors including hedge funds are buying the preferred stock of government-controlled mortgage firms Fannie Mae and Freddie Mac in a long-shot bet they will have a future as private companies.
Fannie Mae (FNMA)’s 8.25 percent of preferred shares have more than doubled this year after the company reported record earnings. Some investors see the odds rising the two loan guarantors may somehow return to private ownership without cutting out existing investors, according to Bose George, an analyst at Keefe Bruyette & Woods in New York. The securities have a par value of $25, meaning investors could recoup more than five times the current price of $4.26.
“The idea is eventually, as these companies have paid back their debt to the government, they could potentially be turned back on,” George said. “From our perspective, you can only make an argument for this if you think the government’s going to change the rules somehow to benefit the preferred shareholders.”
The gains come after the U.S. Treasury Department changed the terms of the enterprises’ bailout last year to force them to turn over profits to the government. The agreement provides no mechanism for them to repay the $187.5 billion they owe the government from their 2008 bailout, a prerequisite to a change in their status.
Jim Millstein, the U.S. Treasury Department’s former chief restructuring officer, who’s been putting forward a plan to privatize Fannie Mae and Freddie Mac, said his firm Millstein & Co. has been receiving more calls about the overhaul from investment managers and policy groups in the past month after the mortgage companies reported improved earnings and a Senate proposal limiting outside use of their increased income.
“It’s premised on a turnaround in Fannie and Freddie’s results and a financial restructuring that enables” them to fully pay back the government, Millstein said. “That now looks like less of a long shot after record earnings at Fannie Mae,” said Millstein, who owns preferred shares in the firms.
“The real question is whether policy makers will use the opportunity of these improved results to restructure Fannie and Freddie, reform the government’s role as a guarantor of housing finance and end the conservatorships,” he said. “Our plan is at least one way to get that done without wrecking the recovery underway in the housing market.”
The recent jump in the preferred shares is a long overdue boost for some investors who first started dabbling in the investment several years ago. Kyle Bass, whose Dallas-based hedge fund Hayman Advisors LP made $500 million in 2007 betting against U.S. subprime mortgages, said at a conference in Las Vegas in May 2011 that buying the preferred shares “could be an eight to 10-bagger from here.” At the time, the securities were trading at $2.40. A little more than a year later he told website TheStreet.com that he’d exited the trade because Republicans and Democrats wanted to kill Fannie Mae and Freddie Mac. Bass didn’t return calls for comment.
Jeffrey Bernardo, chief executive officer of Augustine Asset Management, said his firm started buying Fannie Mae preferred securities a few years ago, when they were trading for less than a dollar and were priced like an option.
“The turn in the housing market has helped Fannie generate profits again,” said Bernardo, whose Jacksonville, Florida- based firm oversees $275 million. “One might think there is a future profit stream.”
Washington-based Fannie Mae and McLean, Virginia-based Freddie Mac buy mortgages from lenders and package them into securities on which they guarantee payments of principal and interest. Since they were taken into conservatorship in 2008, the two companies have drawn $187.5 billion from Treasury and have sent back $65.2 billion in dividends, which count as a return on the government’s investment and not as a repayment.
A group of lawmakers including Massachusetts Democrat Elizabeth Warren, and Senator David Vitter, a Louisiana Republican, on March 14 introduced a bill that would ensure Fannie Mae and Freddie Mac couldn’t emerge from government control even if they end up paying more to the Treasury than they took in aid. The measure would ban sales of senior-ranking U.S. Treasury-owned preferred shares without Congressional approval and includes a provision blocking the use of fee increases at the enterprises to fund other government spending, moves some investors view as protecting the preferred shares.
The securities jumped last week after Fannie Mae said April 2 it had net income of $17.2 billion for 2012, compared with a loss of $16.9 billion in 2011. Freddie Mac reported in February that it earned $11 billion in 2012, compared with a loss of $5.3 billion in 2011. They fell 1.2 percent as of 3:59 p.m. in New York to $4.26. They’re up from $1.67 since the end of 2012.
Holders of Fannie Mae’s common stock, who would be last in line to recover money in a bankruptcy or so-called receivership, have seen the shares more than triple this year to 90 cents, giving the company a market capitalization of about $5 billion, according to data compiled by Bloomberg. Freddie Mac shares have more than tripled to 86 cents since December.
“On the common stock side, I think it’s a total casino,” George said. “It’s not very rational.”
Before any privatization, the companies would need to raise “a great deal” of capital along with repaying the government, Ralph Axel, a Bank of America Corp. analyst, wrote in a March 15 report. New shares would dilute existing holders and the Treasury sweeps of their profits will keep their net worth at no more than $3 billion, a figure that will fall to zero over time. Fannie Mae said in its annual report it owns or guarantees $3.1 trillion of debt.
Regulators who took Fannie Mae and Freddie Mac into conservatorship in 2008 didn’t create an avenue for them to regain independence. President Barack Obama and Democrats and Republicans in Congress have pledged to wind down and replace the two companies instead.
About half of small and regional banks who held Fannie Mae and Freddie Mac preferred shares when they were taken into conservatorships still own them, said Paul Merski, chief economist at the Independent Community Bankers of America. More than 600 U.S. depository institutions suffered at least $8 billion of investment losses, after the lenders ended up as large holders in the stock because of its favorable regulatory treatment, according to a paper last year by Federal Reserve researchers.
Their advocacy for the assets to retain value in any restructuring of the U.S. mortgage-finance system may help hedge funds in Washington. “The community banks have good standing and reputation with policy makers,” Merski said. “They didn’t contribute to the financial meltdown.”
Ed Mills, an analyst at FBR Capital Markets said there’s “zero support” among politicians to have the government- sponsored enterprises come back to life and that the firms’ profitability will face further challenges as they’re forced to shrink. Investors have still been calling him more often about the trade over the past few weeks.
“There’s a lot of momentum behind this,” said Mills, adding he’s spent about 20 hours on the phone discussing it. “Ultimately, as GSE reform is completed, in that bill, the chance that nothing is given to the shareholders is high.”
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