Fannie Mae and the Hedge-Fund Bet
For years, the White House and many lawmakers have been saying the government needs to put Fannie Mae and Freddie Mac out of their misery. Yet they live on. And now their stock charts look like electrocardiograms.
Both companies’ common shares are up more than sevenfold this year, in yet another sign the capital markets have gone haywire. Sure, the outlook for the government-backed mortgage financiers has been improving: Each reported billions of dollars of earnings last quarter. But the beneficiary should be the government, not the owners of the publicly traded shares, which by all rights should be worthless.
By failing to wind down Fannie and Freddie, President Barack Obama’s administration and Congress have allowed the perception to fester that someday there might be a chance, however unlikely or undeserved, that the government may do something to compensate holders of the companies’ common and junior preferred stock. In effect, the shares have taken on characteristics of long-dated options.
With a simple stock option, the longer its life span, the more value it has. Even if the underlying stock is almost worthless now, some development that is unforeseeable today might come along and change that. The more time a person has to exercise the option, the greater the chances are that such an event will arise before the option expires.
The government put Fannie and Freddie into conservatorship almost five years ago, and deferred the hard work of creating a new, viable housing-finance market. Now the act of keeping them alive for so long has created a sense of entitlement among shareholders who are demanding to be treated as nicely as those who were bailed out at American International Group Inc.
Ask yourself this: Under normal circumstances, would you buy stock in a financial institution that told you its assets were worth about $177 billion less than its liabilities? That number comes from Fannie’s own disclosures. Each quarter, Fannie and Freddie publish fair-value balance sheets that show estimates for what their assets and liabilities are worth on the open market, as well as a breakdown of how much is attributable to each class of equity holders.
In Fannie’s case, the net assets attributable to the government, which holds senior preferred shares, were $117.1 billion as of March 31. As for common shareholders, Fannie had a $176.7 billion deficit. Yet at $1.99 a share, Fannie has an $11.5 billion stock-market value. Speculation springs eternal.
Freddie’s fair-value disclosures show similarly lopsided figures. Equity attributable to the government was $72.3 billion as of March 31. For common shareholders, the company had a $124.5 billion deficit. Nonetheless, the company’s stock-market value is $6.1 billion, or $1.89 a share. Forget trying to pick promising companies with great businesses. The government, by its inaction, is encouraging the public to take a flyer on Fannie and Freddie.
Some investors hope Congress will write new laws that create long-term value for stockholders. This is understandable. The bailouts of 2008 and 2009 showed that crony capitalism is a great way to make money if you can get in on the action. Buying Fannie or Freddie shares is a bet that some well-connected hedge funds and other moneyed interests can persuade the government to do their bidding, never mind whether it serves the public good.
This week, Bruce Berkowitz’s Fairholme Capital Management LLC issued a news release that said it owned junior preferred shares of Fannie and Freddie with a $2.4 billion face value, and that it is “ready to help with a restructuring.” Presumably the plan entails making as much money for Berkowitz as possible. Paulson & Co., the hedge fund run by billionaire John Paulson, also has been lobbying for a privatization of Fannie and Freddie to boost the value of preferred shares it bought. If they can profit from an act of Congress, it boosts the odds that lower-ranking common shareholders might benefit, too.
Maybe it’s starting to dawn on the markets that such an outcome would infuriate many Americans, in which case Congress might choose not to cooperate. The companies’ common shares have lost about half their value since peaking last week. Much of the decline came after Bloomberg News reported that two senators were drafting a bill under which Fannie and Freddie would be placed into receivership and liquidated.
There would be a chance, although only a remote one, that public shareholders could see some money flow their way under the legislation being written by Tennessee Republican Bob Corker and Virginia Democrat Mark Warner. Proceeds from the liquidation would be paid first to the government, then to junior preferred owners if there’s anything left and last to common shareholders. Whatever the case, the decision of how to divide the proceeds would be up to the Treasury secretary and a new federal agency that would replace Fannie and Freddie.
Here’s a fair approach: The junior preferred and common shares should be wiped out. They would be worthless already were it not for taxpayers’ money. There was never an implicit government guarantee for them, only the companies’ bonds. The investors who bought the shares knew the risks. Let them crash. It’s the right thing to do.
(Jonathan Weil is a Bloomberg View columnist.)
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