Many remember Freddy Mac (FMCC) and Fannie Mae (FNMA) being at the center of the housing bubble from 2001-2007 and its inevitable burst in 2008. How did the bubble become so large? And what has happened to Freddie Mac and Fannie Mae?
It is important to first look at the background of Freddie Mac and Fannie Mae. Fannie Mae was established by an amendment to the National Housing Act (part of Roosevelts New Deal) as a government agency whose purpose was to act as a secondary market facility that could purchase and hold FHA secured mortgages. In 1968, Fannie Mae was converted by the U.S. Congress into a government-sponsored enterprise (GSE) and two years later Congress took similar action on Freddie Mac. Again, the purpose was to create a secondary market for mortgages, giving banks and mortgage companies the opportunity to sell originated mortgages shortly after the origination. Fannie Mae was also structured as a for-profit corporation in 1968 and Freddie Mac was left under government ownership.
During the 1970’s, high inflation and skyrocketing interest rates pushed hundreds of banks and Savings & Loans (S&L) into disintermediation (the mortgages they held had fixed interest rates and their deposit rates were forced higher, creating significant losses). The Federal Government was forced to provide significant financial assistance to Fannie Mae. Fannie Mae was stressed, but recovered with government help.
This all seemed to work pretty well until the S&L’s Crisis in 1989. Essentially, this crisis, which was precipitated by the 1986 changes in the tax laws, bankrupt the Saving & Loan industry. The primary impact was on commercial properties, most pointedly on multi-family housing where Freddie Mac was most exposed. When Congress reformed the S&L industry, folding it into the national banking platform, Freddie Mac was at the same time restructured into a for-profit corporation owned by the private sector.
So, by the time we enter the housing inflation (1991-2007), both Fannie Mae and Freddie Mac were publicly traded companies. And, since 1970, both had been authorized to purchase and hold non-federally insured mortgages including Alt-A and subprime mortgages. Freddie Mac had issued the first conventional Mortgage Back Security (MBS) in 1971.
To support a flagging economy weakened by the “tech-wreck” of 2000, both Freddie Mac and Fannie Mae were prompted by the Bush Government and Congress to embark on an aggressive strategy of purchasing mortgages with higher loan to value and debt to income ratios and/or limited documentation on the borrower’s income (Alt-A Mortgages). As the mid 2000’s came along, both GSE’s had begun to purchase private label MBS’s that were collateralized with subprime mortgages, which they were forced to offer by politicians. And the U.S. government facilitated the packaging and resale of mortgages that should not have been originated in the first place. As we all know, this would lead to an extreme increase in delinquencies and defaults, an increase large enough to collapse the entire housing market.
On September 6, 2008, both Fannie Mae and Freddie Mac were place into a conservatorship by the U.S. Government to facilitate the Government’s ability to support the companies and maintain the functionality of the U.S. housing market. The U.S. Government has invested $189.5 billion in this process. The U.S. Government sought to recover its investment by retaining any profits from the ongoing operations of the firms, which today remain under the conservatorship.
The US Treasury received $189.5 billion of special 10% preferred stock through which it was to recover its investment. In August of 2012, without any legislative action and without a shareholder vote, the U.S. Treasury changed the terms of the preferred stock requiring Fannie Mae and Freddie Mac to pay all of their profits to the Treasury in perpetuity. This would insure that neither would ever emerge from the conservatorship. And, therefore the common stock outstanding would become worthless, UNLESS THE COURTS DETERMINE OTHERWISE, OR THE TREASURY RECINDS ITS POSITION.
In August of 2012, class action litigation was launched on behalf of the common shareholders. This litigation has not come to fruition, and it has not yet been determined that the Treasury acted within its powers under the bailout legislation. Bear in mind, the defendant is the U.S. Treasury and there is a new Treasury Secretary…enter Steven Mnuchin.
The lawsuit challenges the Treasury’s right to continue to receive the profits of Fannie and Freddie. So, far the Treasury has received $256 billion according the public interest group Pro Publica.
In 2016, Fannie earned $12.3 billion and Freddie earned $7.8 billion, all of which is going to the Treasury. Why should the Treasury change its posture? The Treasury, in fact, owns options at a nominal cost on 79.9% of the equity of Fannie and 79.9% of Freddie.
In order to come up with a valuation post-preferred payment (assuming none of the $256 billion already paid is applied to principal), and the outstanding preferred stock would have to be paid off with debt at 6%, the earnings of the combined entities would be reduced by $11.4 billion Dollars in interest costs. The new combined earnings would be $8.7 billion. Applying a market PE ratio would give them a combined market value of $182 billion. If the Treasury exercises its warrants, the public would be left with $37 billion between the two entities. Dividing that by 1.85 billion shares outstanding between the two entities, one gets a share price of $20.
These are very very crude calculations!! Even if we are off by 50%, the stocks are still cheap at about $2.60 each! But what are the odds the Treasury will release the conservatorship?
The key party in this drama is Steven Mnuchin. And one must read between the lines in order to anticipate his response to the situation. First of all, before he was considered for Secretary of the Treasury, he was an investor in John Paulsen’s Hedge Fund, which publicly disclosed long positions in both FNMA and FMCC. He did, however, liquidate his holdings after being nominated for Treasury.
While being interviewed during the confirmation process, he was vague about the future of the conservatorship, yet prior to his confirmation he appeared on Fox Business and was unequivocal in his pronouncement that the entities 1) should be out from under government control, 2) that they never should have been there as long as they have been, 3) while under government control, they have displaced the private sector in mortgage lending, and 4) they will not be recapitalized and released until they are safe. The link below will take you to that interview.
We find it hard to see a scenario where they will be released prior to legislative action on Dodd Frank, which would be set to 1) free up the financial entities and 2) correct the problems which brought on the 2008 crisis…with an eye toward prior crisis as well and provisions to mitigate the risk in the too big to fail institutions. One prospect would be that the entities would be broken up as part of the release to open the door to private competition and lessen the dominance that FNMA and FMCC currently enjoy.
In a situation such as this, we think it highly unlikely that the entities will be liquidated and extremely unlikely that they will remain perpetual wards of the state.
If you choose to follow us in this transaction, bear in mind, you could lose all of your investment, so we would recommend a very small allocation to your portfolio. Treating them like long term options seems justifiable.
This is not a recommendation to buy the stock just to point out that there may be a good opportunity for suitable investors. And, certainly one could lose money should they invest. There are no guarantees. Also, we need to disclose that many of our clients own these stocks as do our employees and members of our family.