Fannie Mae (NASDAQOTCBB:FNMA) and Freddie Mac (NASDAQOTCBB:FMCC) experienced an incredible run in 2013 -- and a hedge fund known for its success has voted with its dollars that the streak will continue into 2014 and beyond.
This month, Fairholme Funds, managed by noted investor Bruce Berkowitz, officially disclosed $1.3 billion worth of both common and preferred stock in the two government-sponsored entities. Berkowitz had made the position public, but the fund's 13F SEC filing made it official.
This massive position is notable for a number of reasons, one being that Fairholme invests in very few companies.
The Miami-based fund has a $4 billion investment in common stock of insurer AIG (NYSE:AIG) and another $500 million in warrants for AIG, which will allow holders to buy the stock at $45 per share anytime until January 2021. So the investment in AIG could one day be even larger. In addition to the AIG position totaling more than 45% of the portfolio, Fairholme also has a $1.6 billion holding of Bank of America (NYSE: BAC), and another $60 million in warrants of B of A stock.
In total, Fairholme has more than three-quarters of its $9.7 billion tied up in the stock of these four companies. While many have proclaimed AIG and Bank of America to be great investment considerations, questions about Fannie and Freddie have caused many to back away from those stocks.
In November, Fairholme proposed the establishment of two new private companies that would supplant Fannie Mae and Freddie Mac to "purchase, recapitalize, and operate the insurance businesses," causing the government-sponsored entities to ultimately be liquidated.
The proposal called for the new companies to be capitalized to the tune of $52 billion, of which almost $35 billion would be provided through the conversion of existing preferred shares of Fannie and Freddie into the new entities; the remainder would be raised through a new rights offering, available to those same preferred stakeholders.
"This proposal answers the broad bipartisan call for private capital in a way that can advance reform from concept to a viable, sustainable solution," noted Berkowitz of the proposal. "Fannie and Freddie's business model was not consistent with insurance industry best practices. However, in this country we fix valuable businesses by restructuring; we do not simply throw them away."
There is no denying Fannie and Freddie have wildly profitable business models. Fannie Mae reported a staggering net income of $84 billion for 2013. However, Fannie Mae plainly notes it is "no longer managed with a strategy to maximize shareholder returns," and as a result, the net income available to common stockholders wasn't income at all, but instead a loss of $1.4 billion.
The bottom line
Berkowitz and Fairholme are known for the outsized success of their investments in AIG and Bank of America, which were added to the portfolio during the heart of the financial crisis and have since delivered outstanding returns. However, Fannie and Freddie are distinctly different situations, as while all four received government bailouts and watched their stocks get beaten down as a result, neither AIG nor Bank of America was placed into government conservatorship and run exclusively for the benefit of taxpayers.
Fairholme said it "is prepared to do its part to help effectuate this restructuring and to be long-term owners of the insurance businesses, without the need for any Federal assistance or special Federal status," but Congress and the president seem more interested in providing federal assistance to shutter the operations of Fannie and Freddie with disregard to common stockholders.
While almost 90% of the $1.3 billion position Fairholme has in the two organizations is in preferred shares of Fannie and Freddie, one has to believe Berkowitz hopes the government will take into account his proposal, and not disregard the preferred shareholders as it has already done to the common shareholders.
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Patrick Morris owns shares of American International Group and Bank of America. The Motley Fool recommends American International Group and Bank of America. The Motley Fool owns shares of American International Group and Bank of America and has the following options: long January 2016 $30 calls on American International Group. Try any of our Foolish newsletter services free for 30 days.