This Billionaire's Case For Saving Fannie Mae and Freddie Mac

Why is Ackman's Pershing Square Capital investing in companies that the government is tearing apart?

Jun 14, 2014 at 1:00PM

Flickr / insider_monkey.

After researching a recent article I wrote on the aftermath of the financial crisis, I decided to dig deeper into the story that Bill Ackman (rockstar hedge fund manager, CEO of Pershing Square Capital, and on-again/off-again arch-nemesis of Carl Ichan) has been boosting a large position in Fannie Mae (NASDAQOTCBB:FNMA) and Freddie Mac (NASDAQOTCBB:FMCC).

To understand why Ackman would choose to bet on these two government-run casualties of the financial crisis, we first need to take a look at some history.

What happened to Fannie and Freddie?
The tailspins in Fannie Mae and Freddie Mac started during the housing bubble when mortgage originators started approving sub-prime mortgages to borrowers with bad credit. 

The idea seemed to be that by bundling a bunch of terrible sub-prime mortgages into a mortgage-backed security (MBS), you end up with a security that is not nearly as risky as each of the underlying mortgages itself was.

As it turns out, a bundle of crappy mortgages produces a crappy MBS.

The problem was that the investors that were buying these crappy MBSs had no idea how bad they were because many of them were still AAA-rated by credit agencies, the highest rating possible for a security. 

When the sub-prime mortgage borrowers inevitably defaulted on their payments, Fannie and Freddie stopped receiving mortgage payments. That meant that the GSEs did not have the capital to pay the the guarantees they owed to MBS investors, and the market value of MBSs started to tank.

Unfortunately, Fannie and Freddie combined had over $1.5 trillion of these mortgage-related assets on their own balance sheets, which compounded the GSEs massive losses from their guarantee business.

Losses were so overwhelming that Fannie and Freddie required a $187 billion government bailout and were placed under conservatorship by the Federal Housing Finance Agency (FHFA) in 2008.

Initial terms of the bailout
In return for the liquidity to remain operational, Fannie and Freddie initially accepted the following bailout terms from the government. First, the Treasury received warrants to purchase 79.9% of the common shared of the GSEs for a "nominal" price of $0.00001 per share. 

In addition, Fannie and Freddie each issued the Treasury $1 billion in shares of preferred stock that pay an annual 10% dividend. In order to make these dividend payments from 2008 to 2011, the GSEs issued even more shares of preferred stock to the Treasury. However, when Fannie Mae and Freddie Mac eventually returned to profitability in 2012, they were finally able to pay the 10% dividend from their own pockets for the first time. 


Treasury changes the rules
Things were looking slightly up for Fannie and Freddie shareholders in 2012 until the Treasury dropped a bombshell: they amended the terms of their preferred shares to pay dividends amounting to 100% of the earnings of the GSEs.

In other words, this "net worth sweep" means that every single cent that Fannie and Freddie earn from this point forward will be siphoned off by the government. 

Ackman's Case
Bill Ackman and other Fannie and Freddie shareholders believe that this one-sided change in the terms of the bailout agreement is illegal and will eventually be overturned in court. 

Ackman believes that, as a conservator, the FHFA has a duty to preserve and conserve the assets of the GSEs.

Last month, Ackman presented his argument that, if the net worth sweep is repealed, he sees plausible price targets for the GSEs ranging from $23 per share to $47 per share.

Source: Ira Sohn Conference Presentation.

Ackman's plan for the GSEs involves dramatically raising their capital requirements and ditching their fixed-income arbitrage business all together. In his presentation, Ackman asserts,

If the GSEs increase their capital levels and become pure mortgage guarantors, they can be a simple, low-risk, and effective solution for housing finance reform.

Ackman argues that relying on the private sector to take over the role that the GSEs currently serve in the housing market, is risky, untested, and impractical. In fact, Ackman shows that potential minimum capital requirements up to $500 billion for the GSEs existing $5 trillion MBS portfolio is more capital than was raised in all the U.S. IPOs from 2004 to 2013 combined! 

Even if the private sector could come up with this unprecedented amount of capital, g-fees and interest rates could skyrocket to a level that would discourage mortgage originations and lead to another downturn in the housing market.

What's a shareholder to do?
The takeaway message from Ackman's presentation is not that shareholders should expect their $4 Fannie Mae stock to be trading at $40 in a few years. For Fannie and Freddie shares to get to Ackman's target of $23 to $47, a series of favorable events need to take place first.

In fact, until the net worth sweep is overturned in court, Fannie and Freddie shares aren't worth the paper they're printed on.

One thing seems certain: the potential for large returns on these stocks exists, but for now shareholders are left with nothing more than hope.

Warren Buffett just bought nearly 9 million shares of this company
Imagine a company that rents a very specific and valuable piece of machinery for $41,000 per hour (That's almost as much as the average American makes in a year!). And Warren Buffett is so confident in this company's can't-live-without-it business model, he just loaded up on 8.8 million shares. An exclusive, brand-new Motley Fool report details this company that already has over 50% market share. Just click HERE to discover more about this industry-leading stock... and join Buffett in his quest for a veritable landslide of profits!

Wayne Duggan is the author of Beating Wall Street with Common Sense and the developer of Wayne Duggan has no position in any stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

4 in 5 Americans Are Ignoring Buffett's Warning

Don't be one of them.

Jun 12, 2015 at 5:01PM

Admitting fear is difficult.

So you can imagine how shocked I was to find out Warren Buffett recently told a select number of investors about the cutting-edge technology that's keeping him awake at night.

This past May, The Motley Fool sent 8 of its best stock analysts to Omaha, Nebraska to attend the Berkshire Hathaway annual shareholder meeting. CEO Warren Buffett and Vice Chairman Charlie Munger fielded questions for nearly 6 hours.
The catch was: Attendees weren't allowed to record any of it. No audio. No video. 

Our team of analysts wrote down every single word Buffett and Munger uttered. Over 16,000 words. But only two words stood out to me as I read the detailed transcript of the event: "Real threat."

That's how Buffett responded when asked about this emerging market that is already expected to be worth more than $2 trillion in the U.S. alone. Google has already put some of its best engineers behind the technology powering this trend. 

The amazing thing is, while Buffett may be nervous, the rest of us can invest in this new industry BEFORE the old money realizes what hit them.

KPMG advises we're "on the cusp of revolutionary change" coming much "sooner than you think."

Even one legendary MIT professor had to recant his position that the technology was "beyond the capability of computer science." (He recently confessed to The Wall Street Journal that he's now a believer and amazed "how quickly this technology caught on.")

Yet according to one J.D. Power and Associates survey, only 1 in 5 Americans are even interested in this technology, much less ready to invest in it. Needless to say, you haven't missed your window of opportunity. 

Think about how many amazing technologies you've watched soar to new heights while you kick yourself thinking, "I knew about that technology before everyone was talking about it, but I just sat on my hands." 

Don't let that happen again. This time, it should be your family telling you, "I can't believe you knew about and invested in that technology so early on."

That's why I hope you take just a few minutes to access the exclusive research our team of analysts has put together on this industry and the one stock positioned to capitalize on this major shift.

Click here to learn about this incredible technology before Buffett stops being scared and starts buying!

David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

©1995-2014 The Motley Fool. All rights reserved. | Privacy/Legal Information