President-elect Donald Trump has made many investors bullish on the market, which has been on an incredible two-year run. Many believe deregulation and corporate tax cuts could create powerful tailwinds, unlocking positive investor sentiment that could propel stocks higher.
Not surprisingly, billionaire investor Bill Ackman, a vocal Trump supporter, is all aboard this train. Ackman and his fund Pershing Square Holdings have delivered extraordinary gains over the last five years. Ackman now thinks two of Pershing's longtime holdings are set to run roughly 900% thanks to the incoming Trump administration. Let's take a look.
Could a 17-year conservatorship be coming to an end?
In 2013, Ackman and Pershing acquired a roughly 10% stake in the common shares of the government-sponsored entities (GSEs) Federal National Mortgage Association (FNMA 2.81%) and Federal Home Loan Mortgage (FMCC 3.37%), known as Fannie Mae and Freddie Mac. Recently on X, Ackman laid out his thesis about how the two mortgage giants could exit government conservatorship and be recapitalized, leading to significant shareholder gains.
To provide some quick background, the U.S. Treasury Department took Fannie and Freddie into conservatorship in 2008 after the two agencies got caught holding too many subprime mortgage loans. Fannie and Freddie serve as a vital source of liquidity to the mortgage market, buying mortgage loans from financial institutions and lenders and packaging them into securities that are then sold to investors. Fannie packages mortgage loans from larger banks, while Freddie packages them from smaller banks.
While under conservatorship, Fannie and Freddie passed along all of their profits to the Treasury under what's known as the net sweep agreement. The Treasury also holds over $193 billion of senior preferred stock in Fannie and Freddie, as well as warrants that equal close to 80% of Fannie and Freddie's common stock and expire in September 2028. The Treasury injected $187 billion of capital into Fannie and Freddie when taking them under conservatorship and has since seen about $300 billion paid back from the net sweep agreement.
OTC: FNMA
Key Data Points
Shareholders, who got crushed after Fannie and Freddie were taken into conservatorship, have argued that it is time for the Treasury to release the two GSEs from conservatorship, while other hedge fund managers like Ackman have bet on this happening eventually. Things started to move in that direction under Trump's first administration. Treasury Secretary Steven Mnuchin ended the net sweep agreement and allowed Fannie and Freddie to retain profits to build capital. Meanwhile, the Federal Housing Finance Administration (FHFA) established new capital requirements that Fannie and Freddie must reach to exit conservatorship.
A major issue is how Fannie and Freddie can realistically raise tens of billions of capital when the Treasury holds hundreds of billions in senior preferred stock and cash warrants because there is likely to be significant dilution.
Ackman believes the second Trump administration is poised to finish the job. He envisions a path where the GSEs are credited for their previous distributions to the Treasury Department under the net sweep agreement, which would then retire the senior preferred stock. The GSE's total capital requirements would be set at 2.5% of outstanding mortgage guarantees, a level Ackman believes would create a fortress balance sheet that could have covered roughly seven times the losses Fannie and Freddie incurred during the Great Recession. The Treasury could then cash their warrants and sell down the common stock over five years, netting a profit of $300 billion.
How Ackman arrives at the upside
Ackman assumes Fannie and Freddie raise capital in the fourth quarter of 2026, giving them another two years to build capital. The GSEs have strong earnings power, so they can accumulate capital quickly. At that point, they would need another $30 billion to hit their 2.5% capital requirements.
Ackman estimates the value for both Fannie and Freddie to be around $34 per share. That's 888% upside for Fannie and 909% upside for Freddie from their current levels (as of Jan. 2).
While shares surged following Ackman's post, investors should understand the significant risk in this investment and the many variables at play. Ackman assumes the Treasury will credit past distributions toward the senior preferred stock and that the capital requirement will be at 2.5%. However, the Congressional Budget Office (CBO) ran some scenarios about the GSEs exiting conservatorship in 2020, and the lowest capital requirement used was 3%. It's also not clear the Treasury would apply old distributions to the senior preferred stock.
That said, if the administration truly wants to exit the GSEs from conservatorship, it will probably need to make concessions on the senior preferred stock or warrants, and it's definitely possible they use a lower 2.5% capital requirement.
I agree with Ackman that the probability of the GSEs exiting conservatorship has risen significantly. However, many unknown variables could arise, so investors should tread carefully.
Another idea is to buy the junior preferred shares, which still trade at a significant discount. There's less upside than the common shares, but the junior preferred shares have higher priority than the common shares in the capital stack. It depends on where you want to be on the risk spectrum. A smaller speculative position is probably best here.
