A Five-Bagger or Waiting for Godot?

If a company’s quarterly profits exceeded its market capitalisation, you would probably either
conclude that it is on the verge of bankruptcy or that it doesn’t exist. However, Fannie Mae
and Freddie Mac both reported Q4 earnings that were more than double their market
capitalisations. This special situation has attracted numerous prominent investors, including
Bill Ackman and John Paulson, who see major potential for returns.

What Do Fannie and Freddie Do?

Fannie Mae and Freddie Mac are a crucial part of the U.S mortgage market. They borrow
money at low rates and use it to buy mortgages from lenders. They then bundle the
mortgages together, creating a mortgage-backed security (MBS), which they sell to
investors. The majority of their revenues come from a guarantee fee, whereby they
guarantee to pay investors the interest and principal on the MBSs, regardless of defaults in
the underlying mortgages. This plays an important role in the U.S housing market by
offloading risk from mortgage-lenders, as well as making their mortgages more liquid, thus
providing them with capital more quickly to provide other mortgages.

What Was Their Role In The ‘08 Crash?

In the run-up to the Financial Crisis, Fannie and Freddie packaged lower quality loans into
their MBS products. Particularly problematic were Alt-A loans, which had little to no income
documentation and therefore were subject to fraud. When the U.S Housing Market crashed
Alt-A loans defaulted in droves; despite making up only 11% of the companies’ assets, they
made up half of Fannie and Freddie’s $47 billion 2008 losses.
Facing collapse, which would have had horrendous consequences for an already devastated
housing market, the companies were placed into conservatorship (essentially a temporary
form of nationalisation with the aim of financially preserving an organisation) in 2008. The
government replaced Fannie and Freddie’s board and CEO and, crucially, entered into a
preferred stock purchase agreement. Under this agreement, the Treasury injected capital to
cover the corporations’ losses in return for senior preferred stock. Initially, these preferred
stocks had a 10% dividend, but in 2012 this was replaced by a ‘net worth sweep’, whereby
all Fannie Mae and Freddie Mac profits would go directly to the Treasury.

Fannie Mae Common Stock

Will Fannie and Freddie Come Out of Conservatorship?

In 2012, Moody’s Analytics predicted that it could take 15 years for Fannie and Freddie to
repay U.S taxpayers in full. However, they have already paid back $300 billion to the
Treasury, which originally injected $191 billion. Despite being repaid with a healthy interest,
the U.S Government retains its control over the companies. However, of interest to investors
are the recent moves suggesting that action to take Fannie and Freddie out of
conservatorship could be arriving. On January 14 this year, the FHFA and U.S Treasury
announced an agreement that would allow the companies to retain their earnings in order to
build up capital instead of sending all profits to the Treasury. This is important as to exit
conservatorship the companies need a capital base worth 3% of its assets, so that in a
downturn they are able to absorb losses.

The issue is that Fannie and Freddie guarantee such an enormous volume of mortgages
that this 3% capital rule requires the companies to have $283 billion in capital. In 2020 the
companies made combined profits of $19 billion, leading the FHFA Director to comment that
“retained earnings alone are insufficient to adequately capitalise the Enterprises.” Such
funds would, therefore, have to be drawn from the public capital markets. In a positive move,
however, last June it was reported that Fannie and Freddie had hired financial advisors
(Morgan Stanley and J.P Morgan respectively) to aid with a potential capital raise.

Perpetuity Options

There are many obstacles to the exit from conservatorship. For one, any public
recapitalisation effort would be gargantuan. The largest ever IPO Alibaba’s $25 billion raise
in 2014. Fannie and Freddie need over ten times that amount. What is more, any such
moves are reliant on inevitably slow political and judicial procedures. There is also the risk
that the government either shrinks the two entities and creates competitors, winds them
down, or fully nationalises them. However, investor Michael Kao argues that an exit from
conservatorship is the only viable option. The companies are a natural oligopoly, so creating
new, smaller entities would end up making U.S mortgages far more expensive. The
companies cannot be wound down as any moves to do so would be incredibly risky for the
entire U.S mortgage and housing market. What is more, they cannot be kept in
conservatorship or nationalised as this means that all risk is retained by the government.
Michael Kao, therefore, refers to Fannie Mae and Freddie Mac as ‘perpetuity options’; when
they inevitably exit conservatorship, their high profitability and current rock-bottom stock
prices, mean that returns could be 5X or more. However, as Kao can attest to - having first
invested in 2008 - the ‘perpetuity’ part of that description really does carry weight, leading
others to quip that this investment may be more aptly named the ‘Waiting for Godot trade.’

857 Words

References

NYT Article - Clinton pressure

The Balance Article
Housing Wire Article
DS News Article
WSJ Article
Center for American Progress
Market Watch
FHFA Announcement
Michael Kao Powerpoint