Investors, from hedge fund managers, legal beagles to individual investors, all want to see Fannie Mae (NYSE: OTCQB:FNMA) and Freddie Mac (NYSE: OTCQB:FMCC) repay their bailout loans to the government using the quarterly profits they are producing and return the companies back to the stockholders. Right now, that is not the flavor in Washington. Recent statements by several representatives of companies with lawsuits against the government have made noise, but no progress on freeing Fannie and Freddie from the government's grip.
Over the last 6 months (you can review my past articles), I have advocated moving your money to more profitable investments while Washington makes no movement on the issue. I stand by this recommendation as little has changed over time, and the Federal Government has swept quarter after quarter billions of dollars of profits into the Federal Reserve. The end of the third quarter is upon us and once again, with no action by Congress or the Federal Reserve, the billions of dollars of profits Fannie and Freddie earned this quarter will again go to the Federal Government.
The total dollar amount the government bailed the government sponsored enterprises (GSEs) was $188 billion. The initial agreement was for the government to purchase common and preferred shares for a penny on the dollar and billions of shares were created for the government. The government also added stipulations that a quarterly dividend of 10% was to be paid and if the funds were not available, they would have to borrow the money to pay the dividends. In 2012, the government added another stipulation that any profits made by the companies were to be considered dividends and paid directly to the government and not used to pay off the loans. This completely blocked any attempt to pay off the loan and would prevent the companies from ever going public again.
Several lawsuits filed have been brought to force the government into releasing the companies, but we could be years away from any settlement. Hedge fund manager Michael Kao recently stated that the political winds could still shift in favor of Fannie Mae and Freddie Mac shareholders. He cited the Chrysler and UAW issue where the political leadership sided with investors and allowed investors the rights to ownership of the company over giving the company to the UAW's retirement program. I see very little similarity between the two cases, but he could be correct.
Bruce Berkowitz, Perry Captial, Paulson & Co. and Claren Road Asset Management have invested heavily in the junior preferred stock in the government sponsored enterprises (GSEs); however, Perry also acknowledged in a lawsuit on July 7, 2013 that it also owns common shares. As a leading voice in the push to rid the government, the issue remains cloudy without a clear path by the government, the market or investors on how to proceed through the legal minefield. The 2012 amendment came as a further blow to some hedge funds, including Paulson & Co., Perry Capital and Akanthos Capital, who heavily bought into the junior preferred shares of the agencies beginning in 2010 when they were trading for pennies on the dollar on a bet that the shares would recover in value once the companies became profitable again and repaid the government.
While the claim from Perry's attorney Ted Olson of Gibson Dunn & Crutcher argues the amendment "enriches the federal government through a self-dealing pact, and destroys tens of billions of value in the companies' preferred stock," it also contends the deal illegally "destroys value in the Companies' publicly held common stock."
Betting on either preferred or common shares of Fannie and Freddie is largely a wager on politics and law, rather than the more traditional investing in metrics of profitability. The government sponsored entities earn billions in profits each quarter. The question is whether private investors have any right to those profits.
Michael Kao, co-founder of hedge fund Akanthos Capital, is one of the early investors in the junior preferred of Fannie Mae and Freddie Mac. He advocates returning the GSEs to private hands in a General Motors (NYSE:GM) style recapitalization, where senior preferred shares and old preferred stocks are converted into common shares and sold to the public.
Political analysts believe investors such as Kao disregard political reality. The fact is Fannie Mae and Freddie Mac are political poison in Washington.
"The possibility of truly privatizing them isn't there," says Lawrence White, professor of economics at NYU's Stern School of Business and author of Guaranteed to Fail: Fannie Mae, Freddie Mac and the Debacle of Mortgage Finance. Fannie and Freddie were once credible institutions with great human capital, but all of that has gone now, he says. That ship has sailed. The blow to their reputations has been too great for either agencies to exist as their former selves.
Regulations have been tightened over the last 5 years for underwriting standards and the borrower's credit scores. The agencies have also more than doubled the fees they charge to guaranteed loans.
Until Congress decides how to wind them down, they remain in limbo.
Shareholders of Fannie Mae and Freddie Mac meanwhile are eager to see taxpayers repaid so that they can take share in the profits of the quarterly dividends. There are currently no Congressional members on record that are willing to spend any political clout and risk election backlash in supporting the return of the GSEs to investors. Although the issue mostly resides on the back burner with the budget and deficit issues as top priorities, there are two proposals for mortgage financial reform that differ in many areas, but both agree that Fannie and Freddie should be dismantled.
Under either proposal, mortgage rates are set to go up, a borrower would be required to put up at least 20% and have a 750 credit score. Mortgage rates would climb with the risk and required fees, making home ownership harder for first-time buyers and force the savings, taking billions of dollars out of the economy.
Investors, consumers and voters hear sound bites from selected parties and not the whole picture. There is no unbiased party in the discussion and facts are being manipulated by the self-interested parties.
Investor interest in participating in the high risks and rewards of large gains through the lawsuits are suggestive that investors have more hope or blind-faith in the lawsuits than the quality of sound investments. Every individual investor must decide how much of his/her portfolio they want to invest in these sorts of investments. Personally, I would rather not invest in the GSEs in their current state.
Additional disclosure: General statement in the news from CNN and Bloomberg are excellent places to search for more information. Other authors on SeekingAlpha.com have excellent insight also.