On February 23rd, Bill Ackman, Pershing Square fund manager, said "he sees a huge upside on the [Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC)] bet: the hedge-fund manager said he believes the common shares of the mortgage-finance giants could be worth more than 10 times their current value in several years."
How does Ackman get to this assumption?
Well, Fannie Mae and Freddie Mac recently released their full year 2013 earnings reports. For the year, Fannie earned $84 billion and Freddie earned $49 billion. These record-breaking numbers make them two of the most profitable companies in the history of the world. They both acknowledge that a repeat performance any time soon is unlikely. However, using their full year figures, we might get a better understanding of what their earnings may be in 2014.
For the purposes of simplification, one might strip out the one-time items, such as the deferred tax assets, legal settlements, loan loss reversals, derivative gains, and other items that can fluctuate over time. For the purpose of a simple analysis, one might choose to look at net interest income, fee income, administrative expenses, and non-interest expense.
Here's a rough calculation of the Core EPS for each company. This is my best estimate of the recurring profits generated by the businesses.
What market cap does this give the companies?
You will notice that there are a combined 9 billion total diluted shares for both companies. At around $31 per share, the total market cap for the two companies combined is $279 billion. The Treasury's share of this total is 79.9%, or $222.9 billion, if the warrants are allowed to be executed by the courts. This is much more than the total amount received by the companies for their bailouts.
Part of Ackman's investment thesis is that Fannie Mae and Freddie Mac shareholders win their lawsuits against the government. This might mean that the 100% dividend sweep would be ruled un-Constitutional and the entire amount of the dividend sweep, almost $200 billion flows back into each company's balance sheet.
Will shareholders win their lawsuits?
Richard Epstein, of the Hoover Institution, recently provided an update on the subject of the 100% profit sweep instituted by the Treasury in August 2012.
The key inquiry is therefore into the government defenses against the three charges in the underlying law suits: wealth confiscation, the abuse of administrative authority under FHFA, and the breach of its fiduciary duty to Fannie and Freddie's private shareholders.
The government's task is not an enviable one, because the cozy deal between FHFA and Treasury looks like the worst form of self-dealing. Recall that both Edward DeMarco, then acting director of FHFA, and his key aid Mario Ugoletti both came to FHFA from Treasury. To remove any taint from the deal, the government has to show first that it exercised due diligence to see that the deal was fair to all parties, and, second, that, more critically, the deal viewed as a whole was in fact fair the private shareholders. The government has done nothing to satisfy either obligation.
Epstein goes on to speak about the grant of discovery in these cases.
This past week Judge Margaret Sweeney granted Cooper's motion, sweeping aside the government's objections that the claims were not "ripe" for review on the ground that "1) future profitability is unknown, and 2) both Fannie and Freddie are still in conservatorship." Those claims border on the frivolous, given that the government had to know something about its profitability before implementing the Third Amendment. Nor is it credible to assume that the conservatorship should go on forever after the advances have been repaid.
As Judge Sweeney noted, since this evidence "is solely in possession" of the government, discovery is required to equalize the balance, at which point all documents and discussions relating to Treasury's key decisions should become public record.
From this standpoint, it is clear that the 2012 amendment that created the 100% profit sweep was intended to destroy shareholder value. This information was non-public, but most importantly it was contrary to the stated and very public mission of the Conservatorship, which was to put the entities in a safe and solvent position. One might expect that additional unsavory details will emerge in the coming weeks, as the lawsuits proceed and additional discovery brings new details into the light.
Disclosure: I am long FNMA, FMCC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Mostly common stocks of each entity, a few preferred.