Introduction:
The purpose of this article is to examine the bailout performance of government sponsored enterprises (GSEs) Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC), as well as determine the strength of their performance relative to the other bailouts given in response to the 2008 financial crisis.
The semi-detailed analysis provided here will show the reader precisely how well the GSEs have done over the last 8.5 years of its ongoing bailout, and how it ranks among other companies. Results presented will show that their bailout performance can be summed up in words that could be true of their treatment during conservatorship and their performance relative to all other bailout recipients: you've never seen anything like it!
Results - comparing types:
ProPublica maintains a thorough database of financial information for 2008 financial crisis bailouts. All of the data presented in this article is taken from that database, and is current as of 3/15/17. As shown below in Table 1, 969 companies/organizations received a bailout totaling $622.5 billion. There were a number of big bailouts given: Fannie Mae ($116.1 B), Freddie Mac ($71.3 B), AIG (AIG - $67.8 B), General Motors (GM - $50.7 B), Bank of America (BAC - $45 B), Citigroup (C - $45 B), JPMorgan Chase (JPM - $25 B), Wells Fargo (WFC - $25 B), GMAC/Ally Financial (ALLY - $16.3 B), Chrysler (FCAU - $10.7 B), Goldman Sachs (GS - $10 B), and Morgan Stanley (MS - $10 B). All but 24 mortgage servicers have received disbursements; Treasury has committed $23.2 million to those companies but not disbursed payment.
Table 1 - Financial overview of 2008 financial crisis bailout. Data source is ProPublica.
The table shows that these companies can be organized into 13 different organization types: Automotive companies and parts suppliers, banks (community development, public and private), the FHA Refinance Fund, financial services companies, GSEs, insurance companies, investment funds, mortgage servicers, small business association (SBA) security purchases, state housing organizations and TALF (Term Asset-Backed Securities Loan Facility).
Overall, Table 1 shows that Treasury has made $75.81 billion over all bailouts: 8 types of organizations have provided Treasury an overall net profit (i.e., sum of all net profits) of $111.62 billion, while 5 types of organizations have given an overall net loss of $35.81 billion.
The $68.3 billion net profits of Fannie Mae and Freddie Mac accounts for 61.2% of the overall net profit brought in by 610 companies; it is 90.1% of the total net profit ($75.81 billion) when the losses from 335 companies ($35.81 billion) are accounted for. Thus, the total net profit would only be $7.51 billion (~ 10x less) without the GSEs' profits!
A comparison of the GSEs' performance compared to the other bailout recipients is given in Figures 1 and 2 for net profit in dollar amounts and return on investment (ROI), respectively. Figure 1 shows that Treasury has profited from the GSEs far more than any of its other investments. Data is given for the GSEs under two different schemes (green and red stars).
It has been shown elsewhere that the GSEs gave Treasury $45.7 billion ($25.6 B - FNMA; $20.1 B - FMCC) in dividend payments prior to the August 2012 NWS (net worth sweep) amendment to Treasury's stock purchase agreement (SPSPA: senior preferred stock purchase agreement).
What is unusual about those payments is that the GSEs had to borrow from Treasury to pay Treasury those quarterly dividends. The green star represent the values given in Table 1 reported by ProPublica, which do not count them as profits but as part of their disbursed amount ($187.5 billion). The red star, however, considers them as profits. Proponents of either scheme have valid points; I will not resolve that issue here but simply present the data for analysis purposes.
Regardless, Figure 1 shows that public banks were given more ($231.2 billion) and returned less ($28.4 billion) than the GSEs. The GSEs rank 2nd in amount disbursed but 1st in net profit. Six other types of organizations were disbursed less and returned less: TALF, SBA security purchases, private banks, investment funds, insurance companies and financial services companies. The former three were given smaller bailouts of $100 million - $5 billion and returned less than $1 billion in profit; the latter three were given larger bailouts of $10-75 billion and returned less than $1 billion in profit also.
Mortgage servicers, state housing organizations and FHA Refinance Fund have not returned any money to Treasury; their bailouts range from $20 million to $16.2 billion. Losses at community development banks ($315 M disbursed) and automotive companies & parts suppliers ($61.9 B disbursed) is less severe.
As expected, Figure 2 shows that the GSEs have a higher ROI than all other organizational types as a whole, excluding TALF. TALF had the highest return (649%) but was on a much smaller disbursed amount (and return) than the GSEs. Four of the seven types that yielded a profitable return made over $1 billion in profits: public banks, insurance companies, financial services, and investment funds. The latter two gave a higher return (15-25%) on a much smaller investment (< $25 billion), while the former two gave a smaller return (7-14%) on larger investments (~ $70 B and $230 B).
Fannie Mae and Freddie Mac, however, do not fit the trend of the most successful bailouts: They were given a significant bailout ($187.5 B or $141.8 B) and returned a significant portion of (~ 36% or 80%). The other two profitable companies (SBA security purchases and private banks) had almost negligible ROIs (< 2.5%). Losses for community development banks and automotive were less severe (~ 20%) than the 100% losses for mortgage servicers, state housing organizations and the FHA Refinance Fund.
Figure 1 - Net profit/loss amounts of all 13 organizational types as a function of disbursed amounts. Red star denotes GSE data accounting for pre-NWS dividends (see text). Data source is ProPublica.
Figure 2 - Return on investment (ROI) for all 13 organizational types. Red star denotes GSE data accounting for pre-NWS dividends, while red star does not (see text). Data source is ProPublica.
Results - comparing individual bailouts:
It is also helpful to look at the bailout on an individual basis since there is a range of performance among companies in each category. This is highlighted below in Figure 3 and 4 for net profit/loss and ROI, respectively. Although they are overview plots, these figures serves as a visual reference of the net profit/loss and ROI spread when considering the statistical results presented later.
Figure 3 shows that 9 of the 13 types have the same net/profit results for all organizations as the type does overall; the remaining four have companies with both net losses and net profits. The same is true of ROI, as shown in Figure 4.
Figure 3 - Graphical representation of net profits/losses for each of the 13 organization types (bars) and their individual companies (dots). Data source is ProPublica.
Figure 4 - Graphical representation of ROI for the entire type (bars) and individual organizations (dots) among the 13 bailout organization types. Data source is ProPublica.
The financial performance of all bailout recipients is given below in Figures 5 and 6 for net profit/loss amounts ($) and ROI, respectively. Figure 5 shows that the GSEs dominate even upon comparing results on an individual organization basis. First consider a comparison at a similar net profit amount, as summarized in Table 2.
After the GSEs, it would take the next 6 and 16 most profitable returns to equal that of Freddie and Fannie, respectively. Those companies required a much higher investment to achieve the same results of the GSEs: $153-$155 billion (2.33-3.14x investment in GSEs). Thus, the ROI is 19-29% lower for other bailouts.
Those results consider all of the $187.5 billion as disbursed. Upon considering the pre-NWS dividends ($45.7 billion) as part of profits, both GSEs on an individual basis have profits greater than the rest of all other 608 companies' profits combined!
All non-GSE profitable bailouts yielded $48.3 billion in net profits off $343.5 billion disbursed, which is 14.1% ROI. Under either counting scheme, the GSEs combined profits are also more than the other 608 companies' profits combined.
Now consider how these other companies perform with the same amount of Treasury disbursement. The best performance these companies could possibly do would occur under the highest ROIs.
Comparison data for this scenario is shown below in Table 3 for the 'green' and 'red' scenarios for each GSE and them combined. The table shows that for green star data, both Fannie and Freddie have given Treasury $8.9-9.2 billion (1.31-1.44x) more than the other 187 and 387 companies; this equates to the GSEs giving 9-13% more ROI than other companies for the same disbursement!
For both GSEs combined (green star data), the values are higher: $31.4 billion (1.85x) more in profits than 475 companies, which is 17% more ROI. Results are more favorable for the GSEs if the $45.7 billion in dividends is considered profit (red star data). Fannie Mae and Freddie Mac would have $34.3-$39.0 billion (2.57-3.15x) more profits than 83 and 258 companies, which corresponds to a 44-67% higher ROI!
These amounts change to $82.4 billion (3.60x) more in net profits and 58% more ROI than 457 companies for both GSEs combined (red star data). That is the best performance. For near worst performance by other bailouts, individual and combinations within 15 highest disbursements (neglecting net loss companies) are compared. These companies typically have low ROI. Results are shown in Table 4.
The amount of companies each GSE and combined are compared to is much lower (1-4 companies). As expected, the results are better for the GSEs in every respect. The GSEs have higher net profits than their counterpart: $19.7-43.0 billion (green star data) and $45.4-92.7 billion (red star data) more in net profits.
This corresponds to higher return ratios as well: 2.07-5.99x (green star data) and 5.36-10.25x (red star data). Return on investment is also higher: 17-35% (green star data) and 63-89% (red star data).
Now let's focus on the return on investment results presented in Figure 6. The graph clearly shows that a number of companies have higher returns than the GSEs. However, the graph can be a bit misleading, and requires analysis to put the data in perspective. Not considering the pre-NWS dividends as profits (green stars), there are only 16 and 38 companies that have a higher % return than Freddie Mac and Fannie Mae, respectively.
Apart from TALF, this is composed of 9 private banks and 6 public banks for Freddie Mac and 1 investment fund, 1 auto company & parts supplier, 20 private banks and 15 public banks for Fannie Mae. The disbursed (and returned) amounts of these companies is much lower: ~$1M-$2B (Fannie Mae) and ~$1-100M (Freddie Mac). The ROI for the GSEs are pretty remarkable: only 2.6% and 6.3% of profitable bailouts (1.7% and 3.9% of all other bailouts) have higher ROI than Freddie Mac and Fannie Mae!
If the pre-NWS dividends are counted as profits (green stars), then only 1 company (TALF) and 2 companies (TALF and Fidelity Southern Corp. {public bank}) have a higher % return than Freddie Mac and Fannie Mae, respectively. That corresponds to only 0.2% and 0.3% of profitable bailouts having a higher return than Freddie and Fannie, respectively!
Figure 5 - Net profit/loss amounts of all bailouts as a function of disbursed amounts. Red star denotes GSE data accounting for pre-NWS dividends, while red star does not (see text). Data source is ProPublica.
Figure 6 - Fraction of net profit/loss to disbursed amount for all bailouts. Red star denotes GSE data accounting for pre-NWS dividends, while red star does not (see text). Data source is ProPublica.
Table 2 - Comparison of GSE results for other bailout recipients that combine to have similar disbursements. Data is shown for the best case scenario (i.e., recipients with highest ROI) for the two different schemes (green and red stars). 1Data not available since other companies do not attain similar profits. 2Value = Other Companies - GSEs. Data source is ProPublica.
Table 3 - Comparison of GSE results for other bailout recipients that combine to have similar disbursements. Data is shown for the best case scenario (i.e., recipients with highest ROI) for the two different schemes (green and red stars). 1Value = GSEs - Other Companies. Data source is ProPublica.
Table 4 - Comparison of GSE results for other bailout recipients that combine to have similar disbursements. Data is shown for the near worst-case scenario (i.e., recipients with highest disbursement) for the two different schemes (green and red stars). 1Value = GSEs - Other Companies. Data source is ProPublica.
Results - statistical comparison:
Finally, we make a statistical comparison among the 13 organization types. This data is summarized in Table 5. Statistical (mean and standard deviation) values of net profit/loss and ROI among all organizations in each of the 13 types are presented in Figures 7 and 8, respectively. Those values are plotted against the average disbursed value.
Figure 7 shows that the GSEs is the only type with a net profit above $10 B; insurance companies are the only other above $1 B, while 4 others have an average net profit in the range of $100 M-$1 B. The GSEs have returned on average 16.8x more profits than insurance companies and 36.6x more than financial services organizations.
But the average disbursed amount for the GSEs is only 3.9x and 16.7x more than those types, respectively. Thus, the GSEs have one of the highest ROI of any type (2nd to TALF), as shown in Figure 8. Its average ROI is 15-25% higher than the closest three types; it is 30-35% higher than the other four net profitable types.
A statistical comparison of the GSEs to all other bailouts can also be done. Net profit/loss and ROI distributions are presented in Figures 9 and 10, respectively. As expected, data for the GSEs are observed in the highest net profit and positive ROI wing portion of the distributions. Two peaks are observed in Figure 9: one at ~ $2 million (net profit) and ~ -$2m (net loss). Two peaks are also observed in Figure 10: one at ~ 18% and another at -100%.
Excluding the GSEs, the average net profit is $79.4 million, and the average ROI is 18.7%. The average net loss is $121.6 million, with a -77.5% average ROI. Overall, all non-GSE companies were given $435.0 billion and returned only $7.51 billion in net profits. This results in a meager 1.73% ROI, which is far below the 36.4% ROI (green data; 80.4% - red data) that the GSEs yielded.
Including the GSEs gives a total disbursement of $622.5 billion (green data; $576.8 B - red data), total profit of $75.8 billion (green data; $121.5 B - red data) and a ROI of 12.2% (green data; 21.1% - red data). Thus, the only way that Treasury has been able to achieve any type of significant return on its investment is through the GSEs' profitability.
Table 5 - Statistical results (mean and standard deviation) of financial performance metrics for all 13 bailout organization types. Data source is ProPublica.
Figure 7 - Average net profit/loss amounts of all 13 organizational types as a function of average disbursed amounts. Red star denotes GSE data accounting for pre-NWS dividends (see text). Negative x and y uncertainty bars not displayed for some data for visual clarity. Data source is ProPublica.
Figure 8 - Average return on investment (ROI) as a function of average disbursed amount for all 13 organizational types. Red star denotes GSE data accounting for pre-NWS dividends, while red star does not (see text). Negative disbursed uncertainty bar not displayed for some data for visual clarity. Data source is ProPublica.
Figure 9 - Distribution of net profit/loss for all companies in the 13 different organization types. Data source is ProPublica.
Figure 10 - Distribution of ROI for all companies in the 13 different organization types. Data source is ProPublica.
Conclusion and Investment Thesis:
The semi-detailed analysis work presented here is validation of the opening statement: the GSEs' financial performance is unlike any other bailout given. One of the salient points made by GSE opponents to combat GSE supporters is the large amount of their bailout.
The data clearly shows this to be the case. However, the data also clearly shows that the GSEs have blown away the competition: they have returned a much higher return (ROI) for the same amount of disbursed funds, higher net profits for similar ROIs, and they have a much higher ROI than all of the other bailouts combined (36.4%/80.4% vs. 1.73%)!
Another salient point made by GSE detractors is that the taxpayers are entitled to those gigantic returns on investment because they propped them up when they would have otherwise failed. That argument really is coupled to the aforementioned salient point.
Unfortunately, both points are highly flawed if not outright debunked when the triple-verified GSE forensic accounting work of Spittler and Ciklin is considered. The work essentially shows that the losses the GSEs suffered from 2008 to 2012 were largely composed of manufactured paper losses.
Those forced paper losses drove higher dividends; thus, the death spiral that the government repeatedly claims the GSEs were in (which is their legal argument; see Perry Capital et al. opinion and Epstein, for example) is most likely a manufactured government scheme.
But before the GSEs could take advantage of those paper losses, the FHFA and Treasury modified the stock purchase agreement to give Treasury all of the profits for its unwavering financial support. The supposed death spiral and subsequent net worth sweep [NWS] amendment was designed to make Treasury look like a hero and the GSEs like a zero (unprofitable enterprises on the verge of collapse).
The subsequent 18 quarters of profitability for both GSEs (excluding 2 for Freddie Mac) and lack of making any further draws since the NWS was implemented discredit that narrative and make FHFA and Treasury's motives highly suspect. This facet of the GSEs' bailout is critical to the GSEs' bailout performance and addressing salient talking points of their opponents.
If the forensic accounting work is true, then it logically follows that the GSEs never needed a significant portion of the $187.5 billion in financial support from Treasury, the GSEs bailout would not be substantially higher than all other companies, the GSEs could have paid its 10% dividend obligation (as opposed to Treasury paying Treasury for dividend payments), and the taxpayer would not be entitled to all the profits going forward (this really isn't a valid argument in any situation excluding liquidation in a receivership... and that would require funds after debt payments to be less than or equal to Treasury's senior preferred liquidation reference).
The data presented thus far is not the end of the evidence to support the claim that the GSEs' bailout is unlike any other in terms of financial performance. There are two other financial aspects that will add to Treasury's windfall. Table 1 shows that the net profit/loss is composed of 4 revenue streams: returned (of disbursement), dividends + interest, warrants and other proceeds (e.g., commitment fees).
It reflects the aforementioned effect of the NWS; specifically, that all the net profit is attributed to dividend payments. This has been reiterated by government officials like Rep. Jeb Hensarling (Chairman of the House Financial Services Committee), who has gone on record to state: "Fannie and Freddie have not 'repaid' taxpayers one thin dime." The NY Federal Reserve Bank, Atlanta Federal Reserve Bank and GSE opponents like former Chicago Federal Home Loan Bank President and CEO Allex Pollock have also made similar statements that the payments made to Treasury are dividends, not a paying off of their liquidation preference.
The outcome of GSEs conservatorship will determine how much Treasury benefits from its outstanding liquidation preference. If the GSEs are wound down and replaced, Treasury will likely receive at least $189.5 billion (which includes its $2 billion in senior preferred stock). If they exercise their common stock warrants, then Treasury will receive an additional 80% of the remaining assets after debts, senior preferred and junior preferred shareholders are paid off. If the GSEs exit conservatorship and are returned to shareholders, it is less likely that the full amount of its liquidation preference will be repaid.
It is doubtful that the GSEs could issue $189.5 billion in new junior preferred stock and make future dividend payments to them and current junior preferred and common stock holders. Minimal capital requirements would require tens of billions of dollars in additional support prior to exiting conservatorship. A more logical approach would be to end the NWS, apply the previous dividend payments to their liquidation preference, and have the GSEs issue new junior preferred stock to partially or fully cover their remaining liquidation preference and minimal capital requirements.
Trying to raise capital through a new common stock issuance would likely be tough to garner support from the market given Treasury's unexercised warrants, which is the second potential revenue stream after repayment. Recall that the senior preferred stock purchase agreement entitled Treasury to warrants for 79.9% of Fannie Mae's and Freddie Mac's outstanding common stock. This equates to Treasury receiving 6,850,593,432 shares (FNMA: 4,278,057,373 shares; FMCC: 2,572,536,059 shares).
Thus, Treasury reaps a financial windfall of $6.85 billion for every dollar they sell the GSEs stock at. Table 1 shows that public banks have given Treasury the largest profits from warrants at $7.98 billion. Fannie and Freddie's common stock only has to reach 4 for Treasury to triple those profits at $27.4 billion.
Hedge fund billionaire Bill Ackman values the GSEs' common stock at $23-$47 per share (see here and here). Thus, Treasury could make an exceedingly large profit from its GSE warrants, making yet another way in which Treasury's "investment" in the GSEs have outperformed all other bailouts.
There are two fundamental reasons for investing in the GSEs' common stock (3 for their preferred shares). One is the rule of law. It doesn't take a law degree to understand that the FHFA and Treasury haven't been following the law (HERA, 12 U.S.C. and the Constitution). FHFA hasn't been acting like a conservator. One of the guys that wrote the law, Vice President Pence's chief economist Mark Calabria, has stated before that FHFA has been breaking the law since 2008!
He wrote extensively on this with Michael Krimminger. Various legal scholars like Richard Epstein, Tara Helfman, Jonathan Macey, John Yoo, and Saikrishna Prakash have also been outspoken in their support of plaintiffs being on the right side of the law and critical of the government's behavior as illegal. Shareholders also have advocates like Bill Isaac, who is a former President of the FDIC and done numerous conservatorships and receiverships; he has essentially said that the government's actions are not those of a conservator.
So shareholders should be confident that the rule of law is on their side. There have been numerous lawsuits filed in federal and state courts challenging the legality of the government's actions (see GSElinks). The most advanced case has been Perry Capital et al. The institutional and class plaintiffs sued the government on a variety of claims (e.g., APA and breach of fiduciary duty). The Court ruling allowed direct contract claims to survive (remanded back to district court) but the others such as APA claims have not.
Nearly all of the lawsuits have been ruled in favor of the government; most have been decided on a preliminary motion to dismiss, and none have gone to trial. These consistent government wins are unsettling to anyone that is in favor of the law being upheld; but it is a sobering reminder that judges interpret the law and decide the case. GSEs shareholders aren't the first and won't be the last to complain that the Court system made a huge mistake.
However much we disagree with their judicial opinion, their word is final unless overruled on appeal. Many are confident that the courts won't allow this to be upheld through the Supreme Court since we are a society governed by the rule of law and this is such an obvious and egregious violation. But there is also reason to believe that shareholders will win in court from legal proceedings. The second most advanced case is Fairholme Funds Inc. et al.
This case is before Judge Sweeney in the Court of Federal Claims. A recent joint status report show that discovery process will likely not be finished and a ruling on the government's opening motion to dismiss ruled upon until the end of this year. But previous court rulings demonstrate that she is not afraid to air the government's dirty laundry and get to the truth in order to decide the merits of the case. The only other legal case that has potential to impact the GSEs is the Collins et al. case in Houston, TX district court.
Before President Trump was elected in November, one of the Perry Capital attorneys, Ted Olson, argued (the same week as Perry Capital oral arguments) and won a case (PHH vs. CFPB) that declared the Consumer Financial Protection Bureau to have an unconstitutional structure. CFPB appealed for an en banc review in October 2016 and was granted it in February 2017. Following that was the decision by Trump's Justice Department to submit an amicus brief in favor of the plaintiffs (NYSE:PHH), declaring it unconstitutionally structured.
The same Justice attorney (Chad Reader) that filed the amicus brief is the same one that wrote Treasury's support for FHFA's motion to dismiss in the Collins et al. case. And late last week Mr. Reader has filed an advisory notice with the Houston District Court removing Justice's support for FHFA's defense that it is constitutionally structured! It appears that the White House's stance on the CFPB has potentially forced its hand to withdraw its support for the FHFA in regards to it defending its structure. The reader should note that the CFPB and FHFA have the same structure: one director that cannot be fired by the President at will.
Two final points about the legal aspect of this investment. One is to stay up date on legal filings by checking GSElinks legal section and home page frequently. Second is to acknowledge the current potency of the Courts. Investors have been confident for some time that the judicial branch would act in favor of investors well before the legislative branch ever took place. Many (myself included) concluded that the Courts would forcibly release the strangle hold that the government has on the GSEs; that a judicial win would force an executive or legislative action.
Only time will tell if and when a strong legal victory occurs. Apart from Collins et al., the likelihood of a high impact court win is not expected in 2017. The reason why Collins et al. has the best shot at victory is that plaintiffs make the following statements in their opening complaint for declaratory and injunctive relief: "FHFA's adoption of the Net Worth Sweep was also unlawful for an even more fundamental reason: the Constitution's separation of powers does not permit an independent agency with far-reaching powers such as FHFA to be headed by a single Director rather than a multi-member Board.
HERA's concentration of power in one person who is only removable by the President for cause is unconstitutional, and the Net Worth Sweep must be vacated because it was adopted by this unconstitutionally structured agency." If DoJ attorneys are not going to support FHFA's attorneys on this point, FHFA could be fighting an uphill battle. The judge should rule on this issue in the coming months. We have to wait until then to see how the NWS and structure constitutionality is adjudicated.
The second reason for investing in the GSEs is the lack of alternatives. As Bill Ackman puts it, there are no viable alternatives for the GSEs. Removing the GSEs would require either a competitor to take over GSEs' market share or a new housing finance system. The 2008 financial crisis has essentially removed the private label securities (PLS) market, as reported by David Fiderer and Urban Institute. That was their main competitor, which drove them to securitize riskier loans in competition for market share prior to the 2008 crisis.
With the PLS market long dried up, the secondary mortgage market is primarily composed of the GSEs today. FHFA and Treasury have worked over the last 4.5 years to drastically shrink the GSEs' presence by bringing private capital back into the market. This effort was primarily composed of changing the GSEs' business: FHFA increased their securitization profits (i.e., guarantee or g-fees), anticipating that such high rates would provide sufficient opportunity for private capital to flood the market (due to much needed demand smaller g-fees via competition) and take over the GSEs' business.
FHFA and Treasury were essentially trying to create an opportunity to price the GSEs out of the market. Unfortunately for the government, private capital has not seized the opportunity to supplant the GSEs. This is likely due to it keenly observing their behavior towards the GSEs. No private company has wanted to get involved in a market where the government has so brazenly fleeced the profits of their predecessors; they likely thought to themselves: 'if they did that to the GSEs without any consequences, they could easily get away with whatever they wanted against our company.'
This increase in g-fee revenue was to offset the decreased profits from its retained MBS (mortgage backed securities) portfolio, which has been a healthy source of profitability (due to the loan quality sufficiently improving since the housing crisis). FHFA mandated their portfolio shrinkage as part of their strategic plan for conservatorship.
Thus, Treasury and FHFA used these in combination to make the GSEs less profitable and lead to their eventual wind down: they would significantly decrease the GSEs' main revenue stream (retained MBS business) while increasing their g-fee revenue, which would become negligible after private capital returns, leading to drastically smaller market share, g-fee revenue, net profits and eventual lack of profitability and subsequent wind down.
Evidence for this is found in Treasury's pre-decisional Q&A document for the NWS, which was produced in the discovery phase of Fairholme Fund's lawsuit in Judge Sweeney's court. That is the competition part. Now let's look at the housing finance reform, i.e., legislative, side. Separate bills in the House and Senate were previously introduced but never went to the floor of either chamber for a vote. Legislative action is virtually non-existent at this point.
Although there have been many vocal critics of the GSEs like Senators Mark Warner and Bob Corker and Representatives Scott Garrett and Jeb Hensarling, Congress has not done anything about the secondary mortgage market. The inability of Congress to act in the last 8.5 years has shown that housing finance reform is a tough subject to solve. Additionally, Congress has had little motivation to do something with companies that are sending them billions of dollars in profits to spend every quarter, especially in such a fiscally constrained climate.
In regards to the latter, Congress has seen that bad legislation can have horrible consequences, as observed in Dodd-Frank legislation (e.g., see here and here). Thus, lawmakers are rightfully highly cautious to move to an untested new system that impacts our economy in a number of ways. In light of all that, the conclusion is that the only alternative to this quickly escalating problem (the GSEs will have no retained earnings from 2018 onwards in current arrangement with Treasury) is for the GSEs to be returned to shareholders with or without any reform.
Since there is no viable alternative in place (no new market participants or new housing finance system), it would be economically devastating for Congress to remove the GSEs; the housing market is ~ 15% of the U.S. economy (see here and here). Allowing them to operate on razor thin capital for the last 4.5 years (due to the NWS) is fiscally unwise and a policy disaster; winding them down without something else to fill the void and carry out their role of market liquidity is pure insanity.
Lending would grind to a near halt, homebuilding and realtor activity would practically cease, and the 30 year mortgage would virtually go away overnight. It would be political and career suicide for any president or member of Congress to make that decision hoping that the market will work that problem out on its own.
A third reason to invest in the GSEs pertains specifically to preferred stock: liquidation preference and contractual rights. Preferred shares are different than common shares in those two important respects. Common shareholders do not have a contract with the company like preferred shareholders do. Preferred shareholders have a contract with Fannie Mae and Freddie Mac that gives them liquidation preference and a guaranteed fixed dividend if one is declared. Thus, they get paid par value for their stock in the event of a liquidation (assuming their assets are greater than their debts after paying off senior preferred shares), i.e., a wind down.
Common shareholders get whatever is left over after that. This makes preferred shares a much more attractive investment since they currently trade significantly below par (350-600%) and their return is largely guaranteed to be positive in any event (liquidation or return to shareholders), since there would be plenty of money to pay off preferred shareholders (FNMA - $18.8 B; FMCC - $14.2 B).
There is no way for the government can prevent preferred shareholders from getting paid for their shares; both junior preferred and senior preferred shareholders are governed by a contract, and the government will never convince a judge that their senior preferred contract should be honored but a junior preferred contract should not.
Common shareholders have no such guarantee in the event of a liquidation; they are the last in line to get paid, and their return in liquidation or return to market will be diluted by a factor of 5. In the event of a release from conservatorship, there are upsides and downsides to both classes. Preferred shareholders would experience no dilution in their share value, could get par or near par value and would get a very nice dividend (varies with preferred series; great dividend rates exist for many). However, their return is capped at par. Common shares experience no cap.
The huge downside to this class is that they will experience a significant dilution in value (80%), although some still value it at a higher return (10-15x) than preferred shares (3.5-6.0x) over the long run. The largest downside to common shares is the huge uncertainty that they face to being of any value to investors. Prior to the Perry Capital et al. ruling, common shareholders could stomach the understood risk since they believed the Court would set the record straight and preserve their shares' value. Now that there is likely no judicial victory to shape the GSEs' future, the outcome has shifted to a politically shaped future.
In regards to the political aspect of this investment, many could see this as another reason to invest in the GSEs. Both common and preferred shares increased markedly between the time that President Trump was elected and the Perry Capital et al. ruling. The reason for this is the appointment of current Treasury Secretary Steven Mnuchin.
Investors viewed his TV remarks very positively for the GSEs' future. Mnuchin has stated before that housing finance reform is a top 10 priority for the Trump Administration. VP Pence's chief economist, Mark Calabria, recently told a banking summit attendees to expect a set of principles governing GSE reform in the coming months.
Investors anxiously wait to see the direction that the Trump Administration and Congress take on housing finance reform. It is not far-fetched to believe that President Trump and Secretary Mnuchin see the GSEs as a large source of revenue to accomplish the President's ambitious agenda of rebuilding our country's transportation infrastructure and securing our southern border. Trump is a businessman who understands that releasing the GSEs back to shareholders could be a win for the government and shareholders.
Finally, his disdain for President Obama and Obamacare could (believe it or not) play a role in the outcome. Taxpayers are keenly aware that our government operates in a fiscally constrained budget; Trump wants significant cuts to various federal agencies. Thus, if President Trump directs Treasury Secretary Mnuchin to stop the NWS and rebuild capital, a reliable funding stream for Obamacare (and other government programs) would be stopped, causing troubled programs like Obamacare to implode faster.
And given that President Trump believes that the Obama Administration officials have been trying to undermine his presidency (wiretapping claims and the leaking of classified information), it wouldn't be a surprise if Trump decided to direct DoJ to release all 11,000 documents the Obama Administration has been hiding from plaintiffs in GSE lawsuits in an attempt to embarrass him and damage his legacy.
Disclosure: I am/we are long FMCKI.
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.
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