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The End Of The American Dream & GSE's

|Includes: AIG, C, Freddie Mac (FMCC), FNMA

Taking grasp of the American dream is something that every American strives for when trying to make their mark on the world. For countless years, the middle class of the United States has relied on affordable and stable financing on housing so that they could build and maintain equity in their homes and in turn build their wealth. As home ownership is the quintessential goal of most Americans, it may be coming to an end along with those who have provided it for so long, Fannie Mae OTCQB:FNMA and Freddie Mac OTCQB:FMCC. Created for the greater benefit of the middle class, GSE's Fannie Mae and Freddie Mac had been the beacon of light for the American dream and growth of American capitalist culture. Throughout the years the initial business of guaranteeing interest and principle payments on mortgaged back securities had changed and the two government sponsored entities became very much like hedge funds. They issued substantial amounts of debt and becoming massively levered institutions guaranteeing subprime mortgages. Since 2008, both companies have been in conservatorship, majorly owned by the United States Taxpayer through the Treasury. Owning 79.9% of common shares, the United States Government has been lax on the fate of the two institutions that once were the quintessential backbone of the American dream. In all other cases since 2008 of the United States government taking a majority control of a corporation (AIG, Citigroup), the companies had become profitable and shares sold back on the open market for massive gains by the government. In Fannie Mae and Freddie Mac's case, both institutions have become profitable once again and reformed. Since 2008, both companies have paid the government billions of dollars more than initially borrowed. Fannie Mae and Freddie Mac hold a 50% share of outstanding mortgages in the United States and 60% share of annual originations. Being the institutions, which developed the 30-year mortgage, they have been major players in the growth of America and are arguably a necessity in our society, as we know it. This possesses a very unique situation that is quite arguably the most interesting play in the capital markets today. If the institutions were to be recapitalized, this would create opportunity not only for investors to reap substantial profits, but would result in the United States government making upwards of $600 billion dollars through its warrants and continued tax.

Prior to The Great Depression, mortgage availability within the United States was limited and quite hard to take part in for the middle class. Mortgages were generally originated by local commercial banks and insurance companies lending at floating market rates for short periods of time (5-10 year periods). Only appealing to those who could afford variable rates, short periods and large down payments home ownership was only at 45% nationally. Once the Great Depression set in on the United States, the U.S. mortgage market was stunned and required major government intervention to recover. With unemployment at 25%, housing prices down up to 50% and 25% of current mortgages in default, homeowners were not able to make principal payments or refinance to lower rates. Once the Home Owners Loan Corp. was established in 1933 and later, the Federal Housing Administration (1934), mortgages were converted from short-term variable into long-term fixed rate units and credit insurance was provided to the lenders. Once Fannie Mae was created as a semi governmental agency in 1938, it purchased FHA insured loans, which in turn provided liquidity for mortgage lenders. Fannie Mae's sole purpose was to support liquidity and stability within this secondary market which would lead to greater consumption and higher amounts of home ownership. Because home equity is primarily the largest part of peoples net worth, affordability and continuity is extremely important to the United States homeowner culture. The widespread use of the 30-year fixed rate mortgage was developed and is more used in the United States than anywhere else in the world. Requiring a lower down payment and higher amounts of payments, people are able to lock in rates and pay off their home a little bit at a time. Because the 30-year fixed rate mortgage has made it possible for Americans to live a more comfortable lifestyle and provide certainty with a fixed interest rate, it is essential the 30-year fixed rate mortgage does not get wiped out as it has been proposed with the winding down of Fannie Mae and Freddie Mac.

Government sponsored entities were chartered by congress so they could provide liquidity, stability and affordability to the mortgage market. By converting long term mortgages into liquid mortgage backed securities, it provided a financial instrument that could be introduced to the capital markets and be insured against credit risk. Due to Fannie Mae and Freddie Mac's natural oligopoly on the mortgage market, the only way for the 30-year prepayable fixed rate mortgage to be viable at its low cost would be for the institutions to stay in business and not be broken up. By diluting the institutions, the government would be inhibiting the markets to maximize gains through these mortgage backed securities and would be robbing the American people of the American dream of owning a home at a low affordable cost. It is shown that the high level of liquidity of government sponsored entity mortgage backed securities lowers mortgage interest rates which is better for the consumer, (mostly the middle class). The original business model of the GSE's is simple and still works. Cash and insurance generated business along with leveraged positions to positive long term trends in the housing market and giant economies of scale allow for Fannie Mae and Freddie Mac to be the only option at a low cost provider that would not rely on funding from capital markets. Being in the original intended business of 30 year fixed rate prepayable mortgages, as Franklin Delano Roosevelt intended, is a very low risk business that does not pose substantial risk to the institutions. By avoiding past mistakes of taking part in fixed income arbitrage and use of derivatives, recapitalizing and maintaining the inherent business model is the only viable option.

In September of 2008 the government placed Fannie and Freddie into conservatorship with the idea or bringing them back to operation and profitability once the markets stabilized. Since 2008, the Treasury has warrants for 79.9% of the common stock and collects all profit from the institutions disabling the payment of dividends on preferred shares. In 2012, for the first time, Fannie and Freddie both became profitable and have been profitable ever since. Once profitability was realized among the companies, a net worth sweep was announced which would lead to 100% of the profits to be paid to the Treasury. Under the United States Bill of Rights, this violates the 5th amendment, "Private property shall not be taken for a public use, without just compensation". Since the GSE's were put into conservatorship, they have paid the Treasury more than they were given and have not been recapitalized to resume business as AIG and Citigroup were once they were able to stand on their own. This flip-flopping of intentions and untested propositions to wind down the companies creates much agitation when it comes to how the future will be without Fannie or Freddie if any of the propositions are enacted. Because the GSE's have been such large players in the mortgage business and have provided stability in their original intentions, it is very hard to see the United States without a 30-yr prepayable fixed rate mortgage. As seen throughout the country, private equity funding and IPO's through public market funding would never be able to capitalize and sustain the amount of liquidity and power an institution would need to provide the services the way Fannie and Freddie do. The system is definitely not perfect, but it is an oligopoly that produces products and services at low prices, which no free market institutions could ever do. New players in the market would lead to riskier, lower quality securities which would lack the geographical diversity the GSE's naturally have through their sheer size.

Instead of breaking up Fannie Mae and Freddie Mac, the viable option would be for the government to recapitalize them, sell off equity in them and maintain a stable, less risky business model than of that prior to 2008. By doing this, the taxpayer who owns close to 80% of the companies' common stock would profit immensely. If the companies' were recapitalized, the governments position could be anywhere from $400-$600 Billion. Instead of throwing that money away with Fannie and Freddie in proposed legislation, this would allow for a great profit as well as the continuity of the low cost mortgage market to remain liquid and stable for years to come through its original intentions. The most important feature in recapitalizing Fannie Mae and Freddie Mac is not for the government or countless activist investors to make enormous returns, but for the middle class to continue to be able to afford homes in the United States. As the American dream is based on being able to own land and create wealth from hard work, the existence of the 30-year prepayable fixed rate mortgage has helped these American dreams and should be able to for years to come, so that everyone can benefit and homeownership within the United States can continue to rise as it has since the enacting of the 30-year.

Works Cited

Ackman, William, and Pershing Square Capital LP. "It's Time to Get off Our Fannie."

Ira Sohn Conference. New York. 5 May 2014. Presentation.

Roche, Julia La. "Here's Bill Ackman's Presentation On How You Can Make An Insane 1,000% Return Betting On Fannie Mae." Business Insider. Business Insider, Inc, 06 May 2014. Web. 12 Apr. 2015.

Rossi, Clifford V., Dr., and Chesapeake Risk Advisors LLC. "Forging a Path out of Conservatorship for Fannie Mae and Freddie Mac." The University of Maryland. Presentation.

Disclosure: I am/we are long FMCC, FNMA.