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Fannie And Freddie: What Are The Odds?

Summary

Fannie Mae and Freddie Mac seem akin to shell corporations providing cover for the government to grab the profits of the business.

The odds of success in federal court appear to argue against a significant investment for two years or less in Fannie Mae or Freddie Mac.

Individual investors in these entities should broaden their strategies beyond a very long holding period or multiple federal court actions.

When we lay our hard-earned cash on the table, we start to pay attention. The appropriate investing strategy is, of course, to pay attention before laying the money on the table.

With regard to securities issued by Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC), abbreviated here by "F&F", one could attempt to bypass this responsibility by passively investing in The Fairholme Fund, which holds a sizable position in F&F securities. Such a strategy can lead at best to confusion and at worst to permanent loss of capital. On the other hand, the investors who are actively following and analyzing these companies seem to be caught up in the legal minutiae of the ongoing court actions (the "trees") rather than looking at the bigger picture ("the forest"), including the history of the two entities since circa 2008.

Here the author attempts to develop an overview i.e., a big picture, from which to gauge the likelihood of positive returns for investors in these securities. This overview might also help prospective investors to decide what is best for each of them.

1. Recent History

In the heat of the financial crisis of 2008−11, a major transition occurred in the companies, apparently enabled by the public impression that F&F were so far gone as to require a government rescue in order to maintain a stable, viable housing market. Before the financial crisis, the companies bought mortgages, bundled them into securities, and sold the securities to investors. Most importantly, the companies explicitly managed risk in this process. The government supported the companies with an implicit guarantee that supposedly (but not actually) rendered the securities equivalent to government paper itself, at least in the public's mind.

After the financial crisis began, the companies were placed in conservatorship, apparently to rescue them and the housing market from what amounts to oblivion. However, at the Treasury Department, I am guessing that someone must have been (figuratively speaking) dancing in the halls while singing some variation of "Guess what I found?" Answer: cash cows of major proportions. And surprise, surprise, the federal government loves receiving billions of free dollars every year. The federal government is loath to give up this windfall, no matter who populates the White House and the Congress. This lowers the odds of success for individual investors.

So, what are F&F now? They seem to resemble shell corporations - merely facades that provide cover for the Treasury Department to run a Mom and Pop business inside the government.  If this picture is valid, the Executive Branch might quietly control the entire housing industry, surreptitiously lending money to the "housing market" (e.g., banks, builders, and customers), in effect securitizing mortgages itself, and selling them for profit to investors. In such a scenario, the government would get all of the money but would not necessarily manage the risk properly.

2. What about the individual investors in F&F?

"Let them eat cake," seems to be the attitude of the President and Congress. The Treasury Department has executed well-documented moves to ensure that the individual investors in F&F get only cake rather than money and then, only if they buy the cake themselves.

So the only apparent recourse was to file lawsuits in federal court. That should work, shouldn't it? After all, the investors are protected by securities laws and regulations. Oh wait, aren't the federal courts part of the federal government? I wonder whom the government will favor in lawsuits against the government! Do I have to write the answer?

3. So what are the odds of profits for individual investors?

Obviously, I have telegraphed my opinion that the odds are not good for success in court. However, that depends partly on a number of unknowable factors, e.g., the personalities, personal histories, health, and even prejudices, etc., of each court judge, and of knowable factors like the operational details of the particular courts. As intended, let us take a higher level, simplified view, involving general factors like how far into the future we attempt to compute odds and how many court cases or actions will take place in a given amount of time.

For example, Fairholme prefers the "long view" in investing - perhaps many years if necessary. Outside of unpredictable factors, e.g., major events, the longer an odds maker allows for the process of correcting the mistreatment of individual investors, the better are the odds of success. However, in practical terms, the farther out one looks, the more likely will be events that overshadow the historical facts, perhaps even rendering the legal process moot.

For these reasons, let us consider the odds that individual investors will achieve a positive return within the next two years, and let us base the odds on the number of court cases to be settled in that time. Our main data point thus far is the decision (2 to 1) by the DC Court of Appeals against Perry Capital et al. in February, 2017. Based on this lone data point, one can naively choose the probability "p" of investor success in a given court case to be 1/3 or odds of 2:1 against.

Now for the sake of discussion, assume that there are some number "N" of court cases to be settled in the next two years and that investor success in any one of these ensures a positive return for individual investors. For this simple thought experiment, the probability "P" of success in at least one of the N cases is then given by the equation, P = 1 - (1-p)N , where again we estimate  p = 1/3. For N = 2 cases, then P = 5/9 or odds of 5:4 that the investors will prevail in one or both cases. For N = 3 cases, P = 19/27 or odds of approximately 2:1 that the investors will succeed in at least one of the cases, thereby achieving a positive return on investment.

This simple model thus assumes that more court cases give better odds of investor success and that odds of better than 50:50 should be achievable with a few court cases. However, for me, favorable odds of 2:1 for plaintiff success are not nearly sufficient to invest a lot of money in a special situation for a period of up to two years.

4. Conclusions

Based on this simple thinking and modeling of the situation facing individual investors, we can conclude the following:

(1) The government has great incentive to fight individual investors for the right to the endless supply of free money that appears ripe for the taking. In that regard, this is not a game or a mental exercise; it is actually closer to a street fight. And, the government is likely prejudiced in its own favor.

(2) The government appears to have rendered Fannie Mae and Freddie Mac effectively speaking, as having some features of shell corporations, through which the government might run its own business of purchasing, securitizing, and selling mortgage-based securities, thereby controlling the housing market and taking all of the money earned. Such an action by a government, not experienced at running and managing the risks inherent in such a massive commercial enterprise, could incur an unforeseen, possibly major financial disaster in the future.

(3) Individual investors do not seem to have sufficiently high odds of positive returns via lawsuits in federal court to justify a significant investment in F&F for a term of two years or less.

(4) The only viable passive recourse is to hold the investments for several years or more, thereby potentially increasing the odds of a positive return, albeit eroded by such things as inflation and unforeseen negative developments that naturally become more likely or consequential over longer holding periods.

(5) Court cases might not be sufficient in number nor might the probability of success in each individual case be sufficiently high to ensure positive returns, even over a long time period (several years or more).

(6) Investors should consider an enhanced or more active strategy to achieve success. One possible enhancement is a concerted, ongoing, very public campaign to bring the government actions to light and make the politicians and their benefactors squirm. The investors could even point out that the current situation was established during the Obama Administration. I am sure that would sit well with the president - or maybe not!

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: The author indirectly owns investments in Fannie Mae and Freddie Mac securities via ownership of shares in The Fairholme Fund