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Updated Thinking on Fannie and Freddie

This post is an excerpt from the 1st Quarter Investor for my hedge fund.  If you would like to receive a full copy of the letter, please send me an email at derek.pilecki@gatorcapital.com.

I have owned positions in Freddie Mac and Fannie Mae (the GSEs) preferred stock since the two firms were placed into conservatorship in September 2008.  The shares have been extremely volatile.  In the first five weeks of the year, the various classes of Fannie and Freddie preferred stock rose in price from about 2% of face value to about 6% of face value.

There are several factors that contributed to the value increase in these positions:

1.  Fannie and Freddie’s financial results are improving – Both companies have improved their operations while in conservatorship.  The new loans the companies have guaranteed in 2009, 2010 and going forward will be profitable.  The problem vintages of 2005-2008 are being resolved and may be fully reserved for losses.  In the meantime, the companies’ mortgage investment portfolios have been very profitable and are throwing off $16 billion of cash per year at each company.  I believe Freddie Mac will become profitable in 2011 and Fannie Mae is potentially within 2 years of turning profitable.  I believe the regulators have acted wisely in how they’ve managed Fannie and Freddie through conservatorship.  Once the companies turn profitable, the nature of the policy debate will change for the better.

2.  Realization that continued existence of the GSEs makes the most sense - The Republican success in the election of 2010 makes full nationalization of Fannie and Freddie unfeasible politically.  On the other hand, the private market is not capable of providing enough capital to keep the mortgage market functioning smoothly especially at the low prices Fannie and Freddie charge to accept mortgage credit risk.  Evidence that the private market is not capable and/or willing to supply capital to the mortgage market is Fannie, Freddie and FHA’s combined 95% percent market share of the mortgage market since 2008.  The least risky option is to continue with the current system of the GSEs but impose tighter regulation on the companies to prevent bad management.

3.  Recognition that Congress will not resolve the GSE issue soon - Rationality is returning to the GSE policy debate. Cooler heads are voicing their opinions that the GSE model is not broken.  We are starting to see this point made from surprising sources such as Steven Roth’s annual letter to Vornado shareholders.  The problem with the GSEs wasn’t their hybrid public/private model.  The problem with the GSEs was incompetent management that did not recognize the danger of low documentation loans.

4.  News that the GSEs asked the Treasury to reduce the coupon on its senior preferred stock – In late January, the Financial Times ran a story saying that management at both Fannie and Freddie asked the Treasury Department to reduce the 10% coupon it receives on its senior preferred stock.  Freddie Mac may turn profitable this year even after paying over $6 billion in after-tax dividends to the Treasury.  If the coupon rate was lowered, then Freddie could pay back the Treasury that much faster.  Plus, the fact that management asked for the reduction confirms that the companies’ financial situations are in the beginning stages of recovery.

Of course, there should be several important changes to the GSE model to protect taxpayers, such as: Fannie and Freddie should not purchase mortgage loans without full documentation of income and assets, should not purchase private label mortgage securities, should step back from the market when spreads are tight and new business cannot meet their return on capital targets, and should restrict executive compensation.  A final necessary reform is a requirement that any member of the board of directors be required to purchase an amount of common stock equivalent to a multiple of their annual directors’ fees with their own cash.  This would incentivize board members to provide better oversight of management.   As a shareholder, I wish all of these changes had been implemented years ago.

As Freddie turns profitable and recaptures some of the capital that is artificially hidden in its accounting statements (marks on private label securities, valuation allowance on deferred tax asset and generous loan loss reserve), I believe the potential exists for them to repay some or all of the Treasury’s investment.  Once Freddie regains profitability and begins to repay the Treasury, a whole new set of policy options becomes available.  These new policy options would be beneficial to preferred shareholders.  It has been a long road owning Fannie and Freddie preferred stock, but the Fund has made a lot of money from the positions and the potential exists for future gains.  Although these positions will continue to be volatile, I continue to see several scenarios with further upside.