Monday at the Sohn Investment Conference, Bill Ackman treated everyone in attendance to a 110-slide presentation/history lesson/pitch on government housing insurers Fannie Mae and Freddie Mac.
It was part long thesis, part political speech. The activist investor believes that the stocks, currently trading around $US4.20 a piece, could head up somewhere between $US23 and $US47.
That is, of course, if Washington doesn’t go ahead with its plan to dismantle the two insurers and totally reimagine the way Americans buy their homes. Politicians have wanted to dismantle Fannie and Freddie ever since the two entities were caught up in the center of the financial crisis and needed gigantic bailouts.
The way Ackman sees it, the 30-year fixed rate mortgage is as American as apple pie and monster truck rallies, and Fannie and Freddie are the only two entities big enough to handle all the demand from Americans who want to live the dream. Plus, since they’re over 70% owned by the American government, if they succeed we all succeed.
To politicians, “big” is part of the problem with Fannie and Freddie. They’re scarred from 2008 and want to reduce systemic risk associated with size — the kind of risk that made it necessary for the government to take Fannie and Freddie into conservatorship during the financial crisis.
Ackman, for his part, doesn’t see a problem with size, he sees a problem with bad loans. In his plan Fannie and Freddie get to stay huge, but are reformed to take on less risky assets.
The only change he would make would be to get rid of a little something called the ‘net worth sweep.’ The short version is that back in 2012 the government amended its agreement with Fannie and Freddie so that it was the only shareholder that got any of their profits. That also happened to be the year Fannie and Freddie became profitable.
Naturally some shareholders were furious, including hedge fund Perry Capital, which started suing the government over this in the summer of 2013.
A win for Perry Capital is the ideal situation for Ackman. In that scenario, for Ackman to win this battle the government has do to something it has excelled at recently — which is nothing. For the government to win this battle, it has to pass a bill.
“They [investors like Ackman and Bruce Berkowitz] have taken a calculated, educated risk that the government’s not going to do what needs to be done,” former Treasury Secretary Hank Paulson told Business Insider in January.
Paulson is on the government’s side on this one.
The most well-known plan to wind down Fannie and Freddie and turn them into something smaller is sitting in a congressional committee right now. It was proposed by Senators Bob Corker (R-TN) and Mark Warner (D-VA) last June. It’s called the The Corker-Warner Housing Finance Reform and Taxpayer Protection Act, and Ackman seemed to be countering that plan throughout his presentation yesterday.
The bill would wind down Fannie and Freddie in five years and set up the Federal Mortgage Insurance Corporation (FMIC). The FMIC would act as insurance the same way the FDIC does for banks, protecting 10% first-loss, private capital in the mortgage market.
It would also be required to hold “a minimum reserve balance of 2.5 per cent of the outstanding balance of covered securities as a catastrophic backstop that would only be utilized in the event that the 10 per cent first-loss private capital is completely wiped out,” according to the bill.
In his presentation Ackman made a couple arguments that referenced ideas in this plan.
First off, he said that there isn’t enough private capital floating around to cover that 10% figure, which would be about $US500 billion. How does he know? Because over the last decade private companies in the United States have only shelled out about $US386 billion for IPOs.
You can decide whether or not you think that’s a fair comparison.
He also said that the pain of subprime losses will scare away investors — which is something you should ask all the hedge funds specializing in mortgage strategies that have killed it over the last couple of years.
Another private sector problem, he said, is that banks simply wouldn’t do their part and pick up the slack of left-over mortgages not held by the FMIC. Their share of the mortgage market has actually declined slightly since the Savings and Loans crisis of the 1980s, and in 2013 Fannie and Freddie made up 61% of the mortgage market.
But here’s the thing — these Fannie and Freddie mortgages are making money. That’s why the government is finding them so hard to wind down. It’s also why Ackman wants them to live on for his investors.
Ackman correctly points out that we don’t know what Fannie and Freddie would look like in their next life, but if they’re making money now, it’s not crazy to think Wall Street would see opportunity in their reincarnation.
So who else wants a piece?
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