Fannie/Freddie Preferreds - An Introduction

The Federal National Mortgage ("Fannie Mae") and Federal Home Loan Mortgage Corporation ("Freddie Mac") are government-sponsored enterprises which were created to provide liquidity to the mortgage market in the United States. They do this, in large part, by buying pools of mortgages from lenders, securitizing them, and selling/guaranteeing the resulting mortgage securities. While there are endless wrinkles to this description, these entities fed the growing demand for house ownership over past few decades and ate themselves nearly to oblivion during the crash.

After being left for dead in 2008 as they ("F&F") went into conservatorship, both have returned to profitability, to say the least:

(Source: Fairholme Funds)

The US Treasury has invested a total of 189.5$ billion in the GSEs to keep them afloat in exchange for 1) government control through warrants for 79.9% of equity and 2) senior preferred shares. By Q1 2014E all of that investment is projected to be repaid. In particular, 2013 Q3's payment was $30.4+8.6 billion and brings repayments within striking distance of the investment. To clarify, these repayments are the redirection of net income to the government- the majority equity holder.

As a result, both the equity and preferred have surged.

However, where exactly do the junior issues actually stand? The original investment simply diluted the equity and added another layer of debt, but a 2012 amendment siphons off any profits back to the treasury and prevents any nearly any equity ("net worth") from building up. Right now, there is no income/ownership which feeds to preferreds/non-govt common equity, even though the underlying business has dramatically improved and private investors still own 20.1%. In essence, the government has monetized its warrants without having to exercise and has crowded out the remaining owners.

This does open the door for private investors (Fairholme, Perry, etc.) to provide a more definite exit. There have been at least 2 proposals for the junior issues to get paid:

First, there is the legal approach to overturn the 2012 amendment by arguing it violates the Economic and Housing Recovery Act of 2008. Without that amendment, F&F can build up equity based on the billions it is making.

Second, Fairholme has proposed a broad recapitalization and split off of F&F operating entities ( 2nd version) using $50B+ of private capital.
Each approach requires the leaders to put significant time/resources to navigate both the political and legal hurdles necessary to change. This opportunity exists because of the haphazard manner of the F&F bailout, and its resolution requires those in charge to desire private sector involvement on generous terms.

As a miniscule fund, I cannot hope to influence such events. I could however, benefit partially from these efforts by buying at a slightly higher price. The downside is $0 for both common and preferred. Obama/Congress can choose to retain the status quo indefinitely and send all profits back to the treasury. Politically, this may be the easiest as it can produce profits while not angering either aisle. That would make the investment a total loss.

What if the private catalysts above succeed? Preferred could get paid off at par and common trades again freely. If the common is not liquidated, the treasury could get paid handsomely for its warrants in addition to making back all the money it invested (i.e. having its cake and eating it too). 

The upside here is that investors can benefit in the strengthening business, as mentioned above.
Specifically, increases in guarantee rates, stronger underwriting standards, a recovering housing market and growth in market share (10k) have not only made the GSEs more powerful, but also more profitable than ever before. The specific merits of this business can be explore much more in detail, but the overall conclusion is that the Fannie & Freddie (F&F) are back, possibly better than ever.

The question is - what does this mean for private investors?


Disclosure: long FNMAS (Fannie Mae preferred S series).