Back in 2012, Bill Ackman had some suggestions for Federal National Mortgage Association (OTCBB:FNMA) a.k.a. Fannie Mae. The hedge fund manager, known for his aggressive activism, said that Fannie Mae could do well for the housing sector if it held on to its foreclosed homes rather than selling them, he said, “fix them up and rent them and become a residential REIT that owns homes.“
Today, Ackman’s hedge fund filed two 13Ds showing nearly 10% stake in each insurer’s common stock. Pershing Square detailed in the filings that they will push the companies to follow through with a plan for restructuring the GSEs. Bill Ackman intends to engage in discussions with the government and other shareholders to achieve a favorable outcome.
No liability to shareholders
Ackman is buying shares of the two companies, which he warned investors against in a 2011 interview. While on CNBC, Ackman said “these shares should come with a warning.” The hedge fund manager was registering his surprise after a Fannie Mae / Federal National Mortgage Association (OTCBB:FNMA) board member and Harvard Business School professor, Clayton Rose, told him that the board’s fiduciary duty is only to its conservator, meaning the government, and not to the shareholders. He shocked Ackman by saying that the board has no liability if it makes decisions that go against shareholder interests. It seems Ackman has now gotten over his shock and believes that he can actually turn a profit here despite the obvious risks tdue to the heavy government involvement.
Bill Ackman shorts CDS
Interestingly, Ackman’s Pershing Square was among the first hedge funds to predict the fall in the subprime mortgage market during the financial crisis. According to Pershing’s 2Q2012 letter, the fund initiated short positions in Fannie Mae / Federal National Mortgage Association (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) through credit swaps in June’ 2007. It is not known whether Pershing is still hedging the risk of its new long bet by buying credit derivatives anymore or if the funds have exited the short bets. There is more likelihood of the latter. In the second quarter letter, Ackman noted,
Two mortgage insurers, Fannie Mae and Freddie Mac, where we were correct in our determination that both were insolvent, but where we did not expect that the U.S. government would protect their subordinate debt which we shorted through the purchase of CDS. Despite the government?s effective assumption of their debt obligations, we made multiples of our CDS investment on Freddie Mac and incurred only a modest loss on Fannie Mae CDS.
Fairholme Fund holds preferred shares, worth $3.5 billion face value, of the state-controlled insurers, making it the largest stakeholder. The refinancing plan that Berkowitz has proposed includes the acquisition of the core business of the insurers in exchange for preferred stock worth $34.6 billion, and an additional $17.3 billion that will be raised from preferred shareholders in a rights offering. Other than Berkowitz, John Paulson, Richard Perry and The Blackstone Group L.P. (NYSE:BX), also hold prefs of Fannie Mae / Federal National Mortgage Association (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC).
While the federal government seems least interested in any solution that would benefit the shareholders and insists on liquidating the mortgage insurers, the hedge funds have been lobbying for a long time to turn this decision. In July, a House of Representatives’ committee passed a bill that would allow the government to liquidate the GSEs over a five year period. The entities will be replaced with a non-profit, utility-like platform that investors would use to securitize mortgages. The new securities would be issued without a government guarantee, unlike the present ones which are guaranteed.
No favor with government
There is little hope that Fairholme would succeed in buying the two businesses, as both Democrats and Republicans are unaligned to the idea. The plan has to be approved by the government, not to mention the other holders of the preferred stock. Berkowitz has proposed to buy the two companies with approval of half of the holders of $34.6 billion of preferred stock and thus sustain the core business of guaranteeing mortgage-backed securities which the government intends to liquidate.
Fairholme has sued the U.S government, alleging that it violated the law by changing the bailout terms and sweeping in all dividend payments. While the government does not own the entities, it has the option to exercise control on 80% of the common stock. The Obama administration insists that putting the insurers back into their pre-crisis shape would invite another crisis and the only value that all shareholders see in Fannie Mae and Freddie Mac is because the government is sponsoring their business. So far Berkowitz and Paulson have failed to win the argument with the government, so we have to see if the addition of another high profile activist like Bill Ackman would make a difference.
Pershing Square did not respond to our request for comment.