Although Fannie Mae / Federal National Mortgage Association (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) have paid back the $188 billion that they owed the government, their sins have not been absolved yet. Unsurprisingly, Fannie Mae’s former CFO, Timothy Howard, blames the treasury and the regulators for the fall of the mortgage giants during the financial crisis.

In his latest book, Howard calls the bi-partisan plan for liquidation of the GSEs, “a recipe for disaster”. He says that the amount of risk taken by the GSEs would never be possible if they were not backed by the government anymore. Dick Bove, who has weighed in on the Fannie Mae/ Freddie Mac debate several times, also said in a recent note that no bank would be willing to take that level of risk on mortgage rates, especially on the longer dated 20-30 year FRMs, in case the entities are wound down as planned.

Waterstone Market Neutral Fund, a hedge fund that is super-bearish on the value of these mortgage lenders, discussed the future prospects for this industry once again in their monthly letter, a copy of which was reviewed by ValueWalk. Since the fund is shorting Fannie Mae and Freddie Mac, it is banking on a wind-down, which would mean a 100% loss or zero recovery on the GSE’s securities.

GSEs conservator: a game changer

Waterstone explains that it is wrong to liken the case of these GSEs with the recovery experienced by American International Group Inc (NYSE:AIG) and General Growth Properties Inc (NYSE:GGP). The letter notes that the government’s guarantee here as the conservator of the GSEs changes the whole game. The backing from the government is actually the only thing that has given the GSEs such high credibility, and if taken out of the picture, they would be worth nothing.

“The only reason they [the GSEs] can borrow money so cheaply is because lenders assume the government would pay the debt if the GSEs failed, which they did. The only reason the GSEs can guarantee so much mortgages without the necessary capital is the government provided an unlimited line of capital to cover all loses.”

Waterstone points out how Fairholme’s proposal very neatly gives them the full value of their junior preferred shares and ownership in the new entity but smartly takes no liability to pay any debt, which stays with the government. Waterstone Market Neutral Fund recorded a rare but small gain in October – the hedge fund was up 0.5%. The net loss of the long/short equity fund is now -15.2% for the year.

Hedge funds lobbying for Fannie Mae, Freddie Mac

The long/short fund continued to lose in its negative bet against Fannie Mae and Freddie Mac. The letter invites discussions with the long holders of the government sponsored enterprise to understand arguments that validate the bullish view. Waterstone is also not impressed with the latest position in Fannie Mae / Federal National Mortgage Association (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC), disclosed by Bill Ackman. Waterstone adds that all long bets are speculative and are based on a series of ‘ifs’, that may or may not happen in the end. The monthly commentary criticizes Bruce Berkowitz’ Fairholme Capital, the largest holder of the preferred shares and comments on Fairholme’s self-serving proposal to restructure the GSEs,

“We don’t think they are gaining favor with government officials by suing them, calling them un-American and publicly proposing a “solution” that is nothing but self-serving hocus-pocus. They didn’t even consult with any government official on their plan. Several government policy makers and the President quickly rejected Fairholme’s proposal, as they should.”

Waterstone netted a profit in long Dendreon Corporation (NASDAQ:DNDN), a biotech company, and Par Petroleum Corp (OTCMKTS:DPTRQ) and also made a profit in short bet against SUPERVALU INC. (NYSE:SVU) as the company reported disappointing earnings.