Fannie Mae / Federal National Mortgage Association (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) are receiving proposals from hedge funds and private equity firms. That has sparked a bitter dispute between private investors and the Treasury, which currently controls the government-sponsored enterprises (GSEs). The hedge funds plan to take over a big chunk of Fannie Mae and Freddie Mac, according to Henny Sender and Stephen Foley of the Financial Times. The hedge funds’ group pitching the proposal plans to take over Fannie Mae and Freddie Mac’s operation of guaranteeing mortgage-backed securities.
Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) badly needed a large amount of capital during the 2008 financial crisis. So, the ailing agencies began to issue preferred shares worth billions of dollars, and tried to woo investors with favorable regulatory environment. The then Treasury Secretary Hank Paulson vouched for the financial health of the agencies. That helped Fannie Mae and Freddie Mac raise $9 billion through preferred shares, taking the total issuance to $34.6 billion. However, the fresh capital didn’t do much for the agencies. A few months later, Hank Paulson took the agencies under government conservatorship. The U.S. government infused $187 billion to keep them alive. Through its investments, the government owned 79.9% of their common equity.
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GSEs strong than ever today
At the time, few people realized that the original common stock and preferred shares became secondary to the government’s shares. Investors thought the old preferreds would never be worth anything again. But a recovery in the housing market helped these agencies produce billions of dollars in profits. And they still expect to return the entire bailout money to the government by early 2014. In the latest quarter, Fannie Mae reported a net profit of $8.7 billion.
Fannie Mae and Freddie Mac’s position in the market has also strengthened. Today they guarantee 85% of total mortgages, up from just 49% in 2007. Originally, community banks and small insurers purchased the preferred shares the agencies issued in 2008. But when the Federal Reserve launched quantitative easing in 2010 to help the housing market, hedge funds started accumulating those shares. Among those hedge funds were Perry Capital, Fairholme Funds, Claren Road Asset Management, Paulson & Co. and the Blackstone Group.
Fannie Mae & Freddie Mac’s actual losses much lower
Hedge funds’ analyses showed that Fannie Mae and Freddie Mac’s actual losses in 2008 were much smaller than what appeared on paper. According to a suit by Perry Capital, the government-sponsored enterprises (GSEs)’s net losses between 2008 and 2012 were $100 billion less than previously anticipated. The losses appeared large because the agencies were forced to accumulate massive reserves to absorb future losses.
The Treasury saw this miraculous turnaround in Fannie Mae and Freddie Mac’s fortunes in 2012. So, the Treasury manipulated the terms of its preferred shareholdings. The government previously received just 10% dividend on the profits of the two agencies. But the manipulated terms allowed it to take all the profits Fannie Mae and Freddie Mac produced.
Fannie Mae & Freddie Mac’s uncertain future
Both Fannie Mae / Federal National Mortgage Association (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) are in the government’s control today. Congress plans to wind down the agencies. However, hedge funds know that it’s the right time. Banks are pulling away from the mortgage market, and private insurers are left with little capital. The hedge funds’ proposal includes converting their preferred shares worth $34.6 billion and underwriting a $17.3 billion rights issue. That’s like a cash offer from a group of private investors.
Hedge funds believe that the two agencies could easily be worth more than $200 billion. The reversal of the government-sponsored agencies (GSEs)’s reserve should amount to $55-$60 billion, lawsuits against banks could fetch at least $20-$30 billion, plus they are generating at least $25 billion profits a year. Such a lucrative opportunity ensures that hedge funds are unlikely to give up.