Rafferty Capital Markets’ Richard X. Bove weighs in on the Senate’s plan to restructure the housing finance landscape.
The Event
The leaders of the Senate Banking Committee provided the markets with broad outlines of a plan that would replace Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) on Tuesday. While no specifics have been provided, as yet, the Senators’ comments suggested that the new legislation would follow the outlines of the bill introduced by Senators Corker (R., TN) and Warner (D., VA) some months ago. The Corker/ Warner Bill would eliminate Fannie Mae and Freddie Mac in five years and replace them with a new agency the Federal Mortgage Insurance Corp (FMIC).
This new agency as envisioned by Corker/Warner would reinsure mortgages created and partially insured by others. The key problem from the standpoint of public investors is that Corker/Warner would not provide any payment to private sector owners of the common and preferred stocks of Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC). This caused a literal route in the stocks forcing them to drop by about 1/3rd from the high point of the day to the close.
Therefore, even though I do not have the specifics of the new legislation it makes sense to review the core reasons that I am recommending these stocks so strongly. Once the specifics of the new legislation are revealed, I will discuss the specifics more fully.
Three Sectors to be Studied
There are three critical areas to be reviewed to determine if Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) are reasonable speculations, and I continue to believe that they are good speculations:
1. Economic and social issues
2. The court cases
3. The expected ultimate result of the many Congressional Bills on the future of Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC).
Fannie Mae, Freddie Mac: Economic and Social Issues
The United States housing industry is the most subsidized business in the United States. While all of the commentary to this point is why this situation should end, there are two factors that are not being discussed:
1. Why is the industry in this preferred position; and
2. What will happen if the subsidies are removed?
Fannie Mae, Freddie Mac: Preferred Position
Prior to 1935, the United States had no position in U.S. housing. The Depression changed that view. The structure of mortgage finance offered little protection to home owners when the depression came. Millions lost their homes and mass migrations began which destabilized the economy even further. The pain was so intense that the government stepped in and changed the structure of the home finance industry in the country by offering heavy subsidies at every level of the business.
In the 1960s the cities were burning from Los Angeles to Newark. Studies commissioned by the government revealed a well-known fact – i.e., people do not burn down their own homes. The government may have panicked at the time but once again it totally restructured home finance in the United States increasing the subsidies to the industry.
As the decades passed the government discovered that there were compelling economic reasons to continue its support of housing. Housing subsidies could be used to stimulate economic growth. This truism has continued to 2013-14 in the form of the Federal Reserve’s willingness to buy mortgage backed securities to stimulate the economy.
Therefore, the decision to tear apart the financial structures that were created over the past 80 years carries significant risk. The risk is that slums will be created across the nation as low income households live together in ghettos where the ownership of housing may be in large financial conglomerates far removed from the neighborhoods being impacted.
Moreover, housing subsidies, this well used tool to stimulate economic growth in recessions will be gone. Further, the transition from a subsidized industry to a privately driven real estate business carries with it the risk that the value of every home in the United States will decline in value causing a recession.
Fannie Mae, Freddie Mac: Court Cases
There are a number of court cases that argue that the United States Treasury has expropriated the private property of investors without just compensation. These cases are based on two facts:
1. The Housing and Economic Recovery Act of 2008 (HERA) created a conservatorship to operate Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) with the stated intention of returning them to private sector ownership once the problems besetting Fannie Mae and Freddie had passed.
2. In 2012, the Treasury stated that it had no intention of following the law (HERA) and it changed the terms of the conservatorship agreement to eliminate private sector ownership.
3. There was no Congressional action that mandated this change and no court review of what the Treasury had done.
The probability is high that the courts will reverse the action of the Treasury known as the Third Amendment. If this happens, it is highly likely that private sector owners of these two companies will be justly compensated for the expropriation of their property.
Congressional Action
The new bill being introduced by Senators Johnson (D., SD) and Crapo (R., IA) is being treated by the press as if it were already the law of the land. Nothing could be further from the truth. Both the Republican and Democratic parties have yet to take firm positions on what the bill to eliminate Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) should look like. The probability is that there will be no legislation on this issue in 2014 because:
1. There is no clear consensus in Congress as to what should be done with home finance and as stated above the stakes are enormous if the wrong decisions are made.
2. The Congress cannot proceed without a clear statement from the courts as to what is legal and what is not in the actions taken by the Treasury to date.
3. This year is one of political ferment
a. Neither the Democrats nor the Republicans know what the people of the country will do in the November elections, and
b. Taking the wrong stance on this issue will be toxic.
Other Issues faced by Fannie Mae and Freddie Mac
One would think that at some point is this broad debate the following issues will emerge:
1. Without the so-called bail-out of Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) the housing industry would have collapsed and the economy would have failed along with it. The taxpayer did not bail out Fannie and Freddie s/he bailed out him/herself.
2. By keeping Fannie Mae and Freddie Mac alive the housing finance system was able to resolve its issues in a fashion that harmed the least number of Americans.
3. Housing prices stabilized and mortgage interest rates stayed low.
4. In the process of bailing themselves out, the American taxpayer is sitting on a potential profit of $355 billion in preferred stock and warrants – a profit that will be lost if Corker/Warner or Johnson/Crapo is ever put into law.
Conclusion
I refuse to be stampeded by the herd here. These stocks had a meaningful run up due to short covering and now they are plummeting as the shorts redevelop their positions. I will be there when these new shorts are forced to cover again as the courts and then the Congress bring rationality to an issue filled with hyperbole.
The basic fact remains, the system of home finance created by this nation has served it people unusually well for 80 years and I do not believe that it is about to be scrapped. Alan Greenspan said in a CNBC interview that the Dodd Frank Act was put in place by people who never sought to discover the reason of the Great Recession and that Dodd Frank is harming the economy.
I cannot believe that Congress is going to do this again in housing. This time they will feel the brunt of the American people’s anger as housing prices tumble across the country as ill-advised poorly thought out populist legislation is once again put in place.
