Fannie Mae and Freddie Mac have been under U.S. government control for more than a decade now, but it’s finally sounding like that could end. One hedge fund which focuses on the financial services industry has been betting on a positive end to Fannie’s position as a government-sponsored enterprise (GSE), and the fund updated its thesis for Fannie Mae preferred stock in its fourth-quarter letter to investors.
A tough fourth quarter
The fourth quarter was difficult for almost all hedge funds, but it was particularly tough for Gator Capital Management. The fund declined 20.57% in Q4, underperforming the S&P 500 Total Return Index, which declined 13.52%, and the S&P 1500 Financials Index, which fell 13.36%. The financials sector in general was down 11% for the quarter, while regional banks declined 16% and insurance stocks declined 8%.
The Gator team explained that they had expected December to be a strong month because many of their stocks were down from their highs in September or flat for the year. They had expected investors to buy financials stocks in expectation of a strong 2019. However, none of these expectations played out because the markets reacted poorly to the Fed's commentary after it raised the Fed Funds rate.
Fannie Mae preferred stock is "too cheap to sell"
At that point, the Gator team felt many of the stocks the fund owned were "too cheap to sell," so they held onto them so they wouldn't miss any potential rally. January did bring a strong rebound, and they said that as of Jan. 24, they had more than made back what was lost in December. They estimated that the fund was up 17% for 2019 through Jan. 24.
Gator's best-performing positions in Q4 were its Fannie Mae preferred stock, Syncora, Federated Investors and OFG Bancorp, while its biggest detractors were Zions Bancorp stock and warrants, SunTrust, KKR and Credit Suisse. As of the end of December, Gator's largest long positions were Syncora, Zions Bancorporation stock and warrants, Ambac Financial Group, SunTrust Bank and KKR. The fund's biggest short positions were Northwest Bancshares, Community Bank System, Hamilton Lane, CVB Financial and First Republic Bank.
Updated thesis for Fannie Mae preferred stock
The Gator team also discussed at length their long position in Fannie Mae preferred stock. They last wrote in depth about it approximately four years ago, so much has happened on the GSE front since then. They believe the GSE story has finally reached an inflection point, and they now expect the Federal Housing Finance Agency to move Fannie and Freddie out of conservatorship this year. If or when that happens, Gator expects their preferred shares to either be converted to common shares or be refinanced. The firm went on to explain why think this will be the year Fannie and Freddie finally exit conservatorship.
The Gator team noted that the Trump administration has appointed Mark Calabria to be the next FHFA director, and Calabria wrote a paper a few years ago about how the agency was ignoring precedent in the two GSEs' conservatorships. Although it could take as long as six months for him to be confirmed as the new director, Gator management expects that once he's in the post, he will start pressing for Fannie and Freddie to exit conservatorship. Additionally, they noted that acting FHFA Director Joseph Otting has also spoken positively about ending the conservatorships. Treasury Secretary Steven Mnuchin has also long been in favor of Fannie and Freddie leaving conservatorship.
Gator management also noted that the GSEs' former "political foes" in Congress have now retired. Rep. Jeb Hensarling and Sen. Bob Corker were both opponents of the GSEs for a long time, so Gator expects their replacements to bring "fresh perspectives on housing policy."
The fund's management also feels that most of the problems which had been identified over the last 10 years have now been dealt with. As a result, they don't believe legislation is required to reform Fannie and Freddie. They also feel the "narrative" behind putting Fannie and Freddie into conservatorship has now been "debunked." They believe the move was only the first of "several policy errors" which essentially "made it appear as though the GSEs were in a much weaker financial position than they were."
Finally, Gator feels removing Fannie and Freddie from conservatorship would be good for the housing market because the two companies will likely "make reasonable changes at the edges of their credit policy to help improve access to mortgage credit."
The fund's management expects the next step to be a plan for them to exit conservatorship, which they look for in the first quarter. They think the next step will be another amendment to the Treasury agreement to allow the GSEs to retain capital. Other steps they expect include a preferred-for-equity trade and an initial public offering.
Republicans outline plan for GSEs
There is a new development on the Fannie and Freddie front today, which may be the beginning of the first step outlined by Gator management. Senate Banking Committee Chairman Mike Crapo released a plan to remove Fannie and Freddie from conservatorship. Both GSEs would become private mortgage guarantors, but according to Bloomberg, Crapo's plan was light on details for some of the most crucial parts of the plan—including a plan for shareholders of the two GSEs.
Common shares of Fannie and Freddie soared last week after it was widely reported that Otting had said the Trump administration might release both GSEs without any legislation. However, the White House said earlier this week that it planned to work on the problem with Congress, suggesting legislation may be required after all.
Under Crapo's plan, guarantors would insure mortgages backed by Ginnie Mae, but with a limit on share of the market any one guarantor would be allowed to have. The plan also dumps Fannie's and Freddie's goals for affordable housing and replace with what he calls a "market access fund" which would be funded through mortgage fees. However, the plan said nothing about what would happen to Fannie Mae preferred stock shareholders.
This article first appeared on ValueWalk Premium