Brian Boyle, CFA, the president and portfolio manager of Boyle Capital, and Erik Ritland, CFA, the research analyst at Boyle Capital, discuss their investment in Fannie Mae and Freddie Mac, what will it take getting Fannie and Freddie out of conservatorship.
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Raul: Yes, can you tell me more about the Fannie Mae and Freddie Mac situation, just beginning with a primer to understand this investment and the out of conservatorship side of the argument?
Q1 hedge fund letters, conference, scoops etc
Brian: Sure, so we could probably spend two/three hours, I’ll try to truncate it as much as I can. 2008, you had the financial crisis, obviously, a lot of distress in the environment at that time. A number of financial institutions were bailed out, including both Fannie Mae and Freddie Mac, which were the pillars of United States mortgage market. At the time, they were given a line of credit essentially from the treasury that would require them to, whatever they borrowed on, pay the government ten percent interest and then ultimately, they’d have to pay back whatever they borrowed. The line of credit ultimately got to 400 billion dollars.
They borrowed against that somewhere in the neighborhood of 189 billion dollars. Then in the summer of 2012, in August of 12’, on a Friday afternoon at 5:00, which is when you would want to drop bad news, the treasury and the regulator at the time, the FHFA unilaterally decided to change the terms of the original agreement and instead of ten percent interest on the outstanding balance, they were just going to take 100 percent of the profits in perpetuity. All but making the investments worthless because there was no opportunity for investors to participate in the recovery as it occurred.
That action, of course, was challenged in the courts by a number of different parties and a number of different venues and a number of different arguments. From 2012 to the present, those cases have found their way through the various court systems, from the court of claims to circuit courts, district courts, and everything in between. We started looking at the opportunity in 14’, really started leaning into the investment from a weighting standpoint in the summer of 16’.
I would say at times, it felt like we were the only buyers in these securities. Our participation at that time was almost entirely in the preferred securities of Fannie Mae and Freddie Mac. Our premise was not necessarily the legal cases would be successful, but we do think that the legal arguments in support of the shareholders are stronger. We recognize that winning a case against the government is always an uphill battle.
So, we went into it recognizing that that part of it would be a wildcard. At the end of the day, we just felt like you have the linchpins of the U.S. mortgage market, that at times are anywhere from 50 to 80 percent of the overall market. Some administration is going to look at the situation and say, it makes no sense to have these two linchpins of the mortgage market with no capital and essentially in bankruptcy. We believed at some point, some administration, it wasn’t going to be the Obama administration, would come in and address that.
Obviously, Trump won in November of 16’, and these securities have benefited a great deal from his overall victory in 2016. Now, here we are in May of 2019, the securities have been like a rocket so far this year. Our portfolios have been up very strong this year as a result of that investment, primarily. We believe that more so than at any point during the life of this investment for us, the probability of a successful resolution is the greatest that it’s ever been. Where we’re at today is this, in April of 2019, Mark Calabria stepped in as director of the FHFA, this was the first time that the Trump administration was able to appoint their own person in that role.
Mark Calabria is extremely well-regarded, has a great background in the mortgage markets, was also heavily involved in putting together the law that oversees the conservatorship of Fannie Mae and Freddie Mac. The right man, at the right time for this job. Calabria in recent weeks has talked about the government’s interest in getting Fannie Mae and Freddie Mac out of conservatorship and this would piggy-back off of a memorandum that the Trump administration issued on March 27th, that memo had a number of items that it wanted to see as part of broad housing reform, but at the very top of that was exiting this conservatorship that Fannie Mae and Freddie Mac have been in since 2008.
Based on comments that have been made in the last couple of weeks, we’ve seen the securities continue to move up from as low as six dollars in October, to around thirteen dollars today. Really, why we’re positive on the situation from here is, we believe over the next couple of months, the administration’s plan will be crystalized and more and more of the details will be filled in.
By the time we get to the fall, the expectation would be that they’re going to be in a position to stop the current network sweep of 100 percent of the profits. They’ll reach an agreement with treasury that would enable Fannie Mae and Freddie Mac also to exit conservatorship. That would put them in a position to ultimately move down the path of recapitalizing Fannie Mae and Freddie Mac and doing some kind of public offering.
At the end of the day, you have these securities at 13, par value on the securities would be 25 dollars pers share. We don’t know if par value is going to be the endgame, we think that there’s going to be a high probability that that’s the case, but we feel like the risk/reward here is certainly attractive. The downside is probably pretty low, if you believe that they’re going to get this plan done. They need capital in these entities, and in order to get capital in the entities, you have to cut off the tail risk of litigation. The only way you do that is to solve the outstanding litigation. You settle it with the plaintiffs.
They’re not going to go away for 15 dollars a share, they’re probably going to go way for closer to 25 Out Of Conservatorship. That’s ultimately where we’re at. The securities are probably the biggest special situation that you could find and a very uncorrelated investment to the broader market. In a month like May, where the Dow has been down every week, it’s been down five of the last six weeks. This is an investment that has continued to move higher. We think that through the summer months, that upward movement will continue, but regardless, it will do so regardless of what the broader market does. At a time when people have concerns about valuations and trade talk, this is an attractive opportunity in our opinion.
Raul: Yes, it’s very hard to argue against that. Man. Do you think it will play out by fall-time? If not, when do you think the resolution will be resolved?
Brian: Well, it’s important to distinguish between a resolution and the factors that are going to move the stock price. If you look at what’s going to move the stock price, it’s going to be more clarity around the legal cases, and there are some legal cases that could have some favorable decisions this summer, or the most likely driver would be more clarity around the administration’s plan to exit conservatorship. We do think, based on comments that have been provided by Mark Calabria, the director, that by the fall, he will have negotiated a settlement with treasury as it regards to the government’s ownership in these entities.
At that time, it would make sense for them to ultimately resolve the outstanding issues surrounding litigation because you cannot go and do a road show to raise capital, if there’s just potential liability of 100 plus billion dollars hanging out there. The administration indicated that they’d like to be doing that road show sometime early next year, so our view would be, before you go and do that, you have to resolve how you’re going to treat the preferred securities.
In terms of actually getting out of conservatorship, it’s going to be a process, they’re going to need 100 to 150 billion dollars of capital. There’s never been a raise in the history of the markets of that size. You cannot eat an elephant like that in one bite, it will take three/four bites in order to do that. That will be something that will play out over a multitude of years. In terms of realizing the investment potential, we do believe that the next six to twelve months would be the timeline with respect to the securities, where they’re at today to closer to that par value level.
