Ed Demarco’s Fight Against Fannie Mae And Freddie Mac

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Ed Demarco’s Fight Against Fannie Mae And Freddie Mac by Glen Bradford

Executive Summary

People who were put in charge of running Fannie Mae and Freddie Mac have been trying to run them into the ground to end the 30-year prepayable fixed rate mortgage. Since the conservatorship began, Fannie and Freddie have stepped up to meet even more needs of Americans looking to own a home since market mechanisms are failing everywhere else. Begin by borrowing, end up taking is the business model that Fannie Mae supports but Fannie Mae can’t provide support if Fannie itself is taking all its money to Treasury.

Not less than a 10 minute walk from where I live, this week Edward DeMarco shared his views at the ABS East Conference in the Fountainebleau Miami Beach Hotel that 30-year prepayable fixed rate mortgages that have been offered by Fannie Mae and Freddie Mac are not good for Americans. According to Bloomberg News:

During his tenure leading the FHFA, DeMarco attempted to reduce the footprint of Fannie Mae and Freddie Mac, which were seized by the U.S. during the financial crisis seven years ago.

Edward DeMarco says, “everyone should get the 30 year mortgage” and that U.S. policy is focused “too much on increasing debt.” He suggests that more should be done to steer borrowers to loan products that they can pay down faster. During a time after which Fannie Mae and Freddie Mac have stepped in to meet the growing demand of this product by people looking to take part in American home ownership, DeMarco points out that many on both sides of the debate view government guarantees as needed to allow 30-year mortgages to remain widely offered at affordable interest rates, especially loans that can be repaid early without penalties.

[Fannie Mae] was adequately capitalized the day we put them in conservatorship – James Lockhart

Is DeMarco arguing that mortgages should come with penalties or that Fannie Mae and Freddie Mac need a government guarantee? As an investor, the government has guaranteed that my shares are valued as if they are potentially worthless by making deals with itself that use Fannie and Freddie to reduce the money supply by selectively cancelling the value of money that is theirs and pick it up every quarter with the net worth sweep. Investors can’t stop it according to Judge Lamberth who ruled that FHFA can do whatever they want because they are the government and as such according to the law FHFA can act without regard to judicial review.

Fannie Mae and Freddie Mac Are Worthless

The capital that Fannie and Freddie with the Agreements DeMarco put into place in 2012 will remain $0 beyond 2018. The trillians of dollars of securities that they stand behind are going to be run by people who areincentivized to take higher paying jobs somewhere else. As such, the people at the companies are going to gradually either get used to lower pay than they are worth to society or fight for more. As such, it’s possible that there are people that work at this private publicly traded company that don’t invest into the company themselves because they don’t believe they are worth more. I think it’s sad. If you work at a private publicly traded company you should want to participate in as much of your company as possible and when the government is not only telling you what to do but is also taking credit for everything you do and making it sound like you’re helpless without them, you might feel this way too.

The Crisis Of Making Too Much Money

The government has run into problems with turning the lights off on the 30 year mortgage. The first problem is everyone wants one and they are a really profitable business to be in with little risk. In order to turn the lights off, FHFA decided as conservator they were going to project a future where Fannie Mae and Freddie Mac were no longer in business and wrote down all their deferred tax assets making them look like they were going out of business during a time when they have been going out of their way to build business. As such, the government has so far had to take over $100B away from Fannie and Freddie in excess of what they gave them and people are wondering why Fannie and Freddie are making so much money for the government and not for the people who own its shares. People like Pershing Square’s Bill Ackman want to know, “Why should the government take all of the money out of the largest private financial institution forever?”

Edward Demarco says, “taxpayers shouldn’t be left holding the bag for mortgage defaults.” Maybe he wants the government holding the bag? I pay taxes and I want to buy agency mbs, effectively taking that risk along with everyone else that owns them. DeMarco says that Fannie Mae and Freddie Mac shareholders back the guarantee provided to investors that they will be paid back:

If a borrower defaults, Fannie Mae and Freddie Mac guarantee investors repayment of their principal. Before the crisis, Fannie and Freddie shareholders backed that guarantee. How can we encourage homeowners to build equity…

That seems to make sense to me. The best way that I can figure out to build equity requires that I am offered the opportunity to buy into situations that I think will make my life better now and in the future. Fortunately DeMarco suggests two non-controversial steps that require leadership from the White House if they are willing and from Congress otherwise.

Fannie Mae And Freddie Mac Investment

Right now money at Fannie Mae and Freddie Mac flows primarily to three sets of stakeholders:

  1. Private Bondholders
  2. Quasi Government Employees
  3. Government Shareholders

I chose to refer to the employees as quasi government because if they don’t do what their boss tells them to do, they have to find another job. In this case the boss is the FHFA which is the government. In every other private business in the United States there is another stakeholder that is paid and this stakeholder is Private Equity Holders. For them to be paid the private company would have to be released from FHFA control and US Treasury objects to that happening but lawsuits are piling up. In Delaware, Former Delaware Chief Justice has filed that any such preferred security that takes all of the money from a business is illegal and this is relevant because that is what FHFA and Treasury have set up between themselves in secret.

According to Fairholme, there are 11,292 documents that FHFA and Treasury do not want anyone to see that are in some way related to the possibility that FHFA and Treasury have been misleading investors for years. If these lawsuits are as right as they are compelling then investors in the public companies stand to gain. Combined Fannie Mae and Freddie Mac earn over $20B/year according to some estimates by analysts and prominent investors. No one really knows how much of that will ever go to investors but we all know that if Treasury and FHFA had their choice they would be happy to have it all for themselves.

Conservatorships everywhere are dangerous when whomever is put in charge of taking care of them is in the business of taking for themselves. It’s no wonder that this has ended up in the court rooms with billionaires spending millions of dollars a month to battle the government on behalf of taxpayers. It’s almost like Treasury talked to the IRS and decided that Fannie and Freddie would never have to pay taxes again because they were going to take everything and government agencies don’t pay taxes and that justification was provided to FHFA who cancelled their tax assets since what’s the point of a tax asset if you can’t sell it and if you are a tax collector?

Who Are Fannie And Freddie Working For?

I would prefer if the GSEs were taxpayers instead of tax collectors. I think that it is unreasonable for the government to take your money because you decide to buy a mortgage using a private financing company. As such I own preferred securities in Fannie Mae and Freddie Mac . If the net worth sweep is reversed then FHFA gets to decide if the $187.5B with 10% comes from a well capitalized Fannie and Freddie or if the government is going to step away from Fannie and Freddie. In the past 7 years the government has taken over $100B in excess of taxes from Fannie and Freddie and have even built the private company cash flows into the government budget.

It’s a bit odd I must admit. I don’t know exactly how this is going to work out, whether the government is going to take everything forever or if the thirty year mortgage is going to be replaced by some alternative that there doesn’t appear to be any demand for right now. What I do know is that I have talked with people who are close to the action and they have told me that they are going to work for affordable housing initiatives that are funded by the GSEs. Also, Fannie Mae is getting a new state of the art head quarters.

It’s always good to know that Fannie Mae’s conservator was out to kill the company. Edward DeMarco did the best he could given the little time he had to force them out of business but so far has failed to do so. If anything, the only thing I am positive of is that they are here to stay. The question is who owns them and there seems to be some confusion because the government seems to want them dead and alive and unfortunately can’t seem to have it both ways at the same time. They want them dead so that non-governmental shareholders stop asking about them but they want them alive so they can take all of the money for governmental shareholders and non-governmental bondholders. I’m not sure that’s fair but if the courts can’t stop them and they can’t help themselves, who can?

Summary and Conclusion

Currently Fannie Mae and Freddie Mac have 1.8B shares outstanding and don’t be fooled enough into thinking that means that based on $20B a year of earnings the earnings per share is over $10 because the stock trades at less than $3. This massive discount to a normalized P/E multiple is because investors are pricing in various futures of how much money they are actually going to make as well as how much of it the government is going to take in excess of 35% taxes. In 2012, FHFA and Treasury decided that they weren’t going to let Fannie Mae and Freddie Mac keep any money for themselves. If any part in this changes the common stock would be worth more than $0 and perhaps in some potential and questionably likely scenarios upwards of $100 per share. You can’t really fight the government if they are going to take over private companies and take all their money forever. What you can do is buy shares that might benefit if they aren’t allowed to. That’s what I have done and what I recommend. What good is a dollar to me when private businesses don’t want any for themselves? The value of a dollar only exists if they don’t all belong to the government.

In so far of what I think the commons are worth, I think that they are worth as little as what can be deemed reasonable. Seeing as how FHFA is still in charge and Congress sets G-fees and FHFA in the near history has been in the business of shoveling as much money to the US Treasury as possible I would expect this mentality to persist into an FHFA led recapitalization and release. Higher capital requirements eat directly out of common shareholder proceeds. Since Treasury has taken $100B more than they forced the GSEs to take the GSEs now have virtually $0 as their capital base. As such there are a few ways to recapitalize the GSEs but declaring victory on them and releasing them requires that they are recapitalized. As such, I wonder what sort of thoughts the people responsible possibly changing capital requirements might be having. Do you think that it would look better for them to make capital requirements higher protecting taxpayers or to keep them as they are or lower them to the benefit of the speculative rich hedge funds.

Pershing Square’s William Ackman says 2.5% capital requirements are as Jamie Dimon would say are a fortress balance sheet. At 2.5%, Fannie Mae and Freddie Mac commons are worth $15-$20. Capital requirements necessitate cost of capital and I would expect this to perpetuate the ongoing takings. That’s where this debate really is now. The bigger they are, the harder my valuation of commons falls from what they could be worth, the more money Treasury takes, and the better looking the people who have been directly involved doing all of this will look.

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