The Irrational Exuberance of Fannie and Freddie Investors
Some of Wall Street’s most powerful financiers are likely to be disappointed by the Trump administration’s treatment of Fannie Mae and Freddie Mac.
Barrons’ reports:
Wall Street has a pitch for Donald Trump: Cement your place in history as the “Art of the Deal” president with your biggest deal ever.
Hedge fund managers like Bill Ackman have built huge stakes in Fannie Mae and Freddie Mac, betting the government-sponsored entities will be privatized by the president-elect at some point in his second term. Trump has said he wants to do it. Now that he’s taking office, some investors are betting it’s just a matter of time and ironing out the details.
Fannie and Freddie are central to the U.S. mortgage market, owning or guaranteeing around half of all residential mortgages. While they do not make home loans themselves, they purchase mortgages and bundle them into securities that are sold to investors, the heart of the $6 trillion market in mortage-backed securities.
While the pitch has not caught fire with Trump administration officials, it has sent shares soaring. Since election day, shares and Fannie are up by more than 420 percent. But without any real movement on the issue inside the administration, this looks like what Alan Greenspan once called “irrational exuberance.”
In today’s Breitbart Business Digest, we will dive into the history of this troubled trade. In tomorrow’s, we’ll explain why the hoped-for windfall for investors is likely to remain elusive.
A Brief-ish History of Fannie and Freddie’s Bailout
The companies were formed by the U.S. government but were privately-managed and owned and loosely regulated for most of their existence. Market participants believed that the government stood behind these so called “government sponsored entities” or GSEs—an arrangement known as the “implicit guarantee” that allowed the companies to enjoy rock-solid credit ratings and borrow money at ultra-low rates close to what the U.S. Treasury itself borrowed. The companies went to pains to deny their bonds were backed by the government, but investors saw through the facade.
The two companies were seized by the government in 2008 after regulators and the Bush administration became convinced they were on the verge of collapse. In exchange for bailouts that eventually amounted to $180 billion, the U.S. Treasury received senior preferred shares in the companies and warrants to buy nearly 80 percent of their common equity for virtually nothing. They were also placed in conservatorship by their primary regulator, the Federal Housing Finance Agency. The implicit guarantee had become an explicit backstop.
Over a decade ago, hedge fund managers and other investors began to build huge stakes in the companies, believing their junior preferred shares and even their common shares would soar in price if they were released from government control. Fund managers attempted to pressure the Obama administration and later the first Trump administration to privatize the companies, but those efforts never bore fruit.
The original terms of their bailout required them to pay a fixed percentage of the taxpayer backing they had received as a dividend on the Treasury’s preferred shares. When their profits fell short of the required dividend, they made the payments by dipping even further into the pool of funds authorized to support them. This practice of taking more funds from Treasury to pay off earlier drawdowns became known as a “circular draw.” Since the total amount available to Fannie and Freddie was capped, there was the danger that they could exhaust the funds.
Housing officials in the Obama administration worried that the mortgage market could seize up again even before the bailout pool was emptied because forward-looking investors would abandon the market in anticipation of government support drying up. To avoid this bank-run like situation, the Treasury and the FHFA changed the terms of the bailout in 2012 to allow the amount of the mandatory dividend on Treasury’s preferred shares to rise and fall with the profits of the companies. This flexible dividend or “net worth sweep” meant that their was essentially no value left over for the junior preferred or common shares, and it prevented the companies from building the capital cushions they would need if they were ever to return to private control.
Several of the investors who had accumulated shares in the companies sued over the the profit sweep in several federal courts and even state courts, confidently proclaiming that they were sure to wrest the profits and even control of the companies from the government. That turned out to be incorrect. The lawsuits were rejected by the courts almost universally on the grounds that Congress had given the government broad discretion in managing the companies once they were in conservatorship.
A Trump Trade That Failed
When Trump came into office in 2017, many investors were convinced his administration would release the companies. To appeal to conservatives and Republicans, investors argued that the government was violating their property rights by keeping the companies in conservatorship. Many conservatives, however, worried that releasing them would revive the implicit guarantee in which the profits accrued to private investors but the ultimate risk remained with taxpayers.
Nonetheless, then-Treasury Secretary Steven Mnuchin and Trump FHFA director Mark Calabria supported releasing the companies, hoping to reduce the government’s explicit role in supporting the mortgage market. Calabria argued that the law under which they were seized in 2008 did not allow for a perpetual conservatorship. Trump himself said he supports privatizing the companies.
While the release never occurred, the FHFA and the Treasury in 2019 amended the bailout agreements to to allow Fannie Mae and Freddie Mac to retain a portion of their earnings to rebuild capital. In the years since then, the companies have built capital cushions; but because they were no longer paying the government dividends, the amount they owed on their bailout funds piled up even higher.
The enthusiasm for privatization went dormant for most of the Biden administration. But now it is back—with a vengeance. Tomorrow, Breitbart Business Digest will explain why investors are likely to be disappointed again.
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