Financial Times: Fannie and Freddie Investors Look to Trump

The following article by Tom Braithwaite was published by The Financial Times on November 25, 2016. See the online article here.

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It is the curse of Fannie Mae and Freddie Mac. Since the mortgage insurers were bailed out in 2008, some of the most renowned US investors — from John Paulson to Bill Ackman to Richard Perry — have piled into their shares and suffered mysterious losses in their once rock-solid portfolios.

Bruce Berkowitz is another. The founder of Fairholme Capital Management bet on the preferred shares in 2012 and then came a cropper on unrelated investments. A Morningstar “Manager of the Decade” in 2010, Mr Berkowitz’s mutual funds have since trailed the market.

Like the other men, he has gone as far as suing the US government to try to extract value from his Fannie and Freddie stakes. “We’re not asking for a cheque,” he says. But he does want the government to end a four-year-old practice of taking all the institutions’ profits, which has starved other shareholders. “You’ve done very well. You’ve been paid tens of billions. Stop.”

Since the US presidential election, the common shares have surged about 50 per cent on the belief that Donald Trump will relax the government’s stranglehold. Mr Berkowitz, who says “we crossed break-even last week”, is also investing hope in the new team — “maybe you don’t want them to marry your sister or your daughter but they’ve had some success in their lives”.

There are three reasons why Mr Trump might want to break the hex: causing embarrassment, giving payback and building a war chest. First, embarrassment. The Bush administration took warrants for 80 per cent of the equity and preferred stock and a 10 per cent dividend on the bailout funds. In 2012, the Obama administration changed the terms. Instead of taking a dividend, it simply “swept” all the profits. The excuse was that the lossmaking companies might enter a “death spiral” if they had to keep drawing on the bailout money to pay an increasing dividend. The reality was that the companies were about to become very profitable as the housing market recovered; the switcheroo has diverted billions of dollars to the Treasury, which has received more than $250bn in dividend payments since 2008.

In court, disgruntled private shareholders have attempted to extract emails and memos between Mr Obama’s closest advisers and the president himself. They believe those documents will show that the government was concocting a fiction with its “death spiral” argument to prevent the companies’ renaissance.

The Justice Department has fought tooth and nail to keep those documents secret, citing a panoply of presidential privileges. When a judge rejected them and ordered the documents handed over to the plaintiffs, government lawyers filed an emergency appeal, which is still pending.

Mr Trump’s lawyers might keep up the fight. After all, they might want to rely on the same arguments to protect their own secrets in the future. It is also possible that in spite of the dubious reasoning and the ferocious attempt to keep them secret, that the emails are not that embarrassing after all. But it is still a good bet that the stance on protecting the prior administration’s secrets will change. That is only one part of one lawsuit, but it is likely to weaken the government’s overall case that the profit sweep was legal.

Second, payback. When most of Wall Street backed Hillary Clinton, John Paulson was a rare supporter of Mr Trump. The hedge fund manager is also the second biggest non-government shareholder in Freddie Mac, according to data from S&P Capital IQ. If Mr Trump wanted to reward his ally in a privatisation, Mr Paulson’s stake would leap in value.

Third, the war chest. In a dream privatisation, the Treasury would exchange its warrants for 80 per cent of the shares and then sell them to the public, much as it did in AIG, for a price tag that could reach $200bn. That could help fund a Trump infrastructure plan or build a big wall on the Mexican border.

One obstacle is that Fannie and Freddie are being starved of capital under the current regime. They would need an adequate capital buffer before they were privatised — they could get there by retaining earnings but that would take years. A quicker remedy would be to sell new equity to institutional investors. The dilution would be severe for all shareholders but still might offer some upside and sizeable spending money to the government.

Does embarrassing adversaries, rewarding friends and assembling a war chest sound like something Mr Trump might like? The biggest problem is Republican lawmakers.

Many of them — including putative Trump Treasury secretary Jeb Hensarling — have been fiercely opposed to the companies re-emerging in the same public-private form. Then again, at the start of his administration, Mr Trump will have the clout. If he can grasp all the benefits, it would be foolish to bet against him lifting the curse.