Fannie shares seen as worthless despite surge
Fannie Mae and Freddie Mac shares surged to five-year highs last week, giving them a combined market value of $48 billion, about the same as BlackRock Inc., the world's largest money manager, and Starbucks Corp., the biggest coffee-shop operator.
The securities have climbed eightfold this year as the U.S. housing recovery led the mortgage financiers to record profits and speculation grew they would repay the government after their 2008 bailout and be released from conservatorship. Under a new bipartisan bill being prepared by U.S. senators, the companies would be liquidated and the stock could be worthless. Higher- ranking preferred securities, whose buyers include billionaire hedge fund manager Paulson & Co. and Bruce Berkowitz's Fairholme Capital Management, are also at risk from the legislation.
"There is a giant disconnect between investors and Washington over whether there is any value," Jaret Seiberg, an analyst at Guggenheim Securities LLC's Washington Research Group, said in a telephone interview. "Washington can't fathom there could be value and the investment community seems convinced that there is."
Trading in the preferred and common stock of Fannie Mae and Freddie Mac has jumped in recent months as speculation mounted the Obama administration or Congress would address the future of the $9.4 trillion mortgage-finance system. A bill being prepared by Tennessee Republican Bob Corker and Virginia Democrat Mark Warner would keep the government in the market, an outcome the world's biggest bond investors including Pacific Investment Management Co. and AllianceBernstein LP say is necessary.
Fannie Mae and Freddie Mac surged in May from so-called penny stocks -- trading under $1 -- to an intraday high on May 29 of $5.44 for Fannie Mae, giving it a market capitalization of about $31.3 billion, and $5 for Freddie Mac, equal to $16 billion, according to data compiled by Bloomberg. Fannie Mae has since dropped to $2.24 and Freddie Mac to $2.18.
"The speculation is wild," Anton Schutz, president of Rochester, New York-based Mendon Capital Advisors Corp., said in a telephone interview. His firm has about $160 million under management and doesn't own Fannie Mae shares. "I would never engage in owning any security like that, where the government makes the rules."
Fannie's 8.25 percent of preferred stock has risen to $8.24 from 26 cents at the beginning of the year, as investors speculated the securities, which have a par value of $25, could be repaid. Berkowitz's Fairholme Capital Management said this week it owns $2.4 billion par value of preferreds from the two companies and is ready to help with a restructuring.
"Taxpayer dollars expended by the government during a time of national crisis will be fully repaid," Fairholme said in the statement. "And equitable treatment of taxpaying shareholders, including community banks, insurance companies, and mutual funds holding preferred Stock, must be restored with dividends reinstated."
The bill in Congress, which would instead replace Fannie Mae and Freddie Mac with a new agency known as the Federal Mortgage Insurance Corp. that would bear any catastrophic losses on mortgage bonds after private investors or insurers get wiped out, faces a "long and very uncertain road towards passage," according to Ed Mills and Paul Miller, analysts at FBR Capital Markets.
While a draft says the U.S. could offer payments to common and junior preferred shareholders once the government is paid off on almost $190 billion of aid, Guggenheim's Seiberg says the provision is being misread. Investors are assuming that payments the firms are now making from all their profits would be included in the calculation, he said.
"The senators are unlikely to write the bill in such a way that the dividend payments made to Treasury would count as repaying the senior preferred that the government owns," he said. "In other words, Fannie and Freddie are still on the hook" for the funds given to them in the bailout.
The proposal would also shift the revenue the companies earn from guaranteeing existing mortgage bonds, now totaling about $4 trillion, which have helped fuel their record profits as housing emerged from a six-year slump, to the Treasury Department. The government would then take over backing the securities and join with the companies' replacement in determining whether anything is paid out to private investors.
While the draft softened language in an earlier version over the treatment of preferred shareholders, "the distinction is somewhat meaningless because the way it would allow for the resolution of the companies may provide no money for others," said Charles Gabriel, a policy analyst at Capital Alpha Partners in Washington.
Hedge funds that own the preferreds, including Paulson and Claren Road Asset Management LLC, have urged lawmakers to drop plans for abolishing the companies.
The government is guaranteeing about 90 percent of new home loans, including about 60 percent through Fannie Mae and Freddie Mac and the rest through other agencies including the Federal Housing Administration. The companies were created to provide liquidity to the mortgage market and make it easier to buy a home -- Fannie Mae in 1938 during the Great Depression and Freddie Mac in 1970. Even after they helped fuel the housing bubble and contributed to the global credit crash, bond investors still say a version is needed in the U.S.
"The government needs to play a role in housing," said Daniel Hyman, a money manager specializing in mortgage securities at Pacific Investment Management Co., manager of the world's largest bond fund. "The way the world is set up, it can't purchase $5 trillion of additional mortgage assets without government guarantees, or at least certainly not anywhere near today's prices."
Banks are required to hold more capital against securities with credit risk and "foreign buyers still want the government guarantee to be involved in these markets," he said. While the private mortgage bond market is slowly reviving, demand won't be enough without much higher yields.
"You can sneak through a small amount of that stuff but it's not clear where the next trillion clears," he said.
The government needs to reduce its role in the housing market from its current level, according to Michael Canter, head of securitized assets at AllianceBernstein, which oversees more than $250 billion in fixed-income. Still, a fully private model for U.S. housing is "not realistic," and would "constrain credit and increase house-price volatility down the road."
The likelihood of "substantive action" on reforming the mortgage finance system is remote until 2015 after midterm elections, according to Isaac Boltansky, an analyst with Compass Point Research & Trading LLC.
"Ultimately we believe it will be politically unpalatable to facilitate significant recoveries on the junior securities given the concentration of hedge fund ownership, but note this question remains far from answered," he wrote in a note.
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