2023-07-04 08:09:29 ET
Summary
- An update on the events surrounding Fannie Mae and Freddie Mac, focusing on developments relevant to the GSEs' release.
- The upcoming Presidential Election may have a significant impact on the extent and timing of the release.
- The GSEs are making significant progress on earnings retention.
- The 5th Circuit may follow its own precedent in CFSA v. CFPB, resulting in a favorable outcome for FNMA.
- Bill Ackman and Pershing Square's position and recent insights.
In my last article , I wrote an in-depth report on the full scope of events surrounding Fannie Mae ( FNMA ) and Freddie Mac ( FMCC ). This article will serve as an update to that write-up, so I would suggest you take the time to catch up if you are not already. First, and most importantly, I will clarify my view on where an investment of this caliber belongs in your portfolio. I will be reflecting on any developments relevant to the release of the GSEs, as this is at the root of any investment thesis in this space. Finally, I would like to take a look at the distinction between preferred and common shares.
Investment Strategy
In my last article, I prefaced my thesis by asserting the following.
Fannie Mae is a highly speculative and risky investment, but it also offers huge upside potential for investors who are willing to take a longshot bet on housing reform.
My opinion is unchanged on this matter. In fact, I would like to make it even more clear. I have noted a few investors who have perpetuated the idea that either common or preferred shares have a near-certain chance of yielding incredible returns. I want to be clear in stating that there is no such certainty. The outcome of an investment in either Common or Preferred shares is entirely up to the government's objectives which are subject to change. Thus I want to reiterate that, in my opinion, an investment in these GSEs of any kind should make up a small position in one's portfolio. In my case, the total of both is just under 1% of my portfolio. The investment strategy is simple, then. View an investment in these mortgage financiers as a lottery ticket, with better odds than any ticket you've ever bought. In my previous article, I estimated those odds.
I assign a 40% chance to a complete victory, a 30% chance to a middle ground outcome, and a 30% chance to a complete loss. These probabilities are subject to change as new information emerges.
I do still have faith in my prior assumptions as they have held true thus far. These odds are astronomically better than a lottery ticket if you find yourself in concurrence. Regardless, nothing with the word lottery ticket in the same sentence should make up any materially significant portion of your portfolio. Having prefaced everything with this disclaimer, I feel comfortable now sharing that this may well be the most significant potential return on an investment I have ever seen. If scenarios play out accordingly, investors stand to gain as much as 40x their money. Thus the strategy I recommend here is to buy utilizing an amount of money you would be comfortable losing in its entirety, and holding those shares until there is a definitive outcome.
Retained Earnings
Among a long list of possible paths to exit conservatorship, the capital framework remains tall as perhaps the GSE's best hope. These mortgage financiers continue to push toward meeting their respective capital requirements. The two have a combined capital of nearly 100 Billion of the 300 Billion required to exit. Given this, it is more a matter of when, rather than if, they will raise this capital. First, let's take a look at Fannie Mae's capital conditions.
Next, we can venture into Freddie Mac's more colorful but less significant capital disclosures.
Bill Ackmans' Pershing Square Capital
It is often a forgotten component of the ongoing debate that some smart money remains confident in these GSEs. Underpinning my belief in their release is the reaffirmed confidence of this by famed investor Bill Ackman who owns Fannie and Freddie Common Shares. While many cast doubt on his investments, Ackman has undeniably stellar returns, netting an annual average of 32% .
In his most recent investor letter , he asserted the following.
Fannie Mae and Freddie Mac remain valuable perpetual options on the companies' exit from conservatorship. Adverse court rulings have effectively ended shareholder litigation. The Supreme Court denied certiorari in their Court of Federal Claims litigation (the "Takings Cases") on January 9th, 2023, which follows the June 2021 Supreme Court ruling in the Collins litigation that found the Third Amendment to the PSPAs to be authorized under the HERA statute. On March 1, 2023, Pershing Square dropped its remaining claims in the Takings Cases as we did not see a viable path forward.
We continue to believe that the economic and political rationale for Fannie and Freddie's independence remains intact. Both entities continue to build capital through retained earnings which has increased their combined capital to $97 billion approaching a fortress-level of capital. We believe that it is simply a matter of when, not if, that Fannie and Freddie will be released from conservatorship.
Many retail investors speculate about the ongoing court cases, changing of administrations, and even congressional action as the method of exit from conservatorship. I like to defer to dedicated professionals when I can. Pershing Square has many competent analysts who, alongside Ackman, have determined that The GSEs are likely to exit via retained earnings. More broadly, Pershing Square remains invested in their respective common shares.
The 2024 Presidential Election Draws Near
The first potential catalyst and notable update is the matter of leadership. It is clear that one potential path to exit conservatorship is through the POTUS. The looming threat of a Trump or DeSantis presidency might push Biden to monetize the GSEs and utilize them as a cash cow for his housing goals while he can. If Biden does not act, however, Trump or DeSantis could take over in 2024 and privatize them. In my view, Biden seems to have made no effort thus far to do anything about this, but we shouldn't count it out just yet. Trump has made it known publicly via a letter to the 5th Circuit En Banc that he would like to see these entities privatized.
It is also not a stretch to suggest that DeSantis would also support privatization, given his shared views on the free market. In 2.5 years, they would have roughly $~150~170 billion on their books. The House is under Republican control, and the Senate is narrowly under Democratic control. The upcoming election will be pivotal as it relates to the fate of the GSEs. The narrative is that Republicans would be the only party to act on the conservatorship. I would add, however, that the Biden appointee to the FHFA, Sandra Thompson, has indicated that she is interested in preparing the GSEs for an eventual exit from government control, but has not given any timeline or details. As a shareholder, one has to take some solace in the fact that both parties have expressed desires to provide paths to exit from conservatorship.
5th Circuit
I will be brief here as this I don't think a victory that the court level is likely.
It's simple, really, the strongest argument Collins had was crushed by the SCOTUS ruling on 6/23/21. They killed the main argument that the FHFA can't just rob shareholders blind while pretending to be a conservator. That's basic administrative law, but SCOTUS ignored it. They said HERA lets the FHFA do whatever it wants, even if it harms the GSEs and their shareholders.
There's still one claim left, but it's a long shot. It's going back to the fifth circuit after SCOTUS sent it back. That's what the upcoming oral argument is about. It has to tie the illegal act to the NWS harm. SCOTUS already asserted there will be no more forward-looking relief, only backward-looking relief, and I am frankly puzzled by the nature of this. SCOTUS also cited the 4th Amendment in ending the NWS. Of course, my opinion on their ruling is just as irrelevant as it is critical, very.
Common or Preferred?
I explored this question in my last article, which met with some controversy. I will elaborate on my position as it has expanded somewhat since my last article.
Common Shares: The commons offer the greatest risk, alongside the greatest potential return. There are two main scenarios that, if played out, would result in lottery ticket-like returns.
The first is Warrant Conversion. If this scenario plays out, investors stand to earn more than 20x their investment assuming a 10x PE and a 9.68 billion share base.
The second is Earnings Retention, the scenario I believe to be most likely. Assuming a 3% asset growth rate, by 2028, investors would have returned over 40x their money as government warrants expire.
Here is where I want to revisit the remaining fact that Pershing Squares' confidence lies in Common Shares, meaning they expect one of these scenarios to come to fruition. Mr. Ackman is not a perfect investor, but I wouldn't be so quick to dismiss his chosen investment vehicle here.
Preferred Shares:
If you're looking for a higher return and a lower risk than FNMA common shares, you might want to consider FNMA junior preferred shares. Why? Because they have two advantages over the common shares: they rank higher in the capital structure and they pay higher dividends.
Let me explain. The capital structure is the order of who gets paid first if FNMA goes bankrupt or gets dissolved. The junior preferred shareholders are second in line, after the senior preferred owned by the government. The common shareholders are last in line. This means that if FNMA ever gets restructured or privatized, the junior preferred shareholders have a better chance of getting their money back than the common shareholders.
But don't get too excited. The junior preferred shares are not risk-free. They are not backed by the government like the senior preferred shares are. Plus, the future of FNMA is uncertain, as it depends on what the politicians and regulators decide to do with it and, in this way, faces the same risks (albeit less so) that Common Shareholders face.
So, there you have it. The junior preferred shares are an interesting option for investors who want to bet on FNMA's recovery but don't want to take as much risk as the common shareholders.
Risk
I felt this section was especially important to include despite having already addressed the risky nature of the investment. I said it before and I will say it again "FNMA is not a sure thing, far from it. This bet is the product of what is calculated to be a tremendous upside potential, alongside a disastrous downside. I strongly advise against investing any sum you would not feel comfortable losing in its entirety."
So what are the risks of investing in the GSEs?
In my view, there is one risk, but it is complex and very real.
Shareholder's Outcome is Beholden to the Government : Since the 2008 financial crisis, FNMA and FMCC have been under the control of the Federal Housing Finance Agency (FHFA), which regulates their activities and takes all their profits as dividends on the senior preferred stock owned by the Treasury. This means that shareholders have no say in how the companies are run and no claim on their earnings. The future of FNMA and FMCC depends on the political and regulatory environment, which could change with different administrations and legislations.
Thus, it is possible for any class of investible shares to be wiped entirely and made worthless. It is also possible for the government to go in any number of directions with the exit that results in either a lower return or no return at all. Finally, it is entirely possible that the government does nothing and the GSEs remain in conservatorship indefinitely.
Takeaway
This is the best risk-to-reward ratio I have seen in the markets today. The risk is significant, but the reward is potentially unprecedented. I advise investors to exercise caution and work to understand the risks thoroughly. I maintain a buy rating on Fannie and Freddie's Common and Preferred Shares.
For further details see:
Fannie Mae And Freddie Mac: Lottery Tickets With Much Better Odds