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By Andrew Grossman, BillionaireNews.Com Contributor
Two giant corporations were driven to the point of insolvency in 2008 due to massive losses they incurred during the financial crisis of that Fall. The federal government took control of these disasters because their imminent demise would cause a serious threat to the to the United States economy. As added problems, they have been forced to turn over any profits they make to the U.S. Treasury as a condition of the government takeover…all profits earned by Fannie and Freddie go directly to the U.S. Treasury as a part of the receivership agreement. Even worse, there is legislation being considered that would dismantle these companies, rendering any outstanding stock virtually worthless. A few years later, if you were asked to invest in these corporations, you would probably go running for the hills, absolutely certain any money invested in them would never be seen again. You may have even questioned how any broker recommending them could keep his (or her) license? Apparently, a number of billionaires disagree, seeing huge potential profits. How can that be?
Well known hedge fund managers, Bruce Berkowitz and Bill Ackman, as well as famous activist investor Carl Icahn have all bought substantial stakes in Fannie Mae and Freddie Mac. Since billionaires don’t get rich by making stupid business decisions, something they know (that we don’t) must be going on here. Evidently, they have decided that the intrinsic value of these companies is far greater than the market currently trades them at.
Last year, hedge fund manager Bruce Berkowitz, purchased a huge stake in Fannie Mae and Freddie Mac with his Fairholme Capital Funds. Berkowitz has already doubled his money in one year, following his recent $51 million sale. Not a bad return for anybody in the securities business. Profits like that are incredibly rare, no matter how much you have been making. Smart money moves like this are the way people become billionaires.
In November, the Pershing Square hedge fund, run by the activist investor, Bill Ackman, invested half a billion dollars which gave him stakes of nearly 10 percent each in Freddie and Fannie. Ackman certainly appears bullish on Fannie and Freddie’s future, recently saying he believes Fannie Mae stock could be worth as much as ten times its current price in the coming years. He is predicting a potential of as much as 1,000% – yes, ten times his original investment within the next several years. If you can afford to take a big risk, and he certainly can, why stay on the sidelines?
Well known billionaire investor Carl Icahn recently joined the party, purchasing a $51 million stake in Fannie and Freddie’s common stock from Berkowitz. Icahn is known for making huge bets on companies and then pushing for management changes. $51 million may seem like a huge amount to you and me, but it is smaller than many of Icahn’s other investments. His bets have obviously worked out well much more often than not. Considering the huge profits to be made, Icahn believes it is worth the risk. This looks like it could be another successful endeavor. Fannie and Freddie now appear much healthier than they were previously, posting substantial profits for the first quarter of 2014. The company was considered worthless less than six years ago. Who finds gems like this? Well, maybe Carl Icahn. Perhaps this isn’t as big a gamble as he has made in his very successful past.
Berkowitz is certainly not bailing on the companies. Despite selling the $51 million in common stock to Ichan, he still holds a $1.3 billion position in Fannie and Freddie. Since the share price has more than doubled since he made his initial investment this sale locks in some large profits. He also seems to be reasonably optimistic about their future. Even if Fannie and Freddie were to be restructured, as he has suggested, holders of the common stock would benefit. He seems to be taking a more cautious approach than Ackman and Icahn, but Berkowitz is still heavily involved.
What about some of the potential downsides? Berkowitz and some other huge investors aren’t sitting idly by while nearly all of the profits are being transferred to the Treasury. They have filed a lawsuit which alleges the bailout arrangement unlawfully requires Fannie and Freddie’s huge profits to be paid to the government. They allege that this action is illegal as it unduly impairs shareholder value. The fund’s firm and other shareholders are pushing the U.S. to return the companies to private ownership, saying shareholders should benefit from their holdings. This would lead to even bigger profits for the large investors.
Ackman appears to be confident of the lawsuit’s outcome. He recently said he “is convinced shareholders will win their lawsuits against the U.S. government that challenged the Treasury Department’s bailout agreement with the two companies.”(The Wall Street Journal)
A recent statement from the judge presiding over this litigation would seem to back up his assertions. When she ruled against the Justice Department in a dispute about its allegedly withholding evidence, Judge Sweeney recently indicated that she may side with Fairholme, saying she probably has a broader view of her order than that of the Justice Department, according to court proceedings. (Financial Times)
Another potentially serious risk is the government’s continuing efforts to shut down both companies, which would effectively leave shareholders with nothing. The proposed legislation would liquidate Fannie and Freddie and give all proceeds from the sale to the Treasury. Such a serious danger would seem to give any investor pause. However, this potential catastrophe appears more and more unlikely. It is becoming increasing clear that the mortgage insurance companies aren’t going anywhere. The government is loath to discontinue any popular programs unless it is absolutely necessary. Mortgage guarantees appear to be no exception to this rule.
Fannie Mae and Freddie Mac currently own or guarantee nearly 60% of all the U.S. residential loans. These loans are then packaged into mortgage backed securities (MBS) and sold to investors. Therefore, any plan to close them could again lead to a further, even more serious housing crisis. In its most explicit acknowledgement yet that the government cannot scale back the GSEs, Mel Watt, the new director of the Federal Housing Finance Agency and lead regulator for mortgage insurers announced that the size of loans approved for purchase would not be reduced. (Morningstar)
Government action has helped precipitate much of the recent financial crisis, and even lawmakers have little appetite for creating more problems. The potential for creating even more difficulties is a great reason to avoid taking away something many people have come to rely upon. Now that Fannie and Freddie are turning a nice profit, leaving them alone looks like the government’s best move.
Despite this good news, all is not necessarily safe. The most serious risk is a warrant issued to the Treasury by Fannie Mae in 2008 that gives it the option to purchase an amount equivalent to nearly 80% of the common shares outstanding for just one-thousandth of a cent per share, or $0.00001. The warrant can be exercised at any time between now and Sept. 7, 2028. In a dramatic case of understatement, this would, in Fannie’s words, “substantially dilute investment of current shareholders.” This would essentially make the current investment practically worthless.
Although Washington is not likely to close down the mortgage insurance business, it doesn’t want to spend the money to take it over completely, either. Perhaps the billionaires, who despite some politicians may say, are really the people who know what they are doing and will be allowed to manage things properly.
The billionaires apparently believe the huge potential profits justify this risk. A return of more than ten times the original investment is too good for them to resist. The dangers now appear far less serious than they did just last year. Based on recent indications, it looks like their judgment is likely correct. Taking these types of risk are how people become billionaires. If you’ve got an iron stomach, a play in FNMA and FMCC might just pay off.
DISCLOSURE: We do not currently have a position in FNMA or FMCC; however may take a position in it as early as 23 Jun 2014 or at a later date. We find these investments have a great deal of risk, but also see a large upside should the courts rule in favor of the Fannie and Freddie stock holders.