If legislative proposals to reform them are any measure,
Fannie Mae and Freddie Mac are living on borrowed time. A
clutch of proposals seek to privatize or liquidate the
government-sponsored enterprises. This isn’t just because
the two mortgage companies share a scandalous past: accounting
misstatements, fraud charges and questionable executive
payouts, not to mention getting blamed, fairly or not, for the
subprime crisis and then nearly collapsing before a U.S.
Treasury bailout.
http://www.institutionalinvestor.com/article/3426278/asset-management-regulation/fannie-mae-and-freddie-mac-wind-down-or-reprieve.html?ArticleId=3426278&single=true#.VQEsmfnF-U8
It’s also because these huge enterprises continue to
suffer from dual identities: public and private. Founded as
public agencies, Fannie and Freddie increasingly assumed
private aspects. In fact, the very essence of the GSEs was the
ambiguity of corporations that were private in their operations
and public in their mission of affordable home ownership. Part
of being federally “sponsored” was an implicit
guarantee that the government would bail out Fannie and Freddie
if they got into trouble; this allowed them to operate with
tiny capital bases and grow large, profitable and politically
powerful. And bailouts did occur at the height of the financial
crisis. Then–Treasury secretary
Henry (Hank) Paulson Jr. argued that the GSEs’
structural ambiguities were untenable and urged lawmakers to
come up with a more viable long-term structure. Out of office,
he advocated for GSE privatization in his memoir of the crisis,
On the Brink.
Six years later Fannie and Freddie are thriving again, and
the debate over what to do with them continues.
Today, the two GSEs attract a lot of attention: from the
administration, Congress, the mortgage industry and a group of
high-profile investment firms that hold large equity stakes in
them. Leading this pack of corporate activists is
William Ackman, founder of Pershing Square Capital
Management; his
newly reconciled colleague Carl Icahn;
Bruce Berkowitz, founder of Fairholme Capital Management;
and
Richard Perry of Perry Capital. This so-called gang of four
has adopted a take-no-prisoners approach in legal and lobbying
efforts to rescue Fannie and Freddie — and their own
investments — from a possible legislative phaseout. The
activists have loudly protested the government takeover of the
profits they insist should come to them; so far, the government
is winning that showdown.
At stake are Fannie and Freddie preferred shares with an
estimated face value of $33 billion and an equally large
windfall of common shares held by private investors. The
potential upside for the common stock is pegged as high as 10
times face value.
Fannie and Freddie’s misfortunes in 2008 might have
been cataclysmic, but they produced fertile ground for
speculators. Investors bet big on a turnaround of beaten-down
GSE shares that lost more than 95 percent of their value during
the crisis, plunging from the mid-$20s in May 2008 to less than
50 cents a share within days of the bailout. However, as real
estate recovered, the GSEs began raking in profits again: $84
billion for Fannie and $49 billion for Freddie in 2013.
Ackman and Berkowitz made their GSE bets public in
mid-2013.
Berkowitz tops the list, with 15 percent of his fund
invested in Fannie and Freddie preferred, worth an estimated
face value of $3.5 billion. Ackman recently increased his
stakes to 11.2 percent of Fannie Mae and 11.1 percent of
Freddie Mac through a recent total return swap between Pershing
and UBS. Icahn tossed in a $50 million bet in June on Fannie
and Freddie common shares, purchased from Fairholme.
Perry’s position, which remains undisclosed, reportedly
totals about $500 million in preferred shares and a smaller
stake in common stock.
As part of the 2008 bailout process, the Federal Housing
Finance Agency became conservator of Fannie and Freddie and
entered into an agreement with Treasury to receive as much as
$200 billion of bailout money. In exchange, Treasury received
preferred stock valued at an equivalent amount, warrants to
purchase as much as 79.9 percent of the common stock and a 10
percent dividend. Over the next four years, the GSEs received
$187.5 billion in capital infusions from Treasury. The
companies, however, found themselves continually cash-short,
owing in part to the mandatory 10 percent dividend, and
Treasury had to advance cash to them. To end that vicious
cycle, FHFA and Treasury entered into an agreement on August
15, 2012, referred to as “the third amendment” or
“the net-worth sweep.” In lieu of dividend payments,
Treasury would “sweep” all the net income of the GSEs
on a quarterly basis.
The sweep effectively capsized investor plans. The investors
responded by filing a barrage of lawsuits, arguing that the
sweep constituted a violation of the U.S. Constitution’s
Fifth Amendment, specifically the “takings clause,”
which protects against seizure of “private property for
public use without just compensation.”
Perry and Fairholme filed lawsuits in the summer of 2013 in
U.S. District Court for the District of Columbia, with
Fairholme also filing a suit in the U.S. Court of Federal
Claims. Ackman sued a year later in U.S. District Court and
federal claims court. His suits accused the federal government
and the two GSE regulators, FHFA and Treasury, of violating the
takings clause.
In September, however, that legal strategy hit a wall. Judge
Royce Lamberth of the U.S. District Court tossed out the
Fairholme and Perry lawsuits. He declared that the language in
Fannie and Freddie stock certificates supports the profit
clawback by Treasury. The judge summed up: “The
plaintiffs’ true gripe is with the language of a statute
that allowed FHFA, and, consequently, Treasury, to take
unprecedented steps to salvage the largest players in the
mortgage industry . . . the plaintiffs’ grievance is
really with Congress itself.”
“The government essentially took control of the whole
shooting match,” says Daniel Crowley, a public policy
partner at law firm K&L Gates in Washington. “The GSE
takeover was a first for the government. On a macro level the
conservatorship was a takeover of the entire residential
housing market. The issue in the district court is that Fannie
and Freddie are not in liquidation but under conservatorship
and the third amendment had no impact on shareholders’
dividends or liquidation preference rights.” If this is
the case, the investors are taking a long shot.
The activists, in fact, are playing a complex game that
involves far more than just some dividends. They have inserted
themselves into the larger political debate, which involves a
raft of congressional proposals on Fannie and Freddie. In one
scenario the government would eventually sell the GSEs to
investors — privatizing them, as opposed to liquidating
them, which might leave scant rewards for shareholders.
Berkowitz and John Paulson, founder of hedge fund firm Paulson
& Co., have both pushed for privatization. Berkowitz’s
proposal essentially advocates for the sale of the GSEs’
mortgage insurance business to Fairholme and several private
investors. Paulson has met with members of the Senate Banking
Committee and urged it to privatize rather than liquidate the
GSEs.
The fate of Fannie and Freddie is caught up in a tangle of
politics and special interests. Still, despite Republican gains
in the midterm elections, pundits expect housing reform
legislation to move slowly. As for the White House, in 2013 the
administration released a policy paper titled “A Better Bargain for the Middle Class:
Housing,” which outlined its goal of supporting
homeownership and affordable rental housing. The paper
described the GSEs as a broken business model but continued to
support housing affordability through the Federal Housing
Administration (FHA).
That stance captures the tension between the GSEs’ two
missions of producing private profits and serving the public
good. As long as both goals are viewed as legitimate, the
attempt to map out a path for Fannie and Freddie will prove
torturous.
Fannie and Freddie both began life as reform institutions.
The oldest of the mortgage GSEs, Fannie Mae, or the Federal
National Mortgage Association, was launched during the New
Deal, in 1938, to address the housing crisis. Fannie’s
mandate was to act as a secondary mortgage market facility that
would purchase, hold and sell FHA-insured loans. The agency
subsequently underwent several transformations, becoming a
public-private entity in 1954. A second reorganization occurred
with the passage of the Housing and Urban Development Act of
1968, which shifted the agency from mixed public-private
ownership to a for-profit shareholder-owned company. No longer
a part of the federal budget, Fannie funded itself in the
markets.
By 1970 an expansion in the secondary mortgage market drove
the establishment of the Federal Home Loan Mortgage Corp., or
Freddie Mac, to assist thrifts in managing interest rate risk.
Largely funded by another New Deal creation, the Federal Home
Loan Banks, Freddie Mac began to purchase longer-term
mortgages. At about this time, both GSEs began to buy and sell
mortgages not guaranteed by the government.
The expansion of U.S. housing and secondary mortgage markets
over a 30-year period allowed the GSEs to become formidable
economic and political forces. In the 1980s, Fannie began to
issue mortgage-backed securities and build its mortgage
portfolio, while Freddie primarily focused on MBS issuance. The
GSEs capitalized on their special government privileges and
market dominance to actively lobby and shape GSE-related
legislation.
Most citizens had no idea what the GSEs did, but affordable
homeownership was popular. “Homeownership has been at the
center of government policy because it provides the
foundation for the American middle class,” says Henry
Cisneros, who served as secretary of Housing and Urban
Development under President Bill Clinton and is now executive
chairman of urban real estate investor CityView. “The
middle class is important, as they propel and bring stability
to the economy. The moral issue is around making homeownership
available to all without artificial barriers based on race or
prejudice.”
Many critics of the GSEs argue that the seeds of the
subprime crisis were planted during the Clinton era under the
banner of affordable homeownership. Cisneros offers his own
explanation of what went wrong: “The focus of the policies
at the time was to share the benefits of homeownership with
those who were marginalized. It was after the Clinton years
that the initiative was hijacked with people selling predatory
products. The economic exuberance created the bubble and
introduced bad actors with the wrong motives.”
Cracks surfaced well before the subprime crisis. Many
critics point to the tenure of James Johnson, who ran Fannie
Mae from 1990 to 1998, as the time when the GSEs began to exert
enormous political power to drive their private profit-making
activities. Johnson had been former vice president Walter
Mondale’s campaign manager and chief of staff, and he
spent five years at Lehman Brothers Holdings. Under Johnson,
Fannie exerted great sway over Congress, basing its demands for
autonomy on the social good of expanding affordable
homeownership.
“At the peak of their power, Fannie and Freddie
silenced any critics,” says Armando Falcon Jr., who from
1999 to 2005 was director of the Office of Federal Housing
Enterprise Oversight (OFHEO), which at the time served as the
chief GSE regulator. “So many people were on their
payroll, no one could question their actions or be
negative.” Falcon flagged serious accounting and internal
control problems as early as 2003 and came under considerable
attack by the two mortgage giants and their defenders
throughout his tenure.
Still, the exposure of alleged accounting fraud used to
inflate senior management bonuses ultimately led to the firings
in 2004 of Fannie Mae CEO Franklin Raines and CFO J. Timothy
Howard. In 2003, Freddie Mac admitted to using improper
accounting after OFHEO exposed earnings misstatements of $5
billion from 2000 to 2003. Freddie settled with a $127 million
penalty in 2003 and a $50 million fine by the Securities and
Exchange Commission in 2007.
Falcon initiated a new investigation of Fannie in 2004,
discovering accounting misstatements of $6.3 billion more from
2000 to 2003. Two years later the SEC slapped Fannie with a
$400 million fine, one of the largest penalties in a case of
alleged accounting fraud. Falcon left office in 2005 and was
briefly replaced by James Lockhart III.
What nearly destroyed the GSE mortgage machinery was its
exposure to subprime loans, Alt-A loans and private label MBSs.
Alt-A mortgages typically carry a rating between prime and
subprime. These types of home loans carry a higher
loan-to-value ratio, less documentation, lower credit ratings
and higher debt-to-income ratios for borrowers. Private label
MBSs are not backed by Fannie or Freddie and are considered to
be riskier. To accommodate the growing demand for these
mortgages, the GSEs expanded their use of automated
underwriting systems. The rise in AUS usage, beginning in 2000,
effectively reduced cost and turnaround time for loan
approvals. The GSEs are widely regarded as pioneers of the AUS,
which combined underwriting criteria with statistical
algorithms to predict the default probability of loan
applications.
According to a 2009 HUD policy brief, “Fannie Mae and Freddie Mac: Past, Present, and
Future,” 2000–’06 marked an explosion in
Alt-A and subprime lending. In 2003 dollar originations for
these loans stood at $215 billion; three years later they hit
$1 trillion, some 50 percent of the conventional market. A
ramp-up in purchases of private label MBSs also took place,
peaking in 2006 at $80.3 billion for Fannie and $157.5 billion
for Freddie. At the end of 2008, totals stood at $52.4 billion
and $99.9 billion, respectively.
HUD reported that an almost 90 percent reduction in the
value of private label securities accounted for the GSEs’
major losses in 2008. Citing a U.S. Government Accountability
Office study, HUD concluded that exposure to subprime and Alt-A
loans pushed the GSEs into conservatorship.
But the real estate collapse wasn’t the GSEs’ only
problem in 2008. Fannie and Freddie had insufficient capital
underlying their outsize portfolios — one consequence of
the market’s belief that the government would bail them
out — and had overleveraged to meet growth targets tied to
compensation incentives. In September 2008, just days before
Lehman collapsed, Hank Paulson placed both GSEs under
conservatorship with FHFA, which had been formed in the Housing
and Economic Recovery Act of 2008 (HERA), which merged OFHEO
with the Federal Housing Finance Board. FHFA stepped in to
guarantee as much as $300 billion of subprime 30-year mortgages
held by the two GSEs; the guarantee kicked in when appraised
values fell by 90 percent.
HERA granted FHFA, as conservator, broad powers to
immediately take over all rights, powers, titles and privileges
of the GSEs and over any stockholder, officer and director with
respect to the GSEs’ assets. A critical provision, a
no-injunction clause, prevents any court action to be taken
against FHFA in its execution of its duties as conservator. The
FHFA conservatorship sustained Fannie and Freddie after the
crisis. While capital infusions solved immediate liquidity
issues, FHFA embarked on a strategic overhaul to address
management and operational failures. An equally important goal
was the recovery of taxpayer losses in the bailouts. Although
the GSEs’ boards and management remained responsible for
daily operations, they were now on a much shorter leash. Fannie
and Freddie had to operate within set guidelines, initially
focused on recovering the cost of the bailouts and abiding by
SEC rules. These initiatives placed a priority on reworking the
GSEs’ balance sheets and unloading legacy assets with poor
underwriting standards.
In early 2012, FHFA acting director Edward DeMarco unveiled
the Strategic Plan for Enterprise Conservatorships. A core
priority was mitigating taxpayer exposures. The plan also
sought to uphold public policy goals for affordable
homeownership and assisting compromised homeowners in
refinancings and foreclosures. In August 2012, FHFA and
Treasury jointly released the net-worth sweep. The announcement
was accompanied by the first clear signals from the Obama
administration of its intent to eventually phase out the GSEs.
One policy move accelerated the wind-down of Fannie and
Freddie’s retained mortgage portfolio four years ahead of
schedule.
Last year a new FHFA director, Melvin Watt, a former
Democratic congressman from North Carolina, introduced a
reformulated strategic plan. Watt is channeling his
agency’s energies toward ensuring liquidity for single and
multifamily markets while monitoring credit risks and shifting
them to the private sector. Between the two GSEs, a total of
$352 billion in credit risks from unpaid principal balances on
single-family mortgages has been taken off the books.
FHFA’s newest initiative is the development of a common
securitization platform to improve liquidity and transparency
among a wider group of market participants.
Both Fannie and Freddie have been generating record
earnings, making a phaseout more difficult. At the end of 2013,
Fannie posted $83.9 billion in net income and Freddie reported
$48.7 billion. Strong fiscal performance continued well into
the second quarter of 2014. The two GSEs have repaid $192.4
billion to Treasury — more than their draws. That
doesn’t include the dividends, which can’t be applied
to the bailout balance under the terms of the net-worth
sweep.
The GSEs’ return to profitability rekindled debate over
whether to end their public existence and the consequences of
replacing them with untested alternatives.
The political situation in which this debate is unfolding is
a quagmire. Gridlock has prevailed in Congress, but although
Republicans picked up seats in the midterms, including control
of the Senate, neither party has the 60 votes necessary to pass
legislation there, and the White House retains the veto. Fannie
and Freddie now pump billions into the federal government, and
this certainly helps with the deficit. And affordable housing,
though traditionally a Democratic issue, still has broad
appeal. Meanwhile, the 2016 presidential election is looming.
Both parties will be cautious about doing anything that will
threaten the economy or still-fragile housing markets.
Conflicting visions are rife not only between Republicans
and Democrats but within the GOP caucuses. The House GOP has
been clear that its mission is to extricate the government from
the housing market and engineer an orderly wind-down of Fannie
and Freddie. Senate Republicans lean toward a less drastic
reengineering of the GSEs. In January, Alabama Republican
Richard Shelby assumed chairmanship of the Senate Banking
Committee, which has oversight over the GSEs. Shelby is
considered an advocate of reforming the conservatorship model
and a supporter of privatization. Though the bipartisan
Johnson-Crapo GSE reform bill — technically, the
Housing Finance Reform and Taxpayer Protection Act —
managed to pass Senate Banking last May by a 13-9 vote, the
legislation failed to gain a floor vote because of a lack of
Democratic support.
If the GSEs are liquidated or privatized, the biggest
uncertainties involve the impact on housing. A likely increase
in mortgage costs is being debated industrywide. Current
forecasts for new mortgage rates are in the range of 40 to 100
basis points higher. The proposed common securitization
platform remains untested. FHFA’s Watt recently noted that
the platform would be tested by Fannie and Freddie before a
wider rollout would be considered.
For many voters, affordable homeownership has become a
right, with Fannie and Freddie serving as de facto backstops. A
March 2014 Moody’s Analytics study estimated that the
government still guaranteed nine out of ten mortgage loans, to
the tune of $1 trillion. The study also noted that taxpayers
are exposed to credit risk on two thirds of the $10 trillion
mortgage debt outstanding.
Several congressional housing proposals are in play. There
are currently two leading GSE reform measures: the
Johnson-Crapo bill in the Senate and the PATH Act, a House
proposal. The PATH Act primarily calls for a GSE phaseout
within five years and for FHFA to oversee mandatory
risk-sharing programs. FHFA would establish a National Mortgage
Market Utility and act as a regulator for the Federal Housing
Authority and the Rural Housing Service. The National Mortgage
Market Utility would replace GSE securitization platforms and
facilitate access to the secondary market for loan
originators.
In the Senate, Johnson-Crapo will likely be revisited by the
114th Congress. Sponsored by recently retired South Dakota
Democrat Tim Johnson and Idaho Republican Mark Crapo, the bill
calls for increased capital requirements for mortgage
guarantors and a shift of risk-taking to the private sector.
The bill supports a phaseout of the GSEs that would leave
little for shareholders. In their place, Johnson-Crapo would
install a new agency, the Federal Mortgage Insurance Corp.
(FMIC), which would resemble the Federal Deposit Insurance
Corp.(created in 1933 to end bank runs) and would act as a
regulator while providing MBS insurance via a special fund. The
FMIC would take over the insurance function previously provided
by the GSEs, covering 90 percent of losses on MBSs. The
bill’s proponents contend that this provides a joint
public-private risk-sharing mechanism.
There are flaws with the proposal. The government still
maintains a significant exposure to mortgage risk, although the
FMIC can waive the risk-sharing provision in a financial crisis
as often as three times in any three-year period.
Senate conservatives remain skeptical about creation of a
new federal agency and question its effectiveness. Congressman
Jeb Hensarling, a Texas Republican and chairman of the House
Financial Services Committee, asserts it’s a wealth
redistribution scheme. Hensarling is the leading sponsor of the
PATH Act.
Meanwhile, liberals don’t think Johnson-Crapo does
enough for affordable housing. The strongest opposition has
come from Senator Elizabeth Warren. The Massachusetts Democrat
continues to be concerned by what she views as the bill’s
negative impact on homeownership eligibility.
California Democratic Representative Maxine Waters recently
introduced yet another proposal, the Housing Opportunities Move
the Economy Forward Act, containing elements from various
Senate proposals. One key feature: the preservation of the
30-year fixed-rate mortgage.
That’s politically prudent. The 30-year mortgage has
been the cornerstone of the U.S. housing market for nearly 70
years and is both a central achievement of Fannie and Freddie
and a unique feature of the American market. Before the
Depression, most mortgage holders negotiated rates annually.
After World War II, the 30-year mortgage provided stability for
middle-class homeowners, protecting them from interest rate
volatility. With payments spread over a longer time frame, the
30-year mortgage made homes affordable to many first-time
buyers.
Fannie and Freddie play a key role in providing a stable
source of funding for residential mortgages, especially for
low- and middle-income families, through their role in the
secondary market. The GSEs support banks, thrifts and mortgage
companies by purchasing their loans, which they repackage into
pools of securities and sell to investors. The implicit
government guarantee allowed the GSEs to attract investors
despite lower yields on agency securities — in effect,
subsidizing 30-year mortgages. Moreover, loans with long-term
fixed rates that qualify under GSE rules enjoy a no-cost
prepayment option that allows borrowers to refinance or pay
them off without a penalty. Many GSE defenders believe that
without Fannie and Freddie there is no viable securitization
market unless the private sector steps in. Many predict that
without securitization 30-year mortgages will disappear.
Ackman recognizes the importance of the 30-year mortgage.
“The 30-year mortgage is a critical pillar of housing
finance,” he says. “Without its existence there
exists a negative impact on the markets and will result in
repricing of the entire housing stock.”
Those realities inform the way Ackman reads the political
situation. “The chance of GSE reform passing has zero
prospects because the proposal is not economically
feasible,” he says. “To preserve the 30-year
mortgage, the government needs to build up Fannie Mae and
Freddie Mac’s capital base to the point that they have a
fortress balance sheet. The GSEs can then sell their assets to
private investors and become fully privatized, with the
government not needing to backstop any future
activities.”
“Dismantling mortgage GSEs and creating a viable
alternative is challenging,” says Leo Tilman, executive
chairman of Capitol Peak Asset Management, an adjunct faculty
member at Columbia University and an authority on financial
markets. “These organizations were meant to play three
major roles: fostering homeownership, enhancing liquidity of
the mortgage market and stabilizing the mortgage market in
times of crisis. All three will need to be addressed by an
alternative solution.”
The securitization market, which has been slow to recover
from the financial crisis, is a key piece of the puzzle. By all
accounts, progress continues to be made toward transition to a
common securitization platform. A new CEO and two board members
for Common Securitization Solutions, the entity set up by
Fannie and Freddie to manage the securitization infrastructure,
were announced in November. One of CSS’s goals is
maintaining liquidity for 30-year fixed-rate mortgages.
New infrastructure for public securitizations is moving
forward, but private label securitizations are another story.
Securities within the private securitization pool do not meet
GSE criteria. “The PLS business and the GSEs are two
separate markets,” says Mike McMahon, head of investor
relations at Mill Valley, California–based Redwood Trust,
one of the largest private securitization players in the U.S.,
with a 40 percent market share. “PLS has not come back
because large banks have no incentive to securitize, and with
the dearth of securitization activity, large players like BlackRock
and PIMCO
have no economic incentive to hire teams to invest in PLS.
Structural issues affecting PLS have never been addressed
postcrisis. GSE reform will not affect the PLS market unless
the government shrinks or reduces the types of loans that can
obtain a GSE guarantee.”
If there is one group that maintains a vested interest in a
resolution to the GSE conundrum, it’s the corporate
activists. Ackman, Berkowitz and the others acquired their
stakes at deeply discounted levels relative to their par value.
As of the end of the March 31, 2013, quarter, Fannie’s and
Freddie’s common stock was still trading at 70 cents.
Berkowitz, in a 2013 Fairholme news bulletin, declared his
stake to be one fifth of its liquidation value.
The activists are vigorously challenging the legality of the
net-worth sweep. Statements released by Fairholme to
Institutional Investor in October 2014 called the
sweep lawless. Fairholme declared that “a small cabal of
federal employees had concocted this unlawful scheme” and
is hiding behind a “you can’t sue us
defense.”
The activists’ argument is that the government
committed theft in the net-worth sweep. Other institutions,
like the big banks and insurer American International Group,
were bailed out and rehabilitated, not seized.
The activists may be able to count on some support in
Congress. Pat Toomey, the Republican senator from Pennsylvania
and a former investment banker, sits on the Banking Committee.
He publicly denounced codifying the sweep within Johnson-Crapo
and has been outspoken in support of what he considers fair
treatment of investors.
The activists have diverse supporters. Longtime consumer
advocate Ralph Nader is backing a group called Restore Fannie
Mae to end what he calls the unconstitutional conservatorship
of Fannie and Freddie, writing op-eds in the Wall Street
Journal and organizing roundtables to drum up support.
Restore Fannie Mae is a housing lobbying group backed by some
prominent GSE shareholders, including Berkowitz. Timothy
Pagliara, CEO of Franklin, Tennessee, wealth management firm
CapWealth Advisors and his Investors Unite Group are trying to
mobilize GSE shareholders to assert their rights against the
net-worth sweep.
Berkowitz, John Paulson and private equity and
alternative-investment giant Carlyle Group have all argued that
privatization will end the government backstop of housing and
return it to the private sector. Detractors of privatization,
however, assert that putting the GSEs in the hands of private
investors will give them control over the secondary mortgage
market. Private investors rely on free-market mechanisms,
allowing them to potentially command higher rates of return at
the expense of, say, mortgage holders. The other concern is
that big players will crowd out smaller market participants
like community banks, credit unions and mortgage banking
companies.
In fact, the investors have taken different approaches to
the GSEs. Berkowitz’s and Perry’s principal stakes
are in the preferred shares, and Ackman has a large stake in
the common. Preferred shares sit higher in the capital
structure; in a liquidation scenario the common stock will be
last to be made whole. Still, in a presentation delivered at
the Sohn Investment Conference in May 2014, Ackman maintained a
bullish view on the GSEs’ long-term earning power,
estimating it at a combined $16 billion annually, taking into
account current fee levels and a 35 percent tax rate.
Berkowitz’s investment thesis for his preferred
holdings hinges on two possible outcomes. In one, a court
judgment ending the net-worth sweep would allow Treasury to buy
back the senior preferred stock held by Berkowitz. The other
features either a sale of the GSEs’ legacy assets with
common shareholders getting paid or a rights offering
effectively recapitalizing the GSEs with preferred shares at
full value. To date, Berkowitz has been stymied on both
counts.
Ackman’s lawsuit in the U.S. Court of Federal Claims
continues. Judge Margaret Sweeney is presiding over
Pershing’s case and ten other GSE-related investor
lawsuits. This venue may prove more favorable for Ackman. The
court was established to allow redress for claims against the
federal government. The court’s own website describes it
as “the People’s Court” and “the keeper of
the nation’s conscience.”
Even before Sweeney makes a decision, legal gambits are
ongoing. After watching his fellow activists lose in U.S.
District Court, Ackman on October 31 filed for a voluntary
dismissal of his lawsuit there. If Ackman can win his lawsuit
in federal claims court, he may be able to return to the
district court with more ammunition. However, on December 4,
Treasury filed a motion to strike the voluntary dismissal
notice, seeking to have Ackman face the same decision handed
down in Perry’s case, preventing him from using any
favorable ruling at the claims court level before the district
court. “The investors are probably beating a dead
horse,” says K&L Gates’s Crowley. “Forum
shopping is unlikely to result in a favorable outcome. The
court has decided that FHFA and Treasury both acted within the
law. The best recourse for these investors is to take their
claims to the policy arena and engage the administration, the
Hill, FHFA and Treasury.” Should the judicial process
prove unsuccessful, the battle seems destined to shift to
political Washington, much as Judge Lamberth suggested.
Ackman remains unbowed — he’s a veteran of long
campaigns. He says he hopes it won’t have to be done, but
he’d be willing to take his case to the Supreme Court.
Tactically, Ackman has delayed his case so the discovery
process in Berkowitz’s similar suit can go forward.
What will happen to Fannie and Freddie if reform legislation
does not pass? One scenario would be that the GSEs continue
under FHFA conservatorship. But given the White House’s
mandate to reduce retained mortgage portfolios, the void left
would need to be filled. This would probably require private
participation. Institutional investors would, in turn, demand
higher rates of return, boosting the cost of capital, and more
guarantees. In the end, mortgage markets might contract and
grow more expensive.
Meanwhile, the showdown may just be starting. There is no
indication that any of the current proposals have enough
bipartisan support for passage. The White House appears
committed to backing only proposals that address affordable
housing. When asked whether GSE legislation will remain in
limbo, Cisneros says: “There’s every incentive to get
the housing sector on track. This is a big and important
imperative for the overall economy. The economy has been
impacted as housing has not been unleashed.” Which means
Fannie Mae and Freddie Mac may once again be getting a
reprieve. • •
Amy Poster (aposter@BERDONLLP.com) is a director in the
financial services advisory group at New York–based Berdon
LLP. She served as senior policy adviser at the U.S. Department
of Treasury Office of the Special Inspector General–TARP
during the financial crisis.