Berkowitz, Ackman bets on Fannie and Freddie puzzle investors and policy buffs

November 22, 2013

On Thursday, the United States threw cold water on Bruce Berkowitz’s daring proposal to recapitalize mortgage finance behemoths Fannie Mae and Freddie Mac, saying the only way to revamp the home loan market is through proper housing finance reform.

Berkowitz’s Fairholme Capital Management said it wants to buy the mortgage-backed securities insurance businesses of Fannie and Freddie by bringing in $52 billion in new capital, in a bid to resolve the uncertain future of the mortgage financiers by freeing them from U.S. government control. For its part, the government said the way forward would be to create a new housing finance system in which private capital would play a pivotal role.

Up until a few days ago, the idea that the government would hand Fannie and Freddie back to private investors seemed unlikely. Now, the idea appears all but dead. This appears to be bad news for a number of well-known money managers – the most prominent of which are Fairholme and Bill Ackman’s Pershing Square – which recently scooped up shares in both companies.

“When you talk to anybody in Washington, there is an almost universal view that Fannie and Freddie should be a part of the past, that it is a broken model, and also that private investors in Fannie and Freddie shouldn’t realize any returns from those investments,” said Colin Teiccholtz, the co-head of fixed income trading at $14 billion Pine River Capital Management, in New York this week at the Reuters Global Investment Outlook Summit. He described a bet on a stock that relied on taking Fannie and Freddie private as “extreme optimism.”

On Friday, Ackman told Bloomberg TV that he sees “greater opportunity” in Fannie and Freddie common shares than their preferreds. He also said that his firm does not support Berkowitz’s plan.

Ackman invested half a billion dollars to build stakes of almost 10 percent in each company, but his holding is in the common stock and not the preferreds. Pershing said the stocks are “undervalued” and represent an “attractive investment,” but we have no sense yet of what Ackman’s plan or thesis is.

Fairholme Funds bought up preferred shares of Fannie and Freddie with a face value of $3.5 billion at a massive discount, as well as some common shares. Hedge funds Paulson & Co and Perry Capital have also been buyers of the preferred stock – a trade that was profitable if purchased earlier in the year since the shares then significantly rallied, a number of hedge fund managers said during the summit.

 “We’ve looked at it,” said Marc Lasry, co-founder of distressed debt firm Avenue Capital, about the mortgage giants securities. “The problem is it’s a political question. I think you’re making a bet that you’re going to be able to force the government to do something.”

An investor in Ackman’s Pershing Square said the latest investment is “a puzzle to me.”

“It’s probably a reasonable thesis that when the majority shareholder is the U.S. government, if you think the Target board is hard to convince of a policy change, you have got to believe you’re really taking on a tall job to try and influence the government,” the investor said, referring to Ackman’s failed efforts to reinvigorate the retailer.

Indeed any effort to recapitalize Fannie and Freddie, which have been operating under government conservatorship since a taxpayer-funded $187 billion bailout in 2008, would require congressional approval. And so far the White House and Congress have shown zero interest in restructuring plans proposed by private investors. The rejection of the Berkowitz proposal is yet another sign that Washington is determined to keep the insurers’ profits out of private hands.

Robert Hockett, a professor at Cornell University Law School and a fellow at the Century Foundation said the White House and members of Congress won’t be “singing Hallelujah in response to these latest couple of proposals. It’s hard to imagine many people would think that’s a good idea, at least many people on the Democratic side of the aisle.”

Due to changes in the bailout terms Fannie and Freddie now pay nearly all of their profits to the federal government in the form of dividends, and lawmakers on Capitol Hill have said they’re determined to wind down the companies to make sure taxpayers will never be on the hook for big mortgage losses again. Damon Silvers, the Director of Policy and Special Counsel for the AFL-CIO, the largest U.S. labor federation representing more than 12 million working men and women, described the push to privatize as “absurd” at the Reuters Investment Summit this week.

Deepak Narula, who specializes in trading mortgage securities said common shares of Fannie and Freddie, which Ackman owns, could function like an option. “To the extent there is chatter about privatizing, the option value is going to go up. Whether the option is worth anything in the short run is immaterial.”

Of course mortgage traders like Narula are eagerly awaiting a rebirth of private label securitization and said at the summit this week there are positive developments as the two mega-insurers have begun raising guarantee fees and reducing the subsidy they provide to the mortgage market, paving the way for private capital to step back into the business.

“As they continue to do that, at some point it will become more efficient to go through private label securitization for high credit quality borrowers,” Narula said.

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