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March 6, 2012
Despite public statements from the regulator, I believe there is a chance that Freddie Mac can earn its way out of its current indebtedness to the U.S. Treasury. I believe the companies are healing more rapidly than is believed. Their core business is profitable. The 2009-2012 vintages of mortgage originations will be close to pristine. If home prices improve from here, the losses on defaulted mortgages will decline. If employment statistics continue to improve, I would expect mortgage delinquency statistics to improve as well. In the detailed investment thesis below, I focus on Freddie Mac since I judge the credit quality of Freddie Mac’s mortgage portfolio to be better than Fannie Mae’s. It is therefore more likely to return to profitability sooner. This thesis is held by very few investors, but some prominent investors do have similar views. In fact, one fellow holder of the position, Michael Kao of Akanthos Capital, presented his investment thesis on GSE preferred stock at an investment conference last May.
- There is political deadlock on resolving the companies – Much has been written about Congress not addressing the GSE Reform issue. The Obama Administration has only proposed vague guidelines for GSE Reform. The Dodd-Frank Wall Street Reform and Consumer Protection Act did not address the GSEs because there was no consensus among lawmakers on how to change the mortgage finance system. Some lawmakers think the government needs to do more in the mortgage market to provide financing to homeowners. Others believe the complete opposite that the government needs to refrain from providing financing to the mortgage market. Until a consensus appears, we are likely to maintain the status quo with our current system of Fannie and Freddie operating in conservatorship.
- Freddie Mac could potentially pay off the Treasury in 5-7 years - This political deadlock gives Freddie and Fannie time to naturally repair their balance sheets. The new business the companies have put on their books since 2009 has been profitable. As time passes, a larger percentage of their books of business comes from these profitable vintages, and their financial positions will naturally heal.
a. Freddie Mac will probably turn profitable in 2012 – Based on the regulator’s projections, Freddie Mac will not have to draw capital from the Treasury starting in 2012. This implies the company turns at least breakeven beginning this year. Based on my forecast, I think the company will be mildly profitable in 2012.
b. Freddie Mac has five sources of hidden value on its balance sheet:
i. Deferred tax assets (DTA) – Freddie Mac has taken a valuation reserve against all of its deferred tax assets. But, these deferred tax assets are valuable because they will shield the company from paying taxes for the foreseeable future. Once the company reports four consecutive quarters of profits, I project they will be able to reverse the valuation reserve for the DTA, which could add about $40 billion of capital to the company.
ii. Loan Loss Reserve (LLR) – Freddie Mac has a very strong loan loss reserve compared to the major banks. Freddie Mac holds 3.1 years of loan charge-offs in its loan loss reserves. For comparison, Wells Fargo and JP Morgan only hold 1.9 years and 2.4 years, respectively, of losses in their LLR. At some point going forward, Freddie Mac’s management and its regulator will have to stop adding to the company’s loan loss reserve. I estimate there could be up to $15 billion of hidden value in Freddie Mac’s LLR.
iii. Accumulated other comprehensive income (AOCI) – Freddie Mac has a notorious portfolio of non-agency residential mortgage backed securities. These are the subprime securities from 2004 to 2007 that lost a lot of value. The prices of these securities have slowly recovered as the underlying mortgages have been paid down. There is still a potential of an $8 billion difference between potential recovery value and the prices Freddie Mac is marking these securities to on its balance sheet.
iv. Pay-fixed swap portfolio – When Freddie Mac issues debt, it decides whether to issue a typical cash bond or to enter into a pay-fixed interest rate swap. Issuing the bond and entering into the interest rate swap have identical economics. Sometimes, the company gets a lower interest rate with the swap. The downside is the company must mark the interest rate swap to market each quarter. When rates decline, the company recognizes mark-to-market losses. With the 10-year Treasury plummeting to below 2%, Freddie Mac has run several billion dollars worth of losses through its income statement. If rates rise, these losses will reverse. Even if rates don’t rise, these losses will reverse in the form of lower interest expense over time. If the 10-year Treasury rates rise to 3%, I project Freddie Mac will see mark-to-market gains of up to $10 billion.
v. Lawsuit settlement proceeds from non-agency underwriters – Freddie Mac’s regulator, the FHFA, files a lawsuit on its behalf to recover damages from the underwriters of the non-agency securities. It is difficult to project how much the company will recover, but there is certainly a case to be made considering the severity of the losses of the underlying loans. For example, if we look at the individual loan severity in Long Beach Mortgage Loan Trust 2006-11, it is a staggering 85%. This is not possible without a huge amount of fraudulent mortgage loans or a misrepresentation of the number of second lien mortgages in the security.
- The GSE business model is viable – I believe the ongoing business model of the GSEs is viable. I believe the recovery of the companies during conservatorship shows the benefit of tighter regulation. The companies served their mission very well until both were forced to change their CEOs in 2003 and 2004. Neither of the new CEOs had the market sense to step back from the frothy housing market and protect their balance sheets. Instead, each fought to defend market share at the height of the housing bubble. With tighter regulation and better management, the GSEs can return to their missions and role in the market from 1985 to 2005.
a. The mortgage market of 2008 to 2012 proves we need the GSEs - The GSEs (along with the FHA) have had at least a 95% market share since the financial crisis started. This statistic is pretty convincing of the need for the GSEs. The housing market and the ability to get mortgage financing have been difficult over the past 4 years, but without the GSEs it would have been completely shutdown. The private mortgage finance system was dormant during this time. A fully-privatized mortgage finance system would create too much friction in the housing market because home buyers, sellers and their service providers could never be sure that the financing market wouldn’t shut down before the home closing.
b. Banks want the liquidity they get from the GSEs - Banks for the most part want to have the liquidity outlet of the GSEs. Right now, banks are grasping for loan growth, so they are retaining many of their mortgage originations. When deposit growth is not as robust and/or there are more attractive sources of loan growth, banks will want the option to sell their mortgage portfolios to the GSEs.
c. The failures of both Fannie and Freddie could have been prevented with better management and better regulation - both management teams and the regulator failed when the companies aggressively moved into the Alt-A market in 2006 and 2007. This has been corrected and can be permanently fixed by barring the GSEs from purchasing any loans without full-documentation. Alt-A loans (or low documentation loans) promote fraud in two ways: 1) borrowers and mortgage brokers have incentives to lie about the borrowers income on Alt-A loans because they do not have to document it and 2) it allows people who under report their income for tax purposes to get loans backed by government sponsored agencies. If a person is not willing to document their income and pay their share of taxes to the IRS, then they should not be eligible for a loan from a government-sponsored agency. I believe there is no place in the GSE business model for Alt-A or low documentation loans.
- Potential catalysts – There are several potential catalysts for the GSE preferred stock position.
a. Profitability will change the tone of the GSE political debate - If I am correct that Freddie Mac will turn profitable in 2012, the political debate will focus on getting the taxpayers repaid versus what the structure of the mortgage finance system should be.
b. The Obama Administration has incentive to declare victory on GSEs - The Administration has the ability to turn the GSE negative into a political victory by crafting a recapitalization of the companies. The recapitalization could be a conversion of the Treasury’s senior preferred stock and our junior preferred stock into common stock and a re-IPO of the companies to the public markets. This would get the taxpayers’ money back and create victory for Obama by showing that conservatorship worked and he fought to get the taxpayers’ money back.
c. Freddie Mac could begin to pay-down the Treasury’s senior preferred stake - With profitability, Freddie Mac will be in a position to begin repaying the Treasury for its stake in the company. With the 10% dividend rate, any pay-down will have a compound benefit for the company because the dividend burden will be reduced.
d. Potential dividend cut on Treasury’s senior preferred - The best way the Treasury can help the company is to reduce the dividend rate on the senior preferred stock. The 10% dividend rate was set a week before the financial crisis was in full swing with the Lehman bankruptcy and the AIG bailout. The TARP banks have only had to pay a 5% rate. AIG had to pay a 10% rate, but was allowed to waive its dividends at its own Board’s discretion. The GSEs’ 10% dividend rate is an artifact of the timing of the Treasury placing the companies into conservatorship, which was a week before Lehman’s bankruptcy.
- Regulatory actions have been protective of the companies – The FHFA has operated the companies well in conservatorship. Although the regulator’s primary mission is to protect the taxpayer during conservatorship, a side benefit for shareholders is that the regulator’s actions have protected their interests as well.
- Asymmetrical risk/reward – The GSE preferred stock position is a position with asymmetrical payoffs. As of December 31st, the position could gain 18x versus a potential loss of 1x. In other words, the market is predicting only a 6% chance of recovery.
GSE Preferred Stock Investment Risks
Although my investment thesis may seem compelling, there are substantial risks with the GSE preferred stock position. The fund may lose most or all of its investment in this position. If you are considering buying GSE preferred stock for your personal investment account, please do not make a purchase based on this letter. The information presented here is insufficient to make an informed decision. You need to do your own research. While the following is not a comprehensive listing of all the risks, here are some specific risks regarding the position:
- Shrinking book of business – The GSEs have shrinking businesses. Their mortgage portfolios have mandated maximum targets for size that will reduce profitability. Their credit guaranty businesses are also shrinking because mortgage volumes are light and banks are retaining more of their mortgage production volumes.
- Additional taxes and fees – There could be additional fees and taxes imposed on the GSEs similar to the 10 bps fee imposed to pay for the 2-month extension of the payroll-tax cut.
- Accountants and regulator could continue to force GSEs to add to LLRs – Freddie Mac may not demonstrate profitability in 2012 if their accountants and regulator force management continue adding to the loan loss reserve.
- Housing risk – Home prices have not bottomed and mortgage delinquencies have stopped declining, so there is risk that the mortgage market could get worse from here.
- Lack of executive management – The CEOs at both GSEs have announced their resignations, and the political pressure on executive compensation at the companies will make it difficult to attract new CEOs.
- Flat yield curve – Both GSEs are benefitting from the steep yield curve. If the yield curve were to flatten, their mortgage portfolios will produce substantially less revenue.
- Republican President – The GSEs political situation could worsen materially if a Republican is elected President in 2012.