GSE Preferred Stock
Not all research is for securities currently held. Any securities for which research is provided herein may be reduced, completely closed out, or not purchased at all without notice of any kind.
January 24, 2019
We have held a position in the preferred stock of the Government Sponsored Enterprises (GSEs) almost since the Fund’s inception. The GSEs are Fannie Mae and Freddie Mac, which buy mortgages from banks and package them into mortgage-backed securities (MBS). Fannie and Freddie earn a fee for guaranteeing the credit of the mortgage underlying the MBS they issue.
We last wrote about our position in the GSE preferreds in detail in February 2015. There are several recent developments regarding this position, so we thought this would be a good time for us to review our current thoughts on the GSEs.
We believe we are at an inflection point in the GSE investment story. We believe the FHFA will move to have the companies exit Conservatorship in 2019. In this scenario, we believe there will be a recapitalization of both Fannie Mae and Freddie Mac. We think our preferred stock position will either get converted to common shares or will be refinanced. Here are the reasons why we believe the timing is right for the companies to exit Conservatorship this year.
- New regulatory head appointed – The Trump administration has appointed Mark Calabria to be the next Director of the Federal Housing Finance Agency (FHFA). Calabria was a senior staff member for Sen. Shelby when Shelby was the Chairman of the Senate Banking Committee. In 2008, Shelby’s Banking Committee wrote The Housing and Economic Recovery Act of 2008 (HERA), which outlined the terms of Conservatorship.
In 2015, Calabria wrote a paper titled “The Conservatorships of Fannie Mae and Freddie Mac: Actions Violate HERA and Established Insolvency Principles.” In this paper, Calabria outlines how the FHFA was not following precedent set by the FDIC of how the government should treat financial institutions in Conservatorship. Calabria will go through a confirmation process in the Senate during 2019, which may take six months. Once confirmed, we believe Calabria will not continue the current path of Conservatorship for Fannie and Freddie. In the meantime, an interim FHFA Director, Joseph Otting, has been designated by President Trump.
- Interim regulatory head made positive comments about potential Conservatorship exit– Several times over the last few weeks, Otting has stated that a goal is to have the GSEs exit Conservatorship. As recently as last Friday, January 18th, the FHFA put out a statement saying, “He mentioned, as he previously has, that Treasury and the White House are expected to release a plan for housing that will include details about reform and will likely include a recommendation for ending Fannie Mae and Freddie Mac conservatorships.”
- Treasury Secretary has long been in favor of the GSEs exiting Conservatorship – Soon after the 2016 election, Treasury Secretary Mnuchin made statements to several media outlets stating his desire to have the GSEs exit Conservatorship. We believe Mnuchin’s stance on having the GSEs exit Conservatorship remains unchanged. Mnuchin has had a long history of working with the GSEs. He ran the mortgage trading desk at Goldman Sachs, and he also purchased and recapitalized a large mortgage bank, IndyMac, from the FDIC.
- Old political foes have retired from Congress – With the new Congress installed in January after the Mid-Term election in November 2018, two long-time political opponents of the GSEs have retired. Jeb Hensarling retired from Congress. Hensarling had been Chairman of the House Financial Services Committee. Sen. Bob Corker retired as Senator from Tennessee and a member of the Senate Banking Committee. Both of these legislators had a negative view of the GSEs that pre-dated the Financial Crisis of 2008. As new members of Congress replace these old foes, they will bring fresh perspectives on housing policy.
- The FHFA has already effectively reformed Fannie and Freddie – Before 2008, critics of the GSEs identified several issues with the GSE business model. All of these issues have been addressed by the regulator during the 10 ½ years of conservatorship, so there is no need for Congress to pass legislation to “reform” the GSEs.
- On-balance sheet portfolio – Fannie Mae’s on-balance sheet mortgage portfolio has declined from a peak above $790 billion to its current $185 billion. This more than 75% decline reduces the refinancing risk of Fannie Mae’s debt. Because Fannie Mae funds itself in the securities markets, critics had pointed to the risk that, if the capital markets were shut, Fannie Mae may have a liquidity problem and may not be able to roll over its debt.
- Capital levels – The FHFA is in the process of creating new capital requirements that will raise the capital requirements of the GSEs.
- Executive compensation – In 2014, the FHFA published a regulation that limited the compensation of GSE executives. As a shareholder, we favored this regulation because the GSE executives of 1996 to 2004 became greedy and paid themselves too much. Their excessive compensation helped to ruin the franchise by provoking political enemies on Capitol Hill who were envious.
- Credit risk – The GSEs have massively reduced the amount of credit risk they retain.
- They have raised their guaranty fees from 13 bps pre-crisis to 40-50 bps. These additional fees will offset any credit losses before capital levels start eroding.
- The GSEs have narrowed their “credit box” of acceptable risk. They have eliminated no-doc lending and significantly curtailed “layered risk.” The layered risk is when a single mortgage has multiple characteristics that stand-alone would be high risk(e.g., adjustable rate mortgage, a borrower with a low credit score, a high loan-to-value ratio, limited or no documentation).
- Most importantly, the GSEs have been buying credit protection in the capital markets by selling credit risk transfer securities to hedge funds, mortgage REITs, and mortgage insurance companies. The cost of buying this credit protection is less than the guaranty fees the companies are charging, so the GSEs are earning a low-risk profit from their guaranty businesses.
- The narrative behind Conservatorship has been debunked – We have long held that putting Fannie and Freddie into Conservatorship was the first of several policy errors that Paulson, Geithner, and Bernanke made in September 2008 that greatly exacerbated the Financial Crisis. They followed up their GSE gaffe by letting Lehman declare bankruptcy, giving WaMu to JP Morgan, and selling Wachovia to Wells Fargo after leaving Citigroup at the altar. Not to mention the extreme favoritism Paulson showed Goldman Sachs by bailing out AIG and giving Goldman and Morgan Stanley bank charters over a weekend.
Paulson’s move to put the GSEs in Conservatorship was a political act that used the housing market weakness as an excuse to attempt to give the secondary mortgage market to the “too big to fail” banks. At the time, the GSEs were both investment grade rated as well-capitalized. Once in Conservatorship, the Treasury forced the GSEs to take huge accounting losses to put up loss reserves for coming credit weakness. The paper losses never materialized and had to be reversed in future years, but they served their political purpose and made it appear as though the GSEs were in a much weaker financial position than they were.
This narrative had been debunked in recent years through articulate writing from Tim Howard and Bruce Berkowitz. Even Chairwoman Maxine Waters, Chair of the House Financial Services Committee understands this was a false narrative, “Contrary to Republican claims, Fannie Mae and Freddie Mac did not cause the financial crisis. The Financial Crisis Inquiry Commission and others have made that clear. The financial crisis was driven by predatory lending, the private market packaging those toxic, risky loans into securities and then selling those securities to unsuspecting investors. Fannie and Freddie did not drive those actions, but the events that transpired during the crisis made clear the need for their reform.”
- GSEs exiting Conservatorship will be good for the housing market – The housing market, as it relates to housing starts and transaction volume, has not fully recovered to pre-Financial Crisis levels. We believe this is because credit has been too tight. Under Conservatorship, the GSEs have been overly restrictive on their credit policies to prevent any credit losses. After exiting Conservatorship, we think the companies will make reasonable changes at the edges of their credit policy to help improve access to mortgage credit.
As a next step for the GSEs, we expect the FHFA will release a plan in the 1st Quarter for the GSEs to exit Conservatorship. We believe the second step will be for a 4th Amendment to the Treasury agreement with the GSEs that will allow the GSEs to retain capital. Other components of the plan will probably include a preferred for equity swap and an initial public offering (“IPO”). The FHFA may also institute a reinsurance fee on the GSEs for a catastrophic guaranty.