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.
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.
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.
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.
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:
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