Fannie and Freddie fight sparks multibillion dollar proposal

In 2008, as delinquencies and defaults mounted in the US housing market, Fannie Mae and Freddie Mac needed capital. The ailing government-sponsored housing finance agencies issued billions of dollars of preferred shares, enticing buyers with favourable regulatory treatment.

Hank Paulson, then secretary of the Treasury, offered assurances about the financial health of Fannie Mae and Freddie Mac and in nine months $9bn of preferred shares were sold, bringing the total issuance to about $34.6bn.

The extra capital did little to restore confidence as the mortgage market seized up. By September, with the stability of the financial system at risk, Mr Paulson put the agencies in the odd legal state of conservatorship, a status that kept them solvent and at least some mortgage finance flowing.

The government provided a backstop by investing in preferred shares and warrants that could convert to give the government 79.9 per cent of their common equity – just below the level at which it would have to consolidate trillions of dollars of agency debt on its balance sheet.

The original preferred securities and common stock became junior to the Treasury’s shares. Nobody thought much about that at the time because the dire situation made it seem unlikely that the equity and the old preferreds would ever be worth anything again.

“I’ll describe this as a timeout and defer the structure until later,” Mr Paulson told George W Bush, then president, according to his memoir.

Almost every federal bailout from that time has since been repaid. Fannie and Freddie, which together took about $187bn from the government, are on track to return the entire amount by early next year – yet their fate remains unresolved.

Today, they are more indispensable to the market than ever. In 2007, they guaranteed less than half of all mortgages, while now they account for 85 per cent.

They have also become almost inconceivably profitable. They have been allowed to more than double their fees while the quality of the mortgages they underwrite has risen dramatically, with lower interest rates, a higher loan to value and higher credit scores.

In the third quarter, for example, Fannie reported net income of $8.7bn. As their profits swell, a fight between the government and investors over who should share in the spoils has become ever more intense.

Originally, the preference shares were in the hands of small insurers and community banks. But in the summer of 2010, as the Federal Reserve’s quantitative easing buoyed housing, hedge funds began accumulating the shares. “We thought we had reached the bottom and were looking for a way to play the recovery,” recalls one investor.

Moreover, hedge funds’ due diligence showed that the agencies’ realised losses in 2008 were far smaller than the numbers implied. “Their actual condition in fact was never as bad as feared,” states a suit brought by Gibson Dunn & Crutcher on behalf of Perry Capital. “Between 2008 and 2012, the actual realised loss was $100bn less than anticipated.”

Magnifying the actual losses were paper losses that accountants forced the agencies to take in the form of massive reserves against future losses and writedowns of the value of the tax breaks they received.

By 2010, it was clear that they could release the reserves and that the tax breaks were extremely valuable once more.

Seeing the dramatic turn in Fannie and Freddie’s fortunes, the Treasury in 2012 changed the terms of its preferred shareholdings to take all the profits the two produced rather than just a 10 per cent dividend. That produced a windfall: the $100bn collected by the Treasury this year alone enabled the government to postpone hitting the debt ceiling for months.

But the change in the terms triggered a bitter dispute with hedge funds. Their old preference shares, which had steadily gained in value to trade at 32 cents on the dollar before the Treasury’s “sweep” of profits, crashed to a third of that level.

Today, the agencies remain permanent wards of the state. “They are in a financial coma,” declares a lawyer representing one hedge fund. “It is a kind of backdoor receivership.”

The dispute comes as banks are reducing their involvement in the mortgage market, the private label mortgage-backed securities market remains virtually dead, and private insurers have no capital. And while there have been numerous ideas for reorganising housing finance, the hedge funds’ proposal to convert their $34.6bn of preferred securities and help underwrite a $17.3bn rights issue is the closest thing to a cash offer from the private sector.

“We plan to put up real money, this is not just a trade,” says one member of the group.

The future for Fannie and Freddie remains unclear.

Many opponents in America’s financial and political capitals do not wish to see them recapitalised. Wall Street has long regarded the two as unfair competitors and aspired to their business. In Washington, most congressmen are determined to liquidate them on behalf of taxpayers who paid for their rescue.

Well-connected Wall Street groups are trying to drum up government support for their proposal, but the political hurdles are high.

The plan’s creators believe it offers the chance to bring in private capital while leaving taxpayers with a rump portfolio of old mortgage guarantees on which it will turn a profit.

But a group of hedge funds coming in to take over the two agencies is not most politicians’ idea of the ideal private capital.

Many of the hedge funds involved are veterans of bitter corporate bankruptcies but Fannie and Freddie’s restructurings will be nothing like the usual battles over corporate carcases, which play out through well defined legal processes.

The funds’ proposal now sits on the desks of top private equity groups including Bain Capital, Blackstone, Carlyle, Clayton Dubilier & Rice and KKR.

The Wall Street institutions have been retained to drum up support but not everyone is enthusiastic. “This trade reminds me of the adage, buy them for a good time but not a long time,” says the head of one of the largest hedge fund and fund-of-funds operations. “You don’t bet the ranch on this.”

Yet the hedge funds love Fannie and Freddie. They believe that with profits of $25bn-$30bn every year, recoveries from legal action against the banks of another $20bn-$30bn, and a conservative reversal of reserves amounting to at least $50bn, the two could easily be worth $200bn.

“The guarantee business is a great business,” says one investor. “You can’t get rid of Fannie and Freddie.”