January 2, 2025 | Just before New Year’s eve, Bill Ackman of Pershing Square posted a long comment on X encouraging investment in the common shares of the GSEs, Fannie Mae and Freddie Mac. Below is Ackman’s comment in its entirety with our comments and questions in italics. Readers of The Institutional Risk Analyst should review our earlier comments (“Kamikaze GSE Release? Oh Yeah…”) and (“Liquidity Preference: SVB Financial Group, WaMu & Reemerging GSEs”). We also recommend reading the latest notes from Moody's and other agencies on the credit implications of an end to conservatorship.
Bill Ackman
I am often asked for stock recommendations, but generally don’t share individual names unless I believe the risk versus the reward is extraordinarily compelling.
As we look toward 2025, one investment in our portfolio stands out for large asymmetric upside versus downside so I thought I would share it.
We have owned Fannie Mae and Freddie Mac common stock for more than a decade. Today, they trade at or around our average cost. As such, they have not been great investments to date.
Cute reference to "average cost," but total return to date would be of greater interest. We would be greatly surprised if Pershing Square and other fund investors have not reaped big returns on the ST gyrations in Fannie Mae and Freddie Mac, as shown below in a chart from Yahoo. The GSEs are among the two best performing financial stocks in 2023 and 2024 in percentage terms, but much of the latest return came after the November election of Donald Trump. These stocks are clearly attractive for ST trading opportunities, but are they a good LT investment? Do we even know how these business will operate upon release in 2026?
What makes them particularly interesting today versus any other time in history is that there is a credible path for their removal from conservatorship in the relative short term, that is, in the next two years.
Not sure how to define a “credible” path, especially since the largest party at interest is the US Treasury. Also, the likelihood of a price "reset" in residential housing is growing. Until the Trump Administration lays out a specific proposal, it is hard to know whether there is a credible way to exit conservatorship without legislation. The Trump I team at the Federal Housing Finance Administration was never focused on release nor was the Treasury under Steven Mnuchin. His successor at Treasury, Janet Yellen, would not even discuss releasing the GSEs.
During Trump’s first term, Secretary Mnuchin took steps toward this outcome, but he ran out of time. I expect that in the second @realDonaldTrump
administration, Trump and his team will get the job done.
A successful emergence of Fannie and Freddie from conservatorship should generate more than $300 billion of additional profits to the Federal government (this is on top of the $301 billion of cash distributions already paid to the Treasury) while removing ~$8 trillion of liabilities from our government’s balance sheet.
This statement is a little misleading. The unsecured debt and secured MBS are not counted as US liabilities. We don’t know how the Treasury will liquidate the original investment in the GSEs and, most notable, the growing tab for the liquidation preference since the GSEs started to retain capital. Every dollar of capital retained by the GSEs is a dollar owed to the Treasury, like buying equity with a credit card. The cash distributions were to rent the “AAA” rating, something that ends with release along with the funding support from Treasury. That support and the liquidation preference of Treasury is described in last year's 10-K from Fannie Mae:
$119.8 billion has been paid to FNMA by Treasury under the funding commitment;
$113.9 billion of funding commitment from Treasury remains. This amount would be reduced by any future payments by Treasury under the commitment.
The senior preferred stock had an aggregate liquidation preference of $195.2 billion as of December 31, 2023.
In the October 2024 Form 10-Q: The aggregate liquidation preference of the senior preferred stock increased to $208.0 billion as of September 30, 2024 from $203.5 billion as of June 30, 2024, due to the $4.5 billion increase in our net worth in the second quarter of 2024. The aggregate liquidation preference of the senior preferred stock will further increase to $212.0 billion as of December 31, 2024, due to the $4.0 billion increase in our net worth in the third quarter of 2024.
The GSEs have built $168 billion of capital since Mnuchin ended the net worth sweeps in 2019. This is already a fortress-level of capital for guarantors of fixed-rate, first mortgages to creditworthy, middle class borrowers.
References to a "fortress balance sheet" are usually an allusion to JPMorgan (JPM), but it is useful to remember that JPM has the most double-leverage of any US bank. More important, no amount of private capital will get you to a "AAA" unsecured rating.
The scenario we envision is that:
(1) the GSEs are credited with the dividends and other distributions paid on the government senior preferred, which would have the effect of fully retiring the senior preferreds at their stated 10% coupon rate with an extra $25 billion profit (in excess of the preferreds’ stated yield) to the government. This extra profit could be justified as payment to the government for its standby commitment to the GSEs during conservatorship.
Pershing Square seems to conflate the Treasury’s equity investment with the senior preferred stock dividends. These are two different things entirely. Treasury is owed full repayment on its equity investment and also has a claim against the GSEs shown in the liquidation preference since the 2019 amendment to the sweep agreement. Moneys paid in cash distributions on the preferred were to compensate the US as majority shareholder and guarantor. The private shareholders of the GSEs have no claim on these public funds. Treasury's position on getting repaid on cash advances is very clear from the experience with General Motors (GM) and Citigroup (C) and at odds with the Ackman description.
(2) the GSEs’ capital ratio is set at 2.5% of guarantees outstanding, a level which would have enabled the GSEs to cover nearly seven times the their actual realized losses incurred during the Great Financial Crisis — a true fortress-level balance sheet.
The private capital of the GSEs is not really adequate through an economic cycle. First, private capital does not really help. Only sovereign support can backstop an $8 trillion market. People who talk about private capital as being significant to the credit standing of the GSEs don’t get the joke. When Fannie Mae was created in 1938, there was no market in 30-year mortgages. Once US credit support is withdrawn from the GSEs with release, we think the conventional loan market will reprice significantly.
A 2.5% capital ratio is the same required for mortgage insurers who by comparison guarantee the first ~20% of losses on often riskier mortgages with less creditworthy borrowers, compared with the GSEs’ guarantee which attaches at the senior-most <=80% of the property’s mortgaged value. Mortgage insurers therefore typically incur 100% losses on a default whereas by comparison GSE losses on a default are minimal.
Comparing the GSEs to private mortgage insurers (PMIs) is not flattering to the GSEs nor a particularly good argument. Like health insurers, the PMI’s tend to avoid paying valid claims, creating risk for the GSEs and their correspondents. For lenders, the biggest risk in the conventional market is GSE loan putback claims for delinquent loans, usually after a PMI has denied insurance.
The GSEs also have enormous ongoing earnings power, particularly during challenging periods in the housing market where they tend to take significant additional market share. This enables them to quickly recapitalize after a period of housing market stress.
True. This is the best argument for the credit standing of the GSEs, but that still won’t get them close to “AAA.” Of note to retail investors, Ackman never mentions the possibility of a credit ratings downgrade for the GSEs upon release in his stock recommendation. The fact that Moody's, Fitch et al have already written about the conditions for a downgrade sure seems like a material fact.
Assuming a Q4 2026 IPO, the two companies collectively would need only raise about $30 billion to meet the 2.5% capital standard, a highly achievable outcome. Freddie needs more than Fannie (which will need little if any capital) because it has grown its guarantee book more quickly than Fannie in recent years.
The FHFA capital rule for the GSEs is excessive and will likely be reduced. When Moody’s rates the GSEs prior to release, the agency will make very clear that the market position and earnings power of the portfolio, and the support of the United States, are the main positive credit factors for the GSEs. The private capital level is a secondary concern. The $8 trillion in conventional residential and multifamily MBS relies upon the unsecured issuer rating of the GSEs.
We estimate the value of each company at the time of their IPOs in 2026 at ~$34 per share. We assume their IPOs are priced at $31 per share reflecting a ~10% discount to their intrinsic values.
We calculate a profit to the gov’t of ~$300 billion assuming full exercise of its warrants and a sell down of common stock in both companies over the five years following the IPOs.
This number is a tad low. The cash advanced and commitments, plus the accrued liquidation preference, is over $350 billion now and will be closer to $500 billion by 2026. Ackman seems intent upon converting the money owed to the Treasury visible in the liquidation preference to the benefit of the private shareholders. This is a short-sighted move since it will generate a political firestorm inside the Treasury and in Washington. If President Trump, Bill Ackman and other institutional holders really want to see the GSEs released, then they must push for full payment of moneys owed to the Treasury. Otherwise, Ackman's positive statement regarding the GSEs should be viewed as just another ST trading opportunity.
We believe the junior preferreds are also a good investment, but they do not offer nearly the same return because their upside is capped.
Ditto.
Trump likes big deals and this would be the biggest deal in history. I am confident he will get it done.
There remains a high degree of uncertainty about the ultimate outcome so you should limit your exposure to what you can afford to lose if you choose to invest.
And after making a public recommendation to buy the GSE common stock, Ackman tells readers to be careful. That shows a fine spirit. But as we have told readers of The IRA, the whole narrative about GSE release is a canard behind which the astute gain significant short-term trading gains. Whether the GSEs will ever be suitable LT investments for retail investors post-release is something that depends upon a number of decisions that have yet to be made. Our advice to readers is very simple: GSE release is a trade, not a LT investment.
Happy New Year!
2:46 PM · Dec 30, 2024
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