Why Fannie Mae And Freddie Mac Might Be In Trouble

Nearly seven years into the financial crisis, the drama of government-sponsored enterprises Freddie Mac and Fannie Mae continues in the courtroom and in the halls of Congress. Following weak earnings in 2014, concerns about future bailouts have pushed for reform. Meanwhile, hedge fund managers are pressing for dramatic changes following a controversial decision by the US Treasury Department in 2012.

Many wonder what the future of both Fannie and Freddie will look like ahead. But in order to understand the future of Fannie Mae and Freddie Mac, one must understand its past and present.

What Happened to Fannie and Freddie?

In 1938, Congress authorized the foundation of the Federal National Mortgage Association (FNMA), known as Fannie Mae, as a government-sponsored enterprise (GSE). Part of the New Deal, it was founded to stimulate the housing market and make mortgages more available and affordable to moderate- to low-income borrowers. (For more, see: How Does Fannie Mae Make Money?)

The government expanded its role in the housing markets in 1970 after it founded another GSE through the charter of the Federal Home Loan Mortgage Corp “FHLMC,” also known as Freddie Mac. This GSE buys, guarantees, and securitizes mortgages into mortgage-backed securities. This securitization is critical because Freddie Mac essentially guarantees the mortgages in a similar way that the US Treasury guarantees the value and security of US bonds. Historically, both the securities and Treasuries carried similar credit ratings.

That is until September 7, 2008. On this day, the Federal Housing Finance Agency announced that it was placing both GSEs under conservatorship, a process similar to a Chapter 11 bankruptcy. At the time, the two s, which engaged in nearly 50% of a $12 trillion mortgage market, were deemed “an unacceptable risk to the broader financial system.” (See: How Fannie Mae And Freddie Mac Were Saved). Following this announcement, the companies’ shares of common and preferred stock plummeted.

At the time, the government didn’t want to fully takeover both firms. Instead, it decided that through the conservatorship process, the US Treasury Department would inject $188 billion into both firms in exchange for senior preferred stock. This has allowed the Treasury Department in recent years to receive a 10% dividend in addition to acquire warrants to roughly 80% of its common stock. And it is that decision that has set off a firestorm of criticism and lawsuits from hedge funds.

Why Hedge Funds are Suing the FHFA

Hedge fund leaders Richard Perry of Perry Capital LLC and William Ackman of Pershing Square Capital Management LP, and mutual fund manager Bruce Berkowitz, among others, have sued the government over a process known as a “profit sweep.”

In 2012, concerns emerged that the two GSEs would not be able to fulfill their 10% on the senior preferred shares held by the government. In order to alleviate them, the Treasury Department said that Fannie and Freddie no longer needed to pay these dividends in quarters when they lose money. However, when they turn a quarterly profit, all of their gains must be turned over to the Treasury Department. By conducting this “profit sweep,” neither firm is able to boost its capital reserves.

Currently, Bill Ackman’s shop owns a 10% stake in the common stock of both Fannie Mae and Freddie Mac. And while the shares of both entities hover near $2.50, Ackman believes they are worth ten times that level. The hedge funds believe that the Treasury Department has exceeded its authority with its profit sweep rules.

Meanwhile, President Obama and several other key legislators are arguing that the government should replace both Freddie and Fannie. However, hedge fund managers argue that they companies should engage in a restructuring rather than a total replacement.

The Bottom Line

Nearly seven years after the financial crisis, Fannie Mae and Freddie Mac are under increased scrutiny from politicians, hedge fund managers, and ordinary Americans. While many on Capitol Hill have demanded broad reforms, investors are demanding their day in court. Whether the companies face liquidation or replacement, investors remain vocal about the Treasury Department’s change to the firms’ dividend structure.