Fannie, Freddie, and the Long Path Out of Government Conservatorship

Our Call: Since Capstone’s founding, our analysts have covered Fannie Mae (FNMA) and Freddie Mac (FMCC), the two government-sponsored enterprises (GSEs) placed in conservatorship in the height of the 2008 financial crisis. Before President Trump was elected in 2016, Capstone predicted that the new president, regardless of party, would present opportunities for the existing preferred stock in the GSEs. In 2018, as the Trump administration outlined its plans to re-privatize the enterprises, we remained bullish on the risk-reward presented to the securities.

Background: Fannie and Freddie were placed into government conservatorship in 2008, with the newly created Federal Housing Finance Agency (FHFA) as their conservator. They received billions of dollars in bailout funds from the US Department of the Treasury in exchange for almost 80% of the common stock and billions of dollars in senior preferred shares (which originally carried a 10% dividend). In 2012, Treasury and FHFA amended their agreement, allowing Treasury in effect to sweep all the GSEs’ earnings in perpetuity. Private shareholders—both common and junior preferred shares continued to be traded—sued, arguing the arrangement was in violation of the FHFA’s enabling statute and the US Constitution. Following President Trump’s election, his administration has taken slow but steady steps aimed at finally ending the decadelong conservatorships. FHFA has said it expects that the GSEs can exit government control in 2021.

Our Rationale: We have always viewed the junior preferred shares as call options on three policy changes: 1) administrative action to end the conservatorships, 2) the shareholders’ litigation, and 3) legislation. President Trump’s election fundamentally altered the value of the first two. At the same time, we felt that the shares were undervalued because investors were skeptical about the administration’s level of urgency after years of inaction.

Our Process: We conducted a rigorous review of the public record of existing and proposed regulation and legislation. We combined this research with targeted conversations with relevant regulators, policymakers, and other stakeholders to assess the risks and opportunities the companies face. We also conducted financial analysis to determine how exposed they were to the looming headwinds.

The Outcome: FHFA and the Trump administration have announced an ambitious timeline to get the GSEs out of conservatorship. Meanwhile, the shareholders’ litigation has started to see some wins, with the US Court of Appeals for the Fifth Circuit issuing a favorable ruling in 2019. Shares in the GSEs’ preferred stock were up as much as 100% in 2019, as investors began to price in an increased likelihood of action.