[Research] Making Sense of Fannie & Freddie (GSEs) Pt. 1

The businesses

With the advent of a second Trump Administration, the likelihood that the Government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, escape conservatorship seems about as high as it will ever be. This was a ‘top ten priority’ of the first Trump Administration, however, legal technicalities impeded its ability to properly take control of the Federal Housing Financing Authority (FHFA). With no such encumbrances this time, and with a new mandate to reduce the size of the federal bureaucracy, there seems to be light at the end of this very circuitous tunnel.

Opening slide from Pershing’s Square presentation on the GSEs

In usual Bill Ackman style (herein referred to as the “General”), Pershing Square has been making significant noise around the GSE’s imminent path forward.¹ Whether or not this was related to Pershing’s year end performance hurdles, I’ll leave to your imagination. The General (via Pershing) has been long the equity stubs of both Fannie Mae and Freddie Mac (as well as some junior preferred securities) for about a decade. At various interludes over the post-GFC world they have both appeared as imminently viable activist targets. The issue that has impeded the would-be activists has historically been a very uncooperative bureaucracy. While Obama remained in office, a remedy through Government-led action was all but impossible. During that time, Ackman led and participated a number remedies through the courts largely to no avail. Naturally, that changed with the Trump Administration - but it took the entirety of that term to simply lay the foundations of executive authority in place to affect proper reform. Indeed, proper executive authority over the Federal Housing Finance Agency (FHFA) was not established until the start of President Biden’s term.²

Before trying to make sense of the complicated capital stack (pt. 2 incoming), it’s a worthwhile exercise trying to come to terms with the underlying businesses and how they have changed and developed since the days of the GFC. Extraordinary corporate activity works best when it is married to a good business, and I’m fairly sure we are looking at one here.

D-Day

Buffett famously (or infamously depending on your point of view) sold Berkshire’s Freddie and Fannie stakes in 2000. His rationale:

There were certain aspects of the business that we felt less comfortable with as they unfolded. The consequences of what we saw at the companies may not hurt the companies at all, but they made us less comfortable when those activities or practices did not exist at all. We did not sell - and I’ll stress - we did not sell because there would be more government regulation of Freddie and Fannie. If anything, it would be just the opposite.

We felt the risk profile had changed somewhat.

Munger followed up with:

That may be a peculiarity of ours. We are especially prone to getting uncomfortable around financial institutions.

Financial Institutions tend to make us nervous when they’re trying to do well. That sounds paradoxical, but that’s the way it is.³

What both men were referring to here was the GSE’s then present public commitments to shareholders that they would grow earnings per share (EPS) at 15% annually. This was the same reason that Lou Simpson sold Geico’s stake in the GSE’s as well. Prescient as always, these sales preceded the government take over of both companies by nearly a decade.

This commitment to earnings growth, as opposed to a commitment to long term, durable business practices, was one of the factors that led both Fannie and Freddie morphing into unusually large speculators in the US residential mortgage market. By the time both companies were placed into conservatorship, they more closely resembled leverage hedge funds than they did mortgage insurers.

The seeds of this change were set in the 1990’s when both Fannie and Freddie began warehousing (i.e. retaining) insured mortgages on their own balance sheet. Part of this was Government policy. For example, in an attempt to get more “disadvantaged” households into home ownership, the Clinton Administration made a number of directives (including to Fannie and Freddie) that encouraged lending on much more lenient terms to these communities. This was the genesis of the explosion in the subprime mortgage market in the 2000’s but it initially created a problem for lenders: who would want to buy these mortgages?

While this would eventually get resolved (for a short time at least) by way of fraudulent ratings on Moody’s and S&P’s part, the nearer term answer in the 1990’s was to warehouse more and more of these loans on the Government’s, and their proxy’s, balance sheets. Putting aside the acute issue of holding potentially toxic paper, philosophically being a professional mortgagee is not a particularly exciting endeavour on cash-on-cash basis. Significant sums of capital are used to fund loans, and the returns to equity only prove adequate with the use of unusual amounts of leverage.

In a vacuum, Fannie and Freddie’s use of their balance sheets to hold more mortgages than they would have historically wanted to was an untimely occurrence but not necessarily a catastrophic one. The catastrophic decision came later. Prior to the Crisis, both began operating a new business casually called “Fix Income Arbitrage” (an Ackmanism). While this did involve the abuse of their low cost source of funding, as well their AAA credit rating and their implicit Government backstop - what it really meant was that the GSE’s bought higher yielding, lower quality mortgage-backed securities with their lower cost source of funding. This became a significant contributor to earnings in the pre-GFC period.

When unprecedented numbers of mortgage defaults materialised in 2008 and 2009, the GSE’s became insolvent. So died the two largest debt hedge funds to ever exist.

The Post-GFC GSE’s