[Research] Making Sense of Fannie & Freddie (GSEs) Pt. 2

The inputs that matter - and commentary on the capital stack

Not held.

Pt. 1 can be found here.

I’m also running my customary Q1 Deal on annual subscriptions. If you enjoy the writing and would like to support the newsletter long term, you know what to do.

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Christopher Whalen: As I told my readers, this is a trade. There is no destination here, because if we actually release them as they are, I give a very, very small chance of survival.

Jim Grant: Would this be like a little girl releasing her hamster into the wilderness?

Christopher Whalen: It would be like releasing a hamster onto Broadway!

Grant’s Current Yield Podcast¹

A significant amount of uncertainty remains around both Fannie and Freddie’s potential rebirth as public companies. Like a moth to a flame, I find myself engrossed in this complicated and opaque situation. Unfortunately, so much of the opportunity both preceding and proceeding reorganisation will be left up to the whims of the new President and his advisors. Landmines abound.

As Queen Elizabeth I once demurred: ‘Excuse my doubtfulness, and take in good part my answer answerless.’

The context around how the GSE’s will be reintroduced to the public is essential to understanding how this will all shake out.

The Nature of conservatorship

Fannie and Freddie were taken into conservatorship in 2008 not as a result of problems in their core mortgage insurance business, but due primarily to mounting GAAP losses from their $1.5 trillion investment portfolio comprised largely of private-label securities backed by subprime and nonconforming mortgages. Over the past decade their conservator and regulator, the Federal Housing Finance Agency (“FHFA”), has made substantial reforms to how the GSEs operate. These reforms include strict limits on purchasing mortgages and investment assets beyond what is necessary to support the GSEs’ core guarantee business.²

When the Government stood in to shore up the GSE’s (as they did with a multitude of other financial institutions) they committed to buy senior preferred stock (SPS) and received warrants equal to 79.99% of the equity value of both Fannie and Freddie. On the other side of the ledger both companies were allowed to draw down $100B each from Treasury to assist them in addressing their respective balance sheets. Between 2008 and 2012 these draws amounted to a combined $187.5B.

When it became evident that both of the GSE’s would return to significant profitability in 2012, the FHFA made an amendment to the contractual agreement it had reached with both Fannie and Freddie. This amendment ushered in what became known as the Net Worth Sweep. The long and short of this is that, above a certain capitalisation, the Government was entitled to sweep out all of the excess net worth (read profits) of both companies. While this was scandalous at the time, it was enabled by the near unilateral authority inferred by the conservatorship, and the Preferred Stock Purchase Agreements (PSPAs). This contractual amendment was challenged in the Supreme Court on several occasions citing both the Fourth and Fifth Amendments (unreasonable search and seizures and protections against self incrimination). The ultimate result of the litigation was the remittance of the princely sum of $619M to Fannie and Freddie shareholders in damages. Quite a modest figure when you consider that the Net Worth Sweep netted Treasury more than $301B(!) between 2012 and 2022.³

Conservatorship shaped both Fannie and Freddie in unusual ways. We have already discussed how their speculation in lower grade mortgage-backed securities (MBS) was addressed. On one hand the outcome of the Government’s (frankly outrageous) money grab left both companies unusually undercapitalised. An alarming state of affairs considering they were insuring trillions of dollars of MBS. While the GSE’s remained undercapitalised they couldn’t realistically exit conservatorship - and indeed such a mechanism was only weakly conceptualised when conservatorship was affected. At the same time Uncle Sam could appropriate funds without reference to an uncooperative Congress (then under the influence of newly elected Tea Party Republicans).

Likewise, conservatorship made the market for private-labelled MBS nearly moot. If Fannie and Freddie succeeded in taking share pre-GFC by enjoying a AAA credit rating and an implicit Government guarantee, then there was little point in competing with them when they were being explicitly guaranteed by Treasury, and had a vast facility of Government-backed financing to draw down on.