Here's the financial equivalent of the popular Twilight vampire franchise: Politicians are sucking the blood out of resurgent mortgage guarantors Fannie Mae and Freddie Mac rather than returning them in good health to the private sector, where they belong. Washington is using their money in its budget-cap games, leaving the duo in a state of perpetual weakness, like the living dead, imprisoned in the government's ill-named "conservatorship" program.
A number of profit-minded investors that have taken positions in the preferred shares of the formerly distressed mortgage companies are pushing an alternative. The politicians, they claim, are blowing an opportunity both to generate at least $100 billion in deficit reduction from a spinoff to the public and to significantly limit the government's footprint in the mortgage market. Recall that in last month's budget, President Barack Obama took a huge political risk in calling for the sale of the government-owned Tennessee Valley Authority for about $25 billion to help reduce the deficit.
The financial acumen of these investors—which include hedge funds Paulson & Co.; Claren Road Asset Management, owned by the Carlyle Group; and Perry Capital—stands in stark contrast to their seeming naiveté about Washington. No matter how sensible on paper, their investment is unlikely to succeed. As one of my D.C. sources quipped, "Congress can't fix the Post Office, let alone Fannie and Freddie."
I've heard the investors' spiel. It's a good one. They envision two well-capitalized, debt-free, prime-mortgage guaranty corporations operating without government safety nets. Proceeds from the wind-down of mortgage-backed securities now on the books would pay off debt.
The government injected $187 billion into Fannie (ticker: FNMA) and Freddie (FMCC) after their collapse in 2008 in return for special preferred stock. At year-end 2012, the Treasury had received $65 billion in dividends, leaving a balance of $122 billion. The administration estimates that if the two remain in conservatorship for 10 more years, Treasury will get its money back—plus $50 billion—assuming housing's recovery continues. The investors argue that the companies have recovered and, like General Motors (GM) and AIG (AIG), should be turned loose. Based on combined 2012 pretax profits of $28 billion and a conservative 6.5 price/earnings ratio, the two could easily raise $182 billion in the stock market, according to the investors. If the government converted its preferred shares into a 79.9% common stock interest and sold it, then it would receive at least $145 billion. An eight- to-10-times multiple is more likely, generating $200 billion to $250 billion.
Subtracting Uncle Sam's proceeds from a $182 billion stock sale would leave $35 billion for holders of the $33 billion par value in old preferred shares and common stock. If they received their allocation ahead of the common, they'd realize a 100% recovery. Thus, the hedge funds and other vulture investors who bought preferred for $2 to $4 would receive $25, a great payday, to be sure.
Alas, Fannie and Freddie have loss carry-forwards valued at about $60 billion. Left on their books, it's counted as equity capital. The vampires in the administration and on Capitol Hill want Fannie and Freddie to transfer that credit to Treasury for use in deficit reduction. Treasury also continues to sweep capital out of both companies every quarter for its preferred dividends, keeping them weak. And they call this a conservatorship. I call it a vampire's blood bank.
The more attention the common shares gain, the more pressure there will be from the government to stop blood sucking these two companies. Especially since this past few, a lot of big name hedge fund activists likely bought in to argue this.