Bruce Berkowitz Leads Returns for First Quarter with Bet on Fannie Mae, Freddie Mac

Bruce Berkowitz (Trades, Portfolio) still has almost 42% of his Fairholme Fund (Trades, Portfolio) (FAIRX) in American International Group Inc. (AIG), a holdover from his massive bet on U.S. financials post-economic crisis. As of year-end, he also holds massive stakes in his new venture, national home mortgage entities Fannie Mae (FNMA) (20 million common shares and 66 million preferred shares) and Freddie Mac (FMCC) (52 million preferred shares). The average gain of the new positions is the highest of all investors tracked by GuruFocus over the past six months, beating out those of Robert Karr (Trades, Portfolio), FPA Capital Fund (Trades, Portfolio) and Seth Klarman (Trades, Portfolio), who come after with him double-digit gains. In the past half-year, the Fairholme Fund (Trades, Portfolio)'s new positions have advanced 69.67%, while all of Bruce Berkowitz (Trades, Portfolio)'s new stocks went up 44.24%.

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In the last half of 2013, Berkowitz purchased 29 new stocks, which consisted almost entirely of various classes of preferred shares of Fannie Mae and Freddie Mac. Though Fannie Mae shares fell under a dollar in 2010 and languished between 60 cents and a quarter for the next two years due to their leading role in the 2008 U.S. financial crisis, the price popped 421% in the past year. Freddie Mac's share price followed an almost identical path. On Friday, both companies are priced around $3.55 a share.

Berkowitz first disclosed a position in the mortgage companies in the second quarter of 2013 and has been active in influencing their fate since. The premise of his investment at the time centered on their position within the U.S. financial System. The companies back 60 percent of new mortgages in the country, making home ownership less costly and more available for millions of families. In addition, he found them steeply discounted due to a false market perception.

"The Fund was able to purchase the preferred stocks of Fannie and Freddie near one-fifth of liquidation values - a significant bargain thanks to market predictions of U.S. Government agencies expropriating their assets. We see them differently," he wrote in his second quarter 2013 letter.

Berkowitz also immediately filed suit against the Court of Federal Claims and U.S. District Court in Washington demanding that the companies pay dividends to their preferred shareholders. Under a 2012 amendment, the entities are required to wind down by 2018.

The government first became involved with the entities in 2008, offering to bail them out and receive a 10% dividend until it was repaid. Berkowitz explained the new situation in a December interview with USA Today:

"Then in 2012, in good times, the government changed the terms. Instead of collecting a 10% annual dividend, they said "we want everything.'' And they were negotiating with themselves (because Fannie and Freddie are controlled by the Federal Housing Finance Administration). That's what we're fighting."

Later, Berkowitz offered to buy the insurance businesses from Fannie Mae and Freddie Mac for approximately $52 billion in private investor capital, and turn them into new, state-regulated private insurance companies to repurchase and run Fannie and Freddie. As of March 6, Fairholme Fund (Trades, Portfolio)s says the offer still stands and "there are no other viable alternatives to restructure Fannie Mae and Freddie Mac."

Berkowitz's latest public move with Fannie Mae and Freddie Mac occurred March 3, when he sent letters to the board of directors of both entities, demanding sweeping corporate governance changes. He called on the directors to rebuild capital by retaining earnings, halt borrowing to pay voluntary dividends to the U.S. Treasury, become more fiscally responsible in decision making, among other directives. The letters also request an annual shareholder meeting and the relisting of the companies on the New York Stock Exchange.

Berkowitz's missives came a week after Fannie Mae's board paid the U.S. Treasury $7.2 billion in cash dividends and Freddie Mac's paid it $10.4 billion in dividends, officially repaying their respective bailouts.

The restructuring dreams Berkowitz has for the entities hang in the balance as of March 12, when two senators introduced a bipartisan plan to shut them down in five years. According to the draft of the bill, the entities would continue to pay their profits to the Treasury, and private junior preferred and common shareholders' payouts would be secondary. One author of the bill, Republican senator Mike Crapo, told Bloomberg TV on March 13 that the legislation will not dictate the outcome of the suit shareholders have filed. "That will be a decision that's made in the courts," he said.

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This article first appeared on GuruFocus.
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