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Fannie, Freddie Soar as Hedge Funds Score Wins on Two Fronts

Saleha Mohsin and Austin Weinstein

(Bloomberg) -- Fannie Mae and Freddie Mac soared the most in almost three years Monday as hedge funds that have long hoped to make a windfall on their investments in the mortgage giants got a double-dose of good news.

First, shareholders won an important legal victory after markets closed Sept. 6 that gave them renewed optimism of getting their hands on billions of dollars in company profits that now go to the government.

Then, Treasury Secretary Steven Mnuchin said early Monday that he will soon reach a deal that allows Fannie and Freddie to hold on to some of their earnings, so they can start rebuilding their capital buffers.

The step is considered crucial in eventually freeing the companies from federal control, which has been their status since the 2008 financial crisis. That’s because Fannie and Freddie are currently restricted from holding more than $3 billion in capital apiece, far short of what they would need to weather another housing crash as private companies.

Fannie jumped 43% to $3.88 in New York trading, the biggest one-day gain since November 2016. Freddie surged 43% to $3.67, also its biggest rise in almost three years.

Among investors benefiting from the gains are some of the biggest names in finance, including John Paulson, Bill Ackman’s Pershing Square Capital Management and Blackstone Group Inc.

Read More: Fannie-Freddie Soar as Wall Street Hails Court Win, Mnuchin Plan

Treasury is “in the process of negotiating” a plan for Fannie and Freddie to retain earnings with the Federal Finance Housing Agency, Fannie and Freddie’s regulator, Mnuchin said Monday in an interview with Fox Business. “We expect a near-term agreement to retain their earnings,” he said.

Revamping Sweep

For Fannie and Freddie to hold on to their earnings, Treasury and FHFA would have to halt or revamp a controversial policy implemented in 2012 during the Obama administration, known as the net worth sweep, that requires the companies to send virtually all their profits to the Treasury.

Hedge funds and other investors that own Fannie and Freddie shares have long fought to end the sweep through litigation, claiming it was illegal. The shareholders won a big victory Sept. 6 when a panel of federal appeals court judges overturned a lower ruling that had backed the government’s right to take all of the mortgage giants’ profits.

Read More: Fannie-Freddie Investors Fighting Profit Sweep Get Key Win

The Fifth Circuit appeals court judges, based in New Orleans, also concluded last week that the structure of the FHFA is unconstitutional. Investors still face many hurdles, as the decision just kicks the case back to the lower court. Many other federal courts have ruled against the shareholders, making it more likely that an appeal could ultimately be heard by the Supreme Court if the case isn’t settled before then.

Litigating Shareholders

Fannie and Freddie don’t lend money to home buyers. Instead, they purchase mortgages from banks and other lenders and package them into bonds. Those securities have guarantees that protect investors from the risk of borrowers defaulting. Fannie and Freddie backstop nearly half of the U.S.’s $10 trillion of home loans, a process that keeps the mortgage market harming and borrowing rates low.

Fannie and Freddie were put into federal conservatorship in 2008 as the housing market cratered and were sustained by taxpayer aid. They have since started making money again and paid $115 billion more in dividends to the Treasury, through the net profit sweep, than they received in bailout funds.

Assuming that Fannie and Freddie would eventually released, hedge funds started buying their shares for pennies in the years after the crisis. Paulson & Co., Pershing Square and Blackstone Group’s GSO Capital were among those who got in on the trade.

Until now, shareholders have mostly suffered setbacks in their attempts to overturn the profits sweep. Their Sept. 6 win follows what also might be a watershed moment in Fannie and Freddie getting out of the government’s grip: the release of a Treasury report a day earlier that outlines the Trump administration’s plan to end the conservatorships.

Treasury Report

The Treasury document laid out dozens of suggested reforms to protect Fannie and Freddie from another housing crash, shrink their dominant market shares and create new competitors to the companies. Yet, it is only an initial step in what still would be a long and arduous road to freeing the companies from the government’s grip.

The Treasury Department’s proposal left much to be ironed out, signaling many of the suggested changes may not come until after the 2020 presidential election. And if a Democrat beats President Donald Trump next year, the overhaul would likely be scrapped all together.

Mnuchin said Monday that while he hopes to work with Congress to implement changes to Fannie and Freddie over the next three to six months, he is “perfectly comfortable” making administrative fixes if necessary. Only Congress can create competitors to Fannie and Freddie. But there is much the Trump administration can do on its own with FHFA, including ending the profit sweep.

If Fannie and Freddie start retaining earnings, it would still take them years to build up adequate capital to offset big losses. That’s why most officials believe the companies will also have to raise money through other means, such as share sales. In conservatorship, the companies lack of capital hasn’t been much of an issue because they have access to about $250 billion in Treasury funds.

Senate Hearing

The Treasury secretary will testify tomorrow on the administration’s plan before the Senate Banking Committee. Joining Mnuchin will be FHFA Director Mark Calabria and Housing and Urban Development Secretary Ben Carson.

The officials are expected to face aggressive push back for Democratic lawmakers, who are concerned that the administration’s proposals will do more to help hedge funds than assist consumers in getting loans, particularly lower-income buyers.

(Adds closing share prices in fifth paragraph.)

--With assistance from Josh Wingrove.

To contact the reporters on this story: Saleha Mohsin in Washington at smohsin2@bloomberg.net;Austin Weinstein in New York at aweinstein18@bloomberg.net

To contact the editors responsible for this story: Alex Wayne at awayne3@bloomberg.net, Jesse Westbrook, Gregory Mott

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