This Embattled Stock Is a Potential Nine-Bagger in Waiting

It was the single best investment I’ve made in my career…

I bought more than 1 million shares of mall operator General Growth Properties (GGP) shortly before it filed for bankruptcy in April 2009.

My average purchase price was just $0.67 a share. By the end of the year, the stock had soared to $11.56 – and I had made more than 17 times my money.

The shares of most companies that file for bankruptcy generally go to zero because they’re insolvent, meaning the liabilities exceed the assets, leaving nothing for the equity holders.

But GGP was unusual. Its bankruptcy filing wasn’t due to insolvency, but illiquidity. In such cases, the value of the business exceeds the liabilities… But if the company’s assets are so illiquid that it can’t come up with the cash to repay its maturing debt – and panicked debtholders won’t roll the debt forward – a company can go bankrupt.

Just because debtholders force a company to file for bankruptcy, however, doesn’t mean they get the company. They’re only entitled to earn back the debt plus interest, nothing more. Shareholders get any value beyond this.

Throughout the recession and financial crisis of 2008-2009, GGP’s malls continued to generate strong, stable cash flows that far exceeded what it needed to service its debts. Thus, even though the company wouldn’t emerge from bankruptcy until November 2010, investors bid the stock up once the panic passed because they could see the value of the underlying business above and beyond its debt.

The higher GGP’s stock went, the more valuable it became, because the high share price allowed the company to issue fewer shares to pay down expensive debt, resulting in less dilution to shareholders. It was a wonderful, virtuous cycle.

I haven’t seen an opportunity like this in more than a decade – until now…

A similar setup is occurring today in the shares of Fannie Mae (OTC: FNMA), which, along with Freddie Mac (FMCC), are the government-sponsored entities (“GSEs”) that underpin the U.S. housing market.

Like GGP, Fannie and Freddie are wonderful businesses that generate huge cash flows. Like GGP, they encountered distress in 2008, which dragged their stocks almost to zero. And like GGP, as they prepare to emerge from what is effectively bankruptcy (their stocks currently trade on the pink sheets, as GGP’s did), their rising stock prices create a similar virtuous cycle.

Let’s start with some background…

The History of Fannie and Freddie

Fannie Mae was established in 1938 as a government agency, with the mandate to support liquidity, stability, and affordability in the secondary mortgage market. In 1968, it was converted into a for-profit, shareholder-owned business.

Freddie Mac was created in 1970 to securitize mortgages issued by savings and loans institutions. In 1989, it, too, converted into a for-profit, shareholder-owned business.

Even after they were privatized, investors believed – correctly, as we learned in 2008 – that the GSEs had the backing of the U.S. government. This allowed them to access capital at lower rates than their private-sector competitors (banks, thrifts, insurers, etc.). Over the decades, they came to dominate the U.S. mortgage market, the largest debt market in the world.

The GSEs were immensely profitable because they had huge scale, accessed capital at ultra-low rates, and set aside almost nothing in reserves for losses.

They were able to get away with minimal reserves in part because high underwriting standards and rising home prices over the years insulated them from any meaningful losses.

But it was also due to the U.S. government’s implicit backstop. Normally, lenders to leveraged financial institutions like the GSEs require meaningful reserves to ensure that their loans will be repaid in the event of a crisis. But lenders to the GSEs didn’t have to worry about the possibility of losses because even if the GSEs failed, the government would bail them out.

Without the discipline of the marketplace, the GSEs did two things that eventually led to their downfall…

First, they engaged in fixed-income arbitrage, through which they issued debt, bought mortgage assets, and earned the spread between the two rates. Due to their ability to borrow at ultra-low rates (thanks to the government guarantee) and the high leverage the GSEs employed, this was highly profitable. But it was also risky… and led to $47 billion of losses in 2008.

The second big mistake the GSEs made was to lower their standards as the housing bubble inflated. From 2004 to 2007, their competitors were taking share by making risky subprime and Alt-A loans, so the GSEs began guaranteeing and buying them. By 2007, 13% of Fannie Mae’s guarantee portfolio comprised these mortgages, which accounted for nearly half of the company’s credit losses the following year.

It was these two mistakes, not the GSEs’ core businesses, that led to the big losses that exceeded their miniscule reserves and put them on the edge of bankruptcy in late 2008.

That September, to avoid their collapse, the government had to decide whether to put them into “receivership” or “conservatorship.” The former would have entailed taking over the GSEs and winding them down. Instead, in large part because it wanted to avoid putting the GSEs’ combined $5 trillion loan books on its balance sheet, the government chose conservatorship.

In doing so, it provided the GSEs with open-ended lines of credit in exchange for 10% interest on any monies advanced (which ended up totaling $191 billion), plus warrants for 79.9% of each of their stocks. This was an important and necessary action – similar to what the government did with distressed insurer AIG (AIG) – that helped stabilize the housing market and financial system. (I shudder to think of what would have happened had the government not stepped in.)

Critically, however, the government didn’t wipe out shareholders. Rather, it left them with a little more than 20% of the stock – the minimum necessary to avoid consolidating the GSEs’ debt on the government’s balance sheet. This decision has had important implications, as we’ll discuss later.

Remarkably, the GSEs didn’t go away… In fact, they thrived! With most of their competition weakened or bankrupted in the financial crisis, they were able to grow their market share to 70% in 2009 (it’s now around 50%), charge more for their guarantees, and strengthen underwriting standards – all of which dramatically boosted their profits. At the same time, the housing market stabilized and began to recover, reducing losses.

By the second quarter of 2012, the profits finally exceeded the losses and both GSEs reported their first profitable quarters since the financial crisis.

Why Everything Changed in August 2012

Just as shareholders were set to benefit from the GSEs’ improving fortunes, however in August 2012, the government announced something called the “Third Amendment” in which it would take all of the GSEs’ profits going forward. This so-called “net worth sweep” left shareholders with nothing and the GSEs without the ability to rebuild their capital. Since then, the GSEs have sent the government a total of $301 billion, far more than the $191 billion the government advanced.

For those keeping score at home, the GSEs have now repaid the government in full… plus interest… plus the government still owns warrants for 79.9% of their stocks… plus the government has pocketed additional tens of billions from the companies.

By imposing the Third Amendment, the government achieved two goals: One, it solved a political problem. It wouldn’t have looked good for big hedge funds – who were the GSEs’ largest shareholders by that point – to make billions from investments in entities bailed out by the government. And two, the government got access to tens of billions of dollars each year that it could spend as it saw fit.

While this has been great for the federal budget, shareholders are understandably furious. They bought the stock based on the terms of the 2008 bailout, in the same way that private investors bought shares of other financial institutions and automakers that also received bailouts like AIG, Bank of America (BAC), and General Motors (GM).

But then, in the case of the GSEs – and only the GSEs – the government, without warning, arbitrarily changed the terms of the deal. So a number of large GSE shareholders – mostly hedge funds – filed suit, challenging the net worth sweep on a number of grounds.

In our opinion, the shareholders’ lawsuits should have been slam-dunk victories for reasons outlined beautifully in the May 2016 issue of my friend Porter Stansberry’s excellent newsletter, Stansberry’s Investment Advisory. As he concluded…

The government may try to frame this as billionaire hedge-fund managers versus taxpayers… but justice and common sense will ultimately prevail. All it takes is about 90 seconds of researching the actual facts to figure out who’s the real bad guy.

Treasury officials clearly stole from shareholders. Fannie and Freddie executed a political mandate to make housing affordable, and got wiped out doing so. To take their property now would be the worst kind of abuse. And mountains of evidence will show that the government has repeatedly lied in court and court filings.

This can’t possibly go the defendant’s way.

The government’s primary defense is that its actions were essential to avoid a “death spiral” in the national housing market.

This is nonsense! By 2012, the crisis had passed, the housing market was recovering, and the GSEs were having no difficulty accessing the capital markets. In reality, the government’s actions weren’t driven by the fear that the GSEs were going to post ongoing losses… It’s because the GSEs were about to become massively profitable.

If the government was honest about why it implemented the net worth sweep, a court would surely overturn it, so the government’s attorneys continue to make the death spiral argument.

You might think the courts would see through this obvious lie, but for years they rejected the shareholders’ lawsuits for a simple reason: Judges are humans, and they’ll do almost anything to avoid enriching billionaire hedge-fund managers, who aren’t exactly sympathetic plaintiffs.

The Recent Groundbreaking Victory in the Court of Appeals

For years, the situation remained a stalemate. But then, on September 6, 2019 – 11 years after the GSEs went into conservatorship – the U.S. Court of Appeals for the Fifth Circuit issued a judgment that was a huge victory for shareholders.

In it, the Court of Appeals overturned a lower court and ruled that the net worth sweep violated the law and remanded the case back to the lower court “for further proceedings.”

It’s worth noting that the Court of Appeals also ruled that the structure of Fannie and Freddie’s regulator, the Federal Housing Finance Agency (“FHFA”), is unconstitutional because of job protections for the agency’s director, but this is less important.

Here are excerpts from the decision:

We hold the Shareholders stated a plausible claim that the Third Amendment exceeded statutory authority. Transferring substantially all capital to Treasury, without limitation, exceeds FHFA’s powers to put the GSEs in a “sound and solvent condition,” “carry on [their] business,” and “preserve and conserve [their] assets and property.” We ground this holding in statutory interpretation, not business judgment.

In adopting the net worth sweep, the Agencies abandoned rehabilitation in favor of “winding down” the GSEs… this “wind down” exceeded the conservator’s powers and is the type of transaction reserved for a receiver.

As a textual matter, the net worth sweep actively undermined pursuit of a “sound and solvent condition,” and it did not “preserve and conserve” the GSEs’ assets…

[The] net worth sweep continues transferring the GSEs’ net worth indefinitely, well after Treasury has been repaid and the GSEs returned to sound condition. That kind of liquidation goes beyond the conservator’s powers.

The decision is already having an impact…

On September 9, Treasury Secretary Steve Mnuchin said in an interview that the Treasury is “in the process of negotiating with” the FHFA. “We expect a near-term agreement to retain their earnings,” he said.

Then, the following week, when asked about negotiations to end the net worth sweep, Mnuchin said (emphasis added):

That’s something that the FHFA and we are working on. We are actively negotiating an amendment, and I think our objective is to try to get it done by the end of the month.

Background on the Trump Administration’s
Efforts to Privatize the GSEs

The last two months of 2016 following President Donald Trump’s surprise election-night victory were a boon to the stocks of both GSEs.

The new administration indicated that it wanted to strike a deal to liberate the GSEs from government control, which caused the shares to double from less than $2 to around $4. Here’s an excerpt from an interview Mnuchin did with CNBC anchor Maria Bartiromo shortly after the election…

Bartiromo: Would you move to have these privatized?

Mnuchin: Absolutely. We gotta get Fannie and Freddie out of government ownership. It makes no sense that these are owned by the government and have been controlled by the government for as long as they have. In many cases, this displaces private lending in the mortgage markets and we need these entities that will be safe. So let me just be clear, we’ll make sure that when they’re restructured they’re absolutely safe and they don’t get taken over again, but we gotta get them out of government control.

Bartiromo: This is a big deal. These are huge institutions. You think that… if we saw that as not complicated, wouldn’t that have happened already… that it would get out of government?

Mnuchin: Well, I think with [the Obama] administration, it hasn’t been a priority. If it had been a priority, it would have. And in our administration, it’s right up there in the list of the top 10 things that we’re going to get done and we’ll get it done reasonably fast.

For the next two years, however, Mnuchin made little progress. Shares of both GSEs drifted lower to around $1 by the end of 2018.

Last year, shares nearly tripled on renewed hopes that the Trump administration will act unilaterally, without Congress passing a bill, to recapitalize and release the GSEs from conservatorship.

On March 27, 2019 the White House released a “Memorandum on Federal Housing Finance Reform,” which directed Mnuchin to “develop a plan for administrative and legislative reforms to achieve the following housing reform goals.” Those included plans to end “the conservatorships of the GSEs upon the completion of specified reforms.”

In early September – coincidentally, the day before the Court of Appeals ruling – the Treasury issued its plan, which was an important step in the privatization process. But the devil will be in the details: What can be done administratively (i.e., without Congressional action, which is unlikely)? How much capital will the GSEs have to raise? How and when will they raise it? And how much will the government charge for its backstop?

The answers to these questions, which will be determined via negotiations among many different stakeholders – shareholders, the White House, Treasury, FHFA, Congress, advocacy groups, etc. – will largely determine how much value remains for shareholders.

That’s why the legal victory last fall was so important. It not only greatly strengthens the shareholders’ negotiating position, but also gives Mnuchin and FHFA head Mark Calabria the political cover they need to do what they want – namely, implement a recapitalize-and-release plan that treats shareholders fairly and causes the GSEs’ stocks to go up for the two reasons outlined below.

Prior to the ruling, if their plan had led to a substantial rise in the GSEs’ stocks, they would be accused of acting to enrich their Wall Street buddies. But now they can say that, in light of the Fifth Circuit ruling, their hands are tied. They have no choice but to treat shareholders fairly, because otherwise they risk further losses in court.

What to Do With the GSEs

We’ve seen dozens of ideas about what to do with the GSEs, including winding them down and letting private companies and capital replace them. But over the past decade, it has become clear to nearly everyone that the GSEs are too big and entrenched, too systemically important, and too good at what they do to replace them.

In particular, they make possible affordable, 30-year, fixed-rate, pre-payable mortgages that Americans have come to know and love – and which no politician will risk jeopardizing. Love ’em or hate ’em, the GSEs are here to stay.

If they’re not going away, what should be done with them?

Bill Ackman, my college friend and manager of hedge fund Pershing Square, laid out the right answer in a 111-slide presentation at a conference in May 2014. He called for requiring increased capital levels… limiting certain risky business activities such as speculating in fixed-income arbitrage… increasing regulatory oversight, including annual stress tests… and improving governance and compensation plans that discourage risk-taking.

So why hasn’t this happened? To some extent, because the various parties disagree about what should be done… But mainly for two reasons: disagreement over whether Congressional action is necessary, and the appeal of the status quo to politicians and regulators.

The GSEs and the housing market have recovered from the financial crisis and are doing reasonably well, so they’re unlikely to require another bailout. Plus, many in government are delighted to keep collecting $20 billion-plus a year from the GSEs.

Despite the comfortable status quo over the past decade, we’re confident that big changes will happen because Trump’s administration wants to recapitalize and release the GSEs from conservatorship and even if it didn’t, the recent court ruling will force the government to act.

Mnuchin and Calabria are the two key players. Mnuchin has long pushed for administrative action to release the GSEs from conservatorship, but he was stymied by former FHFA director Mel Watt, who was adamant that Congressional action was needed.

Calabria, who was appointed head of FHFA in December 2018 and confirmed in April 2019, has the opposite viewpoint. He has publicly questioned the legality of the net worth sweep and pushed hard to get the GSEs out of conservatorship.

What This Means for Shareholders

Though the GSEs’ stocks were up big last year, they’re still deeply depressed due to uncertainty about whether Mnuchin and Calabria will be able to implement their plan – and whether it will be good for shareholders.

We’re optimistic on both fronts and thus think that Fannie’s shares still have multi-bagger upside potential.

That said, the plan isn’t going to be a giveaway to shareholders. It will require the GSEs to rebuild their capital – so taxpayers will never again have to bail them out – by raising billions of dollars and requiring them to retain all earnings for many years. Plus, the government will charge the GSEs a fee for its explicit backstop. But these businesses are so dominant and profitable that there will be plenty of value left for shareholders.

To a large extent, however, the analysis here isn’t of the companies, but of Mnuchin and Calabria. If they wanted to, they could implement a plan that would crush the GSEs’ stocks by forcing them to do a large capital raise that dilutes shareholders into oblivion, for example.

A key part of this analysis is understanding Mnuchin and Calabria’s incentives. If we assume that they view themselves as fiduciaries for the American people (which they are), it would make no sense to implement a plan that would hurt the stocks, for two reasons. First, the government still owns 79.9% of the common stock (via warrants), a stake that could be worth more than $100 billion. Why would it want to destroy this value?

Second, in order to raise the tens of billions of dollars needed to rebuild their reserves and exit conservatorship, the GSEs need to attract new investors to provide this capital. How are they supposed to do that if they crush the old shareholders? Instead, it makes far more sense to adopt a plan that causes the stocks to go up over time.

What Is Fannie Mae Worth?

Normally, valuing a stock involves a hard step (valuing the business) and an easy one (dividing by the number of outstanding shares).

But in this case, the latter is actually more difficult than the former.

Fannie Mae returned to profitability in the first quarter of 2012 and has been profitable every quarter since then (though we’ve seen big fluctuations due to changes in interest rates, adjusting reserves, etc.).

This makes it hard to estimate normalized profits. But if we start in 2014 – which excludes huge one-time gains in 2013, as the company reversed reserves booked during the financial crisis – the average quarterly profit has been $3.25 billion, or $13 billion annualized.

Interestingly, Fannie Mae’s trailing 12-month profit is almost exactly this amount, so let’s use this number for normalized earnings. This is conservative, as earnings could grow substantially if the GSEs raise their guarantee fees and the yield curve normalizes.

The market is likely to put a below-market multiple of 13 to 16 times on Fannie Mae’s earnings, at least for the next few years while the recap-and-release plan plays out and the company retains its earnings to rebuild capital. Multiplied by $13 billion, this yields a market capitalization between $169 billion and $208 billion. Divide that by 5.9 billion shares outstanding (which factors in the government’s 79.9% stake), and that yields a share price between $29 and $35 – an eight- to ten-bagger from here.

It’s time to back up the truck, then, right? Not so fast…

The problem is, when all is said and done, Fannie Mae will almost certainly have more than 5.9 billion shares outstanding.

For one, the government is going to require the GSEs to build substantial reserves before releasing them from conservatorship. (Recall that today, they have almost none, because the government has been taking all of their profits since 2012.) The recent ending of the net worth sweep is an important step because the GSEs are now building reserves by retaining earnings.

Plus, Mnuchin and Calabria’s plan will likely require the GSEs to do a stock offering to raise capital quickly. In fact, in early February, the FHFA hired investment bank Houlihan Lokey Capital to advise it on what is likely to be the largest public share offering in U.S. history. How much dilution this causes will depend on how much in total reserves the GSEs need to eventually have, how much they are required to raise now, and at what price.

It’s hard to know what the total reserve requirement might be – Mnuchin and Calabria have been cagey about it – but estimates have ranged between $100 billion and $200 billion, so let’s take the midpoint of $150 billion. Splitting that between the two GSEs based on relative assets, Fannie Mae’s share would be $93 billion. If it continues to earn $13 billion annually, it could raise this amount in seven years… But I suspect the government will want the GSEs to get there sooner, so let’s assume a $10 billion capital raise for Fannie Mae as part of the recap-and-release plan.

The dilution that occurs will depend on the share price. Mnuchin and Calabria will likely put forward a plan that removes a great deal of uncertainty, and then take both companies public, which will take their stocks off the pink sheets. This will make them must-own securities for institutions and index funds. At this point, the IPO price would probably be around $10 a share, resulting in a relatively minor dilution of 1 billion shares. Raising $10 billion would increase the outstanding share count to around 6.9 billion.

The other wildcard that could materially affect the share count is what happens to the various tranches of preferred stock, which are currently trading at roughly 50 cents on the dollar. Fannie Mae has $19.1 billion of face value outstanding and Freddie Mac has $14.1 billion. Some preferred shareholders think that, as part of the recap-and-release plan, the government will convert the preferreds to common stock at par.

If this does happen, it would dilute shareholders by nearly half at current share prices, since Fannie Mae’s market cap today (5.9 billion shares x $3.45/share = $20.4 billion) is only slightly higher than the face value of the preferreds.

That said, I seriously doubt this will happen. Mnuchin and Calabria aren’t stupid, and there’s no reason to convert the preferreds at all. They’re a lousy security for the preferred holders (and good for the GSEs) for a variety of reasons: They’re non-voting (unlike the common), non-participating (meaning their dividends are capped, unlike the common), and most important, “non-cumulative,” which means that if the GSEs choose not to pay a dividend – which has been the case ever since the financial crisis – no payments accrue (unlike debt).

While, the GSEs can’t pay a dividend to the common stockholders without also paying a dividend to the preferred shareholders, this is a moot point for the foreseeable future, as the GSEs will be retaining all earnings for many years to come. Thus, I think the government will leave the preferreds outstanding and not pay them any dividends for many years.

This doesn’t make them bad investments… I think they’re likely to eventually be converted at par, which would result in the share prices doubling, but this could take years.

Meanwhile, I expect the stock to be far more than a double. Based on the assumptions above, if Fannie Mae’s share count increases to 6.9 billion, this would result in an intrinsic share price of $25 to $30 – still a potential seven- to nine-bagger.

Despite the big upside from here, we need to size this position small because of the many risks, including…

• The housing market could take a dive, turning the GSEs’ profits into losses and requiring more capital from the government (since they have almost no reserves).

• Mnuchin and Calabria’s plan could run into opposition and nothing happens, in which case the stocks could drift back to $1, where they were at the beginning of this year.

• The government’s recap-and-release plan could call for huge capital raises and/or conversion of the preferreds that leads to massive dilution, crushing the GSEs’ stocks.

• A new president could try to nationalize the GSEs, which could wipe out shareholders entirely.

This story will no doubt feature twists and turns along the way, and it will likely take years to play out. But ultimately, we think shareholders will end up owning almost 20% of two dominant, highly profitable, well-capitalized businesses serving the largest debt market in the world, whose stocks will soon be trading multiple times higher than their current levels.

That said, there is a great deal of uncertainty here. It’s not out of the realm of possibility that shareholders could suffer large, permanent losses, which is why this needs to be sized accordingly.