We hope you didn't just spit out your coffee...
One of our best – and most famous – market calls of all time was our June 2008 recommendation to sell short both Fannie Mae and Freddie Mac.
We said at the time that investors didn't have to worry about the volatility in this trade because we were certain that both stocks were "going to zero." We showed why both companies likely had a net present value that was in the red by several hundred billion dollars.
The "why" was easy to understand: All you had to do was look at the combined balance sheets.
Both companies had relatively small equity-capital bases... But they were guaranteeing around $5 trillion in U.S. mortgages, some of which were subprime. A lot of mortgages, even prime mortgages, weren't being serviced. Some of these bad loans were going to cause losses – although nobody knew how big these losses would be. What we did know was that because of the leverage involved, losses as small as 5% would wipe out ALL of the equity value of both Fannie and Freddie, leaving investors with nothing. As we wrote in the June 2008 issue...
Today, on a combined basis, Freddie and Fannie own or guarantee 45% of all of the mortgages in the United States – $4.8 trillion worth of mortgages. But looking only at the mortgages they actually own and hold on their balance sheets, you find mortgages with a face value of $1.7 trillion. They hold these assets with only a sliver of equity, about $70 billion in "core" capital. On a combined basis, they're leveraged by a little more than 24-to-1. Thus, a 5% loss in the value of their mortgages would wipe out 100% of the equity in each firm...
Nationally, the average price of a home has now fallen by more than 15%. The delinquency rate for all residential mortgages at the end of the first quarter of 2008 was 6.35% – a record high. In addition, the percentage of mortgages in foreclosure is now 2.47%, up almost 100% from last year. Adding the two numbers together, you see that nearly 9% of all of the mortgages in the United States are either in default or in foreclosure. The Census Bureau reports that about 10% of houses built after 2000 stand vacant. This is unprecedented.
I submit to you: Both stocks are certainly and clearly already zeros.
At the time, both companies were worth more than $20 billion in the stock market: Fannie traded around $27 a share, and Freddie traded around $25 a share. Within 100 days, both companies' shares traded for pennies.
Following our advice allowed some investors to hedge the massive losses that occurred in financial stocks in 2008 – garnering us subscribers for life. Shortly after we published, legendary Barron's editor Alan Abelson put our work on the front page of his magazine, generating an incredible amount of attention for us.
Abelson was brave. His support of our research stood in stark contrast to government leaders, such as Treasury Secretary Henry Paulson, who lied through his teeth telling Congress that both lenders were "well capitalized."
So... why have we returned to the story as buyers?
Well, there's a new wrinkle we can't resist: The government is lying again.
As you know, the government didn't allow Fannie and Freddie to actually go to zero. It orchestrated a huge bailout that cost $189 billion over a few years. But it never bought either of the companies entirely. It got preferred shares and warrants, which converted into 79.9% of the common shares.
This was clever. Buying more than 79.9% of the shares outright would have triggered accounting conventions that would have forced the government to "consolidate" all of the companies' obligations with the Treasury's. No politician wanted to officially take on all of Fannie and Freddie's $5 trillion in debts and guarantees.
As a result, even though shares were greatly diluted, private investors still own 20% of both companies. And today, both companies have more than repaid all of their debts to the U.S. Treasury. Even so, the government has simply stolen all of these earnings and now refuses to give the private owners any of their normal rights.
How did the government get away with it? It lied again.
The first time the government lied to investors, it told us Fannie and Freddie wouldn't go bust. (They did.) Now, the government is lying again... about whether Fannie and Freddie will ever be profitable again. This time, it's lying about how valuable Fannie and Freddie have become. This time, the government is lying to maintain control over the financial world's biggest golden goose.
Recently, unsealed court documents revealed the entire sordid story. It won't surprise you to learn that the government is trying to steal hundreds of billions' worth of earnings, long after all of the costs of its bailout have been repaid.
This month's issue tells the story of how all of this happened. But it isn't just a history lesson or a morality tale.
An ongoing court case should return the earnings of Fannie Mae and Freddie Mac to the rightful owners – the shareholders. Such a decision will unlock tens of billions of dollars in shareholder value, potentially sending the share price of both stocks, which still trade freely for around $1.75, up between 500% and 1,000%.
How Liquidity Influences the Value of Financial Assets
In 1907, Royal Dutch Petroleum (one of the world's largest oil producers) agreed to merge with Shell Transport and Trading (one of the world's largest oil transportation firms). The combination was intended to help them compete globally with Standard Oil, rather than worry about competing with each other.
Even though the companies wanted to share ownership, they planned to continue to be managed separately. Thus, even though the companies shared their earnings and dividends, they maintained separate stock listings.
And here's where the craziness of finance begins... Just about every college economics and finance professor in the world would tell you that these two shares should have traded in parity. (They should be worth the same.) But they never did. One listing always traded at a premium. And the other always traded at a discount.
Why? Why do any of the weird things that happen in the markets happen? They happen because people – whose decisions and choices shape the markets – are not rational.
For a long time, the differences between the share prices were driven by the fact that Britain (where Shell kept its headquarters) limited dividend payments. Then, when the British government lifted those legal limits in 1979, those same dividends (not backlogged) resulted in Shell trading at a premium.
Next, in the 1980s and 1990s, the raging bull market in the U.S. came to influence the relative value of both stocks. Royal Dutch was favored because it had U.S.-listed shares, which were big enough to be included in the benchmark S&P 500 Index. Investors who bought index funds automatically bid up the price of Royal Dutch compared with Shell. This period, too, came to an end. In 2002, Standard & Poor's (which maintains the S&P 500 Index) decided to exclude non-U.S. companies from its list.
The fluctuating gap (or "spread") between the share prices of these stocks had no relationship to their underlying intrinsic values. So it offered patient investors completely risk-free profits. All they had to do was wait until the spread became wide enough to make it worth the trading costs and time. Then, they could buy the discounted stock (Shell or Royal Dutch) and sell short the opposite side of the company. Sooner or later, the spread would narrow, allowing investors to make a completely risk-free profit.
After all, if the entire company went bankrupt, the spread would disappear completely, and an investor would profit because he would have been both long and short. If the spread widened, an investor might show a loss for some period of time. But sooner or later, since the two companies were actually jointly owned, parity would return and the investor would profit.
Knowing that people in finance make money from this kind of tomfoolery must boggle the mind of any sane and rational human. Trying to make a lot of money from small discrepancies in share price doesn't make sense to most investors. Who would want to waste his time for a maximum gain of 5% to 10%? He might have to wait five or 10 years to make a relatively small amount of money.
But what if you could make such a wager with truly staggering amounts of money... while putting up hardly any capital?
Well, that would change everything.
Remember Long-Term Capital Management ("LTCM"), the giant hedge fund that blew up in 1998 after the Russian sovereign-debt default? For three years, this hedge fund earned around 40% a year doing trades just like the Royal Dutch/Shell spread trade. In his book When Genius Failed, Roger Lowenstein wrote that by the time the fund collapsed, it was betting $2.3 billion on this exact trade. It had put the trade on when the spread was around 11% – wide by historic standards, with Royal Dutch temporarily trading at a premium to Shell.
To get around the rules that govern margin trading (which are designed to prevent chaotic markets due to overleverage), LTCM had a deal in place with giant Wall Street brokerage house and financial-services firm Merrill Lynch. In exchange for getting most of LTCM's stock-trading business, Merrill agreed to let LTCM use its balance sheet for these kinds of trades.
They simply agreed to "swap" the value of the spread between Royal Dutch and Shell. If the spread widened, LTCM would lose, and if the spread narrowed (which it had to, eventually), LTCM would win. Merrill could hedge this risk by taking the opposite side of the trade in various derivatives markets, which effectively used its balance sheet to help LTCM achieve tremendous leverage and scale.
By 1996, Merrill had committed $6.5 billion to this kind of financing on behalf of LTCM – an amount equal to Merrill Lynch's entire equity-capital base.
What could possibly go wrong?
As I'm sure you can guess, markets – especially markets that have absorbed tremendous amounts of borrowed money – don't behave rationally. Across LTCM's entire trading book were dozens of bets similar to Royal Dutch/Shell – theoretically risk-free bets. Despite the hedge fund having around $1 trillion in the markets, LTCM's Nobel Prize-winning economists determined that the value of the company's portfolio couldn't decline more than $35 million in any given day.
But then, in August 1998, LTCM lost $553 million in a single day. And across its entire trading book, everything went haywire. As it tried to "unwind" its positions, the size of its trading caused the liquidity in the markets to disappear – even in stocks as big and normally liquid as Shell and Royal Dutch. As a result, the prices for all of these financial assets became more and more irrational. At one point, the spread between Royal Dutch and Shell exploded to roughly 20% – and they're the same company!
You probably know the old saw: If you borrow $5,000 from the bank and can't pay it back, you have a problem. But if you borrow $5 billion from the bank (like LTCM did) and can't pay it back, the bank has a problem.
With the markets going haywire and LTCM's losses mounting ($4 billion in about six weeks), Wall Street's banks circled the wagons and begged the Fed for mercy. First, the banks put up $3.6 billion to cover LTCM's bad debts. The next day, the Federal Reserve's then-Chairman Alan Greenspan cut interest rates. He cut them again two weeks later, an unprecedented move. The "fix" was in. The banks would be bailed out, thanks to the creation of a whole lot of cheap, new credit.
Just like that, as liquidity and calm returned to the markets, the value of LTCM's trading book began to increase. The portfolio was up 10% almost immediately. The banks ultimately recouped their entire $3.6 billion investment when they liquidated the portfolio in early 2000.
The moral of the story?
Lots of new credit can fix just about any leveraged financial institution, as long as its underlying assets have enough residual value.
That's the secret behind what has happened at Fannie Mae and Freddie Mac. Sure, the firm had more than $200 billion in losses. But it also had trillions of dollars in mortgages. And as the Fed pursued the greatest expansion of money and credit in the history of our country, liquidity returned to the mortgage markets. When it did, these legacy financial assets soared in value. By around 2012, it was clear that not only would Fannie and Freddie earn a profit again... they would soon produce hundreds of billions in profits.
What do you guess happened next?
Blatant Theft by a Desperate and Tapped-Out Government
Before we get to what happened next, let's rewind to 2008. During the mass bailouts, the government encouraged most of the bailout beneficiaries – the Troubled Asset Relief Program ("TARP") banks – to repay the debts as soon as possible. And most of the TARP banks did just that.
This payback playbook had two notable outliers: Fannie Mae and Freddie Mac, the government-sponsored entities ("GSEs") that guarantee more than 60% of all residential mortgages in the United States. They were doomed to follow a different script... complete with lawsuits, lies, and cover-ups. This month, we'll go through the details... and show you one of the most interesting risk-versus-reward setups we've ever seen.
In the wake of the mortgage meltdown, the U.S. government created a brand-new entity – the Federal Housing Finance Agency ("FHFA") – to regulate the GSEs and orchestrate a bailout.
As the dust settled, Uncle Sam infused the $189 billion in exchange for the preferred shares and common-stock warrants we mentioned earlier... and a generous 10% per year in preferred dividends. (It's worth noting that that's two times what the TARP banks had to pay.)
We know that the primary culprit of the GSEs' losses were subprime loans, combined with some risky leveraged bets. The "new and improved" GSEs set out to minimize or phase out some of the riskier practices that caused their collapse.
First, the GSEs significantly reduced their exposure to subprime and other low-quality mortgages. Back in 2007, these loans made up more than 10% of the GSEs' guaranteed portfolios. Today, they account for less than 4%.
Next, the GSEs significantly increased the guarantee fees from around 20 basis points to 60 basis points of each mortgage insured. This has raised the average guarantee-fee income generated by each loan. These fees are the main source of revenue for their core businesses. This average will continue to increase as the GSEs insure new loans and as older loans with lower fee structures roll off the books.
As the GSEs readied themselves for the post-meltdown world, the Federal Reserve's loose-money policies created a boon for anyone associated with mortgages. With interest rates teetering in the low single digits, demand for 30-year mortgages yielding 5% to 6% remained high.
Not surprisingly, after weathering the losses in the years following the crisis, the GSEs' businesses began taking off in 2012. Since 2011, they generated pre-tax profits of $148 billion and free cash flows of $75 billion. That's a healthy margin of nearly 20%. The GSEs' leaner business model has been dutifully paying its 10% coupon to the Treasury – up to $19 billion per year.
In 2011 and 2012, right as the GSEs turned the corner toward profitability, the federal government found itself in the midst of the ridiculous debt-ceiling debacle. Budget hearings dominated the headlines, and Treasury officials were scrambling for cash. The GSEs were generating fat, consistent dividends, but the Treasury thought it deserved more.
By August 17, 2012, Washington, D.C. was on the verge of an embarrassing fiscal lockdown, and the GSEs were earning their first quarterly profits since 2007. That's when our desperate and cash-strapped government added the "third amendment" to the GSE bailout documents. This represented a historic shift... from quietly nickel-and-diming GSE shareholders to orchestrating blatant theft.
Here's how U.S. District Judge Royce Lamberth – who heard one of the resulting lawsuits – describes it:
The third amendment "replaced the previous dividend formula with a requirement that the GSEs pay, as a dividend, the amount by which their net worth for the quarter exceeds a capital buffer of $3 billion. The capital buffer gradually declines over time by $600 million per year, and is entirely eliminated in 2018."
In simpler terms, the amendment "requires Fannie Mae and Freddie Mac to pay a quarterly dividend to the Treasury equal to the entire net worth of each Enterprise, minus a small reserve that shrinks to zero over time."
This established a steadily decreasing "capital buffer." The math behind this accounting term isn't all that important. But let's just think of the capital buffer as the GSEs' "emergency fund." All responsible businesses (and people, for that matter) should maintain a financial cushion, or emergency fund.
Highly leveraged entities like the GSEs need an especially big cushion to guard against wide "mark to market" profit swings that come from hedging risk with a basket of derivatives. We shorted these entities back in 2008 because their capital wasn't nearly large enough to absorb the potential losses of the risky loans they guaranteed.
And yet, in an ironic twist, by enacting this amendment, the FHFA – an entity that was created to ensure fiscal responsibility of the GSEs – is now forcing the GSEs to systematically reduce their emergency funds to zero by 2018.
Amazingly, the diminishing capital buffer isn't even the biggest change created by the third amendment. Did you notice? The 10% dividend preferred is gone. In its place is a variable dividend.
Specifically, the amendment requires the GSEs to pay the Treasury every single penny they earn in excess of the ever-decreasing capital buffer. That means all profits are sent directly to the Treasury as a dividend.
In the end, this exceptionally bold (and illegal) arrangement serves two purposes: It allows the Treasury to steal every penny of the GSEs' earnings. And it puts the GSEs in a more perilous financial position, making them even more dependent on the government.
This is a clear violation of the "takings clause" of the Constitution's Fifth Amendment, which protects against the seizure of private property for public use without just compensation.
Two Battlefronts for the GSE Shareholders
The victims here, obviously, are the GSE shareholders (who own 20% of the companies), many of whom saw the GSEs as an opportunity to bet on a housing recovery via the stock market. Sure, there was uncertainty. Would the housing market rebound? Would the GSEs storm back to profitability? Would the interest-rate environment cooperate?
Of all the concerns to consider and risks to weigh, one thing that didn't cross their minds was the possibility that our government would change the rules on the fly, thereby rendering shares of Fannie's and Freddie's common stock worthless. And make no mistake, under the terms of the third amendment, these entities are now literally designed to fail.
In the wake of the third amendment, it didn't take long for lawsuits to flow in from every direction. Unfortunately for the Treasury, GSE shareholders include some of the sharpest minds in finance. Guys with deep pockets, who don't mind fighting, and who don't care how much it costs to win. Billionaires like Bruce Berkowitz and Richard Perry and even Wall Street lightning rod Bill Ackman. (Seriously, is there a Wall Street soap opera that Ackman isn't in the middle of?)
At least 16 cases are floating around... all with different plaintiffs, making different claims, asking for different damages, being tried in different jurisdictions. Many of these cases center around a couple of legal terms: receivership and conservatorship.
Traditionally, in a conservatorship role, an entity acts as a kind of "guardian" or "protector" of the troubled party. In a receivership role, the "guardian" effectively takes control of the damaged business, its assets, and its future profits. In many of the lawsuits, the government's role, rights, and privileges will come down to how the courts interpret these roles.
This is, of course, just one of many grievances filed by the plaintiffs. The table below provides a small taste of some of the charges and arguments by both sides in various courts...
The Plaintiffs (Shareholders) Say:
The Defendant (Treasury) Says:
The third amendment substantially changed the value of our shares, and we were not compensated for the lost value.
The bailout itself – and promise for future bailouts – were forms of compensation.
Conservatorship vs. receivership
From 2008 to 2012, the government was happy with the conservatorship relationship. When the GSEs started making real money again in 2012, the government switched to a "receivership" arrangement without warning, thereby nationalizing the entities.
Congress authorized us to act as both a conservator and receiver. The legislation foresees us winding down the affairs of the GSEs as a conservator – a role necessary to stabilize the national housing market – and plenty of statutes say the government has this authority.
The nature of the payments received
The GSEs have already paid you back in full. How can you expect further payments under the terms of the third amendment?
The bailout was an investment, not a loan. This legislation has a duty to the taxpayer.
Was the third amendment necessary?
The GSEs had started to turn a profit as soon as you dumped the third amendment on their lap.
The third amendment arrangement was perfect for a financially fragile entity because it replaced the "fixed" 10% dividend with a variable dividend. We didn't know the GSEs were going to be wildly profitable when we entered the third amendment.
We could fill 100 more pages with additional courtroom commentary. But you get the idea. And in the end, Richard Perry's attorney, Theodore Olson, sums it up well:
[The third amendment] systematically drained these entities of all value, leaving in its wake two unsound and insolvent zombies – a golden goose for the Treasury and utterly worthless for the individuals and institutions who in good faith invested in them.
While their lawyers square off against the Treasury, GSE shareholders face another formidable foe on an entirely different battlefront. Starting right after the crisis, we've seen an ongoing smear campaign against the GSEs.
Look, the guys who ran the GSEs were no Boy Scouts. They got into all kinds of aggressive plays that they shouldn't have. But while they were active players in the pre-crisis market, 10 years of financial scholarship has unanimously concluded that the GSEs did not cause the financial crisis – a conclusion echoed by the Financial Crisis Inquiry Commission.
There is some bipartisan support in Congress to wind down the GSEs and leave their lucrative business to the professionals – namely, Wall Street banks. Of course, it's widely known that the Wall Street-backed lobbyists are the ones controlling the plan's congressional supporters... and those lobbyists could be behind the public smear campaign as well.
You can't blame Wall Street for trying. If we've learned anything over the last 70-plus years, it's that buying, packaging, selling, and insuring government-backed loans can be a steady and profitable business.
As you might expect, there is a certain "cross-pollination" among the two groups of GSE foes. Many Treasury bosses eventually left their posts to join the ranks of banks, private equity, and lobbying firms. They now spend their time trying to unwind the GSE businesses.
GSE shareholders have been fighting these battles on both fronts for years. We have been watching from the sidelines... waiting to see how everything developed. Recently, we've sensed some important changes. Momentum has begun to swing in favor of GSE shareholders.
There are signs that the "wind it down and give it to Wall Street" plan is losing steam. Banking analysts have countered many of the supposed advantages to the plan, pointing out that banks would suffer the same challenges that the GSEs face. Many GSE shareholders – especially Ackman – have smartly argued that it would be hard for the current banking system to digest an operation and asset hoard as massive as the GSEs.
On the legal front, a couple of cases have been getting a lot of attention lately. Judge Lamberth initially dismissed one particular case. But the plaintiffs appealed, and a three-judge panel of the U.S. Court of Appeals in Washington, D.C., is now hearing it. As part of another round of proceedings, a judge may soon release up to 11,000 previously sealed government documents. This is where it gets good...
Uncle Sam's Public-Relations Nightmare
Throughout the discovery phase of the various lawsuits, the federal government has ruthlessly protected these 11,000 documents. That isn't as easy as you'd think. The government has played every privacy card available, up to and including President Obama invoking "executive privilege."
This move raised more than a few eyebrows. After all, that's a level of privilege typically reserved for national security. The government maintained that this level of security was necessary to protect financial markets. As if the Microsoft Outlook calendar of some underling at the Treasury could bring the global banking system to its knees.
Just what are they hiding?
Well, at this point, only a handful of the documents have been unsealed. But it's already clear what lurks beneath. Lies... lots of them.
For example, we have a juicy exchange between Fannie Mae CEO Susan McFarland and Treasury bigwig Mary Miller from August 2012. McFarland let Miller and others know that Fannie Mae was heading toward profitability and provided official forecasts that the GSE would continue to be profitable for years to come.
McFarland also divulged that now that Fannie had returned to profitability, it could reap an additional $50 billion in income by releasing its "deferred tax assets reserve." (Don't worry about the accounting mechanics. Just know that this essentially meant that Fannie Mae would save $50 billion in cash on its tax bill over the coming years – cash that could be sent to owners as profits instead.)
This conversation probably wasn't illegal or even unethical. It's questionable, sure, but CEOs give investors projections all the time.
What's unethical is that this conversation happened just days before the Treasury changed the rules via the third amendment, thereby ensuring that patient GSE shareholders would be frozen out of the now-healthy GSE business. This blatantly contradicts the Treasury's assertion that it didn't know that the GSEs were healthy prior to enacting the third amendment... and that its intention was to prevent a "death spiral."
This is information from recent depositions and just seven unsealed documents. There could be 10,993 more coming. Who knows what we'll find in those.
Here's what we know...
- In the wake of the mortgage meltdown, the Treasury gave the GSEs $189 billion.
- Since the bailout, the GSEs have repaid more than $240 billion to the Treasury.
- Uncle Sam has a PR nightmare coming, in the form of thousands of documents that will almost certainly contradict comments made by public officials.
While they defy common sense, some of the government's defense arguments are legally sound. But these cases will largely be resolved in a public-relations forum, not a strictly legal forum. 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.
This unusual set of circumstances has provided us with what is without a doubt one of the best risk-versus-reward setups of my career.
The Big Long
Before we move on, let's get one thing straight: This is the mother of all speculations. It is not for your rent money. It's not even for your dog-food money. For asset-allocation purposes, you can put this in the same category as your plane tickets to Vegas.
While we think the plaintiffs (shareholders) will prevail, you need to understand this fact: Under the third amendment that currently governs the GSE bailouts, there will be no profits left over to ever pay common-equity holders.
However, the plaintiffs have a great case and a great shot of overturning the amendment that blatantly stole their property. Herein lies our opportunity. Fannie and Freddie shares currently trade around $1.75. That's less than one times earnings – a valuation typically reserved for companies in grave danger of bankruptcy. In other words, the market has priced these shares as if the plaintiffs have almost no chance of winning.
But what if the plaintiffs win? What would these shares be worth?
The GSEs operate two different businesses: one, providing mortgage insurance/guarantees, generally on safe, 30-year, fixed-income mortgages, and two, investing in various capital markets and speculations. Fannie Mae refers to this as its "Capital Markets" business. Freddie calls it "Investments." We'll just call it "Capital Markets."
The Capital Markets business earns profits on the spread between the interest it earns on its long-term mortgage assets and the interest it pays on its government-subsidized short-term debt.
Normally, this business model is profitable. But it also exposes the GSEs to interest-rate risk. If short-term interest rates rise above the long-term rates the GSEs earn on their investments, their profits can disappear.
So to hedge the risk, the GSEs buy complex derivatives to reduce their exposure to interest rates. Changes in interest rates can send the value of these derivatives either soaring or crashing, causing large gains or losses. Both GSEs are significantly scaling back these lines of business. We wouldn't be surprised if they phase them out completely. We think valuing them separately from the "traditional" business makes sense.
In contrast, insuring prime mortgages is a safe and highly profitable business. All of the problems that caused the credit losses and the eventual collapse of the GSEs resulted from the risks taken by the Capital Markets business and low-quality mortgages within the mortgage-guarantee portfolios. But as we explained earlier, the GSEs have significantly reduced their exposure to this risky debt. Sufficient reserves now fully cover the old subprime low-quality debt on their books. Newer loans are almost all prime.
Since the GSEs only break out revenue and profits (and not cash flows) by business, we'll use an earnings multiple to value the businesses. The Capital Markets business has large swings in its income because of fair-value adjustments to the value of its investments and derivatives each period. In recent years, its income also included some legal settlements from TARP banks who purposely sold toxic debt pre-crisis. But stripping out all of the noise and accounting for the fact that the government is requiring the GSEs to wind down these assets to at least $500 billion by 2018, we estimate that the business will earn $2 billion a year in profits going forward.
The more stable mortgage-insurance business insures around $5 trillion worth of mortgages – around $3 trillion for Fannie Mae and $2 trillion for Freddie Mac. Let's assume that it will earn 60 basis points of guarantee fees each year for this service, a total of $30 billion a year in revenue.
Let's also assume that credit-loss provisions (estimates of future bad loans) will eat 20 basis points. That's a conservative estimate, considering the loan book will now be mostly prime going forward. After deducting interest expense, administrative costs, taxes, and preferred dividends, Fannie's mortgage-guarantee business nets $7 billion and Freddie nets $4 billion – a total of $11 billion annually.
We'll use a price-to-earnings multiple of 15 times to value the companies. That's below the S&P 500 multiple today of 19 times and below the GSEs' historical average.
This brings us to an estimated market cap of $102 billion for Freddie and $56 billion for Fannie. Dividing both values by the diluted shares outstanding (including the Treasury's common shares), we estimate that Fannie's and Freddie's shares are both worth $17.55 per share, not including any value for the separate Capital Markets businesses. The Capital Markets businesses would add another $3.33 per share of value to the combined GSEs, assuming the same multiple.
That's a total value of $38.43, for one share of each entity. The current combined share price of Freddie and Fannie is only $3.34. If the GSEs' share prices return to this conservative valuation, we'll realize a gain of more than 1,000% – a 10-bagger!
Even if our valuation is wildly optimistic, that's still an incredibly compelling risk-versus-reward setup.
This is not a typical Investment Advisory recommendation. This speculation is a bet on the American judicial process. A win for the plaintiffs will ignite a meteoric rise in the GSE shares. If the government wins, the GSE securities will all drop toward zero.
Speaking of the "GSE securities," if you call your broker or look at your online brokerage order form, you'll notice something unusual. There are literally dozens of securities for these entities.
Most of these securities are thinly traded preferred shares. (These aren't the Treasury's preferred shares.) Holding certain GSE preferred shares offers some interesting advantages. (Each of the billionaires we mentioned holds a significant chunk of his stakes via preferred holdings.) But we don't think the "preferreds" are right for our portfolio. Preferred shares won't be nearly as easy to buy, and many of your brokers won't have them in inventory.
But you can still get in this trade. Common shares are a good way to make this "bet." They are as easy to buy as almost any other equity, and they will appreciate just as quickly as the preferred issues.
The GSE common shares trade on the "over the counter" (OTC) exchanges, so the ticker may look a little different for the various brokers. But Fannie Mae will be listed under some variation of FNMA (for example, FNMA.OTC or FNMA-OTC). Freddie Mac trades as some variation of FMCC. We have called several of the major brokers, and all of them assured us the shares should be obtainable, the same way you buy shares in any other company.
If things go badly in the courtroom, the market will dump shares so fast it's unlikely you'll be able to effectively execute a stop-loss trade. Given this fact and the extremely speculative nature of this particular trade, we recommend you enter this trade in a quantity that totals half your "normal" position size. Take half of the money you would normally put into one of our investments and divide it evenly between Freddie and Fannie shares. We'll hold them as a single, combined position.
In our official portfolio, we will buy an equal dollar amount of Fannie and Freddie shares, up to a combined value of $2.25 per share, and we recommend you do the same.