The Federal Housing Finance Agency (FHFA) recently announced that it has hired investment banking company Houlihan Lokey as a financial advisor to "assist in the development and implementation of a roadmap to responsibly end the conservatorships of Fannie Mae and Freddie Mac." This is a key step in the process of releasing Fannie Mae (FNMA -3.86%) and Freddie Mac (FMCC -3.12%) from government control, which has been a goal of housing reform since the Great Recession.
The potential changes will affect almost everyone in the financial ecosystem, from banks to mortgage lenders, mortgage insurance companies, borrowers and taxpayers. Not only that, it will provide closure for investors who own Fannie Mae and Freddie Mac stock.
The net worth sweep
Fannie and Freddie buy completed mortgages from banks and independent mortgage originators. They package them into securities and then sell them in the market, typically to banks, sovereign wealth funds, and pension funds. They also back them (meaning they will guarantee these investors are paid regardless of whether the borrower makes their mortgage payment or not).
Fannie and Freddie were bailed out at the height of the 2008-09 financial crisis when many of the loans they held on their balance sheet soured and defaults rose as real estate prices fell. The government effectively took them over (putting them into conservatorship), which is how things stand today. There is common stock that still publicly trades, however it is unclear what this stock in the companies actually represents. The government took over 79.9% of the equity of both companies and has been taking 100% of the profits for itself. This began under the Obama administration and is referred to as the net worth sweep. It amounts to a 100% tax rate. The only reason why the government left 20% of the stock outstanding was to avoid having to consolidate Fannie Mae's debt on the government's balance sheet. Absent that consideration, the stock would have been wiped out.
Image source: Getty Images.
So what is the stock worth?
The Trump administration has indicated it wants to end the net worth sweep, and in September 2019, announced that it will permit Fannie and Freddie to retain up to $45 billion (in other words keep some or all of the profit) in preparation for full privatization.
As for the common stock that currently trades: What happens to it? Will it just get diluted by the stock offering and then trade on equal footing with the new equity? That is certainly a possibility. For example, when a company enters Chapter 11 bankruptcy, the common stock will still often trade, albeit for a few pennies a share. The equity of the post-reorganization entity will be a different class than the extant common stock and will be given to the bondholders. The existing common stock will typically get delisted soon thereafter. Fannie Mae also has $140 billion in preferred stock, which is senior to the common.
As of now, nobody knows what will be the fate of the Fannie and Freddie shares currently trading. That will be up to the government. Looking at the stock and saying "Gee, Fannie Mae earned $16 billion in 2018 and the market cap is only $4 billion" or "Fannie Mae will be permitted to retain $45 billion; 20% of that is $9 billion, so the common is trading at less than half times projected book value" is not the right way to look at the stock. It exists solely due to the convenience of the government.
Given that the government controls the companies and all profits are taken by the government, what does this stock actually represent? Ownership? Perhaps. A share of the profits? Definitely not.
In many ways, the common stock of Fannie Mae and Freddie Mac represents a litigation lottery ticket. Much will depend on the opinion of the president's administration. The Obama administration was dead set against paying stockholders anything. In their mind, the companies were insolvent when the government bailed them out, and if the GSEs had gone through a typical bankruptcy, the shareholders would have been wiped out. Current FHFA director Mark Calabria has said he will wipe out the current stock in each "if he has to."
Any potential IPO will be massive
More interesting is what will happen with the capital raise that Houlihan Lokey has been hired to do. By some reports, the amount of capital that needs to be raised to make this all work out will be over $100 billion. To put $100 billion into perspective, the biggest IPO of all time (Saudi Aramco) raised $25.6 billion. Raising $100 billion is no sure thing, and the IPO will certainly be one for the ages. Much of the success or failure of any potential IPO will depend on what these entities' roles will be going forward.
What will Fannie and Freddie's role in the mortgage markets look like?
Finally, the big question will remain regarding Fannie Mae and Freddie Mac's mission and government guarantee. Prior to the crisis, the government guarantee for mortgage-backed securities issued by the GSEs was implied, but not explicit. After the crisis, the guarantee was made explicit. Going forward, the government would like to see private entities ensure the loans, and for the government to have more of a backstop role. In addition, questions remain over the role for the GSEs in assuring affordable housing and what sort of requirements will be imposed. All of these questions must be answered before a prospectus can be drawn up.
Given that any serious housing reform will require legislation, gridlock in Washington, D.C., could be the biggest issue. While almost everyone in D.C. agrees the taxpayer shouldn't bear the credit risk of the vast majority of the mortgage market, Americans have become used to the 30-year fixed-rate mortgage, which is a distinctly American product and exists solely because of the government subsidy. Ironically, in most of the world, the bank bears the credit risk and the borrower bears the interest rate risk (overseas most mortgages are variable-rate). In the U.S., the taxpayer bears the credit risk and the bank bears the interest rate risk. Virtually every politician defends the 30-year fixed-rate mortgage and wants it to remain. Affordable housing goals are another sticking point. There are major partisan differences over affordable housing. These two issues could end up derailing the biggest IPO of all time before it even gets to the bankers.
