In a November interview, the nominee for U.S. Treasury Secretary Steven Mnuchin told Fox Business unequivocally that the privatization of mortgage giants Fannie Mae (FNMA) and Freddie Mac (FMCC) isn't merely a topic of interest for the Trump administration but that it is "on the Top 10 list of things we're going to get done."
Mnuchin's more recent comments, particularly those made during his Senate confirmation testimony, suggest that the hard-line stance may have softened on privatization of the two government-sponsored enterprises. But if recent experience has taught us anything, it is that the Trump administration moves very quickly when it decides to address an initiative.
That being the case, investors should be asking how they can profit from the privatization of Fannie Mae and Freddie Mac. The answers come from the equities, private-mortgage and real estate markets.
The equities market holds the most basic approach to profiting from the privatization of Fannie Mae and Freddie Mac. Although the U.S. government is the de-facto owner of both Fannie Mae and Freddie Mac by way of warrants allowing Uncle Sam to take over as much as 80% ownership of the entities upon demand, they still are publicly traded.
Mnuchin's comments on privatization have had an immediate and substantive impact on the share price for both Fannie Mae and Freddie Mac, leading to a clear conclusion: The market likes the idea of privatization. Thus, one approach to profiting from privatization could be to acquire shares of Fannie Mae or Freddie Mac, particularly because the sub-$5 share prices for both are more akin to options rather than equities.
Another area of opportunity is in the private-mortgage market.
If indeed the market for 30-year fixed-rate mortgages dries up, it seems likely that the U.S. banking industry could gravitate toward a system similar to that used in Canada. There, mortgages achieve borrower-friendly low payments via 25-year amortization, while mollifying lenders by including substantial prepayment penalties and a five-year balloon payment requirement.
However, many borrowers will remain who prefer the tried-and-true 30-year fixed-rate mortgage. Although it isn't likely that institutional capital will support these kinds of loans sans full insurance from the government, many enterprising individual investors will happily provide that type of funding outside the formal banking system through a form of financing called seller financing in which the seller of a property allows a buyer to purchase a property by making a down payment and a series of monthly payments rather than with one lump sum payment of cash.
Furthermore, these types of private seller-financed loans are frequently configured so that monthly payments are similar to local rental rates. In most cities across the U.S., this approach yields an effective interest rate for the seller-financed mortgage of about 10% annually and is thus very attractive for investors.
Finally, the real estate market presents an additional and perhaps the finest investment opportunity that could arise as a function of privatization.
If the federal government extracts itself from issuing mortgage insurance, real estate prices will be negatively affected rather substantially due to a shortage of funding in the most broadly preferred loan configuration: the 30-year fixed-rate mortgage. The gap created by the government's exit isn't likely to be filled by institutional lenders, who don't view 30-year fixed-rate mortgages as an attractive investment.
To the institutional investor, 30-year fixed-rate mortgages represent substantial risk for several reasons.
The first is that interest rates are fixed, so existing loans in a lender's portfolio don't become more profitable as rates rise, but borrowers, on the other hand, are allowed to pay off the mortgage at any time they want without penalty. And borrowers frequently refinance their mortgage as rates drop, which is exactly the time when loans become most valuable for lenders.
Because 30-year fixed-rate loans are structurally undesirable to many in the institutional capital markets, real estate prices would likely suffer as the capital source for real estate purchases is reconfigured.
This reconfiguration would require 12 to 24 months, during which time U.S. real estate prices would fall due to a shortage of capable buyers. But the value of that real estate will remain high, thus creating an extraordinary window of opportunity for investors with access to cash to purchase real estate at considerable discounts to true value.
During this period, hedge fund activity in the real estate market will rise again along with individual investors calling upon their own capital reserves held in their 401(k)s, self-directed individual retirement accounts and other cash savings.
Privatization of Fannie Mae and Freddie Mac clearly creates opportunity for profit, but that opportunity will exist only for investors who are cash-rich and level-headed during volatile times. General economic volatility and the real estate market would quite certainly increase for a period of time following the privatization.
Yet the question remains: Will it actually happen?
The jury is out on that question. Although Mnuchin was unequivocal about the issue in November, statements that he has made since during his Senate confirmation testimony suggest that maybe his and the Trump administration's resolve on privatization isn't as firm as it was.
But if it happens, be ready with cash, because in the chaos created by privatization will be extraordinary opportunity.
The author is an independent contributor who at the time of publication owned none of the stocks mentioned in his hedge fund or in his self-directed 401(k).