Let Fannie Mae, Freddie Mac Live, Hedge Fund Investor Says

NEW YORK ( TheStreet) --Politicians are fixated on winding down Fannie Mae ( FNMA) and Freddie Mac ( FMCC) in the name of housing reform, but they are yet to come up with a better system to replace them, according to Michael Kao, founder of hedge fund Akanthos Capital.

Kao is one of a small number of professional investors who are making a seemingly long-shot bet that junior preferred shares of the housing giants that now trade for pennies on the dollar will recover in value once the government's $187 billion bailout is repaid.

Kao has long been a supporter of returning the GSEs to their old public/private model where they behaved as private companies with the public goal of providing access to credit.

In a presentation at the Value Investing Congress in 2011, Kao argued that the GSEs were not the sole cause of the crisis. While they deviated from their mandate, he says, this was a failure of regulation.

"The public-private model is a time-tested model," says Kao and argues that it is the only way the government can continue to subsidize housing, without assuming direct responsibility for $5 trillion worth of mortgages. What it needs is better regulation and an approach to business that encourages competition from private capital.

But there is no appetite in Washington to recapitalize the government sponsored enterprises or GSEs and return them to their private form. Politicians want to see the housing giants, which epitomize the problem of too-big-to-fail, permanently replaced.

Earlier this week, bipartisan legislation was introduced by Tennessee Republican Senator Bob Corker and Senator Mark Warner, a Virginia Democrat, to replace the GSEs with a new federal agency that backstops private capital.

Under the new legislation, Fannie Mae and Freddie Mac will be replaced by a new government agency called the Federal Mortgage Insurance Corporation. The agency will collect premiums from the industry. In the event of a crisis, the FMIC will act as a backstop, stepping in to insure investors of conventional mortgages from losses but only after private capital has absorbed the first 10% of the loss.

It is a proposal that accomplishes little, according to Kao.

"It seems silly to unmake existing agencies to recreate new ones from scratch, which do the same thing guarantee mortgages, only from a more hampered position," Kao said in a telephone interview.

Kao believes the transition to FMIC would come with considerable risks. Fannie and Freddie back nine out of every 10 new mortgages now, so the stakes of getting it right are high.

The agency would lack the infrastructure that has been built over seven decades. This would have to be built from scratch.

The FMIC is required to have capital equal to 2.5% of the insured amount, which based on the current book amounts to about $150 billion. Yet, he says it is unclear how the agency can earn that capital. Fannie and Freddie, however, already have the earnings power to build that capital.

Finally, Kao notes, the FMIC model does not in any way incentivize private capital to enter the market and willingly assume a 10% hit.

Kao readily acknowledges that returning to the old model will not solve too big to fail. But he does not think FMIC solves it either.

Kao does not believe the government backstop would have fared any better than Fannie and Freddie did in the 2008 mortgage crisis, given the size of the losses. "If there had been an FMIC model then, it would have failed and the government would have bailed it out."

While the Corker-Warner bill gets points for making the guarantee explicit, Kao believes regulation could direct a more explicit guarantee in the case of the GSEs as well.

The hedge fund manager emphasizes that he is not advocating that Fannie and Freddie return completely to the way things were. Instead, he says the agencies will need to be regulated like public utilities, with limits on the kind of mortgage products they can be involved in.

Importantly, the housing giants should be required to increase the fee they charge for guaranteeing mortgages, known as g-fee, to as high as 85-90 basis points from the 50 to 55 basis points they currently charge.

"The g-fees have been artificially low for a long time. Part of the problem in the past was that they charged fees way below market. Banks were not willing to underwrite risk at those rates," he said.

But if the GSEs raise fees, the business will be profitable enough to attract private players into the market. "If you mandate g-fee increases to a certain point, the hope is private capital will come in and cannibalize a chunk of business," he said.

Essentially, Kao's thesis is that "The road to privatization of the mortgage market is greater profitability," and taxpayers and creditors might as well participate in the ride, he argues.

Kao proposes following the General Motors ( GM) template for recapitalization, where senior preferred and publicly traded preferred shares are converted into common.

Kao's fund earned 239% in 2009 from making a bet on General Motors, when shares were trading for pennies on the dollar.

The government will get an 80% stake in the companies under the recapitalization plan, which they could eventually sell at a decent multiple.

Kao estimates that the enterprises are worth $200 billion to $300 billion.

Political analysts believe that investors like Kao ignore political reality, but the investor believes the government will ultimately reach the same conclusion as he has.

The government will never be able to walk away from its role of subsidizing the housing market, although there will be plenty of debate on ending its subsidy.

That being the case, it is always going to encourage some form of guarantee and keeping Fannie and Freddie alive might be the most low-risk and pragmatic way to do so, says Kao.

"At some point Congress is going to wake up to the reality that the only way to move forward is with better regulation," he said.

--Written by Shanthi Bharatwaj in New York.

Disclosure: TheStreet's editorial policy prohibits staff editors and reporters from holding positions in any individual stocks.

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