On Fannie, Freddie Reform, Wall Street Is Left of Maxine Waters

NEW YORK (TheStreet) -- It is a strange world when the call to keep bailed-out mortgage finance giants Fannie Mae  (FNMA) and Freddie Mac  (FMCC) alive and preserve the government's legacy contribution to American homeownership comes not from Washington liberals but from Wall Street.

Practically every reform proposal being considered in Congress supports the winding down of the government-sponsored entities or GSEs, ending the implicit government subsidy that fueled an unsustainable growth in homeownership in the run up to the bubble.

Yet, big institutional investors are arguing that the companies, which are now making record profits and will have paid out dividends almost equal to the $188 billion in bailout money by December, should be rehabilitated and privatized.

"In this country we fix valuable businesses by restructuring; we do not simply throw them away," Fairholme Fund's Bruce Berkowitz said last week.

The billionaire investor is proposing that the mortgage insurance businesses of the agencies be recapitalized and spun off into two private, state-regulated insurance companies. The new companies would be capitalized with $34.6 billion from the conversion of the GSE's junior preferred stock to common shares. At least another $17 billion of new capital would be raised from the junior preferred stockholders in a rights offering.

The proposal was touted as an answer to the broad bipartisan call for more private capital in the private sector, but the likelihood of it being accepted appears slim.

"An offer of this nature would not be in the public interest," Senator Bob Corker (R.,Tenn) told Bloomberg in an email. "Without meaningful legislative reform we would still have dominant entities owned by the private sector but operating with an implied government guarantee, leaving taxpayers at great risk."

Berkowitz is one of a small group of professional investors who, in recent years, have scooped up Fannie Mae and Freddie Mac common and preferred shares for pennies on the dollar.

Early investors bet that the companies would return to profitability and repay the government, a la AIG (AIG), but their hopes were quashed when the Treasury amended the bailout agreement in 2012. Under the revised terms of the agreement,the companies had to sweep almost all of their profits to the Treasury as dividends. This effectively prevented them from building capital that would allow them to repay the government.

Berkowitz and other investors including hedge fund Perry Capital have filed lawsuits against the Treasury, arguing that it violated shareholder property rights when it amended the agreement. The Treasury says it has acted appropriately.

Despite the likelihood of a long-drawn legal battle with the government, the investor interest in GSE shares has only grown.

On Friday, activist investor Bill Ackman's Pershing Square Capital Management disclosed that it had a roughly 10% stake in Fannie and Freddie common shares. The fund said in a filing that it would be in discussions with the management and the government about the restructuring of the companies.

The Fannie/Freddie trade may have attracted major league investors but political analysts believe the bets could backfire as there is no appetite in Washington to a) return the agencies to their former avatars as publicly- traded companies with a federal charter and b) allow Wall Street firms to profit off their restructuring.

Both the Corker-Warner bill, the bipartisan reform effort put forward by the Senate Banking Committee and the PATH bill, advanced by House Financial Services Committee Chairman Jeb Hensarling, call for a new mortgage finance system to replace the GSEs.

What's surprising is that these proposals to kill Fannie and Freddie, two agencies that helped subsidize homeownership for decades, have elicited little protest from the far left.

Even Congresswoman Maxine Waters (D.,Calif.), the House Financial Services Committee's top ranking Democrat, who was once an avid supporter of Fannie Mae and Freddie Mac, appears to have accepted a future without the agencies and is proposing an alternative model.

"Both sides of the aisle absolutely believe that we have got to do reform because of what happened with the subprime meltdown that we experienced in this country," she said at a recent housing policy forum organized by the Bipartisan Policy Center. "But I have to tell you, even if I wanted to say 'look how well Fannie and Freddie are doing, let's just leave them alone and let them keep going,' we are past that point now. We can't do that. Despite the fact that they are doing well, everyone remembers what happened. They remember the debt, they remember the meltdown, they remember the foreclosure and the fact that Fannie and Freddie undermined their own [underwriting] criteria when they were challenged."

Waters is expected to introduce a proposal that calls for a cooperative-owned securities issuer that would address the "perverse incentives created by Fannie Mae and Freddie Mac's ownership structure of private shareholders."

So what makes these big investors think the government will change its mind, given that even the most liberal policymakers are against the status quo?

Perhaps they believe that it is only a matter of time before policymakers are swayed by populist sentiment.

Winding down and replacing the GSEs with a brand new, untested housing finance model could be hugely disruptive to the mortgage market and could destabilize housing, they argue. Does the government really want to risk rocking the housing market, which has just begun to recover?

Even if the government was to continue offering a limited guarantee, analysts say the cost of mortgage credit may rise as much as 100 basis points as private capital would demand a higher return for their risk than the GSEs.

Policymakers who promise reform have the tough job of explaining to their constituents that their mortgage rates are going to go up.

Sure, that may be the price taxpayers have to pay for a safer housing market. But political observers also know how difficult it is to roll back subsidies.

Consider the recent efforts to raise flood insurance premiums to repair the finances of the National Flood Insurance Program. The Briggert-Waters Flood Insurance Reform Act of 2012 was a bipartisan plan that instructed the Federal Emergency Management Agency or FEMA to phase out subsidies so that premiums more accurately reflect risk.

About 20% of policyholders are likely to see their premiums increase annually, though only a fraction of them will see really steep hikes. But there is a big push to delay the implementation of the rules from none other than Maxine Waters, who co-authored the reform bill.

"I am outraged by the increased costs of flood insurance premiums that have resulted from the Biggert-Waters Act," she said in a statement. "I certainly did not intend for these types of outrageous premiums to occur for any homeowner. When I agreed to coauthor this legislation, our goal was to create a bipartisan solution to repair our National Flood Insurance Program. Neither Democrats nor Republicans envisioned it would reap the kind of harm and heartache that may result from this law going into effect."

It is not hard to see this kind of pushback happening in the debate over housing finance reform.

Investors are betting that as the cost of mortgage reform sinks in, there will be a shift in thinking in Washington. Housing reform measures would likely be diluted and an increasing number of politicians might favor just "rebranding" Fannie and Freddie.

That sounds plausible, especially if it happens to be an election year.

But in trying to advance a populist agenda in Washington, Wall Street seems to have underestimated their own unpopularity. "We believe the prospects for significant recoveries on the GSE junior preferreds is inversely proportional to the amount of lobbying and public pressure fund managers exert. No matter the type of fund -- hedge, mutual, or private equity -- the bulk of lawmakers will publicly distance themselves from any proposal which could be framed as "enriching" money managers no matter its merits," Isaac Boltansky, an analyst with Compass Point said in a note last week. "Simply put: Wall Street is not viewed as a sympathetic constituency in D.C. and that fact will not change as the 2014 midterm election comes into focus."

Right now in D.C. it  apparently pays to be anti-Wall Street even more than it does to be pro-homeownership.

-- 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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