BlackPacific Capital


The 500lb Gorilla in the Room

Posted on 21 October, 2016 at 13:05
Weekly Market Assessment
The Big Lie: The 500lb Gorilla in the Room

Fannie Mae is the 500 lb. gorilla in the mortgage business room.  For those unfamiliar, Fannie Mae also known as a GSE (Government Sponsored Enterprises) is a simple and straightforward insurance company. It is hands down one of the two largest financial institutions in the United States, with over $5 trillion in mortgages. No other major financial institution comes even slightly close to the scope and scale that Fannie Mae exerts in the secondary mortgage business.   They buy loans that banks and other lenders originate so those banks and lenders have the funds to issue new loans, enabling more people across the country to buy, refinance, or rent a home.  

Fannie Mae guarantees the timely payment of interest and principal on mortgage backed securities that are purchased by investors. Bruce Berkowitz, a legendary fund manager who is suing the government explains Fannie Mae here:  “They are not banks. There isn’t a local Fannie Mae branch on the street corner. Unlike the big banks, Fannie Mae did not commit any consumer fraud in the run-up to the financial crisis. The two do not originate mortgages and they do not deal directly with individual homeowners. However, when it comes to funding our nation’s housing market, Fannie Mae is mission critical. The company has helped tens of millions of American families buy, rent, or refinance a home’s even during the toughest economic times when banks and other lenders shun mortgage risk. Bottom line: Fannie Mae and Freddie Mac are the housing finance system in America, and earn a nominal amount (less than 40 basis points) for ensuring that the venerable 30-year fixed-rate mortgage remains widely accessible and affordable.”  

They provide the funding required for banks to make a loan, they buy pools of mortgages from banks and sell these bundled up mortgages to investors with a “government guarantee" on the principal and interest payment.  Fannie Mae is the 30 year mortgage and remains the bridge to the American dream of home ownership!   

What Happened to Fannie Mae

The story goes like this, in the fall of 2008, the world was coming to an end and teetering on the edge that would official destroy the world was Fannie Mae and Freddie Mac becoming insolvent.  To prevent this from happening the U.S. Treasury contracted a deal/bailout. The terms were dictated by the Treasury, the government provided Fannie Mae with $116 billion in funding for what is called Senior Preferred Stock Purchase Agreement (SPSPA) which carries a 10% dividend on its shares, complete control over the management and board, a senior liquidation preference along with warrants to purchase 79.9% of the Fannie Mae’s common stock for $0.00001 or around ~$40,000!  You read it right, a company just a year earlier was worth over $50 billion was essentially bought for $40,000. So under pressure from the government for fear of insolvency, Fannie Mae took the deal and was put into conservatorship and the world was saved from complete destruction, all thanks to the U.S. Taxpayer. 

Fast forward to 2012, where out of left field comes an amendment to the deal that has brought us to where we are today. It’s called the “Net Worth Sweep” or the “3 amendment”. What this amendment did was eliminate the original 10% dividend that was owned to the government on its preferred shares and replaced it with a complete 100% sweep of all profits to the United States Treasury that the company generated in perpetuity!  If you thought that was bad, which was basically a de facto nationalization of a private company, the amount the Government collects each quarter from Fannie Mae, not a penny is used to pay down the debt of the $116 billion provided by Treasury! Wow! So to this day, even though Fannie Mae has repaid $150 billion to the Treasury, Fannie Mae still owes $116 billion to the U.S. Treasury. How is this even possible or fair in the United States?  

What makes the timing of this Net Worth Sweep amendment even more interesting is up until 2012, Fannie Mae had been withdrawing funds from the Treasury to keep the company going. When in 2012, the tables turned and Fannie Mae was going to be extremely profitable for the foreseeable future. Coincidence, I think not and recent unsealed documents further back this up. The decision to funnel the profits into Treasury’s general fund came just months before Fannie Mae returned to profitability.  The housing market had recovered and certain paper assets which the Bush administration had ordered them to be written off four years earlier, regained value and under accounting rules, those values had to be put back on the books. To the tune of $50 billion dollars! Fannie Mae was back from the dead and was again making money, a lot of money. 

Where Are We Now…

To put it simply, nowhere! This is another gigantic example of how the Government works. Fannie Mae remains in conservatorship even eight years after the financial crisis and remains the last piece of the financial puzzle to close the book on the Great Recession. It operates at a profit with billions in net income but with no retained earnings and remains extremely undercapitalized, which means $0 capital to buffer against any future losses. That should scare everyone as Fannie Mae is the center of the housing market and has no protection in the case of something bad were to happen. It remains the first company in conservatorship history where the conservator Mel Watt who heads the FHFA is unable to end the conservatorship of Fannie Mae without the consent of the U.S. Treasury. This is another issue that will be addressed in the future.

 Fannie Mae and Freddie mac have repaid the government $130 billion more than what would have been paid to the Treasury had they not changed the terms of the "original bailout” deal. Clearly, Fannie Mae was not in a so called “death spiral” that the Government claimed, with returns like that.   The government continues to hold Fannie Mae captive while Congress tries to reform the housing model, while at the same time robbing them of all their profits forever and keeping the $116 billion in debt outstanding along with being completely undercapitalized with $0 capital to buffer against future losses.   If this doesn’t sound crazy to everyone, I don’t know what would in the financial world. Fannie Mae has clearly become nationalized; yes it can happen in the United States. All of this goes against the basic principles of a conservatorship. This of course has unleashed a wave of lawsuits against the Government that continue today, from accounting fraud to illegal takings claims, there remains 30 outstanding lawsuits today that will be discussed throughout these assessments.  This is a very brief overview of what has and continues to happen to the most important financial institutions in the United States!  

Categories: Weekly Market Assessment