President Trump is running out of time to do what hedge funds and other investment firms with big ownership stakes in Fannie Mae and Freddie Mac have wanted since he took office: put the mortgage giants on a path to exiting government control.
While Trump has long vowed an overhaul of the companies, he’s made little progress in four years and now has less than two months to act. Fannie and Freddie’s regulator, Federal Housing Finance Agency Director Mark Calabria, wants to make sweeping changes before President-elect Joe Biden is sworn in — but Calabria can’t pull the trigger without the blessing of Treasury Secretary Steven Mnuchin.
It’s hard to see Mnuchin and Calabria having enough time to actually end Fannie and Freddie’s federal conservatorships before Trump steps down, though they could modify the government’s stake in the companies. Even a partial shift could translate into windfalls for hedge funds. The preferred shares they own would likely soar if the Treasury Department relinquished or altered the terms of its roughly $220 billion stake of senior preferred shares in Fannie and Freddie — a move Calabria is urging.
Spokesmen for Treasury and the FHFA declined to comment.
Opposing a speedy revamp are housing-finance industry executives and giant bond investors like Pacific Investment Management Co., who argue that drastic revisions could be disastrous for mortgage-backed securities and residential real estate. They want Biden to work with Congress on legislation that would ensure mortgage policy doesn’t swing dramatically after every election. And they question the need to mess with housing, one of the few bright spots for the struggling U.S. economy.
Fannie and Freddie don’t make mortgages. They buy them from lenders, wrap them into securities and guarantee repayment of principal and interest to investors, essentially backstopping $5 trillion of home loans. The U.S. bailed the companies out with around $187.5 billion and took them over as mortgage defaults mounted at the height of the 2008 financial crisis.
For the next couple months, the focus will be on what Trump could do on his way out the door and the implications for the Biden administration. At stake is the future of the U.S. housing-finance system, including trillions of dollars in mortgage bonds. Here are some top questions:
What can Trump do?
With no time for legislation, investors are focused on a last-minute amendment that Mnuchin and Calabria could make to the deals that were struck when the government rescued Fannie and Freddie in 2008. The agreements provide the companies with a lifeline of as much as $254 billion if they run into trouble due to widespread mortgage defaults.
The reason for urgency is that the bailout deals contain several provisions that, if not revised, would likely make it impossible for Calabria to release Fannie and Freddie without the cooperation of Biden’s Treasury Department.
For one, the agreements require Treasury’s consent for the conservatorships to end, unless Calabria were to put the companies into receivership. They also limit how much capital Fannie and Freddie can retain to a level far below the hundreds of billions of dollars they would need as private companies to endure a housing shock.
Plus, building up capital buffers to protect Fannie and Freddie from losses is reliant on selling massive amounts of stock to private shareholders. Investors would balk at buying loads of new common shares as long as $222 billion in senior preferred equity took priority in the capital stack. That means Treasury’s stake almost certainly has to be dealt with for Fannie and Freddie to exit U.S. control.
Senior FHFA officials have also said they want to permanently end the sweep of Fannie and Freddie’s profits to the Treasury.
Why is Treasury’s stake critical to hedge funds?
If Mnuchin announced Treasury was giving up its equity stake, reducing the value of its shares or converting its holdings into common stock, a major obstacle to ending the conservatorships would be removed.
That in turn would likely trigger a sharp jump in the value of Fannie and Freddie’s preferred shares. Higher prices would allow investment firms to sell their preferred shares at a significant profit without having to worry about whether Fannie and Freddie ever leave government control. Among the beneficiaries would be Paulson & Co.’s John Paulson, a big contributor to Trump.
Common shareholders could be hurt if Treasury converted its stock because doing so would lead to dilution that erodes private investors’ ownership stakes. On top of the senior preferred shares, Treasury owns warrants to acquire nearly 80% of the companies’ common stock.
Calabria wants something done about Treasury’s senior preferred shares but Mnuchin hasn’t agreed to take action, according to people familiar with the matter who asked not to be named in discussing private communications.
Is there time?
Within Treasury, a comprehensive amendment to Fannie and Freddie’s bailout agreements would typically be reviewed by lawyers and policy staff in multiple departments, a process that can take several months even after the broad strokes are agreed to.
Mnuchin would need to hit the gas and finish that process by Jan. 20. Complicating matters is that Treasury has few staff devoted to housing policy and it’s distracted by more pressing matters, like its response to the coronavirus pandemic.
Who’s opposed to an overhaul?
In November, the Structured Finance Association sent a letter to Mnuchin warning that a last-minute change to the bailout agreements could spook the mortgage-backed security market and possibly cause borrowing rates to rise.
It echoed warnings from Pimco and other investors earlier this year that releasing Fannie and Freddie without legislation would prompt some overseas investors to severely curtail their stakes in the U.S. market. The concern is that funds would be hesitant to own Fannie and Freddie mortgage bonds if the companies were outside the government’s grip and the bonds had no explicit U.S. guarantee.
FHFA officials dispute that the revisions they’ve advocated for would lead to higher mortgage rates, and they point to other instances where investors predicted panic that never materialized.
But it’s unclear how Mnuchin and Calabria taking action would benefit Republicans who will remain in Washington after Trump leaves town. Few Americans pay attention to mortgage securities, so it’s hard to see voters rewarding GOP lawmakers should that market avoid the perils that bond investors have warned about. Yet there very well could be political consequences for higher housing costs.
Can Biden just undo it?
Because the FHFA is an independent agency, Calabria doesn’t technically have to step down until his term ends in 2024. But it’s doubtful he has that long to free Fannie and Freddie even if he and Mnuchin alter the companies’ bailout agreements.
That’s because the U.S. Supreme Court is scheduled to hear a case this month that will decide whether the president should be able to fire the FHFA director for any reason. The court ruled in favor of such a stance in a similar case regarding the Consumer Financial Protection Bureau, suggesting Calabria’s days are numbered. Legal analysts expect the Supreme Court to issue its decision by the middle of next year.
Biden could undo many of Mnuchin and Calabria’s changes to Fannie and Freddie’s bailout accords if he gained authority to remove the FHFA chief before the companies have been released from conservatorship.
The Supreme Court is also scheduled to hear arguments that an earlier amendment to the bailout agreements robbed Fannie and Freddie of tens of billions of dollars in earnings that they should have been permitted to retain. If the court sides with shareholders, that could give the government more impetus to release the companies.
Calabria could try to free Fannie and Freddie under a consent agreement before Biden terminates him if a bailout amendment lets him. Such an arrangement would likely limit Fannie and Freddie’s executive compensation, dividends and other business activities until they raised more capital.
However, if the bailout amendment leaves Treasury in control of the fates of Fannie and Freddie, there’s a good chance the Biden administration keeps them in limbo for the foreseeable future.
