I’ve been spending some time studying the housing market and a number of companies that directly and indirectly do business in that industry. I have a view on the fundamentals of the housing market that I might write about another time. But as a somewhat related aside, a few studies out there have noted how we, as humans, naturally fear financial panics but incorrectly and inadequately prepare for the next panic using tactics that would have helped prevent the previous one. In other words, we frequently engage in “fighting the last war”. This also leads us to fear that the next crisis will unfold in a very similar way that the last one did. There is some sense in this; financial crises and market crashes have many common denominators. But I think it also leads to some irrational fear at times, and this can lead to inefficiently priced securities.
The bank stocks in 2016 were a prime example of this sentiment-driven inefficiency. Until 2017, bank stock valuations were unduly held down in part by the memory of the fall of 2008. Any time there was even a whiff of macroeconomic trouble, these stocks were crushed. This occurred despite the large banks having far greater capital levels, much safer balance sheets, stronger competitive positions, and much better earning power. Bank of America traded for around 7 times what I estimated their current earning power was in early 2016. J.P Morgan traded at similar levels. But the scars of a crisis take a long time to heal, and thus these stocks got cheap whenever the memory of 2008 resurfaced.
As a side note: the banks are also an example of something I have tried to illustrate previously: that sometimes even large cap stocks get mispriced. There was no “edge” to be gained (at least not by me) from analyzing Bank of America. But that doesn’t mean that the stock can’t be mispriced. In fact, Bank of America is currently valued around $300 billion, which is nearly $200 billion more than it was valued at just over two years ago. The intrinsic value of the business has changed some, but it certainly hasn’t changed by anywhere near as much as its market value has.
Regardless, I think sometimes broad sentiment can lead to mispricing, because broad sentiment and herd behavior are a part of human nature, and this influences stocks of all sizes.
In a much less severe manner, I think a similar focus on the rearview mirror might be leading to some undue negative sentiment in housing stocks. Some of the stocks are cheap, but many are mediocre businesses that earn low returns on capital and are highly leveraged, making them largely unappealing to me. And some are not investment candidates, but yet are really interesting to study. Two that fall into that category are Fannie Mae and Freddie Mac, the so-called government-sponsored enterprises (GSE’s).
The Business of Fannie and Freddie
10 years ago last month, these companies were seized by the government and put into conservatorship, where they have remained ever since. I recently read Shaky Ground by Bethany McLean. It’s a great book, and it prompted me to read through a few of the old Fannie Mae annual reports. I’ve looked at the GSE’s in the past, and I’m familiar enough with their business, but the 10-year anniversary of the crisis seemed like a great time to revisit the history books. The following are some notes and thoughts I collected as I read about these firms.
Fannie Mae is a story of how problems arise when there are massive conflicts of interest, attempts to serve two masters (government altruism and private capitalism), and misguided management incentives that encouraged risky bets and aggressive accounting.
Basically, Fannie makes money in two main ways:
- They collect a fee for guaranteeing mortgages (specifically, Fannie promises to pay investors for any shortfall on principal or interest payments on the loans that back the Fannie MBS)
- They earn a net interest margin on their own portfolio of mortgages (they make a spread between the cost of their funding and the interest they collect on their assets)
So there were two main businesses inside of Fannie Mae (and Freddie Mac). One was a great business that had essentially a monopoly on guaranteeing prime quality mortgages. Fannie’s core business was effectively a toll bridge that a huge swath of the US housing market had to cross (it collected a residual fee on roughly one out of every four mortgages in the US). The other business was effectively a giant hedge fund, that was leveraged to the hilt and engaged in a multi-trillion dollar carry-trade.
The second business got them into major trouble during the crisis. Using low interest debt to buy higher interest assets was an easy way for them to make money (they had cheap cost of funds because Fannie’s lenders viewed their debt as essentially government credit). Cheap debt combined with management incentives to make more and more profit led to a very risky situation that eventually blew up.
Fannie feared losing market share to “private label” MBS (which were securities created by banks and weren’t guaranteed by the GSE’s). This fear was driven in large part due to misplaced incentives and pressure from Wall Street. Fannie began buying riskier and riskier assets for its own portfolio (subprime loans and other risky mortgage assets). What I found crazy about this is that one division of Fannie’s business (the “hedge fund”) was buying these securities for investment while the other segment (the good business that collected guarantee fees) determined those same loans were too risky to guarantee.
Government Conservatorship
The book outlines some of the history of the GSE’s and then goes into the post-crisis period of conservatorship, when the government seized control of the firms, fired their management, and propped them up by giving them a large credit line, which guaranteed that Fannie’s lenders would get paid. Essentially, the government made explicit what was already implicit and widely accepted to be true: that Fannie’s debt was backed by the full faith and credit of the US government.
This process saved what certainly would have been a systemic crisis of epic proportions, involving trillions of dollars, millions of American homeowners, and even foreign central banks, which owned GSE debt (which meant, as McLean says, a Chinese citizen with a savings account was effectively providing the financing for an American homebuyer in Kansas).
In fact, one of the main motivations for bailing out Fannie and Freddie was that the US government didn’t want to alienate foreign central banks, which not only owned Fannie and Freddie mortgage-backed securities but were huge lenders to the GSE’s under the (technically false) assumption that their debt was guaranteed by the government. In other words, foreigners were under the false impression that they owned government debt, and Hank Paulson was worried that if the GSE’s defaulted on their debt, foreign investors would begin doubting the credit of the US government itself.
The post-crisis period since 2008 is just as strange. Conservatorship is designed to conserve the company’s assets and basically nurse the company back to life. Fannie and Freddie are certainly back to life, and making massive profits (the GSE’s borrowed a total of $191.4 billion and have now sent back $279.7 billion and counting). Sometime in the next year, the taxpayers’ cumulative profits on Fannie and Freddie will eclipse $100 billion. Lots of people complain about the GSE’s lack of capital since the government takes all of their profits, but taxpayers have a nice cushion to draw on if the GSE’s do require capital in the future.
The whole situation is hugely controversial, from the duration of government ownership to the unilateral decision the government made in 2012 to begin taking all of the GSE’s profits (in lieu of the 10% interest on the money lent).
Political Gridlock and the Status Quo
The conservatorship has no expiration date, and there seems to be no political will to change the status quo. Politicians on both sides of the aisle claim to have a desire to end the government ownership and many talk a tough game about abolishing the GSE’s, but no one wants to be responsible for doing something that would almost certainly increase the cost of mortgage financing for millions of Americans. Without a government guarantee, not only would the cost of an average mortgage rise, but there would likely be no lenders willing to finance a house at a fixed rate for 30 years. No politician wants to be held responsible for disrupting the functioning of a $12 trillion mortgage market (in which 87% of those mortgages are 30-year fixed).
The result is that Congress introduces bills that get rid of the Fannie and Freddie name, but essentially keeps the current system in place. Everyone knows what the key ingredient is, and that is a government backstop. The popular opinion at the time was that Fannie and Freddie exemplified what happens when the government gets involved in private sector matters. Vocal constituents at both ends of the political spectrum led to a fair amount of bipartisanship agreement that Fannie and Freddie had to be done away with (this consensus included more Republicans than Democrats, but it did have the Obama administration on board as well).
But at the same time, politicians understood that despite the negative sentiment, killing the GSE’s and removing the government from the mortgage market would result in far worse political consequences (because killing Fannie and Freddie without a government-backed replacement would mean more expensive or even unattainable mortgages, and politicians know that their voters don’t like paying more for things or having things taken away from them, especially something as important as a fixed-rate 30-year mortgage). So what do you do if you’re a politician with these two competing motivations? You write a piece of legislation that technically abolishes Fannie and Freddie, but builds something very similar with the same key ingredient (a government backstop).
What’s Next?
So all of this gridlock has left us with an unsolved situation. Conservatorship isn’t intended to be permanent, but my own reading of the situation leads me to believe that there is no near-term solution and I wouldn’t be surprised if we are in the same situation a decade from now (the government’s warrant to buy 79.9% of the GSE’s common stock expires on September 7th, 2028, so maybe that will be a date that ends up being the catalyst for legislative action, but then again, the government has been known to rewrite their own contracts when it comes to the GSE’s).
The issue for those interested in reform is that the status quo does appear to be working fine. Banks and mortgage companies are able to write loans and sell them to Fannie and Freddie, investor demand for GSE securities is strong, the secondary market has plenty of liquidity, and as a result, homebuyers can finance their homes with a fixed-rate 30-year mortgage at a competitive interest rate. This doesn’t mean what the government did was right, and there is some evidence that the US Treasury changed the rules of the game because they knew windfall profits were around the corner (plus, no one in the administration wanted to see headlines of hedge funds making billions thanks to a government-revitalized GSE profit machine). The courts have thus far sided with the government on the legality of the “net worth sweep”, but it’s clear to me that regardless of whether the government should or should not be involved, the mortgage market is functioning well and that the GSE’s are one of the main reasons for that.
And so I think it’s likely that the GSE’s will remain in existence, and likely will remain in conservatorship until something upsets the status quo. That “something” might have to be another financial crisis, which doesn’t seem likely (at least in the near-term), and so I think investors hoping for a resolution will continue to be disappointed.
Investing in the GSE’s?
I’ve done this recent reading about Fannie and Freddie partly because my research the past couple months has taken me to various parts of the housing market, of which these two giants are still ever-present. But I’m not at all interested in investing in any of the GSE common or preferred securities. The value of a business is based on the amount of cash you can extract from it over time, and I don’t feel like I have any good way to predict how much cash shareholders will be able to extract from these firms until and unless the government sets them free.
The problem is this: Fannie and Freddie are absolutely needed in America’s housing market, but that doesn’t mean the current Fannie and Freddie will survive. They could be killed and replaced by essentially an exact replica (with a different name). This seems more likely to me as it attempts to satisfy those who have come to despise the existence of Fannie and Freddie, while also preserving the sacred cow that is the 30-year mortgage and the important impact it has on our economy. (The reality of course is that to accomplish the latter, you need the government backstop that Fannie and Freddie provide, so Congress might change their names and restructure their organizations, but they likely won’t change much about the way the current system works.)
To Sum It Up
Despite my lack of interest from an investing standpoint, these companies and their history are really interesting to study. As I’ve mentioned before, a side interest of mine has always been to study some of the great financial panics in the past (see here and here for two related posts). This last month has given me an excuse to revisit the 2008 crisis (which nicely coincided with my interest in investigating certain companies in the housing market).
This wasn’t really a book review, and was more of just a collection of some notes I wrote down in my Fannie and Freddie file. But I highly recommend Bethany McLean’s book Shaky Ground. It is an excellent primer on the GSE’s, and it tells an interesting story of how they were started, how they evolved, and what led to their epic collapse. In addition to the specific economic and financial causes of their downfall, the GSE’s are a fascinating case study on incentives, herd behavior, and conflicts of interest, and also a glaring example of what can go awry when these ingredients are cooked up together.
John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that employs a value investing strategy with a primary goal of patiently compounding capital for long-term oriented investors.
To read more of John’s writings or to get on Saber Capital’s email distribution list, please visit the Letters and Commentary page on our website. John can be reached at [email protected].