Wall Street Journal - Fairholme Seeks to Profit From Growing Interest in Fannie, Freddie

News Article

By Nick Timiraos

Fairholme Capital Management's offer to buy parts of Fannie Mae and Freddie Mac isn't likely to fly for now in Washington, say analysts, but the mutual-fund company is gambling that the move creates a new avenue for it to profit from its growing investment in the companies' shares.

Bruce Berkowitz, Fairholme's chief investment officer, made the offer Wednesday to acquire a portion of the companies and recapitalize them in a deal it valued at $52 billion. It made the offer in a letter to the Federal Housing Finance Agency, Fannie and Freddie's regulator.

Under terms of the plan, Fairholme and other investors who own Fannie and Freddie preferred stock would receive $34.6 billion, the original value of the shares that many hedge funds have bought at deep discounts. The investors would use that money and kick in at least an additional $17.3 billion to capitalize the companies as state-regulated bond insurers. The $5 trillion in existing mortgage investments of Fannie and Freddie would remain with the government.

Fairholme hasn't yet discussed the proposal with the FHFA or Treasury, according to people familiar with the matter. Industry analysts took a dim view of its prospects. "I'd be shocked if they respond positively," said Jeb Mason, a Treasury policy adviser in the Bush administration who is now a partner at Cypress Group, a financial-services consultancy.

The plan doesn't appear to meet the Obama administration's criteria for any overhaul. In a statement Thursday, a Treasury official said, "The administration remains committed to reforming the housing finance sector by responsibly winding down [Fannie and Freddie] and ensuring that any new system preserves broad access to credit for responsible borrowers, strengthens the economy and promotes financial stability."

A spokeswoman for the FHFA declined to comment

In July, Fairholme sued the FHFA, arguing that the government is illegally expropriating the companies' assets. That suit is moving slowly through the courts. Fairholme's latest purchase proposal could reflect an opening settlement offer as part of that legal campaign, said Isaac Boltansky, a policy analyst at Washington-based Compass Point Research & Trading, a dealer-broker.

Analysts said Fairholme's increasingly activist campaign also highlights a growing disconnect between Washington and Wall Street over the value of the companies' shares, which have risen sharply even as the government has taken a series of steps to prevent them from recapitalizing. Fannie and Freddie last week said they would return $39 billion in profits to the Treasury during the fourth quarter.

Under their bailout agreement, Fannie and Freddie can't build capital and they are required to send all of their profits to the Treasury, meaning that investments in the shares reflect political and legal bets, not financial ones. Still, the shares have soared so far this year. The "S" series of the Fannie preferred stock, for example, closed at $8.68 Thursday, down 1.9% for the day but up nearly 420% for the year.

"The value of those preferreds appears to be reflecting a legislative or administrative outcome that doesn't appear" likely, said Mr. Boltansky. He said that the louder shareholders get in their campaign, the lower the prospects for returns because "lawmakers will publicly distance themselves from anything that could be seen as enriching money managers, no matter the merits."

The White House and FHFA have signaled that Fannie and Freddie should be wound down and that Congress should be charged with redesigning the nation's housing-finance market.

Rep. Scott Garrett (R., N.J.) said that the proposal smacked of "Fannie and Freddie 2.0." Even if the new firms weren't provided any government support, he said he was concerned about a rerun of the past crisis, in which the government long insisted the firms weren't supported by the government until their 2008 rescues. "There was never a guarantee by the federal government until there was," he said.

Mr. Garrett also said it would be up to Congress, and not to the FHFA or Treasury, to decide the companies' fate. The FHFA's leadership "is looking rightfully so for Congress and the administration to act on this, and that's where the focus should be at this point."

The Fairholme proposal largely mirrors plans being advanced in Congress to replace Fannie and Freddie. But some analysts said that the Fairholme plan wouldn't be workable in its current form without threatening significant disruptions to the mortgage market.

"Taxpayers can do a lot better than this deal," said Sen. Mark Warner, (D., Va.), who has co-sponsored a bipartisan bill to replace Fannie and Freddie with a new system of federal reinsurance for certain mortgage-backed securities.

The Treasury committed massive sums to keep the companies afloat for years after their 2008 takeover. The government never assumed full ownership to avoid bringing the companies' assets and liabilities onto the federal ledger, and their shares, while considered worthless, continued to trade. By 2010, some investors began buying the preferred shares, a form of senior equity that pays a dividend, at deep discounts.

The government upended those bets last year when it amended the terms of its rescues, requiring them to send all of their profits to the Treasury instead of a previous 10% dividend.

The shareholder battle with the government could also draw attention to what some investors have said is the government's ham-handed ownership of Fannie and Freddie, which are operating under a legal process known as conservatorship. "What the Fairholme proposal highlights is that FHFA has not restored the companies' solvency, as the conservatorship statute obligates them to do," said Jim Millstein, a former Treasury Department restructuring officer who oversaw the government's sale of American International Group Inc.

Source