Berkowitz announced his Fairholme Fund (FAIRX) had taken a $500 million preferred equity stake in Fannie Mae (OTCBB:FNMA) and Freddie Mac in May. The crux of his strategy is that he was able to purchase the shares at prices depressed to one-fifth of liquidation value by the government’s policy of expropriating the companies’ profits.
Fannie Mae’s three-year stock price history:
Expropriating profits did not set well with numerous investors in the companies’ preferred shares, and triggered several lawsuits, including Berkowitz’s. The plaintiffs (holders of non-cumulative preferred stock of Fannie Mae and Freddie Mac) argue that the government’s August 2012 amendment to take 100% of the companies’ profits – just as they were returning to profitability – i.e. the “Net Worth Sweep,” deprived preferred stock holders their property rights, violating the Fifth Amendment.
Previously, when the U.S. Treasury took Fannie Mae and Freddie Mac into conservatorship in 2008, it create a new class of Senior Preferred Stock which ranked senior to all other preferred stock and held a dividend of 10% of the Treasury’s outstanding “liquidation preference” in the companies, according to court documents.
The Net Worth Sweep prompted at least eight lawsuits since June 2013 – including one by guru Richard Perry’s Perry Capital. The government responded to the onslaught of litigation by requesting a stay of “indefinite duration” in Fairholme’s case with the court until the various other actions were resolved. The granting of a stay could have pushed Fairholme’s case back months or even years.
Fortunately for Berkowitz, on Sept. 18, the court denied the government’s motion for a stay, meaning his case can move forward.
Berkowitz explained his view of the sweep amendment in a Sept. 17 interview with CNBC:
I don’t understand the 2012 amendment, the sweep amendment. The 2012 amendment was established as if we were still in 2008. The lawsuit is about protecting our property. For all I know there could be a typo in the third amendment. It makes no sense to me. The government cannot unilaterally change the rules and harm minority shareholders by privatizing losses and socializing gains. That doesn’t work in America.
But Berkowitz still faces a further challenge: legislation to dissolve the two companies and replace them with a new government entity, the Mortgage Insurance Corporation (FMIC), with co-sponsors Sens. Bob Corker, R-TN, and Mark R. Warner, D-VA. The legislation, known as the the Housing Reform and Taxpayer Protection Act of 2013, would create a new entity tp “provide a federal backstop for investors in certain mortgages, like the GSEs currently do, but that backstop would only be triggered after private investors had already absorbed the first 10 percent of any potential losses,” according to Zillow, which interviewed the senators on Sept. 19.
The bill already has bipartisan support, and several similar bills have been introduced. President Barack Obama has also called for the abolishing of the companies.
Berkowitz, along with other fund managers such as John Paulson of Paulson & Co., believes that the government should instead restructure the companies. If he is wrong and congress passes Corker and Warner’s or similar legislation, shareholders could go uncompensated.
Berkowitz made a fortune on a similar bet with AIG (NYSE:AIG) during the financial crisis. Like AIG, Fannie and Freddie required billions in Treasury funding to remain afloat ($187 billion in total), and are almost done repaying it ($131 billion so far). Recognizing this, the market has traded up shares 246% this year. He has a roughly 59% average gain on his AIG shares.
Berkowitz described the type of companies he looks for in his recovery bets in a CNBC interview this year: "At Fairholme, we buy essential, critical, systemically important companies that look like they are down and out but franchises are still intact, they are still absolutely essential to companies and are here to stay and it is no different for Fannie and Freddie."
An incipient housing market recovery means that the companies are returning to profitability.
Several housing recovery indicators:
On Aug. 8, Fannie Mae reported its sixth consecutive quarterly profit – $10.1 billion for the second quarter. It attributed the strong quarter to stable revenues resulting from increasing home prices which reduced loss reserves.
As litigation and legislation move forward, it will become clearer what chance Berkowitz stands to receive dividends on his stake in Fannie and Freddie.
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