Whose Freddie Investment Thesis Is Right?
Bill Miller has increased his stake in Freddie (FRE) and now owns 12.2% of the company. Besides Bill Miller, other smart managers such as Richard Pzena, Charles Brandes, David Dreman and others are long on FRE.
On the other hand, there are smart people like Bill Ackman, Whitney Tilson and others that short FRE.
Being an amateur investor myself, it is scary to see very smart people on different side of the bet. My knowledge is too shallow to analyze the complexities of FRE's portfolio and the severity of the housing slump.
However, I have been thinking...
If Miller, Pzena and Dreman were right, the earning power would be $3-$5 per share 2 to 3 years out. Using a PE of 10, FRE would be worth $30 to $50. Let's say $30. At its current price of $4, that is a 7.5-fold increase.
If Ackman and Whitney were right, FRE would worth 0.
Assuming 50% chance of 7.5-fold increase and 50% chance of going to 0, the expected value = $15 per share.
With such a high positive expected value of $15, this seems like a potential good bet?
What are readers thoughts on the above? Shoot me an email.
Disclosure: None
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This article has 16 comments:
- Mark J. Grant
- 1 Comment
Aug 20 08:14 AM----------------------...
The Financial World is currently under siege. I am not sure if there is a
better way to put it but it might as well be an economic jihad fostered by some terrorist group. There is certainly no let up in the Press and I wonder who is making what bets after reading some of the commentary provided by the tribal leaders and warlords of the global marketplace. Some of the more recent articles such as the one’s recently in IBD and Barron’s struck me as so short sighted as to lack common sense.
“Common sense is not so common.”
-Voltaire
On the Agency front the mistake is this; these are not totally private
companies and yet the mentality of these and other articles are treating them if they were no different than GE or IBM. The viewpoint is also so skewed that they do not understand the ramifications of what they are suggesting; in my opinion. If a Government Sponsored Enterprise were to default on one of its obligations, anywhere in the debt structure, the trust would be broken. This could be at the preferred level or the subordinated debt level because if an Agency were to default there then why would any person think their promise to
pay was valid at any other place or point in time? The point is clear to me; if an Agency of the U.S. Government does not honor its obligations then there is no value in the Federal Charter. Further down the path of rational thinking; if one American Agency does not honor its commitments then why would any investor expect any other American Agency to honor their commitments? It seems to me that the fallout from FNMA, as an example, of not paying their Preferred dividend would be disastrous for not only the credit of FNMA but also Freddie
Mac, FFCB and the Home Loan Banks. The violation of a payment of debt by any Agency will forever invalidate the meaning of a GSE and, in a larger sense, the reputation and honor of the U.S. Government and yet that is what recent articles have suggested to minimize the short term difficulties of Agencies that support and fund Housing in the United States.
In my opinion the viewpoints recently expressed in these and other articles take no consideration of the extreme fallout that would accompany an Agency not paying their debts; any of their debts. The price of the equities of FNMA and Freddie Mac were down 22% and 25% just yesterday and the falling knife has become the meat clever in a nose dive. I have noticed in Life that it may seem like the easiest course not to meet one’s obligations. There seem to be a rather large group of people that feel that temporary setbacks can allow you to not stand up to your responsibilities. I have always felt that our government
and the Agencies represented by Federal Charter followed a higher standard and I pray that I am correct in this assumption because the notion that they should not pay their debts would be a travesty for America; an absolute and final statement that the value of a GSE was nil and void.
“All the perplexities, confusion and distress in America arise not from defects in their Constitution or Confederation, nor from want of honor or virtue, so much as downright ignorance of the nature of coin, credit, and circulation.”
-U.S. President John Adams
If some U.S. Agency does not pay its debts then the greater sadness will not be in the loss to portfolios but in the loss of common sense of our political leaders and the resultant loss of trust by investors in America and in the rest of the World who will learn quite conclusively that the United States does not honor its obligations. If you think that is too harsh then so be it but I choose to believe that a Government Sponsored Enterprise has a meaning and that a Federal Charter invokes an obligation of the Federal Government. To be more pointed; I am ashamed and disgusted that Bernanke or Paulson or the President
has not stood up and said, unequivocally, that the American Government will support, if necessary, all of the debts of a U.S. Agency. The rhetoric to date has been jumbled and unclear and misleading either by attempt or construction and I find it disheartening as an American citizen. I am happy to share the burden of increased taxes if necessary to support an obligation of my government, any obligation, as I expect the politicians that represent our country to be honorable in their statements and actions and to pay the bills of the Federally Chartered Agencies as they would pay the direct obligations ofthe debt that is guaranteed in our Constitution.
Congress has asked FNMA and Freddie Mac to assume a greater role in housing given the current difficulties and then the government is supposed to abandon them when they have financial issues as a result? There is no claim of Fraud or mismanagement beyond the normal political barbs of those of different stripes and yet supposedly responsible people in national publications are calling for the abandonment of obligation under fire. To be honest I am greatly saddened by the rhetoric of many of these people and amazed at their lack of judgment and inability to grasp the stark reality of what they are suggesting.
"Government loses its claim to legitimacy when it fails to fulfill its
obligations.”
- Martin L. Gross
Mark J. Grant
Managing Director
Corporate Syndicate
Structured Products
Southwest Securities
Mjgrant@Bloomberg.net
- Ishortyou
- 408 Comments
Aug 20 08:22 AM- tcornelison
- 69 Comments
Aug 20 08:36 AM- jackeast
- 6 Comments
Aug 20 09:03 AMA. In order to solve the crisis a quick look at the underlying issues of the crisis are important.
1. The rate of increase in housing prices was artificially accelerated by the availability of high risk loans. The loans were high risk in that people could not afford to pay the principle and interest while maintaining a quality of lifestyle commensurate with the property they were purchasing. Risk increased as the available cash flow of home owners was not enough to create capital reserves to offset future risk. The loan types were generally variable rate mortgages that even financially savvy borrowers could not adequately assess risk.
2. Supply over the last few years was increased in response to the artificially accelerated rate of home price increases. While the rate of home prices increases was high and capital was easy to come by a large portion of the pool of potential buyers entered the pool of buyers. Those “potential buyers” who transitioned into the “buyers” pool were forced to purchase homes that would normally have stayed out off the market or been eliminated from the market due to development, nature, or disaster for inflated prices. So while these homes in “normal” markets would not have been marketable or tradable in a period of “abnormal” markets they became commodities that were prized by two classes of buyers. The first were marginal buyers who generally would have stayed in the “potential pool” of buyers and “investors” who desired to purchase and “flip” with marginal and minimal “upgrades” to the properties. Further, the accelerating pool of “new” homes added to available supply making the calculus for home buyers more complicated. i.e. Pay slightly more for a new home or slightly less for an existing home. More and more buyers were choosing the former over the latter. This increased risk and resulted in builders having competitive advantages over existing homes. The competitive advantage resulted in more new home construction. At the same time the dynamic of the marginal buyer and investor and now exacerbated by those seeking to “trade up” increased the supply of existing homes. A general but not unreasonable increase in basic commodities created situations in which marginal buyers (i.e. those that recently transitioned into the buyer pool because of the previous dynamics) became unable to service their mortgage debt. As these properties entered the market as sell before foreclosure the supply increased even more. This portion of the supply was marked at very close to cost causing a DECELERATION in the median price of homes in at risk markets.
3. The availability of rental properties became reduced as they became converted to finance and buy properties. This began to drive up the cost of renting. As the cost of renting increased, the calculus of buy versus rent increased the number of those transitioning from “potential buyers” to “buyers”.
4. Eventually the pool of available buyers became maximized to the market conditions and there were no new entries into the demand market. At this point demand began to decelerate. All those who could trade up had done so. All those who could buy a house to live in had done so. The available leverage and capital of “flippers” was maximized.
5. As demand decelerated, the time it took to sell properties increased. Loan brokers and financial institutions as well as construction firms and sellers attempted to reduce this time to sell through special “fast track” loan programs and incentives. Eventually the only way to reduce the time to sell was to reduce prices. This reversed home price increases and began the process of accelerating decreases in home values in the system. As comparable homes were sold for less and less month over month investors began to question the actual value of the collateral behind financial instruments.
6. As interest rates reset on homes and the true cost of ownership began to affect marginal buyers a new class of supply entered the market; the foreclosure. While this class of supply had generally been available to the market they had generally been in demand by the investor and developer. The market could not absorb this extra supply and as housing prices had entered the phase of declining values already, these new entries resulted in drastic rates of declines in “key” markets.
7. Declining values of collateral and leveraging strategies by financial institutions resulted in decelerating returns on loan portfolios and even losses. These losses were identified rightly as due to the decrease in value of properties, which erased the value of collateral, the increasing costs of foreclosure, the decreasing revenue for loan generation, the decreasing interest payments from the pool of home owners, and the increasing cost of refinancing debt as the capital markets began to doubt the value of financial instruments in a new wave of analysis.
8. Risk insurance and cost of capital increased as the traditional backstop of losses, the insurers exited the market place. The scope and depth of losses in the insurance sector locked up the entire market place and made the cost of refinancing and capitalization such that losses mounted. The result was two-fold: 1) increased capitalization that reduced the amount of liquidity in the market and 2) increased cost of gaining capital at the retail level. The result was pushing a large portion of those in the “buyer pool” back to the “pool of potential buyers” and drying up demand.
9. With even less demand and an over abundance of supply prices fell at an even accelerated rate.
10. Psychology of the market place now dictated that the entire pool of buyers analyze the risk of entering a falling market. At this point the cost of moving first may be the further erosion of the value of one’s home and missed opportunity to purchase higher quality at equal or less cost. The buyer market then became limited to those who “HAD” to purchase as a result of market conditions.
11. Interest rates for those financing and the information requirements (i.e. total cost) increased dramatically further eroding demand for properties.
12. The end result is a stagnant market of buyers and sellers and financial institutions with an increasing portfolio of under or non performing loans making all the financial instruments that are supported by the market of an uncertain value. This has further eroded both availability of capital to fund purchases and the ability of financial institutions to finance its debt increasing threats of insolvency. As certainty and confidence is eroded the problems become worse and a feed-back-loop results.
Now that the underlying process leading to the current “crisis” is understood some solutions can be formulated.
B. Reduce supply.
Stabilizing the values of homes is essential to create certainty as to the value of securities and collateral. It will also change the calculus of buyers who are staying out the market because of hopes that they will be able to buy more for less. Reducing supply would also decrease the time that homes are on the market creating conditions that will decelerate the rate of foreclosure. This too will create conditions of certainty and solve the under-and non-performing loan problem.
There are several possibilities for reducing supply and they include:
1. Offering grants to localities to purchase properties to turn into green-space or to place in land/property trusts for later development.
2. Offer terms that would allow the refinance of properties to reduce the foreclosure of homes. Terms such as 40 year or 50 year mortgages at increased interest rates with provisions that state that the property cannot be sold or transferred for 2, 3, or 5 years. The lender can force refinance instead of foreclosure.
3. Market clearing houses can be established where people in foreclosure can have the option of “trading down”. Financial institutions can offer homeowners the ability to refinance into a lower cost home removing it from supply, keeping a marginal home-owner in the home owner pool and maintaining the very highest valued properties in the supply system. These properties would be the most likely ones to benefit from the “trust” green-space programs mentioned above. They are also the most likely to be successfully managed in foreclosure.
4. Financial institutions should enter into property management agreements utilizing programs such as the Defense National Relocation Program that offers property management services for relocating home owners. Properties are rented. By transiting homes from the sale/finance pool to the rental pool two things are accomplished. 1) Those entering the rental pool may be able to remain in their homes as renters paying less cost such as insurance and local property taxes. These costs are transferred to the lender. However, with rental rates as they are, it is possible that even with decreased rates due to increased supply that the lender will be able to cover the costs with rents. 2) Financial institutions are able to maintain the book value of their collateral (real property does not suffer from mark-to-market issues) and still maintain a revenue stream. A provision for refinance and repurchase may be included in the lease/rental agreement offering the potential for future revenue and a ready market of borrowers when future conditions improve.
5. Increase the costs associated with selling a home. For those home owners who cannot show cause for sale( i.e. not in threat of foreclosure as certified by their financial institutions) will pay a tax penalty on the sale of their home regardless of whether they make a profit or not. Something like a .005 tax on the total proceeds of the sale payable into a “Green Space and Trust” account for giving block grants to localities for purchase and clearing homes. This could be in effect for 2 or three years while the market cleans itself up.
6. Decrease the costs of home purchase if one is not also selling a home. Offer a tax rebate equal to the total costs of closing (minus down payments and points) payable in 5 years if the home is owned as a primary or secondary residence for 3, 4, or 5 years. The payment can be prorated based on the length of ownership. The payment can also be divided into two segments, one payable to the lender as a principle payment and one payable to the owner. The rebate could be recouped by the federal government at a rate equal to 10% or 20% a year from the mortgage tax deduction in the years following the payout.
7. Increase the regulatory requirements to offer adjustable rate mortgages. For instance, increased equity in the home through higher down-payments, or increased monthly payments into an “Interest rate adjustment account” to offset the affects of interest rate increases.
8. Allow new home construction companies to purchase their own inventory at reduced prices to claim the loss on their taxes and to not pay sales tax on the properties if held for 2 or 3 years.
9. Allow construction companies and owners of residentially zoned lots to “charge off” or deduct an “opportunity cost” equal to some percentage of the assessed value of the land if the land is undeveloped for 2 years after the deduction. If developed then the individual or company has to pay back the savings resulted from the deduction + 20%.
C. Close the gap between cost of capital for the financial institution and the return on loans given.
1. Embrace the fractured pricing of the housing market by creating new loan segments. Break the housing price market into segments of 100K each in which each higher segment has higher real interest requirements. For instance on a 30 year fixed, the “base” bracket may be between 0 and 100K and equate to the 5 and 6 % range. From 100 – 200K the interest may be between 6 and 6.5% range. Between 200K and 300K the rate may be between 6.5 and 7%. Over 300K the rate may come back to between 6 and 6.5%.
2. Restructure equity requirements based on tiers or categories of loans. For under 100K the equity requirement may be 0%. From 100K to 200K the equity requirement may be between 5% and 10%. Between 200K and 300K the requirement may be between 10% and 15%. From 300K to 400K the requirement may be 20%. Over 400K the requirement may be 10-15% again.
3. Extend the period of repayment to reduce monthly payments on existing loans without refinancing, sort of an automatic renegotiating of terms. By extending the period of the loans and reducing principle payments it decreases the likelihood of default but increases the total expected interest payments to the loan. A 200K loan at 7% moved from 30 to 40 years would reduce the interest and principle payment from $1330 to $1242 a month.
4. Use savings from Dividend Cuts and equity offerings to reduce debt through retirement and repurchase. Repurchase of low quality debt at prices lower than issued with higher quality debt issues and cash would reduce borrowing costs for institutions.
5. Reduce leverage from the current 3:1 (for FRE) to 2.5:1 or less through the process of retiring debt and building cash reserves.
6. Increase cash flow to reduce borrowing requirements. Renegotiate mortgage terms to allow interest reductions, special incentives, and benefits for increasing principal payments.
7. Increase and capital cash flow to reduce borrowing requirements. Encourage voluntary increases to ESCROW and manage ESCROW accounts like Debit Card accounts. Pay interest on excess escrow balances and charge fees for the use of the account. Fence ESCROW DEBIT Accounts as capital reserves not to count in leverage decisions so that a “cushion” or “emergency reserve” of capital exists.
D. Increase Demand
1. Allowing the cashing out of 401K and IRAs for the purchase of homes if the family is “trading down”, the refinance of a home if lived in for more than 1 year and will live in for the next 5 without penalty, or the making of mortgage payments if in foreclosure and have lived in the property for more than a year and will live in it for more than 3 without penalty. If a family uses these funds then the financial institution has to forgive all interest and fees related to the foreclosure proceedings.
2. Stabilize the value of homes through the previously mentioned actions in order to eliminate the tendency of current buyers to wait for a better or lower price.
3. Provide grants and tax incentives for investors to purchase “distressed” properties and to transform them into green spaces.
4. Provide tax incentives for investors to purchase properties in foreclosure, to hold them for 2 or 3 years and then to redevelop or sell them. The incentive could be NO tax on the profit, a tax loss on the purchase that is then offset by a gain when and if sold, or any other program.
5. Allow the purchase of lots zoned for residential single home construction to be held for 3 years. At the end of three years the lots may be developed and no federal taxes paid on the assessed value of the land when sold, only on the property built on it.
6. Allow companies and individuals to purchase residential lots from themselves and to not pay federal taxes on the profits from the assessed value of the land if held for 3 years, only on the value of the property built on it.
E. Accept Losses to reduce Losses
1. Allow the “forgiving” of a % of an outstanding mortgage coupled with rate and term adjustments in order to reduce monthly payments and bring mortgage rates in line with actual values. The owner will pay taxes on the forgiven amount as income, the financial institution accepts a “loss” less than foreclosure, and the terms of the financing are transformed to create a new lower risk asset. For instance: 200K at 8% on a property worth 170K (for whatever the reason for drop in value) with 27 years left, turns into a Mortgage for 180K at 8.5% for 40 years saves over $200 a month when reduced payments and re-assessment of the property and the corresponding tax savings are taken into account. The government collects income taxes on the $20,000.00, the financial institution takes a tax loss on the $20,000.00, and instead of losing 1/3 or more by Foreclosing the financial institution only losses 10% on the revaluation and increases by .5%.
2. “Donate” distressed properties to localities for them to turn into green spaces or rental properties for low income persons. These properties can be “written off” at a value equal to the foreclosure costs and balance of the mortgage.
3. Offer programs by which local communities can purchase/finance distressed properties for destruction/rental/gre... space initiative/business development. For instance, a distressed property in a community could be refinanced under a special community works program at a low interest rate to be paid for by a locality such as a city or even a neighborhood corporation. A group of 25 home owners take partial (4%) ownership of a property that is foreclosed in their neighborhood that is then rented to own to a child care provider at a cost per month equal to the mortgage. While the child care provider may not have the capital to purchase the property the community does. The child care provider then provides care for the community and locality at market rates. This could be the same for any type of community home based business, a medical clinic, or even a library or dentist.
4. The property could be financed by a community and be torn down at cost to the lender in exchange for the community taking a refinanced stake to turn the lot into a neighborhood playground, green space, or held in common for later sale. On a 200K home each resident of the community (if 25 were included) would finance $8,000.00 over 30 years at 5%, or less than $50.00 a month. This may be added to a community association dues and the federal government may grant tax deduction status to the interest and any profit from the use or sale of the lot/property. The amount may be managed on an individual basis by the loan provider. 25 low risk loans at the price of 1 HIGH RISK loan. $50.00 is a small price to pay to maintain the value of homes in a community. And the cost is borne by the community that benefit from a maintenance of value. This also reduces supply and increases demand.
- mcingram1976
- 2 Comments
Aug 20 09:07 AM- cranky
- 7 Comments
Aug 20 09:15 AMSince when is equity considered an obligation? The common and preferred equity of the GSEs is risk capital that is leveraged with borrowings. No sacred trust would be broken if the US Treasury's action resulted in the loss of these shareholders' investment. If they are going to be made 'riskless' why should they reap the upside and why would the Treasury just Nationalize the GSEs?
- Donp
- 4 Comments
Aug 20 10:09 AMSeldom have I read such a clear and to the point treatment of any topic. Hopefully it will be possible to get one of the presidential candidates to step aside for you. We have gotten to a point were the web pages of financial sites like CNBC are beginning to resemble the “inquire” I expect stories of two headed investors and alien hedge funds. any day now.
- User 246139
- 1 Comment
Aug 20 10:13 AMA. They raise more equity capital, B. They shrink their assets, and/or C. Their regulator takes them over.
For option A, FRE announced in May they were raising new equity capital and almost 4 months later they have not. It appears there is not any appetite for a $5.5 billion equity investment in a government agency
(to use Mr. Grant's term).
For option B, if the government agencies (Mr. Grant's term) shrink their assets then they would not be supporting the mortgage market which would mean that the government agencies (Mr. Grant's term) would not be fulfilling their missions. If the government agencies (Mr. Grant's term) are not fulfilling their missions then why would they exist? They have to fulfill their missions other wise there is no point in having those government agencies (Mr.Grant's term).
So if option A is not possible because no non US government entity is willing to invest new equity capital in the government agencies (Mr. Grant's term) and option B is not possible because it would negate the reason for the existence of the government agencies (Mr. Grant's term), then option C is the only alternative.
So the question is will the government agencies (Mr. Grant's term) fall
below their capital requirements as determined by their regulator?
- TomArmistead
- 143 Comments
My Website
Aug 20 10:24 AMThe Barron's article is puzzling to me: the author, Jonathan Laing, has done some very accurate and factual articles on the likes of ACA and MBI, but the article on FNM and FRE struck me as a hatchet job.
Like many relics of the New Deal, FNM was funded on a "pay as you go" basis. Mark to market accounting applies a draconian liquidation value to going concerns, totally missing the value of future profits. Like any other relic of the New Deal, it is a political target. The scheme is, to create a crisis, do a power grab on FNM and FRE, nationalize, then privatize. It's the final goal that drives the crisis.
Does anyone remember when Alexander Haig declared himself in charge? When power grabs go to far, they encounter resistance. Anyway, I like the odds at today's prices.
- mythoughts
- 47 Comments
Aug 20 03:23 PM- raventrader
- 1 Comment
Aug 20 04:20 PMYou do have a good point though- the upside (long FRE and FNM) has a greater potential for returns in the best-case scenario! And the upside has defined risk. If I buy 100 shares of FRE, the worst that can happen is that it goes to zero. The most I can lose is $324 (if I bought it right now). Not bad- I could handle the loss, and the profit could be significant.
Now, if I take the down bet, I could lose a lot- let's say the stock triples after I short it. That means I'm out $648. If it does increase by a factor of 7.5, I'd be out over 2k!
Shorting a low-price, beaten-down stock like that never seems wise to me. For one thing, as soon as that stock starts to jump, people will cover their short positions, and that means prices will skyrocket even faster than they fell.
Besides, when you're short a stock, you get charged interest.
There's no simple way to mathematically model this situation, but I'd say common sense says go long or stay out.
- JasonC
- 346 Comments
Aug 20 04:55 PMThe political system has to allocated the loss. The loss is already baked in, there is no avoiding it. But if everyone fights tooth and nail for five years over who gets stuck with what part of it, we won't have an economy left at the end of it.
Grant alludes to a fact I have myself detected in the recent crisis. Huge numbers of people are rooting for a complete collapse of the financial system. They are not friends of the United States.
The treasury should support Fannie and Freddie and make entirely clear that the shorts in them will be annihilated. It can readily do so. It will be highly profitable to do so.
But in the meantime the political system has to stop longing for the destruction of capitalism, playing blame games, and trying to avoid the inevitable. Allocate the loss. Make markets liquid again. And we will move on.
There will be no great damage from any of it, if this is done rapidly and sensibly. All the houses are still there, all the productive capacity of the people is still there. The houses are worth more than they were 7 years ago, and are going to be in any conceivable workout. Nothing will make them worth 2005 prices. So 2005 buyers lose, tough toenails. The world will turn.
- msgtb
- 48 Comments
Aug 20 06:42 PMIn fact, GSE securities carry no explicit government guarantee."
The only thing that is guarantied by the U.S. Government is that the loans will be stood behind.
The idea that common and preferred share holders of these GSE's should be made whole is absurd!!! Anyone who bought the publicly traded stocks didn't want to pay the U. S. Government some of their money when the GSE's went up. I assure you that the taxpayers are not going to allow owners of common or preferred stock in the GSE's recover a dime. People are writing their congressmen and senators daily about this subject and with the elections coming up soon they don't want a real blood letting at the polls.
Its sad to say but even as old a Greenspan is he at least has a clue. His plan to take over the GSE's is the most likely course of action. If Secretary Paulson uses taxpayer money to bailout shareholders of the GSE's there will be hell to pay!
- TERN
- 42 Comments
My Website
Aug 20 08:25 PM"Huge numbers of people are rooting for a complete collapse of the financial system. They are not friends of the United States."
They are not friends of the World.
Due to its greater flexibility, the US would recover sooner from such a calamity than the rest of the OECD.
I strongly agree with MarkJGrant and other commentators, who hold that the obligations (not the shareholders) of GSE's must remain sacrosact. If they have to be renationalized to achieve that, so be it.
The alternative is Third World credibility and status for the US.
- Lockstep Investing
- 49 Comments
My Website
Aug 20 08:51 PMThe US has never defaulted on any debt and they will not allow it now.
- Your boy
- 1 Comment
Aug 20 11:32 PMMore by Dah Hui Lau