Fannie Mae (FNMA) and Freddie Mac (FMCC) saw big gains on news that Pershing Square, the hedge fund led by activist investor Bill Ackman, acquired a 10% stake in both companies in the third quarter. The investments are classic cases of distressed equity investment, and rely partly on the hedge funds’ own abilities to convince the Federal government to sell off these investments instead of winding them down.
Both the Federal Home Mortgage Corp and the Federal National Mortgage Association have been heavily maligned, politically risky entities that are often misunderstood by the general public. Since both were reduced to near worthless penny stocks after the housing collapse of 2008, they have been synonymous with everything that was wrong with mortgage financing and government intervention in private markets, depending on your political vantage point.
More recently, the names haven’t exactly faded from memory, but most Americans are unaware that both companies have reported record profits in 2013, with dividend payments to the Treasury reaching parity with the $187.5 billion in taxpayer aid both entities received at the height of the mortgage meltdown.
Smelling opportunity, hedge fund investors are hoping that their stakes gives them enough clout to convince Washington that these entities should be recapitalized, because they are profitable. The business sense is clear, but the political risks are clearer; as Bloomberg put it, “Any effort to recapitalize Fannie Mae and Freddie Mac would require government approval and the White House and Congress have shown no interest so far in plans proposed by private investors.”
It would be difficult for the government to approve such a recapitalization if it profited hedge funds investing in distressed assets. The political fallout of such a move, especially from Congress, would be extreme. It would be hard to convince the electorate that these entities have become profitable, valuable assets requiring investment, especially if that investment would translate into gains for hedge funds.
It’s difficult to say whether Ackman’s decision is a smart one or not—and it’s tougher still to determine whether more passive investors should follow the trade. FNMA is up over 1000% since the crash, and massive short-term profits were on the table for anyone willing to jump in during the lean years of 2010, 2011, and 2012. Now that the stock is up 1241% YTD, the decision to buy is highly speculative and extremely risky. For now, the bet seems to be not so much on a mortgage recovery, as the bet would’ve been a year or two ago, but on to what extent Ackman can successfully convince lawmakers to hand FNMA over to market forces, and let its investments grow.