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Fannie and Freddie Reversal Dings Fairholme

The fund is not the only casualty, but it's one of the biggest.

Kevin McDevitt, 03/14/2014

On Tuesday, the Senate may have signaled the end of the party for Federal National Mortgage Association (Fannie Mae) FNMA and Federal Home Loan Mortgage Corporation (Freddie Mac) FMCC shares, just as things really got rolling. The common shares of both government sponsored enterprises (GSEs) have fallen by about 50% on the news that the Senate may produce a bipartisan proposal for winding them down. Until Tuesday, the shares of both had more than doubled during the past three months alone, with Fannie Mae gaining an astonishing 1,900% during the past 12 months and Freddie Mac soaring 1,700%. Granted, these gains were off incredibly low bases, and the shares don't even trade on a major exchange.

This sell-off will have no impact on most fund investors, since most managers have steered clear of the two GSEs' common shares since the companies went into conservatorship in 2008. But interest has been revived by investments in both the preferred and common shares from hedge fund managers such as Bill Ackman and Fairholme's FAIRX Bruce Berkowitz. Recall that Berkowitz initially bought the preferreds last summer, while Ackman bought the common.

The distinction between the two investments was notable since the preferreds, which are higher in the capital structure, left Fairholme shareholders better protected. This has played out over the past two days as the common shares have fallen by far more than the preferred shares. Fannie's common shares are down roughly 50% from the 52-week high, while Fairholme's largest Fannie preferred holding is down only about 10%. Fairholme itself fell 2.3% on Tuesday alone.

But as we discussed in Fund Times last week, Berkowitz upped the ante when he established positions in the common shares of both Freddie and Fannie this past fall. As we said then, the two new positions in the agencies were just 1.1% of Fairholme's November 2013 portfolio, but they signal Berkowitz's increased confidence in his claim against the U.S. government and his belief that the shares won't be rendered worthless. Berkowitz is suing the government to restore the rights of preferred and common shareholders following the Treasury Department's 2012 decision to send all profits to the government.

However, Tuesday's announcement that the Senate is considering a bipartisan proposal to wind down the two entities could be a serious roadblock. The legislation would replace the two GSEs with government bond insurance. An explicit goal would be to "wind down and eliminate Fannie Mae and Freddie Mac." The proposal has initial support from the Obama administration, but it's uncertain how it will fare in the House. If the House and Senate reach agreement, it's possible that legislation could be passed this year, although it could easily stretch into 2015. Naturally, this could lead to additional volatility for the preferred and common shares. Berkowitz, for his part, continues to argue against the need for legislation, only an end to the GSEs' conservatorship and tighter oversight.

Who Else Is on This Journey?
We have no opinion on how this will all resolve, but there are likely at least several more innings to go. In the meantime, it's interesting to note that Berkowitz is no longer alone in the mutual fund world with his investment in Fannie and Freddie common shares. There are only a dozen or so intrepid travelers joining him on this journey, but a couple of names jump out.

One surprising shareholder is American Funds Capital Income Builder CAIBX, which owned nearly 12.5 million shares of Fannie as of December 2013. To be sure, this is a drop in the bucket for the $91 billion fund. The position made up just 0.05% of the December portfolio. It's also not entirely out of character for American Funds, as the firm has taken the occasional very small flyer on fairly speculative names. Its funds even occasionally own very small stakes in private firms that are likely to go public at some point.

Another family with a deep-value philosophy dipped its toe in through Third Avenue Focused Credit's TFCVX stake in Freddie. Two things are curious, though, about this fund's position in Freddie. First, Third Avenue Focused Credit, as the name implies, is a high-yield bond fund, which makes it surprising that it would own common shares at all, much less those not paying a dividend. Second, although the fund did own a 0.9% position in Fannie Mae preferreds, these aren't paying a dividend either since the U.S. Treasury decided in August 2012 to send all dividend payments to the government in order to repay the $188 billion bailout.

Fund Managers Turning Away? 
The implications of all this are far bigger for Fairholme's shareholders than for any other mutual fund investors. However, it's interesting to see who else has come along for the ride. Perhaps after Tuesday's news, far fewer fund managers will even consider joining them.

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