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Shares of Federal National Mortgage Association (FNMA) or Fannie Mae and Federal Home Loan Mortgage Corporation (FMCC) or Freddie Mac rallied about 3.0% and 6.3%, respectively, following Bill Ackman’s presentation in favor of the companies on May 5. However, as the overall market indexes were down, the stocks could not maintain trend the next day.

In response to the Obama administration’s intention to wind down and replace the government supported enterprises (GSEs) – Fannie Mae and Freddie Mac, Bill Ackman released a presentation consisting of 111 slides with a different view on the probable move. Ackman, founder and CEO of hedge fund firm Pershing Square Capital Management LP, which has a 10% stake in these GSEs, strongly advocated the reform of the firms rather than complete closure.

Fannie and Freddie are institutions in the U.S. mortgage investment industry with a presence spanning 80 years. The firms do not generate mortgage loans but purchase them from lenders and provide credit guarantee. Precisely, such loans are packaged as mortgage-backed securities (MBS). Notably, these firms offer credit guarantee to $5 trillion of U.S. mortgages.

Owing to the subprime mortgage crisis, the firms reached the brink of bankruptcy and were rescued by the Treasury. Currently, the U.S government owns these firms under “conservatorship” of Federal Housing Finance Agency (FHFA), proposing to financially aid the companies with hefty amounts instead of acquiring full ownership.

Gradually, with recovery of the economy and the housing market, the firms managed to book profits. Notably, for 2013, Fannie Mae recorded profit of $84 billion, marking an all-time high, while Freddie Mac posted record profit of $48.7 billion.

Initially Fannie and Freddie were supposed to distribute 80% of the profits to the Treasury. However, in 2012, such a ruling was amended, requiring 100% distribution of the earnings. Consequently, many shareholders filed lawsuits against the government and the Treasury against such a ruling. Further such a move restricted the capital generation ability of these firms.

Current Mortgage Market Scenario

During first-quarter 2014, the housing market showed signs of recovery with improving home prices. However, strong origination and refinancing is still missing owing to the lack of credible improvement in the mortgage market.

In order to revive the housing market, several proposals have been put forward. Apart from winding down Fannie Mae and Freddie Mac, these proposed reforms include capital infusion from private sector and government guarantee for the MBS.

What Does Ackman Say?

Ackman believes such proposals are not only irrational but will bring in reverse results. He believes not only will the government have to provide guarantee to the $5 trillion MBS, but will have to continue doing so in case the private sector fails to raise adequate capital. This may lead to market disruption and weigh on taxpayers money.

Further, in the absence of Fannie Mae and Freddie Mac that possess a strong standing in the industry, adopting proposals that are untested will give rise to significant risks.

However, Ackman suggested several proposals that primarily focus on reforming the GSEs while establishing the need to continue the 30-year Fixed-Rate Mortgage product. Notably, this core product has several underlying  benefits – smaller monthly mortgage payments, certainty of recurring monthly mortgage payments, safeguards against rising interest rates and  the option to refinance at a more lucrative rate when interest rates falls.

Further, Ackman suggested winding down the Fixed-Income Arbitrage Business (FIA) of Fannie Mae and Freddie Mac. During the financial crisis, huge losses were incurred primarily owing to its investments in subprime and Alt-A mortgage assets. Also, Ackman highlighted some inherent risk in the FIA business owing to its features.

Ackman also indicated that shares of Fannie Mae and Freddie Mac can trade at a value from $23 to $47 over a period of time – which is significantly above than the current trading price.

Finally, Ackman expects the government to come forward with measures to reform the GSEs in a similar way it acted to save the ‘Too-Big-to-Fail Banks’ – such as Bank of America Corp. (BAC - Analyst Report) and Citigroup Inc. (C - Analyst Report) from the crisis.

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