President-elect Trump has many investors bullish on a market that has had two years of incredible performance. Many believe that deregulation and corporate tax cuts could create a powerful tailwind, unleashing positive investor sentiment that could push stocks higher.
Not surprisingly, billionaire investor Bill Ackman, an outspoken supporter of Trump, is on this train. Ackman and his fund pershing square holdings corp. The past five years have been extraordinary achievements. Ackman now believes Pershing’s holdings in two of its long-standing holdings will reach about 900% due to the incoming Trump administration. Let’s take a look.
In 2013, Ackman and Pershing acquired approximately 10% of the common stock of the government-sponsored entity (GSE) Federal National Mortgage Association(OTC: FNMA) and federal home mortgage loan (OTC: FMCC)known as Fannie Mae and Freddie Mac. Recently, Ackman laid out his argument on X about how the two mortgage giants could exit government regulation and recapitalize, resulting in substantial gains for shareholders.
To provide some brief context, the U.S. Treasury Department placed Fannie Mae and Freddie Mac into supervision in 2008 for holding multiple subprime mortgages. Fannie Mae and Freddie Mac are important sources of liquidity in the mortgage market, buying mortgages from financial institutions and lenders, packaging them into securities, and selling them to investors. Fannie Mae packages mortgages from larger banks, while Freddie Mac packages mortgages from smaller banks.
During the period of conservatorship, Fannie Mae and Freddie Mac transferred all profits to the Treasury Department under so-called net sweep agreements. The Treasury Department also holds more than $193 billion in senior preferred stock in Fannie Mae and Freddie Mac, as well as warrants equal to nearly 80% of Fannie Mae and Freddie Mac common stock that expire in September 2028 .
Frustrated shareholders following the conservatorships of Fannie Mae and Freddie Mac believe the Treasury Department should now deregulate the two government-backed enterprises, while other hedge fund managers like Ackman are betting that the situation will eventually occur. Under the first Trump administration, things started to move in this direction. Treasury Secretary Steven Mnuchin ended the net sweep agreement and allowed Fannie Mae and Freddie Mac to retain profits to build capital. At the same time, the Federal Housing Finance Administration (FHFA) established new capital requirements that Fannie Mae and Freddie Mac must meet to exit regulation.
A major question is how Fannie Mae and Freddie Mac can realistically raise tens of billions of dollars when the Treasury holds hundreds of billions of dollars in senior preferred stock and cash warrants that would potentially be severely dilutive.
Ackman believes a second Trump administration is ready to get the job done. He envisioned a path in which previous distributions from GSEs to the Treasury would be credited under a net sweep agreement, and the senior preferred stock would then be written off. The GSE’s total capital requirement will be set at 2.5% of outstanding mortgage loan guarantees, a level that Ackman believes will create a strong balance sheet that can cover the losses suffered by Fannie Mae and Freddie Mac during the Great Recession about seven times. The Treasury could then cash in the warrants and sell common stock over five years, netting $300 billion.
Ackman assumes Fannie Mae and Freddie Mac will raise capital in the fourth quarter of 2026, giving them two years to raise capital. Government-supported enterprises have strong profitability and rapid capital accumulation. By then, they will need another $30 billion to meet the 2.5% capital requirement.
Ackman estimates Fannie Mae and Freddie Mac are worth about $34 a share. Compared to current levels (as of January 2), Fannie has upside of 888% and Freddie has upside of 909%.
While shares soared following Ackman’s post, investors should understand the significant risks of this investment and the many variables involved. Ackman assumes Treasury will credit past distributions to preferred stock and the capital requirement will be 2.5%. However, the Congressional Budget Office (CBO) has some scenarios for the GSEs exiting regulation in 2020, using a minimum capital requirement of 3%. It’s unclear whether the Treasury Department will apply the old allocation to the senior preferred stock.
That said, if the government really wants to get the GSEs out of regulation, it may need to compromise on preferred stock or warrants, and it’s definitely possible they could use the lower 2.5% capital requirement.
I agree with Ackman that the likelihood of government-backed companies exiting regulation has increased significantly. However, many unknown variables may arise, so investors should exercise caution.
Another idea is to buy junior preferred shares, which are still trading at a deep discount. It has less upside than common shares, but junior preferred shares have higher priority than common shares in the capital stack. It depends on where you want to be on the risk spectrum. Here, smaller speculative positions may be best.
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Bram Berkowitz serves on the Federal National Mortgage Association. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
Billionaire investor Bill Ackman believes two stocks could soar about 900% under the incoming Trump administration Originally published by The Motley Fool
