The Exquisite Timing of Private Equity's $52B GSE Play

WASHINGTON, DC-Fairholme Capital Management has submitted a proposal to purchase Fannie Mae and Freddie Mac on behalf of private investors in a deal in which the GSEs are valued at $52 billion. Hours after the proposal landed, no doubt with a thud, on the federal government's table, there was no response one way or another, a source familiar with the proposal tells GlobeSt.com.

Little wonder: the privatization of the GSEs will be, despite all the talk of their liquidation over the years, a massive undertaking if it goes through.

One thing the deal does have going for it, though, is timing. A month ago, when the Republicans were in the doghouse with the American people over the shutdown, the deal probably would have been a non-starter. Today, David Johnson, CEO of Strategic Vision, tells GlobeSt.com, the deal potentially has legs.

That is because now the polls are trending in favor of Republicans as Obamacare and President Obama's personal popularity takes a hit. If the 2014 races become more competitive for Republicans, expect to see Democrats work to make a deal, Johnson notes. "In general the Republicans are for privatization of the GSEs, the Democrats not as much. But there could be potentially room for a deal depending on how the polls continue to move."

Another reason for reluctant Congresspeople and/or the Obama Administration to move forward with the proposal: comprehensive tax reform appears less likely to happen this year. The GSE privatization could be an olive branch both parties could extend to the business sector.

Of course, it won't just be politics that could potentially hold up negotiations with Washington.  Everyone from federal bean counters to pundits to amateur activist shareholders are going to dive into Fairholme's $52 billion valuation of the GSEs. A significant question will be whether it is a fair price or a raw deal for the US Treasury.

Fairholme says the proposal will not disrupt the more than $1 trillion new mortgage market. In the place of a federal guarantee, investors will commit  to bear risk now, it maintains.

The proposal calls for two, state-regulated private insurance companies that would purchase, recapitalize and operate the insurance businesses of Fannie and Freddie.

These companies--which will not be called Fannie and Freddie--would not have a Federal charter or special status, and the legacy book of investments and insurance in existence on a specified cut-off date would be wound down over time. The proceeds would be used to repay the US Treasury. The new companies and their private owners would earn profits only from the new business written by the state-chartered insurers after the cut-off date.

The companies would be capitalized with $34.6 billion in exchange for preferred stock in the entities, and $17.3 billion or more of new capital raised from preferred stockholders in a rights offering. The two new companies would be regulated by state insurance authorities as well as applicable federal agencies. All capital received in the conversion of preferred stock of Fannie and Freddie, along with attributable profits, would be retained by the new companies as locked-in capital for a minimum of five years to support writing new insurance. No dividends or distributions would be paid using that capital during this initial five-year period.

Details about the proposal can be found here.

The proposal suggests that the two companies could be operational sometime next year if the federal government decides to move forward. As it does, count on the following being part of the conversation--either publicly or behind doors.

Affordable housing. The proposal calls it an important goal--but one better addressed with other tools.

The GSEs' new moves. They have, in various ways, been pushing towards more risk-sharing with the capital markets.  In October, to name one example, Fannie Mae priced its first C-deal--a new series in which the GSE farms out some of the risk in its portfolio to private investors. The GSEs have been developing offerings to meet current investor demand in other ways. Freddie Mac recently launched its first multifamily bulk loan transaction. Have these measures been enough to appease some in Congress that want to see them liquidated and privatized? More importantly, what of the investors that got a taste for these offerings and were expecting more to come to market?

The GSEs' are close to being whole with taxpayers. They have almost repaid the Treasury for its bailout in the financial crisis and everything beyond that will be gravy for the Treasury. Which brings us to our last point…..

The GSEs are a cash cow. Their fees, which lenders pay in exchange for the guarantee, have been eyed before in Congress and, based on a letter sent to the ongoing budget conference, they are being eyed yet again. Called "g-fees", they are a tempting source of revenue and have been tapped in the past to cover other, unrelated policies. In 2011, for example, they were used to cover the extension of the payroll tax holiday. As the budget conference negotiations get underway, it appears that some in Congress are eyeing the GSE and their fees yet again.

The Hill reported that several associations representing the housing and banking industries, including the American Bankers Association, the Mortgage Bankers Association, and the National Association of Realtors, sent the budget conference a letter "respectfully" requesting that Congress "not use g-fees as a revenue source in any budget agreement."