(The Motley Fool) - The U.S. presidential election is just days away. Vice President Kamala Harris and former President Donald Trump tied in the polls and the election is likely going to come down to the wire.
Investors are thinking about the outcome and trying to position their portfolios for either a quick gain after the results or creating a longer-term strategy based on which candidate will win and which party will control Congress. Billionaire investor Bill Ackman and his fund Pershing Square Holdings are among these investors and hold positions that could swing one way or the other based on whether Harris or Trump wins. Here's Bill Ackman's $277 million bet on the election.
A bet on the government-sponsored entities
In 2013, Pershing Square purchased a roughly 10% stake in two government-sponsored entities (GSEs): the Federal National Mortgage Association (OTC: FNMA), known as Fannie Mae, and the Federal Home Loan Mortgage Corporation (OTC: FMCC), known as Freddie Mac. Both Fannie and Freddie securitize mortgages and sell them to investors, providing the mortgage market with a vital source of liquidity. They enable banks and other lenders to get mortgages off their balance sheets and make more mortgages so they can always meet demand.
However, the two got caught holding too many subprime mortgages during the housing crisis of the Great Recession. The U.S. Treasury Department would go on to inject capital into both of the GSEs and take them into conservatorship. Shareholders have seen the stocks of Freddie and Fannie, which now trade on the over-the-counter market, plummet since the Great Recession.
During the last decade-plus, shareholders and contrarians like Ackman have endlessly speculated that the government might eventually release the GSEs from conservatorship and recapitalize them. Since the Treasury Department injected $187 billion into the GSEs after the subprime mortgage crisis, the GSEs have returned more than $300 billion in profits through an agreement with the Treasury, which ended in 2019. The Treasury also holds billions of dollars of Fannie and Freddie senior preferred stock and warrants that expire in 2028
In 2019, the GSEs were allowed to start building capital to reach new capital requirements needed to exit conservatorship and recapitalize. This event could lead to big gains for existing common and junior preferred stockholders. But the path forward is uncertain. Although the GSEs are building capital quickly, they still face a big deficit that is made even larger by the overhang of the Treasury's senior preferred stock and warrants. The process would likely culminate in a huge initial public offering (IPO) to bridge the gap, but it's unclear how existing shareholders, the senior preferred stock, and warrants would be dealt with in such an event.
A Trump victory would be a catalyst
Regardless of your political ties, it is hard to dispute that a Trump victory would be a major catalyst for the GSEs exiting conservatorship. Trump's administration started the process of exiting the GSEs from conservatorship during Trump's first term, and several reports have suggested Trump would continue these efforts if elected. Trump's administration could speed up the timeline and pick a new Treasury secretary that will make terms for the Treasury's senior preferred stock and warrants more amenable in a recapitalization.
Trump has floated the idea of choosing the billionaire hedge fund manager John Paulson as Treasury secretary if he wins the election; that might be hard to pull off because he reportedly has a big position in the junior preferred shares of Fannie and Freddie, a significant potential conflict of interest. Even if not picked, Paulson is likely to have influence, given that the billionaire hedge fund manager has been a longtime backer of Trump.
Ackman's fund Pershing Square also discussed the idea of a Trump presidency and its impact on the GSEs in its 2023 annual report:
The U.S. Presidential election in November 2024 may present the opportunity for a change in the status quo. Both companies' stock price increases in 2023 and year to date reflect optimism around a potential reprivatization in the event former President Trump is reelected. The Trump administration had begun the process of releasing Fannie and Freddie from conservatorship, a process which would likely be completed in a future Trump administration.
A Harris victory doesn't necessarily end Fannie and Freddie's prospects of exiting conservatorship, but it would almost certainly slow them. I would expect a Harris administration to kick the can down the road on this issue.
Either way, Fannie and Freddie offer an interesting risk-reward proposition for investors with a long runway. I own a small position in the Fannie Mae junior preferred series S stock. Trading art about $5.40, these shares have a fivefold upside if redeemed at $25 par value. The common stocks of Fannie and Freddie could potentially have many multiples of upside if the two GSEs are recapitalized but they are also the riskiest shares, being lowest in the pecking order in the capital stack. It's unclear if the two GSEs could raise enough capital to settle up with the Treasury and existing shareholders while also drawing enough interest from new shareholders.
Ultimately, Ackman's bet is very risky and could require a lot of patience. Shares of Fannie and Freddie have surged this year on hopes of a Trump victory, and I would expect that trend to continue if Trump prevails on election night.
By Bram Berkowitz
