Malt Liquidity 24
Free B̶r̶i̶t̶n̶e̶y̶ Fannie (but also Britney)
The Circus appears to have closed
A story I have followed with casual interest over the years is the fight to remove FNMA from government conservatorship, which was announced back in 2008. After the immediacy of the mortgage crisis was resolved, however, FNMA was never returned to private hands, and to this day remains a government-controlled entity. Since around 2010, shareholders realized that they were not getting any of the profits from the core business as the government was withholding the profits and neglected to inform the shareholders. This became an issue due to the fact that since FNMA had the government propping them up, they were the only mortgage lender actually providing mortgages in any real volume coming out of the recession, and they started making pretty large profits:
With interest rates low and banks not lending, Fannie and Freddie became the only mortgage game in town. By Sept. 30 of [2013], the companies had returned $185 billion to the Treasury.
But FNMA, like many stocks, has both regular shares and preferred shares which pay dividends. And a few hedge funds realized that if they bought the preferred shares, which theoretically entitled them to a portion of FNMA earnings but traded at a massive discount to the value they would be worth but for the withholding of earnings, and sued successfully, they might be able to alter the flow of FNMA profits from the Treasury to shareholders.
This was given a huge boost when Steve Mnuchin was named Treasury secretary, as he had made quite a bit betting on mortgage recovery himself and was definitely familiar with the trade:
Steven Mnuchin, president-elect Donald Trump’s nominee to be U.S. Treasury Secretary, said Fannie Mae and Freddie Mac should leave government control and that the incoming administration “will get it done reasonably fast.”
As such, FNMAS preferreds went from ~5 to above 10 shortly after inauguration, and continued to rally up until 2020, where perhaps more pressing issues came to the attention of the Treasury, and the dream sort of died.
This is the kind of trade I love though! I have definitely talked about latency edge and quantitative edge, but inherently, legal edge could be thought of as one of the few types of informational edge that have a deterministic outcome in markets - if you are convinced your lawyers will do a better job than the other side’s (and after all, you’re paying them, so you know better than anyone else what they’re up to), it makes sense that you’d have edge on products that have a shot at being saved through courts. The most infamous example of this, of course, is Elliott Management’s acquisition of Argentinian debt, consequent lawsuit, and seizure of a warship. But if the Fed won’t even allow credit reality to hit new bond issues, one can hardly expect the government to cede control over mortgages willingly.
Indeed, the hedge fund drama surrounding the conservatorship of Fannie Mae could be considered the “Free Britney” movement of financial markets. What seemed like a longshot back in 2013 came so close to happening during Mnuchin’s term, only to have the rug pulled out at the very end. And much like Britney (rather than a court-backed conservator) should be in control of her own finances, I sort of feel like the government shouldn’t be controlling half of the mortgage market. Alas, with Mnuchin gone, this trade is probably dead for another 4 years:
A recapitalization of Fannie and Freddie was viewed as a nonstarter by officials in the Obama administration…
…Advisers close to President Biden have said he would be in no hurry to privatize the companies, which guarantee roughly half of the $11 trillion U.S. mortgage market.
Surely there aren’t a bunch of ex-Goldman alumni in office this time to make the case… oh, they’re from Blackrock this time around? Well, if you ever see an ETF with a prospectus of “stocks we hope the Supreme Court bails out”, you know which shares to look at first, I guess.
E-Mail your heart
If FNMA is the “Free Britney” movement of finance, then it would follow that quarterly hedge fund letters are the Malt Liquidity of finance, right? Usually, I love reading hedge fund letters because they generally fit into one of three categories: really good quarter affirming genius and extrapolating this performance into Dalio-esque predictions of the future in a vaguely spiritual manner, bad quarter and utter bemusement and weak laughter at markets being completely out of whack, and bad quarter and apologizing in tears for losing money. A couple of fun letters came across my desk this week, and for the first time in a long, long time, a sense of near-sympathy bubbled as I saw Bronte Capital knowing exactly what was going wrong, but were utterly flummoxed as to how things would change:
Our results this quarter are poor. Our long-held strategy of shorting garbage stocks has hurt us and hurt us some more…
Historically the biggest driver of our short book – and the driver that has worked best for us – is shorting stocks aggressively promoted to retail investors. We seek to find the most cynical and self-serving promoters who promote fads, frauds and failures to retail investors. But “sold to naïve investors” is a basic tell.This tell has not worked in 2020. Indeed, it is a way to lose considerable money as a shortseller. When you think the retail investors being promoted this new shiny fraud (that they cannot possibly know anything about) are hitting exhaustion, a new wave of newbies – with their Robinhood accounts – comes to bid your short up double or triple…
This is a common theme you will see between this past year’s letters, this blaming of retail for being spread-insensitive traders and generally just doing weird stuff like buying SIGL stock when Elon tweets about something completely unrelated. But I have been harping on the same things repeatedly! It must be hard to have a mandate to invest a strategy that you’ve pitched to people that you know won’t work in this current market, but how can you justify collecting fees if you just, I dunno, sit out a year?
[Pinduoduo] was founded only in 2015 and has over USD216 billion in market cap and is a fast-growing multi-level marketing scheme. We are familiar with multi-level-marketing schemes (we own a big position in Herbalife) and we are aware of the problems they face in China. Pinduoduo has none of the features that we associate with sustainable multi-level marketing schemes (and we think we have some expertise). Moreover, large hierarchical organizations in China (including such schemes) either wind up being heavily answerable to the Communist Party or dismantled as a threat to the Party. The accounts at Pinduoduo are “interesting” in the same sense as the purported Chinese proverb. And Pinduoduo has never generated cash, whereas MLMs normally have negative working capital and are highly cash generative in the growth phase. But, whatever, Pinduoduo is fast growing and it is in China.
Oh, and no we have no position long or short in Pinduoduo. We would love to short it – but in this market we would just get thumped.
You can feel the trauma of someone who’s been forced to close out multiple great short positions for no reason other than the stock having been bid up randomly.
In shorting frauds, this is the sort disaster that sometimes befalls you:
a.)You short a stock at $10 run by a promoter who you suspect is a liar. You are (as nearly as possible) certain that this stock is worthless. You hope to cover at $1
b.)The promoter makes up a story that somehow retail seems to think is real and the stock trades at $40
c.)You are forced to buy some back – because there is no conceptual reason why the stock can’t trade at $80. After all it is no sillier at $40 or $80 than it was at $10 (it was worth 100 percent less at all times)
d.)After you cover the stock normally goes to $1 (as you expected all along) though it might go through $100 on the way
When you manage large amounts of capital, you can’t just outright buy puts on stocks due to outsized risk of ruin - as Bill Ackman found out, investors do not like it when positions decline 90% due to the levered nature of options and, you know, not actually holding the underlying. And shorting has proven to be extremely dangerous with so much risk of being blown out to the upside for no reason - they’re absolutely right when they say if a stock should be trading at 10 and isn’t, it really makes no difference to anyone other than your prime broker who is letting you borrow the shares in the first place whether it’s trading at 40 or 100. It’s really a damned if you do, damned if you don’t proposition, as short selling in this environment requires such precise timing because if you time it wrong, you’re just instantly blown out due to retail bid pressure. And everything just looks so damn shortable! It’s a good thing that so many of these hedge fund managers extol the benefits of reading - perhaps it’s time to dust off “Catch-22”.
This means that collectively we have spent over USD100 million buying back stock we think is worthless. We are appalled.
We all see the writing on the wall, for we know the Fed cannot prop the market up forever, but in real time, it is impossible to see how exactly this market breaks. We only have historical precedent and oodles of examples of mean reversion to know that sometime, somehow, some way, it must happen. These kind of fuzzy realities are impossible to trade on the downside, because, again, shorting requires extremely precise timing, and, especially now, the magnitude of potential losses is so outsized. This is a truly unique kind of paralysis that hedge fund managers have to deal with that, honestly, I’m glad I don’t have to spend each day ruminating on.
On that note…