Inside the mind of a Fannie-Freddie bull

February 12, 2011, 1:40 AM UTC

Hedge fund manager Derek Pilecki thinks Freddie Mac will turn profitable this year and pay back the government. Is he crazy or just contrarian?

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At a time when the odds are stacking up against the future of Fannie Mae and Freddie Mac, it seems as though almost no one will publicly defend the embattled mortgage financing giants. In 2008, during the peak of the financial crisis, the companies were nationalized to avoid huge losses after being saddled with toxic mortgages.

As of October, Fannie and Freddie have cost taxpayers roughly $151 billion in taxpayer funds to cover their losses. More losses are expected on the horizon.

The U.S. Treasury Department on Friday, in a much-anticipated report, unveiled a plan to wind down Fannie and Freddie over the next several years. And fees that the troubled companies charge for guaranteeing home loans sold to investors should be increased to ease the private sector back into the housing market.

Indeed, it’s hard to find reason these days to defend Freddie and Fannie. But the ailing mortgage giants do still have a few bullish shareholders. One of them is Derek Pilecki, founder of Tampa-based hedge fund, Gator Capital Management, who currently owns 400,000 shares of mostly Freddie preferred stock. He beefed up the firm’s holdings when shares fell dramatically after the U.S. government put the companies under conservatorship, paying as low as 30 cents per share to as high as $2 per share (it trades today for around 62 cents per share). His logic: The stocks were cheap but prices will come back.

We caught up with Pilecki, who thinks Friday’s Treasury report is a step in the right direction, especially since the recommendations include putting the companies in competition with private agencies. But he doesn’t think lawmakers will have much success winding down the companies – at least not any time soon. Even while Pilecki’s firm earns no dividend for holding shares of the companies because it’s under conservatorship, he has great faith in the companies and thinks Freddie will turn profitable this year.

Here’s an edited transcript of our talk.

What do you think will be the outcome of the Treasury’s recommendations – specifically, to shrink Freddie and Fannie?

Just because they come out with a plan doesn’t mean they’ll be implemented. I’m thinking not much will come out of it, at least in the next two years. Congress won’t pass any bill or take much, if any, action.

There isn’t a middle ground that is acceptable to anybody. We’re about to start the Presidential cycle. I don’t think people will spend the political capital to get the legislation done.

So what’s your outlook for Freddie and Fannie this year?

I believe Freddie Mac is going to turn profitable in 2011 and be able to pay back the U.S. Treasury. If they’re in the process of paying back the Treasury, it would be impossible to wipe out shareholders.

I think their loan loss reserves are adequate. It’s approximately $35 billion. I don’t think they’re going to have to continue to add to these reserves. They have enough money set aside to cover their losses.

Also the mortgages they put onto the books in 2009 and 2010 are very profitable because lending standards have tightened.

The criticisms aren’t new. Some of them I fundamentally disagree with. One criticism is that the pubic-private model didn’t work. I disagree — I think they just had bad management. They didn’t conserve capital. They reduced underwriting guidelines. That is the wrong move when home prices are at all time high.

So what changes need to happen now?

I think there should be changes. They’re simple. First, the companies should not be able to insure any loans without full documentation. That would have eliminated 80% of their losses—that one simple rule. Also, the companies shouldn’t buy any mortgage securities issued by Wall Street or private label securities. I think those two rules would have eliminated 90% of their losses.

Anything else?

Freddie is going to come back and it’s going to surprise people.

I hope I don’t sound crazy.

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