Freddie Mac Sub Debt Buy-Back: Heinous and Grossly Unfair

After the bell on Friday (ahem) Freddie Mac (FRE) announced that it would buy in $4.4 billion of its Sub Debt. This deal is another coup for our pals at Goldman Sachs (GS) who got the Lead Manager slot on the deal. No doubt but that GS has a ton of these bonds in portfolio. Some details (click to enlarge):

“We’re doing it to provide liquidity to this market, and retiring these high-coupon bonds also reduces our cost of funding,” Lisa Gagnon, a company spokeswoman, said. (Bloomberg)

That statement is malarkey. They are doing this to provide liquidity for sub debt holders? Why on earth would they care about that? Do they think they can sell new sub debt? Certainly not. They are bailing out the sub debt holders and that does give those holders liquidity but this has nothing to do with supporting a market. As for reducing their funding cost, that is bunk too. They are paying a big premium over par to buy in this paper. They have to borrow another 10% to get the deal done. It will take years for them to amortize this premium.

The money for this deal is coming straight from Treasury. So it will be cheap money. But this is not a fair comparison. They are arbing the Treasury/taxpayer AAA once again. These bonds are not now and never were guaranteed by Treasury. The conservatorship allows continued payment of interest but does not make these bonds money good. This buy back just puts more taxpayer money at risk to the Agencies.

There may be an interesting ‘unintended consequence’ from this move. I think there is a great lawsuit based on this. I am not a lawyer, so I would love some comments on this from those that are.

Freddie has $14.1 billion of preferred stock outstanding. In the conservatorship this was wiped out. The Pref. stock is now changing hands around $1 versus the $25 offering price. There are always layers to a corporate balance sheet. Broadly they include:

• Senior Secured
• Senior Unsecured
• Subordinated
• Preferred Stock
• Common Stock

In a bankruptcy the assets are distributed to these classes of creditors by a judge. The higher you are in this layer cake the better off you will be. Typically the secured and senior guys get out more or less whole. The sub debt gets something and the pref. is usually converted to new common. The old equity ends up being heavily diluted or worthless.

Preference is the guiding principal in dividing this up. But equity comes into the equation as well. In the case of the FRE sub debt buy back there is neither adherence to the rules of preference, nor is their any consideration as to the equity or fairness of this. How can the sub debt that is one notch above the pref. be money good++ while the pref. gets nothing? There is nothing fair about that.

If you do not like that legal argument try this approach. Sixty days prior to the Agencies crashing into conservatorship the President of the United States, The Treasury Secretary of the United States and the chief regulator of the Agencies, Mr. James Lockhart all made the same public statement: “The Agencies are Adequately Capitalized”. Bush, Paulson and Lockhart knew at the time that those statements were both false and misleading. Those statements were intended to calm down the nervous creditors, including the Pref. holders. If this had been a true public company there would have been hell to pay. The SEC would have been involved.

So what could this look like? There are 560mm $25 preferred shares outstanding. I think one could clear the whole lot at a $10 price. That implies a settlement of less than 35 cents on the dollar. That would be more than fair given that the sub debt is money good. Well, that settlement would be worth a cool $5 billion. A 20% payout would make for a $1 bil payday for the lawyers. Not bad for a lay up case.

These rules are simple. There is a hundred years of court cases in support of that. D.C. is breaking them.

Note: Fannie Mae (FNM) has sub debt outstanding as well. Look for them to make an announcement of a sub debt buyback within a month . This means the lawyers can win twice. Double the fees to $2 bil. That should provide the proper incentive.

Comments

[Dave Wrixon:]

>Freddie has $14.1 billion of preferred stock outstanding. In the >conservatorship this was wiped out. The Pref. stock is now >changing hands around $1 versus the $25 offering price. There >are always layers to a corporate balance sheet. Broadly they >include:

* Senior Secured
* Senior Unsecured
* Subordinated
* Preferred Stock
* Common Stock

>In a bankruptcy the assets are distributed to these classes of >creditors by a judge. The higher you are in this layer cake the >better off you will be. Typically the secured and senior guys get >out more or less whole. The sub debt gets something and the >pref. is usually converted to new common. The old equity ends >up being heavily diluted or worthless.

Which Planet are you from? Obama has made it clear that he will pick winners and loser based on his own sense of moral adroitness. The Constitution is suspended until further notice. Ask the GM Bondholders!

Jul 12 02:35 AM

[Bruce Krasting:]

The GM bondholders got killed. The got 25 cents on the dollar. Sad for them but that is the way this is supposed to work out. If you owned GM bonds you took a risk. There was a reward attached to that as well. The GM story worked out the way it is supposed to.

So the Admin. did the 'right thing' re the autos. The are doing the exact opposite when it comes to the Agencies. I doubt that O understands what this is about. He has other bigger issues on his table. This stuff is left to FHFA. They actually think this is the 'right thing to do'. For them it is. For the taxpayers who foot the bill it is not.

Jul 12 08:56 AM

[John Lounsbury:]

Bruce - - -

Thanks for the education.

Jul 12 03:35 PM

[adAstra:]

Seconded. Thanks.

Jul 12 04:25 PM

[marathonman:]

I must admit that I had to read a few times to comprehend. Having said that, an informative piece. The Agencies are not adequately capitalized, but the Treasury is (for now)!

Jul 12 07:35 PM

[Deehena:]

Interesting post but Krasting is comparing apples to oranges. Subordinated debt is nevertheless debt and preferred shares are equity with zero rights to recompense in bankruptcy. Any consideration a bankruptcy judge may give to preferred holders is a GIFT.

Jul 12 10:44 PM