After the recent increase in the common share price of over $2 a share for both GSEs, I wanted to know if the Federal National Mortgage Association (OTCQB:FNMA) and the Federal Home Loan Mortgage Corporation (OTCQB:FMCC) could be viable investments, which could return a substantial about of money ...
On September 6, 2008, the Director of FHFA placed Freddie Mac and Fannie Mae into conservatorship. On September 7, 2008, Treasury and FHFA announced several actions regarding Freddie Mac and Fannie Mae. These actions included the execution of the Purchase Agreement, pursuant to which we issued to Treasury both senior preferred stock and a warrant to purchase common stock.
The excerpt above is an extremely high-level and brief synopsis from Freddie Mac's 2012 10-K. If I were to compare though, Fannie Mae's 10-K to Freddie Macs, it would almost be identical if not exactly the same regarding the terms and conditions under the conservatorship the Treasury received. The senior preferred shares issued to both GSEs were senior to all other previously issued preferred shares and paid an annual interest rate of 10%. Also, as it applies to both GSEs, warrants that can be exercised for one one-thousandth of a cent ($0.00001) per share, shares of common stock equal to 79.9% of the total number of common stock outstanding on a fully diluted basis. The warrants can be exercised in whole or in part at any time until September 7, 2028.
As a condition to receiving the money from the Treasury, the companies are unable under the Purchase Agreement to:
- Prohibited from paying dividends or other distributions on or repurchasing equity securities
- Issuing additional equity securities
- Issuing subordinated debt
- Enter into any new compensation arrangements or increase amounts or benefits payable under existing compensation arrangements without the consent of the FHFA, in consultation with the Secretary of the Treasury.
The fourth point is quite laughable considering the Obama Administration went after the "Fat-Cat" bankers for getting paid a hefty salary. The top six employee's at Fannie Mae made over $15 million base salary and bonus and Freddie Mac's top six employees made over $12 million base salary and bonus in 2012. As these companies are mandated by the government and currently run by the government, as an investor, I'm outraged that these executives are getting paid "Fat-Cat" private sector salaries!
The past six quarters has been extremely profitable for these companies as they are now posting a profit and are close to paying back the $180 billion borrowed during the crisis. The senior preferred stock (Treasury Senior Preferred Stock) the Treasury issued were also getting paid their 10% annual dividend until August 17, 2012, when the Treasury amended the Senior Preferred Stock Purchase Agreement stating the amendment will help with achieving certain objectives as stated in the FNMA 2012 10-K below:
- Making sure that every dollar of earning that Fannie Mae and Freddie Mac generate will be used to benefit taxpayers for their investment in both firms
- Ending the circular practice of Treasury advancing funds to the GSEs simply to pay dividends back to the Treasury
- Acting upon the commitment made in the Administration's 2011 White paper that the GSEs will be wound down and will not be allowed to retain profits, rebuild capital, and return to the market in their prior form
- Supporting the continued flow of mortgage credit by providing borrowers, market participates and tax payers with additional confidence in the ability of the GSEs to meet their commitments while operating under conservatorship, and
- Providing greater market certainty regarding the financial strength of the GSEs.
The latest amendment was the fourth to occur on the senior preferred stock purchase agreement; the subsequent amendments taking place on September 26, 2008, May 6, 2009, and December 24, 2009. I don't recall the TARP money paid to Goldman Sachs (NYSE:GS), Bank of America (NYSE:BAC), American Insurance Group (NYSE:AIG), JP Morgan (NYSE:JPM), Morgan Stanley (NYSE:MS), Wells Fargo (NYSE:WFC), General Motors (NYSE:GM), U.S. Bank (NYSE:USB), etc. having their preferred stock agreement amended four times.
The one modification that makes logical sense is point 2, above, as when the companies emerge profitable, it doesn't make sense to pay a dividend with money they're receiving from the receptor.
The August 17, 2012, amendment replaced the 10% annual dividend on the senior preferred stock with what has been called the "Sweep Amendment," based on the net worth of the respective GSEs.
The Sweep Amendment simply states that the senior preferred stock 10% dividend will be waived, but replaced, starting January 1, 2013 through and including December 31, 2017, by all the excess earnings the companies generate by taking total assets - total liabilities above a capital reserve amount of $3 billion during 2013 and the reserve amount decreasing by $600 million each year till January 1, 2018, at which date all excess earning go directly to the Treasury.
What's an Investor to do?
From my standpoint choosing between investing in Freddie Mac or Freddie Mae, really doesn't matter, considering the fate of both companies are one and the same, just like the terms of the Treasury senior preferred stock agreement and warrants. What does make a significant difference in my opinion though, is the capital structure one chooses to invest in. One can invest in the common equity or the preferred shares, except of course the senior preferred shares (Which would be nirvana for any investor). The top security of each graph is the common equity, which there is only one class, below those are all the series of preferred stock one can choose from.
Investing in the common shares of either of these GSEs is like swimming in the deep end of the pool as a little kid, having an older brother push your head down, while at the same time having sharks tear away at your feet. What I mean by this analogy is it'll take a significant amount of time to realize any profit in the long run considering there's more factors working against an equity investor such as:
- None of the principal amount borrowed has been repaid. All the payments thus far have been to satisfy the dividend payments on the senior preferred shares
- All of the preferred shares are next in line to get paid back before any equity holder receive a cent in dividend payments
- If the GSEs get restructured or even get significantly down sized the common equity holders possibly will be completely wiped out
- Probably the most important point - The Treasury hasn't exercised one warrant as of 9/30/2013, which as mentioned above is one one-thousandth of a cent ($0.0001) per share, shares of common stock equal to 79.9% of the total number of common stock outstanding on a fully diluted basis, and the warrants can be exercised in whole or in part anytime until September 7, 2028
For day traders or those of us with "Fat Fingers", the common equity may be a way to make or lose an extreme amount of money in a short time span.
Investing in the preferred shares isn't as dramatic as swimming in the deep end of the pool from my analogy above, but nevertheless, still contains risk. The preferred shares of both companies out-rank the common equity as far as being first in line if any money gets distributed in the form of dividend payments. The one significant difference between the common and preferred shares though, is that the preferred shares were initially issued with a binding contract to the preferred holder, outlining the dividend payments, maturity dates, and par amount if the shares were ever to get redeemed at a future date. As there are many preferred shares to choose from, I'll discuss the Federal National Mortgage Association Preferred Stock Series S (FNMAS).
Terms of FNMAS (Refer to the offer Circular link)
Dividend Rate: For the period beginning December 31, 2010: The greater of (I) 7.75% per annum and (ii) 3-Month LIBOR plus 4.23% per annum; Dividend rate will reset quarterly
Payment Dates: Last day of every quarter
Optional Redemption by Fannie Mae: On December 31, 2010, and on each fifth anniversary thereafter, at $25 per share plus accrued dividend from the most recent payment, whether or not the dividend was declared
Stated Value: $25 per share
Series S preferred stock is currently trading at around .30 on the dollar. The terms are Fixed-to-Floating rate non-cumulative, and as one would expect no dividends are being paid on these shares yet. But under the assumption the Treasury will get paid in full through the Senior Preferred Stock Purchase Agreement, and the Sweep amendment gets swept away, Series S will be entitled to a preference, both as to dividends and upon liquidation, over the common stock. In addition, Series S preferred stock will rank equally, as to dividends and upon liquidation, with all other currently outstanding series of Fannie Mae preferred stock.
Personally I have taken a sizable position in the Series S preferred shares (FNMAS). As there are multiple scenarios which could play out, let's examine three potential possibilities 1) Lose entire investment, 2) Paid in full at par $25, and Series S doesn't get redeemed on its fifth anniversary, and 3) Somewhere in the middle.
As I've mentioned in my other articles, I'm not disillusioned with the facts and I understand preferred shareholders have an uphill battle, but less so than the common shares. In scenario 1, there really isn't much analyzing to perform as your initial investment times zero will be zero. In scenario 2 (Best possible outcome), your .30 on the dollar goes back to par and/or Series S doesn't get redeemed and you start getting paid dividends at an annual rate of 7.75%. So your initial investment at .3 has now netted over 200%, plus a annualized dividend payment of around 25% of your initial investment. Now for scenario 3, which is somewhere in between scenario 1 and 2.
In scenario 3, most likely outcome as there are a number of events, which could lead to a higher price:
- Treasury amends the senior preferred stock agreement for the fifth time having the excess earnings go towards paying back the initial senior preferred stock borrowed funds
- Treasury amends the senior preferred stock agreement allowing dividends to be distributed after Treasury is paid in full
- Treasury amends the senior preferred stock agreement allowing for the excess earnings to go towards retiring the senior notes and preferred shares
- Fannie Mae starts to wind down distributing proceeds in order of senior priority, which is around the current price of the FNMAS
Many of the outcomes can definitely take mutations in one way or the other depending on what the Treasury and FHFA decide.
After researching both GSEs, I believe the preferred shares are the way to trade the GSEs, given that the potential upside is over 200%, with limited downside at current prices. I've come to the conclusion the Treasury Sweep agreement will most likely be amended in some form or another and the preferred shares will receive around .30 on the dollar in the event of a liquidation. If there's no liquidation, anywhere between $0.30 and $1.00, plus dividends, with my initial investment intact, then my analysis would be any investors dream considering the risk-reward ratio is 2.5:1 potentially.
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