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Summary

  • The 100% profit sweep: unreasonable in spirit, law and effect.
  • New equity terms can strengthen Fannie, Freddie, banks too.
  • Congressional staff might want to check out this article.

Contents:

1. A Few Statutes

2. New Equity Terms

3. Vouchers for Equity

4. Senators' Sentiments

5. Obligations to Community Banks

6. Fiduciary Duties, Representations

7. Senate Committee

8. Disclaimer

1. A Few Statutes

Seeking Alpha has excellent background on Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC). I'll skip background, review my thoughts on the infamous Third Amendment ("TA") and suggest new equity terms for Fannie, Freddie, banks and other financial institutions.

I've owned Freddie Mac preferred shares since 2012, eyeing its tax assets and future earnings. I bought more after the August 2012 TA would sweep 100% of its income into U.S. Treasury, considering that contra its conservator's mandate "to preserve and conserve the assets and property of the regulated entity" (Title 12 U.S. Code § 4617) and Constitution Amendment V: "nor shall private property be taken for public use, without just compensation." (Fannie Mae was less clear to me; I owned some of its preferred shares briefly.)

Deeming the shares not property would have been incompatible with Treasury receiving warrants to buy Freddie's common shares and with the Housing and Economic Recovery Act of 2008 (HERA), amending 12 U.S.C. § 1455: "the Secretary of the Treasury shall take into consideration … The need to maintain the Corporation's status as a private shareholder-owned company."

Its conservator, the Federal Housing Finance Agency or FHFA (I can't pronounce the acronym), "may operate the regulated entity with all the powers of the shareholders, the directors, and the officers of the regulated entity" (§ 4617). "With great power comes great responsibility," as Spider-Man and his Uncle Ben said (echoing Voltaire and President Franklin D. Roosevelt) in Spider-Man (not sarcastically). "In exercising any right, power, privilege, or authority as conservator or receiver in connection with any sale or disposition of assets of a regulated entity for which the Agency has been appointed conservator or receiver, the Agency shall conduct its operations in a manner which--(NYSE:I) maximizes the net present value return from the sale or disposition of such assets" (§ 4617).

In disposing of all assets that are Freddie's current and future income, besides contravening § 1455, the Third Amendment--the 100% income sweep--could not have met that § 4617 requirement. It appears to be contravention of the conservator's duty, unlawful abrogation of HERA and an unconstitutional taking by Treasury. It may be reversed as no party to it could have legally agreed to it.

When the dust settles, regulators may grapple with Fannie and Freddie (or successors), banks and others participating in housing finance with a problem: owners' interests aren't well aligned with regulators' interests in maintaining well-capitalized firms. Owners may prefer to ride out downturns, to delay raising capital, putting public guarantees of liabilities at undue risk. This can change with new equity that I call saber-toothed equity or, more gently however blandly, self-regulating equity. Better yet, let me sound like Michael Jackson and call it ABC equity for now.

2. New Equity Terms

Say Fannie or Freddie (or successors) want (or you want) X equity-to-assets. Instead of one class of shareholders running the show, the equity may be divided into three classes with teeth. Class A preferred shares might be near 10% of X, class B preferred shares might be near 30% of X and common shares might be near 60% of the X target equity. Each share class would elect directors who represent only one share class. Any owner or beneficiary of one share class couldn't vote with another share class.

When a firm's total equity falls below an agreed threshold such as 80% of X, or its credit metrics or pre-provision earnings deteriorate to any worrisome preset threshold, class B directors could cause a rights offering of common shares to boost its equity. At the same time, class B directors could elect new management.

When a firm's total equity falls below a worse threshold, or its credit metrics or pre-provision earnings deteriorate to any horrid preset threshold, class A directors could appoint new management and cause rights offerings of both class B and common shares.

Each class B preferred share holder might, then, receive a right to buy one more class B share before a consolidation of two class B shares into one, reducing the dividend per former class B share by half. Class B dilution can be structured in different ways.

Common shareholders might, then, receive rights to buy common shares that raise the firm's total equity to X target equity-to-assets based on its highest assets in the trailing 24-36 months reduced by subsequent net loss and any spin-off or sale of assets, motivating no less lending for capital sufficiency. (Otherwise it could be a damaging incentive to slash assets, curtailing credit.) The rights may enable buying shares at a discount, say 10-15%, from volume-weighted average share prices before the buy. Share purchase rights should trade publicly so that shareholders may exercise or sell their rights, as some may lack resources to buy more shares.

Class B directors would cause common equity raises to not be diluted by class A, who would cause class B and common equity raises to avoid receivership. The existence of class A can motivate class B directors to raise deficient common equity promptly, even when regulators are on vacation. (Ideal regulation may require minimal regulatory action, I suggest, not by abdicating regulators' authority but by aligning private incentives with public interests.)

Meanwhile, class A or B directors would consider replacing management that presided over deficient capital.

From time to time as its assets grow, a firm would issue new A and B shares to maintain A and B capital within some percentages of its total equity. It might do that via rights offerings (with rights to buy new A and B shares at modestly less than market prices, granted to the A and B shareholders and traded publicly so they may exercise or sell the rights) and class A and B dividend reinvestment plans.

This new equity can work with any capital amount. Say losses on failed mortgages may average near 50% of principal while 10% of conventional mortgages may fail in a bad case. Firms might hold 5% equity to such assets. Sixty basis points return on the assets could be 12% return on equity. Say A, B and C classes are 10%, 30% and 60% of total equity respectively. It would enable 6% dividends for class A preferred shares, 8% dividends for class B preferred shares and 15% return on common equity. Returns on equity will vary, naturally, and may fall amid competition.

Regulators can let owners experiment with the rights offering details and metrics that can trigger dilution and new leadership without termination pay. The variation can be welcomed as new terms will unlikely be perfect; over time, we can learn who wrote ABC details best. Even bad ABC details can be okay as no new terms would preclude regulators' exercising their powers.

ABC terms can be an overlay on the existing regulatory system. With self-regulating ABC equity, shareholders can be motivated and empowered to keep firms well-capitalized without delay. ABC equity may be enacted for Fannie and Freddie (or their successors), banks and other financial institutions, strengthening them all.

3. Vouchers for Equity

Jacking up financial system equity may appear impracticable, yet is not. Of banks in Europe, I've suggested (in articles elsewhere) the European Central Bank (ECB) print and give citizens vouchers that buy competitively priced, newly issued common shares. The financial amount of vouchers could be deposited at ECB, earning nothing until it's released in tranches equal to banks' future loan losses that are also net losses (disregarding goodwill impairment, amortization and non-cash payments) sustained over years.

A move along those lines may stabilize devastated financial firms, recapitalizing them well, averting credit contraction, or shift firms to higher capital, without raising the firms' stated earning assets! That is: without terribly raising inflation. Should the vouchers be given to firms' shareholders or to citizens at large? Maybe: to citizens broadly when firms are widely undercapitalized per rules long in effect, and to just shareholders when regulators adopt much higher capital requirements. There is, in any case, no clear impediment to appreciably higher financial system equity.

4. Senators' Sentiments

Senators seeking to uphold confiscation of Fannie's and Freddie's equity (legislation draft GRA14195 proposing to uphold the Third Amendment at or near page 388) have been interesting, even as their efforts to strengthen housing finance merit praise.

"With where it's trading now," one Senator was quoted widely as saying, "I'd be getting out with a handsome profit."

The Senator implied his committee's bill would wipe out Fannie and Freddie shareholders, who could exit satisfactorily. As John Keynes noted, though, "there is no such thing as liquidity of investment for the community as a whole" (General Theory, Kindle edition). In every sale, in other words, there must be a buyer. Someone will own each share at the end of each day. Whoever it is should be treated in accord with statutory promises.

"There's a real question about the Treasury's sweeping of all the profits," said another Senator quoted widely. Yet his committee's draft bill affirmed it. He explained along the lines, reported widely, "I was a venture capitalist…. So once I got a 30-to-1 return … talk to me about Fannie and Freddie making money."

The sentiment is fascinating. In what percentage of the Senator's venture capital investments did any minority investor welcome a controlling shareholder sweeping all profits into its own account?

As to Treasury's terms before the sweep, what would the Senator think about venture capitalists receiving 10% annual dividends on capital invested and 79.9% of common shares in capital-strapped companies with past and prospective earnings? Would he consider the terms light?

What of indirect returns on the investment in Fannie and Freddie, on myriad economic activities that incur tax?

("According to the Mortgage Bankers Association, every $1,000 in reduced economic activity in the real estate industry produces an additional $400 in lost income in the larger U.S. economy." That was in a 2000 note from Ernst & Young Economics Consulting and Quantitative Analysis, "The Economic Impact of Increased Risk Based Capital Requirements"; and who better to assess their own value than the MBA. Whatever the actual impact, it's not nil.)

The Senator knows that venture capitalists seek more than a base yield on preferred shares by converting them to common shares. When the government seeks all income rather than collects on its stake in the enterprises, whether sold or run-off or revitalized, how is it acting like a venture capitalist?

And how, in the Senator's view, do statutory mandates "to preserve and conserve the assets" (§ 4617) of "a private, shareholder-owned company" (§ 1455) accord with confiscating the company's earned assets perpetually?

The Senator may have meant that Treasury should get more than its capital invested: it should get a return on it. Treasury should, setting aside the Third Amendment--100% income sweep.

Senators may prefer to defer reversing it to Treasury, FHFA or the courts. Yet perhaps those who write laws ought to foremost honor them. Affirming the Third Amendment, they appear to be disregarding the conservator's statutory duty, disregarding the Constitution and neglecting their suasion in mediation, maintaining the sweep even in draft legislation.

5. Obligations to Community Banks

A perplexing part of the story is those affected by it, as community banks heavily bought Fannie and Freddie preferred shares. Camden Fine, President and CEO of the Independent Community Bankers of America, addressed Treasury:

Since banks received special regulatory capital treatment for them and since banks are generally prohibited from investing in stock of other corporations, Fannie and Freddie preferred stock were important investments with full regulatory blessing.

Shockingly, Secretary Paulson fully acknowledges in his new book On the Brink that this action [making conservatorship] constituted an "ambush." It took place shortly after he and the GSE regulators issued statements that supported the ongoing viability and capital levels of the GSEs in their current form as "shareholder-owned companies"….

ICBA urges immediately restoring the dividend payments on Fannie and Freddie preferred shares and paying injured holders the amount of suspended dividends from September 7, 2008….

Helping restore the $15 to $20 billion in community banks capital value crushed by the unwarranted Treasury actions perpetrated on preferred shares can foster $150 billion to $200 billion in new lending as banks can leverage this capital.

6. Fiduciary Duties, Representations

Secretary Paulson's On the Brink recounts Fannie's and Freddie's boards accepting conservatorship. "They had fiduciary duties to their shareholders, so they would want us to make the strongest case we could. We emphasized that if the government didn't put them into conservatorship, the companies would [could] face insolvency and their shareholders would be worse off."

The directors could have negotiated from strength, recognizing that Treasury wanted to invest in Fannie and Freddie in conservatorship and not receivership, that tax assets might have stayed on their books and saved draws from Treasury, yield on those draws might have been nearer 5% than 10%, and Treasury's preferred shares might have ranked pari passu with other preferred shares. But facing a Treasury Secretary and Federal Reserve Chairman, citizens may tend to acquiesce.

Treasury emphasized: their shareholders would not be worst off with the conservatorship. Now taking 100% of Fannie's and Freddie's income, Treasury appears to be transgressing its representations--its Secretary's representations that the directors could agree to the conservatorship per their fiduciary duties.

In spirit, then, the 100% income sweep appears inappropriate. Per the statutes, it's inappropriate. And, in effect, it injures community banks and others who can use the equity to generate tremendous economic output. The Third Amendment--100% income sweep--appears to be a triad of unreason in spirit, law and effect.

7. Senate Committee

The U.S. Senate Committee on Banking, Housing, and Urban Affairs is marking up draft housing finance legislation. Senators can affirm or reverse the Third Amendment in it. Only in the unanticipated event they reverse it, the draft could accord with the statutes.

To be tested in due course, ABC equity is one idea for improved guarantors in the sector and an improved financial sector broadly.

8. Disclaimer

Nothing herein should be construed as investment advice. I may buy or sell any security. At publication: I own Freddie Mac preferred shares, long-term holdings, haven't owned its common shares and do not own Fannie Mae securities. While pecuniary interests may and may not conflict with beneficent policy, I work on both.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Source: A New Solution For Fannie And Freddie