The bottom line up-front is there is no clear path to the future for Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC). What we do know is the current Administration has not pushed to find any resolution, and receives the dividend payment in the U.S. Treasury each quarter. Congress has several drafts on the table, but has been unable to get support in a timely manner to push legislation forward that creates a solution. The courts are fielding as many as 20 lawsuits on various aspects of the conservatorship, all focused on different aspects of the actions and intent of driving a solution.
The endstate will affect the mortgage market, prospective home buyers, the American economy as a whole, and the investors. The present and future investors are observing how all three branches of the government respect the investors' ownership rights, and how they plan to resolve the current situation.
INVESTORS WANT TO KNOW
There are many factors driving the news on Fannie and Freddie, but investors want to know if and when the GSEs will come out of conservatorship, and what the endstate will look like. Will the GSEs return as they were, with tighter investment restrictions and the opportunity to make money for their common shareholders? Will the current junior preferred share holders be the new common shares, with the current common share holders kicked to the curb? Will the Congress finally do something and restructure the whole market industry with a new agency? All these issues and more affect the current value of the shares. Some analysts state the common shares could be valued as high as $60, if the government would release the GSEs out of conservatorship. I will describe the current picture and most likely courses of action that will move Fannie and Freddie into the future.
In the initial agreement between the GSEs and FHFA, the government has the right to exercise warrants to purchase up to 80% of the GSEs' value for the price of one penny for 1000 shares. This is the point I view as manipulation, due to the position the FHFA had over the GSEs at this point in the financial crisis.
Fannie and Freddie had their tenth profitable quarter, sending $10.2 billion in profits to the U.S. Treasury for first quarter 2014. Fannie and Freddie combined borrowed about $188.3 billion, and have repaid over $202 billion. The GSEs are required to pay all profits to the federal government due to the third amendment to the bailout (referred to as the "Sweep Amendment").
Congress has several drafts floating within the House and Senate, however, none have any momentum at this time. For the near term, the mid-term elections will halt any progress. There is no anticipation that after the elections in November, Congress will be able to gain sufficient support for any substantial legislation. This means for the next 2 years, we anticipate the GSEs will earn profits each quarter and forward to the U.S. Treasury.
There have been several efforts in Congress to dismantle both Fannie and Freddie, and replace them with a new agency. The most current is from Congresswoman Maxine Waters, Ranking Member of the Financial Services Committee. On March 27, 2014, she released a comprehensive legislative proposal to reform the housing finance market. Known as the Housing Opportunities Move the Economy (HOME) Forward Act of 2014, the legislation would end Fannie Mae and Freddie Mac.
Rep Waters is quoted: "Reforming a 10 trillion dollar housing finance market is an immense undertaking that must be carefully considered. Fannie Mae and Freddie Mac's return to profitability and repayment of taxpayer dollars has led some to rightly speculate whether the enterprises need any reform at all. I believe that we have an opportunity to address some of the fundamental flaws of the current system, by ending the perverse incentives created by Fannie Mae and Freddie Mac's ownership structure and providing an explicit government guarantee that is paid for by industry." You can read the article at: RestoreFannieMae.com. (Here is the link, and you will scroll down to the article, "DEMOCRATIC REP. MAXINE WATERS UNVEILS GSE REVAMP PLAN")
Another draft bill in Congress furthers the conversation started by legislation released by Senators Bob Corker (R-TN) and Mark Warner (D-VA) and, more recently, Senators Tim Johnson (D-SD) and Mike Crapo (R-ID). All the drafts being circulated to-date have focused on dismantling both Fannie and Freddie and replacing them with another agency.
There are about 20 current lawsuits in state and federal courts at various stages. Some will be dismissed and others combined through the court processes, however, the decisions the courts make will push the solutions forward, possibly in different directions.
The most discussed case includes the Berkowitz's Fairholme Funds Inc. On February 26, 2014, Judge Margaret M. Sweeney of the U.S. Court of Federal Claims granted Bruce Berkowitz's Fairholme Funds Inc. a motion to conduct discovery in its lawsuit against the U.S. government that challenges changes that the Treasury Department made to its bailout of Fannie Mae and Freddie Mac. This suit challenges the constitutionality of the bailout terms and the unconstitutional expropriation of assets and illegal self-dealing between Treasury and the firms' regulator, the Federal Housing Finance Agency, which is charged with running the companies during their federal conservatorship. If this position is upheld by the court, the government would be forced to relook its control on the GSEs and possibly create a process to relinquish control.
This group has publicly circulated its recommended restructuring by buying out the federal government's position of senior preferred (after the warrant is exercised by the government for nearly 80% ownership) and allowing the junior preferred to become the new common shares, and pushing the current common shares to worthless paper. The initial response to this was unaccepted by the FHFA spokesman, the Administration, Congressional representatives, and common share holders. There has been no support for this solution from outsiders.
Jonathan Macey and Logan Beirne of Yale law school described, in their white paper "Stealing Fannie and Freddie", how the federal government used uneven and/or unfair treatment of the GSEs. Here are 2 short paragraphs from the article.
"Politicians are running rough-shod over the rule of law as they seek to rob private citizens of their assets to achieve their own amorphous political objectives. If we were speaking of some banana republic, this would be par for the course - but this is unfolding in the United States today."
"During the severe economic downturn of 2008, many institutions suffered. The federal government's reaction was as chaotic as it was mixed - e.g. orchestrating the sale of Bear Stearns, allowing Lehman Brothers to fail, propping up Citigroup on favorable terms, bailing out AIG multiple times. For automotive giants, Chrysler and General Motors, the government resorted to a "political bailout."
Instead of the traditional bankruptcy reorganization process, the Obama Administration opted for a "quick and surgical" reorganization that would "make it easier for Chrysler and General Motors to clear away old liabilities." The bankruptcy process is meant to follow standard rules, in which the proceeds of unencumbered assets are distributed to creditors according to a strict priority schedule, governed by the nature of each creditor's claim. Secured creditors, such as bondholders, come before the unsecured creditors, which in the case of Chrysler and General Motors, included union health and retirement funds."
The article describes how the government selectively chooses who it helps and who was allowed to go under. Fannie Mae and Freddie Mac were selected to be a cash cow for the federal treasury. Nowhere in the financial rules or laws of our country does it provide for the government to execute the conservatorship in this manner. The federal government made the rules to meet their desires, with no respect for others involved.
Most Americans agree that the federal government did the right thing to step in during the 2008 financial crisis, but the agreements the federal government created as conservator trampled on the rights of the share holders with the "Sweep Amendment".
I agree with their opinion, but anticipate many more discussion points toward the solution. There will be a solution, but the courts will weigh in and provide direction, guidance, possibly standards on the treatment of current share holders and code of conduct of any new conservatorship practices by the FHFA. All of this will drive the future of Fannie and Freddie.
At some point in the future, the government will come to closure with the GSE debacle.
1. The government may return control to the common share holders. The government may (likely to occur) exercise their rights to the warrants. Exercising these warrants would provide the FHFA 80% ownership and force an expensive buyout at a highly profitable position for the government. If this option occurs, expect the federal government to extract the most value from the GSE through the sale of its shares.
2. Congress may wind down the GSEs and stand up another agency with higher cash reserve requirements. One of Congress's main themes in all the drafts has been that all future losses are taken by investors before the government would step in to support the agency. The government may exercise their rights to the warrants, that would repay the senior preferred shares first, leaving the junior preferred with little to none, and the common share holders with nothing.
3. The courts could provide rulings that direct specific action for Congress and the FHFA to comply with. The solution most highly desired is the return of control to the share holders, although there will be too many stipulations to speculate on. The court actions will take years with initial hearings, the dismissal and consolidation of multiple cases, and then the appeals process. Once again, we would expect the government to exercise all its warrants to extract the most value from the GSEs.
Investors drive the price of shares up and down in the market today as the news occurs. Investors will not receive any dividends from the quarterly profits until this is settled by all parties involved. It is our position, one we have held for several years, that investing in Fannie Mae and Freddie Mac is not a place for growth or prosperity at this time. For those who wish to invest in the GSEs and wait-and-see, the rewards could be high. For investors wanting to grow their money today, there are ample opportunities to get a 10% or better return on your money this year.