This article was co-written with Glen Bradford.
Sometimes things are happening just because that's the way that they've been happening for awhile. This is one of those times. Sometimes, things can be done to make things better if people only knew. For those who know, it is time to show and tell. For without the pursuit of the truth, there can be no expectation of achievement.
There are many people saying many things supporting various perspectives regarding the two private companies Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC). Much like a political football, it's really difficult to boil off the nonsense from the discussion to get it down to what are really the key points. We understand. As an associate of Glen's remarked earlier, "I could read this stuff until I'm blue in the face and I still wouldn't be qualified to have an informed opinion."
And so, we intend to provide what we see as undisputed facts. From there, we will entertain what we see as likely outcomes and speak to the implications.
We can begin with a recent report released by Height Analytics that suggests that Fannie Mae and Freddie Mac could be released from Conservatorship if they are able to retain a combined $52.7 billion. This is the capital required under the existing laws passed by Congress prior to the financial collapse. Even more interesting, they may already have enough capital to meet this requirement, but it is hidden in their balance sheet. This is an analysis of the current situation as things stand, not to mention the implications of a win in the courts that would reverse and undo the third amendment net worth sweep. We find this analysis to be one that has unsurprisingly not yet had its day in the sun. Let's shed some light.
The calculation breaks up the entity's assets into two groups and provides a 30% cushion on top of the capital requirement. Insured mortgage-backed securities require capital of 0.45% and owned assets (everything else) requires a 2.5% capital buffer. This stands in sharp contrast to the 10% capital requirement offered by a recent Senate Bill.
Here is the analysis that computes the capital needed under the existing law.
But you say, Fannie and Freddie only have about $15 billion in stated total equity capital today (Fannie has $8.09 billion and Freddie has $6.9 billion). This is where the issue becomes hazy, as many shareholders believe there are additional sources of capital that are not being disclosed properly.
Regarding the loan loss reserves, historical charge-offs have been $21.3B, $15.3B and $9.0B for the periods of 2011, 2012 and 2013, respectively. Using the most recent quarter's charge-off rate of $1.599B to straight-line the expense over the next few years, we see that the Fannie Mae has reserves adequate to cover the next 6.55 years of loan losses. For comparative purposes, Bank of America (NYSE:BAC) has 2.26 years of reserves and Citigroup (NYSE:C) has 2.0 years of reserves. This indicates that Fannie Mae might be as much as $29 billion over-reserved.
For the legacy book business, we estimate that the fair value is understated on the seasoned loans in the portfolio. These loans were originated prior to 2009 and carry above-market interest rates. This represents only 22% of Fannie Mae's portfolio and it is uncertain how large the actual fair value premium would be on these loans in the current rate environment, without knowing their exact interest rates and terms.
A similar analysis can be performed with Freddie Mac. The company's loan loss reserve at the end of the first quarter was $24 billion and charge-offs for the period were $1.457 billion. This implies that there are about 4.12 years worth of loss reserves booked for Freddie Mac. By our estimate, Freddie Mac has an excess of $12 billion in their reserve accrual and therefore, the adjusted equity book value for Freddie Mac is closer to $18.9 billion. The fair value adjustment provided by the loans held at amortized cost is more difficult to ascertain for Freddie Mac. The company reports to hold $140.4 billion in unsecuritized loans at amortized cost.
So far, this has just been an analysis of what things are as they stand today. Right now, the two private businesses are in Conservatorship, which is different from receivership. The two businesses have borrowed a combined $187 billion and have paid back a combined $213 billion. There have been ongoing discussions for decades regarding a better solution for everyone involved, but realistically Fannie Mae and Freddie Mac are the two least expensive ways to provide Americans access to own a home.
Regarding the capital structure of the two, right now the net worth sweep precludes them from building capital. That is to say 100% of the profits go directly to the government. If that ever changes, the next in line is the preferreds and finally the common. On top of that, the government appears to have 79.9% warrant coverage at a strike price that is effectively $0. We are not sure if the government is going to be able to exercise these warrants or not, much like we are not sure whether or not the third amendment net worth sweep is legal or not at this point in the game. We do know that at this point they have not yet been exercised. It would seem that if the third amendment is reversed then perhaps the legality of what has transpired with the warrants may be up for consideration next.
In the meantime, the government appears to be producing contradictory statements in its defense. The good news is that as long as you don't place too big of a position into these two businesses, in the event that some way, some how, the government wins and shuts down the GSEs at a time when the regulator is setting out to grow them, the time will be ripe to short many securities in the face of what would be an actual depression the likes of which we avoided in 2009 because the GSEs bailed out our entire country by providing lending solutions when others could not.
Extraordinary FHFA Powers
The independent regulator of Fannie Mae and Freddie Mac is the Federal Housing Finance Administration (FHFA). There are differing viewpoints on the FHFA's power. Last Tuesday, Josh Rosner, Managing Director at Graham Fisher & Co., gave a presentation for Investors Unite in Washington D.C.
Rosner made the following points about the powers of the FHFA.
To start, "as a result of HERA, the FHFA has the authority to set stronger capital standards for Fannie and Freddie." This could include keeping the current standards, which call for approximately $52.7 billion in capital, or the regulator could decide on a higher capital threshold.
"As a result of the original Conservatorship agreement, there has been no defined method for the GSEs to repay the government and no definition of whether repayment would be based on a return of capital or return on capital." If FHFA will not or cannot decide this, then the courts surely will.
"As a result of the Third Amendment to the Preferred Stock Purchase Agreement (PSPA) the GSEs have no ability to build capital." If FHFA had the power to enter into a Third Amendment to the PSPA, they can also create a Fourth Amendment to this agreement.
The bottom line is the FHFA's powers provide more logical and non-political solutions to an administrative problem.
Fannie Mae may likely have adequate capital to be released from Conservatorship, but the FHFA and Treasury entered into an unlawful sweep of profits in August 2012 which has impaired the companies' ability to emerge from Conservatorship. The government's argument against discovery in the recent legal battles includes circular logic and we expect that facts around the Conservatorship will emerge very soon. If injunctive relief ends the net worth sweep, expect fair value gains on reserves and certain assets.
Disclosure: The author is long FMCC, FNMA. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Both authors are long the common stock. Family members are long the common and preferred stock.