Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) were created long ago in an effort to promote equal opportunity access to home ownership in America. These securities trade on the over-the-counter bulletin board since the Federal Housing Finance Agency delisted them on June 16, 2010. Before that and for the majority of their history they were publicly traded on the New York Stock Exchange and were both Fortune 50 companies. Combined they have roughly $5,000,000,000,000 in assets. This article is about the legal process of deciding who owns what when the tax collector claims everything in the name of protecting taxpayers. Yeah right.
For months shares in Fannie Mae and Freddie Mac have been falling sharply so the question is, "Is the recent surge in price a dead-cat bounce?"
Recent legal briefs in Delaware have made new strides towards unlocking shareholder value. On top of that, oral argument in the Perry appeal is scheduled for April 15. From an event driven perspective, investors are now looking at months, not years, to the point in time at which big decisions are made regarding the scope of information that will be made available for public scrutiny. In the event that the government is shown to have been lying and obviously breaking the law, equity securities in Fannie and Freddie are set to appreciate. In the event that evidence produced by discovery discredits plaintiffs claims, the shares are worthless. Let's begin by taking a look at how we got here.
In 2008, Fannie Mae and Freddie Mac were adequately capitalized when they were put into conservatorship. Immediately upon entering conservatorship, U.S. Treasury and the Federal Housing Finance Agency (FHFA) entered into an agreement issuing 80% warrant coverage and a senior preferred security with a cumulative 10% cash dividend or 12% PIK that would be given to Treasury in exchange for accounting losses at Fannie Mae and Freddie Mac.
Internal government records reveal that the government was committed to ensuring existing common equity holders would not have access to any positive earnings from the GSEs in the future. This fact doesn't seem to be lost on the FDIC which according to Gary E. Hindes was selling GSE equity securities to investors at this time. This action might lead an investor to reconsider the governments actions as detrimental to taxpayers and outside the scope of good faith.
The Third Amendment: Net Worth Sweep
The American Enterprise Institute's Alex Pollock and James Glassman recently proposed a free market solution to Fannie Mae and Freddie Mac where they pointed this out:
In 2012, the government, in an agreement between conservator and the Treasury-that is, an agreement between the government and itself-changed the deal.
Alex and James continue along and propose rescinding the Third Amendment. If you remember, Mario Ugoletti's affidavit was provided to the DC District Court and was used as part of grounds for dismissal of lawsuits challenging the Third Amendment in October of 2014. Since then legal filings suggest that Ugoletti subsequently reneged on his earlier declaration and that interim CFO Susan McFarland corroborates the prevailing story coming from the plaintiffs --- that Fannie Mae and Freddie Mac were to be enormously profitable and in the face of this the government decided to take everything from the two taxpayers.
The irony here is that accounting fraud reports (1, 2, 3) suggest that this return to profitability was not only inevitable, but was to be a direct result of reversing earlier write downs. According to these reports, the earlier writedowns FHFA forced on Fannie Mae and Freddie Mac were designed to cover up the fact that Fannie Mae and Freddie Mac were cash profitable.
White House Forecasts
The White House most recently has upgraded its forecasts for how much money it is going to take from Fannie Mae and Freddie Mac. This is something to keep in mind while we wait for new numbers to come out.
In Q1 of 2014, the White House forecasted U.S. Treasury would take $179.2 billion in profits from Fannie Mae and Freddie Mac across the following 10 years.
In Q1 of 2015, the White House forecasted U.S. Treasury would take $191.2 billion in profits from Fannie Mae and Freddie Mac across the following 10 years.
These forecasts are increasingly interesting for those of us who still believe that the government is protecting taxpayers by taking that money for itself instead of letting taxpayers have it. One would think that perhaps if the government was truly trying to protect taxpayers, they would let taxpayers keep their own money instead of forecasting that they will be collecting more than the bailout at a time where they already have taken from taxpayers more than the bailout.
Even still if you take the government's forecasts and figure that combined the two will earn $185B across a 10-year period that breaks down to an average of $18.5B/annum. Right now that would break out to over $10/share of earnings per annum for each of the common shares if the government wasn't taking it all for themselves and the firms were considered to be adequately capitalized. Ackman factors in an 80% dilution coming from the government's warrants suggesting that those shares may only have $2/share of earnings if they are allowed to recapitalize organically over time. The challenge here is that FHFA is in charge and may consider alternatives that increase the fully diluted share count.
The earlier mentioned Gary E. Hindes is working with former Chief Justice of the Supreme Court of Delaware Myron T. Steel. In the latest filing, they are looking to solicit feedback from the Delaware Supreme Court regarding the legality of a preferred security that basically is a common security:
In the legal filing, plaintiffs go as far as to demonstrate that the government is claiming that it can enter into agreements with itself to suspend laws at its discretion:
My favorite argument by Steele reads as follows:
Were the Net Worth Sweep to be upheld as permissible under Delaware and Virginia law, a very troubling precedent would be set for those states' corporate laws, for stockholders of corporations of those states, and for the mergers and acquisitions community as a whole, because such precedent would appear to extend equally to corporations not under conservatorship and without the federal government as their senior preferred stockholder, and thereby permit the directors of a Delaware or Virginia corporation unilaterally to contract away all of the net worth and profits of the corporation for all time to a single preferred stockholder. Certifying the question now to the Delaware and Virginia Supreme Courts will allow those courts to provide guidance on this important issue of Delaware and Virginia corporate law, which is the central issue in this litigation, and provide needed certainty to corporations and their directors, officers, and stockholders. Additionally, certification of this issue will serve the interests of judicial economy in this case, because the answer could resolve the dispute between Plaintiffs and Defendants at the threshold stage.
What Steele is saying is that the net worth sweep sets a precedent whereby preferred shares of any Delaware or Virginia corporation can contractually be given the net worth of the company. Note that dividends are not interest and are always voluntary. Being able to contractually give away the net worth of a company to a preferred shareholder undermines the valuations of any publicly or privately traded Delaware or Virginia company. If left standing, there is little to nothing preventing company executives at such companies from taking the Treasury and FHFA accounting write-down and reversal playbook and making a bank-backed vendor-financing agreement that facilitates the transfer of the company's profits in any direction of their choosing. This standpoint is primarily why I find myself all-in, because it is my view that if Fannie and Freddie equity shareholders have worthless shares then perhaps we aren't the only ones. At that point, the value of any public company's shares are contingent on insiders not doing what is in their own best financial interests.
In the most recent Delaware briefs, Steele walks through and cites more legal sources in good faith than I've seen previously in other plaintiff briefs and from a legal perspective appears to completely dismantle Treasury and FHFA's defense. The logic goes that FHFA could not exercise powers that they did not have and that they appear to have circumvented state law regarding preferred shares in what appears to be an attempted nationalization. The results are not yet in, so we aren't supposed to be so sure yet, but when there are public books written by the people who did it bragging about the actions that they took, it doesn't take much to figure out what likely happened. Again, it is worth noting that at the time of this article there are no currently active and pending lawsuits against the auditors, which is subject to change. One would think that if the reports on the accounting fraud were right, those would have shown up by now but at the same point one would think that we all could take the government's word for it when they say they have followed the law. So, what exactly did Ugoletti and McFarland say about what really went on? We aren't sure. What we do know is that what they said according to plaintiffs appears to defeat the government's argument that it was entering into the Third Amendment to save Fannie Mae and Freddie Mac from having to pay dividends in excess of their income which allegedly had become a circular process. I would say that's simply by design.
Summary & Conclusion
With the government taking everything and declaring sovereign immunity among other things, taking an ownership position in equity securities of Fannie Mae and Freddie Mac can be considered a risky investment. That said, I have borrowed over $250,000 and own over 90,000 combined shares of FNMAS/FMCKJ because I have read every word of all of the legal filings and think that the court system will do what politicians seem unwilling to or at the very least provide grounds for the correction of the court of public opinion at which point it is possible that during an election year this becomes an election issue. There are active blogs available to those willing to entertain the good story. David Fiderer has been right all along. Also, there are people who claim that they have had conversations with insiders and that these conversations at the very least suggest that as a reader you should do your best to independently verify the claims made by Treasury.
When you're dealing with two companies that, as the story seems to suggest, have been under the control of a government regulator that may have a history of favoring minority shareholders it's tough to put a price on the common shares, but hedge fund titan William Ackman and analyst Richard X. Bove seem to think that the commons are worth $20 or so. As for me, I'm not going to forget the administration's commitment, especially when they have been trying to keep it for 7 years and counting.
Disclosure: I am/we are long FNMAS, FMCKJ.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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