"Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) will transform into low-risk, public utilities with regulated rates of return, just like your local electric company," says legendary and famed investor Bruce Berkowitz in his annual report. If you ask me, he sounds a lot like William Ackman when he puts it that way. No matter how you shake it, that's a significant change from the status quo, which involves the perpetual allocation of profits to the government.
The Dream of American Homeownership
Fannie Mae and Freddie Mac are two private companies that are forecasted by the White House to produce tens of billions of dollars per year across the next decade to go against the federal budget deficit. In 2008, after decades of operational success since they were brought into existence by the government to help promote home ownership equality, they were placed into a government-run conservatorship. This is their story. As a current or prospective investor, this is not your standard investment because:
- Calculating the fully diluted share count is problematic.
- Their income is regulated by Congress.
- The government has otherwise taken over $108B away from the companies since conservatorship has begun.
Fairholme's Annual Report
Fairholme has been footing the brunt of the legal bill for producing discovery, so it's only natural that their annual report has some interesting tidbits.
Unlike the big banks, Fannie Mae and Freddie Mac did not commit any consumer fraud in the run-up to the financial crisis.
That's an interesting point that I agree with, but for the sake of balance, there are experts like Peter J. Wallison, Edward Pinto, and perhaps Ed DeMarco who would suggest that although Fannie and Freddie did not commit consumer fraud on the front lines themselves, that perhaps they were involved somewhere up the food chain. This is where Fannie Mae's prior CFO Timothy Howard's recently filed amicus curiae makes leaps and bounds.
Timothy Howard's New Brief Is 20% Different And 100% Better
Timothy Howard has had a tough go, but there is light at the end of the tunnel. Previously, he was denied admission as an expert to view discovery material in Judge Sweeney's court of claims and he filed an amicus curiae in the D.C. District Court of Appeals. He's outdone himself this time ladies and gentlemen in his brand new amicus curiae in the District Court for the District of Delaware. Tim refers to the blueprint of how to nationalize two public companies:
Most importantly, actual delinquency rates for Fannie Mae and Freddie Mac mortgages demonstrably prove that Fannie Mae and Freddie Mac are disciplined sources of mortgage credit:
$326 billion of non-cash accounting charges is a number that I personally found surprisingly large, and it goes to show that the only way to make two extremely cash-money profitable Fortune 50 companies look like they need money is to fabricate massive losses:
There's a lot in there, and it's action packed, and I loved every bit of it. It is absolutely fascinating to me how the government has systematically taken everything from two massively profitable private companies and further how this may play out for junior preferred and/or common shareholders.
Valuation And Risk
A new reply brief for class plaintiffs was filed that at least to me seemed to extend the notion that FHFA's interpretation of First Hartford and Delta Savings suggests that certain rights only exist in receivership and not conservatorship with the logic being that eventually the conservatorship may be converted into a receivership, implying that a perpetual conservatorship is the best of all worlds, where the government can keep taking everything and there's nothing you can do about it. That's really the risk of investing in Fannie Mae and Freddie Mac. If you think that is crazy, you aren't alone.
What gets even crazier is that political solutions here involve issuing new stock by exercising the warrants and providing that to affordable housing. The implication here is that after taking over $108B out of Fannie Mae and Freddie Mac through conservatorship, the solution is to then take 80% of what belongs to them and give it away to political interests. Fannie Mae and Freddie Mac are simply the gift that keeps on giving. In that outcome, Richard X. Bove has proposed a common stock valuation around $20, which is on the low side of the valuation provided by William Ackman.
Depending on how it is all resolved, things may get worse for common shareholders. It is possible, albeit unlikely in my opinion, that a reversal of the third amendment is paid to the companies to recapitalize them at which point the Senior Preferred Stock is converted to common massively diluting common shareholders, not unlike what happened during the AIG (NYSE:AIG) recapitalization. If you factor in the warrants into a resolution like that I'm not sure what if any upside is left for the common shares. That doesn't even begin to get at the possibility that the government may want to retain some form of preferred security that serves as a token reminder to the public that the implicit GSE taxpayer backing comes at a price. Ironic that this backing is really a tax collector backing if you ask me, but that nomenclature continues to get lost in the whirlwind of misinformation propagated in the name of preventing Fannie and Freddie from taking any credit for how great they are and sharing their greatness with the world.
Summary And Conclusion
It's tough to value two companies that give all of their money to the government at any price greater than $0, but there's a lot of money at stake, and this fact has not been lost on the government because it's happily been taking all of the money and part of that money has been used to fight private shareholders in court to prevent them from getting anything. It's kind of like bank robbers negotiating with themselves to buy the bank they are robbing with the money they are taking from inside the bank vault.
Fairholme says that these cases likely get adjudicated this year. That's promising for at least the preferred shareholders because as outlined above, it remains unclear how this plays out for common shareholders. Frankly, the problem is that FHFA is in charge, and that means it really isn't in charge. What I mean is that Treasury is calling the shots, and that means that the exit plan has probably already been deliberated and decided over, and that taking at least one more quarterly payment is in Treasury's best interest. If that's the case, then the question becomes how much capital do Fannie and Freddie have when this is resolved or adjudicated in some way and how long does it take for them to recapitalize or are they capitalized in the process of adjudication? I don't really know, but what I do know is that the preferred shares look like a lay-up of at least 100% return this year from these prices.
Disclosure: I am/we are long FNMAS, FMCKJ, FNMA, FMCC.
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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