Q1. What is the purpose of this article?
A1. The purpose of this article is to highlight recent developments with respect to Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC), which are together known as the government-sponsored enterprises or GSEs.
As the recent Freddie Mac and Fannie Mae earnings reports for 2Q2016 make clear, the GSEs are very profitable companies. However, those profits have, since August 17, 2012, flowed to the coffers of the U.S. Treasury (Treasury), rather than being retained at the GSEs, thereby rebuilding book equity capital. Thus, Treasury receives the benefit from the GSEs' earnings recovery rather than the GSEs' common and preferred stockholders, who ordinarily are entitled to the residual after the firms' other obligations have been met.
This situation continues to be the subject of litigation in various U.S. District Courts (in DE, IL, IA, and KY), the U.S. Court of Appeals, and the U.S. Court of Claims. The ongoing litigation has to do with the 3rd Amendment to the Senior Preferred Stock Purchase Agreements (SPSPAs), which are formal agreements between the U.S. Treasury and the two GSEs, approved by the FHFA. As conservator, the FHFA is supposed to act on the GSEs' behalf.
The 3rd Amendment to the SPSPAs was announced by Treasury and FHFA on August 17, 2012. With the continued release of documents "discovered" at the Court of Claims, it has become increasingly clear that Treasury expedited the 3rd Amendment process because it realized that the "window" for instituting the net worth sweep would soon disappear. The FHFA, in apparent violation of HERA of 2008, seems to have "gone along" with Treasury's proposed 3rd Amendment. For all meaningful intents and purposes, it has become increasingly clear that the Treasury has effectively become the co-regulator of the GSEs.
Suffice it to say that these issues are extremely important for GSE common and preferred investors. I would caution investors to evaluate these issues carefully before investing in GSE common and/or preferred stocks.
Q2. Freddie Mac recently reported its 2Q2016 earnings. Do you have any comments?
A2. Yes, I do. Freddie Mac reported total comprehensive income for the 2nd quarter of $1.1 billion. $933 million of this will flow to Treasury via the 3rd Amendment. Net income was $1.0 billion.
After the September 30, 2016 dividend payment, Freddie Mac will have paid $99.1 billion of dividends to Treasury, compared to draws of $71.3 billion.
Freddie Mac reported derivative (deriv) losses of $2.058 billion in 2Q2016, compared to $4.561 billion the previous quarter. Generally, it can be said that Freddie Mac experiences deriv losses when the Treasury yield curve goes down in a quarter and deriv gains when the Treasury yield curve goes up in a quarter. Note that this is a simplification that doesn't exactly reflect Freddie Mac's hedging practices. Still, the Treasury yield curve went down substantially in 1Q2016, leading to large deriv losses, e.g., the 5-year T bond went down by 49 basis points in 1Q2016 compared to 24 basis points in 2Q2016. In 2Q2016, deriv losses were about 45 percent of 1Q2016 deriv losses.
In a previous Seeking Alpha article, I noted that about one-half of Freddie Mac's draws on the Treasury resulted from deriv losses. The Treasury yield curve went down dramatically with the advent of the 2008 financial crisis and remains low compared to "normal" historical conditions. Given this, my hope has been that eventually the Treasury yield curve will go back up and that Freddie Mac will have deriv gains rather than deriv losses going forward.
Freddie Mac notes in its earnings news release that:
In an effort to reduce the probability of a draw due to changes in interest rates, the company entered into certain structured transactions that have resulted in additional financial assets being recognized and measured at fair value. In addition, the company continues to explore other strategies and activities that may reduce the probability of a draw.
My concern here is that Freddie Mac's financial advisors and investment banks may be more interested in helping Freddie Mac's deriv counterparties than helping Freddie Mac. The deriv counterparties, obviously, would be motivated to unwind the deriv transactions once it becomes evident that deriv gains are more likely than deriv losses. It is not necessarily the case that Freddie Mac's financial advisors are focusing solely on what is best for Freddie Mac and its investors.
Q3. Do you have any comments about Fannie Mae's 2Q2016 earnings?
A3. Yes, I do. Fannie Mae reported total comprehensive income of $2.9 billion for 2Q2016, with a dividend of $2.9 flowing to Treasury in September 2016. Net income was also $2.9 billion.
Deriv losses (formally, "net fair value losses") were $1.7 billion in 2Q2016, compared to $2.8 billion in 1Q2016. Thus, Fannie Mae's deriv losses were less than those of Freddie Mac, even though Fannie Mae is a substantially larger company. This helps to explain why Freddie Mac is especially interested in reducing its exposure to volatility in deriv gains/losses.
As of the September 30, 2016 dividend payment, Fannie Mae will have paid a total of $151.4 billion in dividends to Treasury, compared to draws on the Treasury of $116.1 billion.
Q4. In your opinion, did Fannie Mae and Freddie Mac undervalue tax assets and overstate loan loss reserves during the 2008-2012 period?
A4. No. Allegations have been made that the GSEs' accounting for deferred tax assets (DTAs) and loan loss reserves during the 2008-2014 period were unreasonable.
In light of what was known at the time, it is my view that the GSEs' accounting practices with respect to deferred tax assets (DTAs) and loan loss reserves cannot readily be said to have been unreasonable. Fortunately, the GSEs' recovery from the financial crisis was successful. The GSEs accounting statements reflected this improvement in a timely and reasonable manner.
During the midst of the financial crisis, there was uncertainty about the GSEs' future profitability. Thus, a "valuation allowance" was created which effectively zeroed out the DTAs, leading to significant book losses, which resulted in very bad earnings losses. Based on what was known during the midst of a financial crisis, it was not unreasonable to expect that the GSEs would be unprofitable for the foreseeable future.
The most important question is whether the GSEs reversed the valuation in a timely and reasonable manner once it became clear that the GSEs' profitability had recovered to the point that they could be expected to be profitable going forward. Once the GSEs had restored their profitability, then there was the question of whether the GSEs' restored profitability justified the release of the DTAs. The basic "rule of thumb" is that two years of actual positive earnings and an expectation of profitability for two or more years in the future would justify releasing the DTA valuation allowance.
In the period before August 17, 2012, it was known by FHFA and Treasury that Fannie Mae was returning to profitability and that the release of the DTA valuation allowance could occur in the relatively near future. As it turned out, this was announced in the 1Q2013 earnings release. It is my understanding that the 2012 10-K was delayed as a result of a dispute about the release of the DTAs, resulting in a delay until 1Q2013. For Freddie Mac, the release of DTAs was announced in the 3Q2013 earnings release (Freddie Mac had had an earnings loss in 2Q2011, which delayed the release of Freddie Mac DTA valuation allowance). Thus, it is hard to see that the GSEs' accounting for DTAs was unreasonable during the 2008-2014 period based on what could be known by a prudent and diligent company and its auditors at the time.
I also find that Freddie Mac's accounting for loss reserves cannot be said to have been unreasonable based on what was known at the time. I haven't examined Fannie Mae's accounting for loss reserves.
Freddie reported a benefit (rather than a provision) of loss reserves of $775 million in 2Q2016, compared to $467 million the previous quarter. This is the 6th consecutive quarter that Freddie Mac's earnings have been higher than would otherwise be the case because loss reserves were reduced. Moreover, during the 2012 to 2015 period, Freddie Mac increased loss reserves in only five of the 16 quarters (three quarters in 2012 and two quarters in 2014). This is not to say that Freddie Mac (per the FHFA's guidance) had necessarily over reserved for credit losses during the 2008-2011 period.
It is probable that Freddie Mac's decisions regarding the provision of loss reserves were not unreasonable based on what was known at the time. It is just that things have worked out well compared to what was expected at the time of the 2008-2010 financial crisis, e.g., Freddie Mac's serious delinquency rate is now down to 1.08 percent, compared to 4.03 percent in January 2010. This has allowed Freddie Mac to reverse out loss reserves over the last few years, thereby increasing its earnings.
In a previous Seeking Alpha article, I investigated Freddie Mac's loss reserve practices. I found that "[m]y view is that, with the benefit of hindsight, the increases in loss reserves that Freddie Mac's management made during the 2008-2010 period seem reasonable." I noted that the most important point of the story for Freddie Mac investors (including the Treasury) was that recoveries and transfers have reduced the net charge-offs borne by Freddie Mac investors. Indeed, FHFA might not have been as motivated in pursuing put-backs and fraud (improper disclosure) cases against the banks but for the 3rd Amendment.
Q5. You've previously raised the question of whether Treasury is effectively the co-regulator of the GSEs. Has any new information come to light?
A5. Yes. Discovery at the Court of Claims has been useful in terms of making it more and more clear that Treasury was directing and supervising FHFA. Certain documents have entered the public domain that were identified via discovery at the Court of Claims.
Two pages (pp. 54-55) of a deposition of Jim Parrott have become public. Note that Mr. Parrott served for several years in the White House as a senior advisor at the National Economic Council, where he led the team of advisors charged with counseling President Obama and the cabinet on housing issues. During his deposition, Mr. Parrott was asked a question about whether White House staff had reached out to "folks on the Hill," i.e., Congress, during the period before the 3rd Amendment was announced. Mr. Parrott stated under oath in the deposition that "this was a Treasury-driven process. So to the degree there was outreach to the Hill, it would have come from Treasury, not from, from me." Thus, it appears that Treasury was "leading the charge," while keeping the White House informed and involved.
Note that Jim Parrott was enthusiastic about the 3rd Amendment. In an email dated August 18, 2012, Jim Parrott wrote to key Treasury staffers that:
You guys did a remarkable job on the PSPAs this week. You delivered on a policy change of enormous importance that's actually being recognized as such by the outside world (or the reasonable parts anyway), and as a credit to the Secretary and the President. It was a very high risk exercise, which could have gone sideways on us any number of ways, but it didn't-great great work."
Without putting words in Mr. Parrott's mouth, it may be the case that the 3rd Amendment was a "high risk exercise" because it flows all of the GSEs' earnings to the Treasury, preventing the GSEs from rebuilding their book equity capital and from restoring dividends to its common and preferred investors. Mr. Parrott points out that:
No principal is written down no matter what the quarterly payment is. Dividend is variable, set at whatever profit for quarter is, eliminating ability to pay down principal (so they can't repay their debt and escape as it were).
This is the so-called "fellow traveler" email where Mr. Parrott says he "feels like fellow travelers at this point" with Peter Wallison, Ed Pinto, and Alex J. Pollock of the American Enterprise Institute (AEI).
Mr. Parrott, in another email, points out that:
[W]e've closed off possibility that they every go (pretend) private again and sped up the clock on the wind-down of their portfolio, all while increasing the stability of the market by removing concern that these guys run out of support before we have a place to which to transition.
This comment was drafted as a possible response to a question from a staffer for Congressman Garrett (R-NJ).
This exercise may also have been "high risk" because it is not consistent with HERA of 2008, which states that:
(7) AGENCY NOT SUBJECT TO ANY OTHER FEDERAL AGENCY.-When acting as conservator or receiver, the Agency shall not be subject to the direction or supervision of any other agency of the United States or any State in the exercise of the rights, powers, and privileges of the Agency.
Q6. Does FHFA appear to accept that Treasury is a co-regulator of the GSEs?
A6. Yes. Director Mel Watt has said that any changes to the SPSPAs "would have to be initiated by Treasury, not by me," Thus, Director Watt seems to accept that he is under the direction and supervision of Treasury with respect to the SPSPAs.
Q7. Please discuss how FHFA notified GSE common and preferred stock investors on the 3rd Amendment.
A7. Acting Director DeMarco provided this notice on August 17, 2012:
The steps taken today between the Federal Housing Finance Agency (FHFA), as conservator of Fannie Mae and Freddie Mac, and the U.S. Department of the Treasury to amend the Preferred Stock Purchase Agreements (PSPAs) are important for ensuring stability in the housing finance market. These steps reaffirm our commitment to move forward with the components of the Strategic Plan for the Conservatorships of Fannie Mae and Freddie Mac, which includes building for the future, gradually contracting their operations, and maintaining foreclosure prevention activities and credit availability. Replacing the current fixed dividend in the PSPAs with a variable dividend based on net worth will help to ensure stability, fully capture financial benefits for taxpayers, and eliminate the need for Fannie Mae and Freddie Mac to continue to borrow from the Treasury Department to pay dividends. As Fannie Mae and Freddie Mac shrink, the continued payment of a fixed dividend could have called into question the adequacy of the financial commitment contained in the PSPAs. In addition, the faster reduction in the retained mortgage portfolio will further reduce risk exposure and simplify the operations of Fannie Mae and Freddie Mac.
These changes provide certainty to Fannie Mae, Freddie Mac and market participants as they continue to perform their critical mission of providing liquidity and stability to the country's housing market. The steps today are also important as Congress and policymakers contemplate the future of Fannie Mae and Freddie Mac.
Q8. In your opinion, did this provide sufficient notice to investors in GSE common and preferred stocks?
A8. No. It is my understanding as an economist and financial analyst that even in an "informal adjudication" under the Administrative Procedures Act of 1946 that:
Occasionally, the Constitution itself may transform an informal adjudication into a more formal one, because the Constitution imposes 'due process' requirements when the government takes from a person his 'life, liberty, or property. The process 'due' typically involves notice, opportunity to present arguments and evidence and to cross-examine witnesses, an impartial decision maker, and possibly legal counsel.
As I've discussed in other Seeking Alpha articles here and here, I'm using Justice Breyer's book on Regulation and its Reform as my authority on "informal adjudication" and "due process." It appears to me that:
1. The FHFA failed to give GSE common and preferred investors "notice of what they intended to do well in advance of their doing it."
2. FHFA did not "provide reasons for their action and publicly present evidence supporting it."
3. FHFA did not allow GSE common and preferred investors to "present arguments and evidence" before the FHFA's decision was made.
4. FHFA must "overcome court review of showing through argument and evidence that their position is reasonable." This is where we are today. Investors in GSE common and preferred stocks await court review of the 3rd Amendment.
Q9. FHFA references its Strategic Plan in its August 17, 2012 press release. Did this document provide adequate notice to GSE common and preferred investors that their investments in GSE securities had been expropriated?
A9. No. While FHFA focuses on "taxpayers" throughout the document rather than GSE common and preferred investors, nowhere in this document is there an explanation of how and why it was that the GSEs were no longer entitled to share in the benefits of the GSEs' future profitability. Nor was there provided notice, opportunity to provide arguments and evidence, an impartial decision maker, and representation by legal counsel. [Note: I suspect that FHFA wasn't obligated to ask for public comment of its Strategic Plan.]
Q10. Has Acting Director DeMarco admitted that capital requirements are an important consideration in GSE regulation?
A10. Yes. In his deposition, Acting Director DeMarco admitted that capital levels was "a key regulatory responsibility of the agency - or as I have stated, is a key component of the safety and soundness of a regulated financial institution." Nevertheless, DeMarco agreed to the 3rd Amendment, which prevents the GSEs from building up their book equity capitalization via the retention of earnings thereby preventing them from achieving safety and soundness.
Q11. Is there any evidence that the Acting Director DeMarco was not an impartial decision maker?
A11. Perhaps. Discussion of this question, however, will have to await coverage in a future Seeking Alpha article.
Disclosure: I am/we are long FNMAS, FMCKJ, AND OTHER GSE PREFERRED STOCKS.
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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