Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) are two Fortune 50 companies that shareholders are fighting in court to get back from tax collectors who usurped control in 2008 and transferred over $100B in cash from taxpayers to themselves so far. The Housing and Economic Recovery Act of 2008 (HERA) is the statutory framework governing the Federal Housing Finance Agency's (FHFA's) conservatorship of Fannie and Freddie which are often referred to as the Government Sponsored Enterprises (GSEs). The conservatorship began innocently enough, by questioning solvency, ignoring liquidity and then entering into an off-balance sheet accounting agreement in a conservatorship that gives the government control and all the rights of shareholders; in its own words, "all rights means all rights."
As long as Fannie Mae and Freddie Mac are run by tax collectors on behalf of tax collectors and are maximizing tax revenue for tax collectors shares owned by taxpayers are intrinsically worthless because their discounted cash flows are $0.
GSE Equity Investment Thesis: For starters, the government's death grip on the GSEs is so fierce one doesn't have to wonder very long why the government wants them so bad. At first, the government started by taking all of their money, but the government is setting goals for the GSEs that give away their money to Wall Street according to the prior CFO of Fannie Mae's analysis of CAS Notes. Factor out the current level of G-fees and factor in the possibility of a change in capital requirements and you're on your way to valuing the equity. Combined at current levels Fannie Mae and Freddie Mac make somewhere between $10B and $25B per annum and what doesn't get transferred to Wall Street using CAS Notes now goes to the government. There are two types of equity in the GSE universe: common and preferred. Richard X. Bove and William Ackman suggest share valuations starting at $20, but I'm not so sure. I figure the preferreds will be at par soon enough due to the accounting lawsuits.
Perry Capital Appeal - Any Tuesday or Friday This Month
Assuming the Perry Capital Appeal reverses the net worth sweep, the government may declare victory by further diluting the commons either by issuing more shares or regulating their earnings power.
Richard Epstein suggests that the leading reason to end the conservatorship is because FHFA has proven itself incapable of conserving:
Indeed, perhaps the strongest reason to end the conservatorship is that there is under current law no way that these shareholders can challenge FHFA in its administration of Fannie and Freddie assets. It is always risky business to have a faithless trustee in charge, and that is what seems to be the case here. It should be evident that the entire matter has been mishandled from start to finish. It is time for the Circuit Court to set matters right.
CAS Notes Sound Like Money Laundering According to Prior Fannie CFO Timothy Howard
Prior CFO of Fannie Mae Timothy Howard has taken a deeper look at the Connecticut Avenue Securities (CAS) risk-sharing transactions. I've attempted to pick excerpts that summarize his perspective:
I never would have guessed this.
They are a sham, and a complete waste of the company's money.
For this tranche, which is supposed to absorb losses that exceed 2.75 percent of the pool up to a maximum of 4.0 percent, there is no scenario, out of 64, in which it is shown to take any losses.
Fannie is offering investors a "risk-sharing" security that according to its prospectus is risk free.
I think I know what's going on here. At Treasury's urging, FHFA has set a goal for Fannie to "transfer credit risk on at least 90 percent of the unpaid principal balance of newly acquired single-family mortgages in loan categories targeted for risk transfer." Fannie has chosen CAS transactions as the main way to meet that goal.
Wall Street has every incentive to sustain this charade: it has a committed issuer (Fannie), a happy group of 1M-2 Note buyers (who so far this year have gotten securities with little risk, paying an average floating rate of LIBOR plus 550 basis points), and a very happy group of 1M-1 Note buyers (who have gotten securities with no risk, at a floating rate of LIBOR plus 190 basis points). The mystery is why Treasury and FHFA keep pushing what its prospectuses make clear is a Potemkin program.
The money that gets transferred out of the GSEs before these risk sharing transactions used to only go to the government. These risk sharing transactions open up the doors to transferring GSE net revenue to taxpayers.
Prior CFO Timothy Howard calls this a Potemkin program, but handing away someone else's money for nothing is more than just a house of cards or a Truman show. Kangaroo court or money laundering sound more applicable because FHFA seems to be allowing those who participate in the CAS program to front run the tax collector net worth sweep. I would expect that in the event the new lack of capital paradigm gets reversed in court that perhaps one of the first things to go would be the CAS program.
Tax Collectors Running GSEs As Government Tax Collecting Agency
Earnings figures for Fannie and Freddie do not include the 10 basis points of guaranty fee income that borrowers pay as a result of the 2011 Temporary Payroll Tax Cut Continuation Act which resulted in $732 million of such fees being collected and passed onto the Treasury Department.
According to a real estate lobbyist in an email exchange with IMFnews, the current g-fee charges are rip-offs. According to IMFnews, industry trade groups are becoming more vocal regarding what they view as high guarantee fees.
The implication is that if plaintiffs prevail in their lawsuits and redirect this money back to the companies that earned it, the government will have less incentive to keep the g-fees as high as they are. It would appear that in this sense the government doesn't mind charging taxpayers more than they'd let taxpayers charge themselves as long as it is taking the money.
Preferred Shares May Have More Upside Than Just Par
If you are operating under the assumption that there was a breach of contract and the net worth sweep converted the government's senior preferred into common then part of a settlement may result in shareholders on a settlement date getting paid back dividends. If you combine this outcome with the cash flow being put back to the GSEs due to FHFA accounting fraud getting caught by the lawsuits filed in Florida, then some of the preferreds that are currently trading at less than 20 cents on the dollar may get back dividends greater than the price they can be bought for today. In my case, these dividends could more than extinguish the debt that I've taken on to buy them.
Summary & Conclusion
As a shareholder, this is all very disheartening. I was under the impression that the government was where all the GSE's money was going. It seems that is no longer the case. It seems that money is now escaping through so-called risk sharing transactions that in reality are as risk-free as you can get. Judge Sweeney continues to release government documents that are cited by plaintiff briefs but there are still over 10,000 documents that the government is withholding that plaintiffs are fighting for with a motion that is fully briefed and pending ruling.
This is not your usual investment opportunity. The premise is that you're effectively betting on a failure to nationalize. Fortunately for investors the evidence stacks up. The government's interpretation of the law requires piecemeal reading, incomplete administrative records, and an acceptance that they can do whatever they want. Fortunately for the government's defense Lamberth agreed. On the outset of a legal victory for plaintiffs, the government still regulates capital levels and g-fees. It remains to be seen what happens with the warrants which is one of the biggest wild cards for common shareholders. Given the nature of the CAS deals, the PSPA combined with massive non-cash accounting writedowns 2008-2012, and the net worth sweep it is safe to say that the government has been in complete control thus far. It will be interesting to see how that changes with legal rulings.
Disclosure: I am/we are long FMCCH,FMCCP,FMCCT,FMCKI,FMCKO,FMCKP,FNMFN,FNMFO.
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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