Pershing Square Capital Management, L.P. sent the following letter Friday
to the U.S. Treasury Department regarding Fannie Mae (NYSE: FNM) and
Freddie Mac (NYSE: FRE):
• • •
September 5, 2008 The Honorable Henry M. Paulson, Jr. Secretary United
States Department of the Treasury 1500 Pennsylvania Avenue, N.W.
Washington, D.C. 20220
Re: Fannie Mae/Freddie Mac Restructuring
Dear Secretary Paulson:
We understand that a Treasury plan for Fannie/Freddie (“the GSEs”) may
be announced this weekend. We thought you might find useful some further
thoughts on potential GSE solutions.
As you are likely aware, we had previously distributed a proposed
restructuring plan for the GSEs. In that plan, under a prepackaged
conservatorship, equity interests would be extinguished, subordinated
debt would be exchanged for warrants, and senior debt would be exchanged
for new senior debt and common equity in the newly recapitalized
entities. The government would write a put to the new common equity
holders which would expire in three years.
It appears, however, that the GSEs may need help more quickly, and
conservatorship may not be triggered until the GSEs are formally
determined to be undercapitalized. As such, in the event the government
needs to inject capital immediately, we suggest you consider the
following transaction (“the Transaction”).
In order to minimize risk to taxpayers while being equitable to other
constituents, we suggest that the Treasury consider purchasing senior
subordinate debt in the two companies in an amount sufficient to address
their capital needs in the short to intermediate term. This senior sub
debt would be junior in right of payment to the outstanding senior
unsecured debt and senior to the outstanding sub debt, preferred stock,
and common equity. We refer to the outstanding sub debt, preferred and
common stock as “the Subordinate Securities.”
The issuance of senior sub debt is permitted under the GSE legislation
and under the existing terms of the outstanding debt and equity
securities of the two entities (please see the attached memo for further
details). As a condition of Treasury’s purchase of senior sub debt, the
GSEs would defer the interest payments on the outstanding sub debt
(which can be deferred for as much as five years), and the dividend
payments on preferred and common stock. All of the Subordinate
Securities would continue to remain outstanding according to their
The new senior sub debt should have a market-based coupon and Treasury
should receive low-strike price warrants (penny warrants) for a
substantial portion, i.e., 49% of the two companies. The coupon and
warrant structure should be as close to fair-market-value terms as
possible. The ultimate determination of fairness would be the
willingness of non-government investors to purchase the Transaction
securities on the same basis as Treasury. As part of the Transaction,
the GSEs would deleverage their capital structures by paying down senior
debt from the free cash flow generated by their core businesses further
improving the position of the new senior sub debt.
The benefits of the Transaction are as follows:
• The Transaction can be accomplished under the existing terms of the outstanding GSE securities without any required consent other than from the GSEs.
• The new security would be senior in right of payment to the existing sub debt and preferred stock minimizing the risk to tax payers while providing substantial support to the outstanding senior debt that has been deemed implicitly guaranteed by the government.
• The new debt interest payments would be tax deductible, reducing the after-tax cost of capital to the GSEs, particularly when compared with preferred stock.
• In the event the outlook and performance of the GSEs and their assets were to improve dramatically, the senior sub debt could be redeemed, distributions to the Subordinate Securities could resume, and their values would increase accordingly.
• In the event that the GSEs’ fundamentals continued to deteriorate and they became undercapitalized, the GSEs could be placed in conservatorship. In
conservatorship, their balance sheets could be restructured along the
lines of our original plan or another plan with the Treasury’s senior sub debt treated preferentially to the Subordinate Securities, again minimizing risk to the tax payer.
• The Transaction would be fundamentally fair to all constituents and would respect the existing terms and corporate hierarchy of all outstanding GSE securities.
• The Transaction would minimize moral hazard issues for sub debt, preferred, and common stock investors.
Most importantly, we believe there are serious negative implications for
other large financial institutions in the event the Treasury were to
bail out Subordinate Security holders. The Treasury and OFHEO have done
substantial research on the benefits to capital market discipline from
large financial institutions’ issuance of subordinate debt, and the
destructiveness of the government implicitly or explicitly guaranteeing
See: Report to Congress “The Feasibility and Desirability of Mandatory
Subordinated Debt”, Board of Governors of the Federal Reserve System and
United States Department of the Treasury (December 2000), available at:
“Subordinated Debt Issuance by Fannie Mae and Freddie Mac”, Valerie L.
Smith, Office of Federal Housing Enterprise Oversight, OFHEO WORKING
PAPERS, Working Paper 07 – 3 (June 2007), available at
“Signals from the Markets for Fannie Mae and Freddie Mac Subordinated
Debt”, Robert N. Collender, Samantha Roberts, Valerie L. Smith, Office
of Federal Housing Enterprise Oversight, OFHEO WORKING PAPERS, Working
Paper 07 – 4 (June 2007), available at:
(Due to its length, this URL may need to be copied/pasted into your
Internet browser's address field. Remove the extra space if one exists.)
“Subordinated Debt and Bank Capital Reform”, Douglas D. Evanoff, Federal
Reserve Bank of Chicago, Larry D. Wall, Federal Reserve Bank of Atlanta,
FRB Atlanta Working Paper No. 2000-24 (November 2000), available at
To the extent the Treasury were to bail out the GSEs’ subordinate debt –
which was: (1) never implicitly guaranteed by the government, (2) always
rated below Triple A by the rating agencies, and (3) held by investors
who knowingly took on the risk of loss in exchange for a substantial
credit spread above the GSEs’ senior debt – it would endanger the
systemic benefits from subordinate debt issuance for every highly
leveraged banking institution in the world and the capital markets at
Furthermore, we do not believe that the Treasury can purchase GSE sub
debt, preferred stock or common stock without incurring an immediate
loss to tax payers because of the enormous amount of existing debt
senior to these instruments. At a market coupon or dividend yield (to
the extent that one were to exist), any debt issued pari passu to the
existing sub debt, or preferred stock issued pari passu or even senior
to the existing preferred stock would require a yield that would be
uneconomic for the GSEs. No third-party investor would purchase these
securities regardless of their terms in light of their junior position
in the GSEs’ capital structure.
Please note that Pershing Square and affiliates own CDS on the
subordinate debt of the GSEs. We also note that nearly all participants
in the capital market debate on the GSEs are either long or short the
outstanding GSE securities.
We are contemporaneously releasing this letter to the public in the
interest of market transparency.
William A. Ackman