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In 2008, Derek Pilecki founded Gator Capital Management (http://www.gatorcapital.com). From 2003 through 2008, Derek was a co-Chair of the Investment Committee and a Portfolio Manager for Goldman Sach’s Growth Equity Team, where he helped to manage $30 billion in high quality growth stocks.... More
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Gator Capital Management
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  • Rebuttal to KBW’s “the GSEs are Worthless” Analysis
    On Monday, the respected financial services boutique brokerage firm,  KBW, published a report declaring the common and preferred shares of Fannie Mae and Freddie Mac to be "worthless." The conclusion of the report was based on a contrived scenario where Fannie and Freddie are separated into good-bank/bad-bank entities and the future profits are diverted away from paying down the government's ownership stake in the companies.  If this scenario were to happen, it would be another huge subsidy for the big mortgage banking firms at the expense of taxpayers like you and me.  
     
    Bank Co-operative Model is a Bad Idea
     
    Fannie and Freddie should not be restructured into bank-owned co-operatives. The brokerage report held up the FHLB System as a model for the future structure of Fannie and Freddie. The FHLB System is a poorly constructed system and is not an enviable model. The FHLB System allows the large banks to borrow money at government subsidized rates. The banks can use this borrowed money for any kind of lending they want such as auto loans, commercial loans, boat loans or even loans to foreign countries. This system has not prevented the FHLB Banks from posting large losses during the housing crisis. Another reason the FHLB System is bad is that it presents sizable systemic risks because it has no permanent capital. Members of the FHLB system can withdraw their capital on 90 days notice. In spite of nominally higher capital levels, the fact that FHLB capital is withdrawable makes the banks less stable than Fannie and Freddie. Moving Fannie and Freddie to a less stable capital structure is a bad idea.
     
    Good-Bank/Bad-Bank Proposal Doesn't Make Sense
     
    Separating Fannie and Freddie into a good-bank/bad-bank as the KBW authors propose will not work because it is not a classic good-bank/bad-bank restructuring. First, in this proposal, the bad bank can't support itself. Second, the authors transfer ownership of the good-bank to new owners. The concept of a good-bank/bad-bank split only makes sense if both entities are viable and self-supporting and have identical owners. The good-bank is a clean entity and can be more easily valued by the stock market. The bad-bank is capitalized to be self-standing and management can workout problem assets over time to realize maximum value without worrying about the timing of accounting gains or losses. The classic practical application was Mellon Bank in the 1980's. In this report, the authors propose setting up the bad-bank as a non-viable entity from the start, and they assume a transfer ownership of the good-bank without any compensation. I submit that you can claim any financial institution in the country is worthless under the authors’ version of a good-bank/bad-bank scenario.
     
    Holes in the KBW/GSE Model
     
    There are multiple problems with KBW’s model that shows Fannie and Freddie having problems paying back the Treasury.
     
    1. Bad-Bank Focus– As discussed earlier, as long as Fannie and Freddie are not separated into good-bank/bad-bank entities, they will be able to use revenue from new business to payoff the Treasury’s ownership position. Using the revenue from the good-bank will add $38 billion to Fannie and $25 billion to Freddie.
    2. Double Counting Operating Expense – KBW’s model has operating expenses double counted. This adds $14 billion in expense to Fannie and $10 billion in expense to Freddie.
    3. Severity Assumption is Too High – KBW uses 60% severity in its base case compared to John Hempton’s severity assumption of 45%. (BTW, the definitive analysis of the current value of Fannie and Freddie can be found in John Hempton’s series of blog postings on Fannie and Freddie.)   I trust Hempton’s assumption more than KBW’s as he builds it up by vintage year. This accounts for $29 billion at Fannie and $15 billion at Freddie.
    4. Mortgage portfolio run-off is much greater than mandated by Treasury – KBW assumes a run-off of the current on-balance sheet mortgage portfolio at a rate faster than mandated by the Treasury agreement. This accounts for $18 billion in lost revenue at both companies.
    5. Assumed NIM is low – KBW assumed a 1% net interest margin which is low given the steep yield curve. If we assume Fannie and Freddie can keep their current margin for a three more years then revert to a 1% margin, it adds another $19 billion of revenue to both companies.
     
    With these changes to KBW’s model, I calculate both companies can payback the Treasury:
     
    ($ billions)                                              Fannie           Freddie
    Assumed shortfall from KBW model          -49               -39
    No good-bank/bad-bank separation           +38              +25
    Not double counting expenses                  +14              +10
    Hempton’s severity assumption                +29              +15
    Slower portfolio run-off                              +18              +18
    Current NIM                                            +19              +19
    New Capital Surplus                                +69              +48
     
    With any model, the results are heavily dependent on assumptions. The user of a model must be well-versed in the assumptions before relying on its output. This analysis shows that by changing (and/or correcting) a few assumptions in the KBW/GSE model that the companies have plenty extra capital to pay back the Treasury, which is the opposite conclusion of the KBW report.
     
    Another important assumption in the KBW model, which makes the GSEs’ capital positions look weaker is the assumption that they cannot raise capital from the public markets. Once the GSEs return to profitability, they may be able to raise equity to repay the Treasury.
     
    Conclusion
     
    The GSEs aren’t worthless until Congress restructures them and shareholders no longer have valid claims. Until Congress passes a law, the GSEs are working hard to mitigate their problem loans and to provide continued credit support to the housing market. Their income statements will flip from posting losses to reporting positive net income as we pass the peak loss years on the mortgages of 2006-2008. Freddie reported a profit in the last quarter, and it will be difficult to wipeout Fannie and Freddie shareholders once they return to sustained profitability.

    Long: FNM & FRE preferred; no position FNM & FRE common
    Tags: FNM, FRE, housing
    Oct 20 04:17 pm | Link | 1 Comment
  • Make Fannie's Deal No Worse Than TARP
    Given Freddie Mac’s recently report profitable 2nd quarter earnings report, it is time for Treasury Secretary Geithner to amend the terms of Fannie Mae and Freddie Mac’s Senior Preferred Stock Purchase Plan with the Treasury to be comparable to the preferred stock purchases the Treasury made in commercial banks last October under TARP.
     
    Reasons to Change Fannie and Freddie’s Deal with the Treasury

    1. Fannie and Freddie should not have a materially worse deal than the banks just because their deal was cut 4 weeks before TARP.
    2. Fannie and Freddie are critical to the domestic economy as they have been the only source of mortgage capital for the past 12 months.
    3. The mortgage market will need private capital in the future and cannot rely on government support forever, so Fannie and Freddie will have to raise more capital in the future. If the GSEs are going to raise capital in the future, the Treasury is going to have to treat existing capital better than its current deal with the GSEs.
    4. Fannie and Freddie incurred higher expenses because they were team players and supported the Obama Administration’s economic recovery plan. Changing their deal would be a small payback for the support they have given the country and the Administration.
    5. Recognition that placing the GSEs in conservatorship was a political attack by led by former Treasury Secretary Paulson and Fed Governor Kevin “Hey, Brah” Warsh.
    6. Recognition that former Treasury Secretary Paulson caused a decline in the GSEs stock prices by not outlining the terms under which he would provide capital to the GSEs in the July 2008 legislation. Sec. Paulson then used circular reasoning in claiming that the GSEs had to be taken over because they had low stock prices and couldn’t raise capital. In fact, they couldn’t raise capital because he would not state the terms of a potential future Treasury investment.
    7. Paulson’s reasoning for the harsh treatment of GSE shareholders was that shareholders had to pay for the poor risks taken by the companies’ management teams. I disagree since many shareholders were giving advice to the respective managements to raise capital and reduce risk. Rich Pzena was the most outspoken shareholder on this point. Plus, Paulson reversed his position on this issue once he was proven wrong with his handling of the Lehman situation and treated the bank shareholders on much more friendly terms.
    8. Eliminating the dividend on Fannie and Freddie’s preferred stockholders was a failed experiment on the part of Sec. Paulson and destroyed the new issuance market for preferred stock.  It also hurt many small banks that held Fannie and Freddie preferred stock in their portfolios. 
    9. GSE preferred stock is still primarily owned by small banks.  When dividends are restored, the value of the preferred stock will increase by 10x.  This will add approximately $30 billion in restored capital to the commercial banking industry.  If banks levered this capital 12x, this raises industry lending capacity by $360 billion.
    10. The losses by the GSEs since entering conservatorship have been inflated because a) they are mostly write-downs of deferred tax-assets which the companies still retain and b) the credit reserve build was bigger than expected because Sec. Paulson sent the economy into a tailspin by not providing an orderly wind down to Lehman Brothers.
     
    Terms to Change

    1. Lower Preferred Stock Coupon to 5% from 10%. There is no justification for the GSEs to pay a higher coupon than the banks.
    2. Change the Treasury’s warrant from 79.99% of the GSEs’ equity to terms identical to the warrant deal received by the banks under TARP. Similar to the preceding point, there is no justification for the GSEs to give the U.S. a higher equity stake for than the banks did.
    3. Make the Treasury’s preferred stock pari passu with existing preferred stock. This is another move to equal the banks’ deal under TARP
    4. Eliminate asset size restrictions on Fannie and Freddie’s mortgage portfolios. This provision proves my Republican conspiracy theory for placing the GSEs into conservatorship. There is no reason to shrink the GSEs at this point.  We need the GSEs to expand their balance sheets. The Fed has temporarily stepped into the breached left by the GSEs not growing. But, what is going to happen when the Fed steps back from the mortgage market? We need the GSEs to support the market as the Fed reduces its balance sheet.
     
    The GSEs deal with the Treasury Secretary should be updated to be similar to the deal the banks received under TARP. Based on the nobler GSE housing mission, there is an argument that they should be treated better than the banks. The banks have no legs to stand on because the FDIC insurance they receive from the federal government is a larger subsidy than the implicit guarantee Fannie and Freddie enjoy.

    Disclosure: Long FNM preferred and FRE preferred, No position in FNM or FRE common
    Tags: FNM, FRE, Housing, Public Policy
    Aug 26 07:48 am | Link | Comment!
  • You Don't Want Berkshire to Pay Dividends

    This year Carol Loomis asked the question whether Berkshire should start paying dividends since the stock price hasn’t risen in 5 years.  This was in reference to Buffett longstanding quote that he will pay a dividend when he thinks he can’t create at least $1 of market value for each $1 of retained earnings.  Jeff Matthews refers to this as a question that Buffett avoided answering in this thought provoking blog post.

    My opinion is who cares whether Buffett answered the dividend question. If you are even asking the question, you should sell your Berkshire stock. The reason to own Berkshire is to get access to Buffett’s capital allocation decisions. Based on his well-documented track record and his well-know thought process, most Berkshire investors think Buffett can make better investment decisions and/or has access to better investment opportunities than they do. The last thing Berkshire investors should want is to have Buffett return the cash back to them in a taxable transaction. Then, the investors will have to decide how to allocate the returned cash.

    Historically, investors have wanted management teams to pay dividends because they don’t trust management to spend the free cash flow from the business wisely. The business may be not need capital reinvestment, like Coca-Cola, or it may be a business in secular decline where the best thing to do is harvest the cash rather than reinvest. Shareholders of these businesses probably want managements to pay dividends to make sure they don’t destroy value.

    Since the main reason to own Berkshire is to get access to Buffett’s capital allocation skills, if an investor wants Berkshire to pay dividends, then they should sell the stock instead because they obviously don’t believe in Buffett’s ability to create value by allocating capital.

    There is a scenario where it makes sense for an investor to want Berkshire to pay a dividend. Maybe an investor thinks Buffett destroys value but think Berkshire is so undervalued that they can make a return by owning the stock and getting him to change his dividend policy. I don’t think Berkshire is anywhere close to a valuation level where this would make sense. At $91,500 per share, Berkshire trades at 1.4x tangible book. It would have to trade below tangible book value for this strategy to make sense.

    The reason to invest in Berkshire is get access to Buffett’s skills as a capital allocator. If you want him to pay a dividend, you shouldn’t own the stock. You should ignore the 5-year rolling test about whether he adds more $1 of value for each $1 of retained earnings. He is never going to pay a dividend because he’ll never admit that he can’t add value. If he ever does decide to pay a dividend, you won’t want to own Berkshire.

    Disclosure: Long KO and no position BRKa, BRKb.

    Tags: BRK.A, BRK.B, KO, dividends
    May 27 05:35 pm | Link | Comment!
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