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Michael Spacey
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This is a pseudonym. Started my career in structured finance, moved into corporate debt, and now I'm investing in equities. My investment style is focus on the fundamentals, figure out what the company is worth, then check across the capital structure for opportunities. Writing is a way for me... More
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  • Value Of GSE Preferreds Under Different Scenarios (Part I) 3 comments
    Mar 22, 2014 5:10 PM | about stocks: FNMA, FMCC

    Scenarios, Probability, and Estimated Returns for GSE Prefs

    I'm thinking through the possible outcomes for Fannie Freddie. Clearly there are lots of moving pieces but I think the key variables are:

    o Whether Johnson-Crapo plan (or similar plan) gets implemented. Basically this gets private sector to take a first loss before a government entity. Fannie/Freddie would be wound down.

    o Whether the 3rd amendment (the net worth sweep) is successfully repealed.

    o There exist another possibility which is the equitizing the jr. preferreds. Here I call it the "Fairholme Scenario" as the Fairholme proposal is an example of such outcome. This proposal not only has flexibility to operate as a private guarantor under Crapo-Johnson, but also makes the 3rd amendment essentially irrelevant.

    So the decision tree looks something like this. Also below are explanations for the (rough) probabilities that I assigned.

    (click to enlarge)

    · Johnson Crapo - (60% probability of getting passed) The chance of the bill getting implemented exactly "as is" would be almost 0%.. However the broad idea of a private sector "first loss" buffer has been gaining traction for more than a year, starting with Corker Warner and reconfirmed again by Johnson-Crapo. I believe this is a likely outcome as it strikes a sensible compromise between the far left (go back to a precrisis Frannie) and far right (zero government backstop). In this case Frannie would be gradually wind down, so that even if 3rd amendment gets repealed, Jr Prefs are worth at most 40% of par as they get say 8% * 5yrs of coupon payment before the whole thing gets wind down.

    · 3rd amendment - I'm willing to be aggressive and say there's a 70% chance it will be repealed as the hedge fund lawyers seem to be running circles around Frannies lawyers. Conservatively I'd say 50/50. At the end it really doesn't matter to the risk and rewards. The with the jr. prefs trading at ~45 cents on the dollar and assuming par recovery if 3rd amendment gets repealed, you're looking at 50 - 130% annualized return if lawsuit get resolved in one or two years. These are not good returns for a high probability of 100% loss.

    · The Fairholme Scenario (equitizing Jr Prefs): 1/3 chance of happening if Johnson Crapo gets passed. Importantly 1) the bill has left room for privatization in order to facilitate "a smooth resolution", 2) This is one of the only ways private investors get any value if the bill gets passed, and I expect investors to fight for it

    So how does the return distribution look? Not so great, theres about 24% chance of losing 100% of your money (Jr prefs worth 0 under scenario 2 & 4), and almost another 30% chance of losing a small amount (scenario 3). So we're talking about 50% chance of losing money. The Fairholme Scenario (Scenario 5) has estimated 20% probability and return of "??". This will need to be a 10 bagger for me to sign up to this trade. Is it?

    Estimated Return on the Fairholme Scenario (Part II Preview)

    Estimated teens return - I'll show the work in part II but here's the basic approach:

    · Calculate IRR for 10 years projected cash flow. Johnson-Crapo allows a 10yr phase in period for a private guarantor to ramp up to the 10% capital requirement.

    · Cash flow estimation as follows:

    o Beginning out flow = cost of jr preferred based on market price + extra capital from rights offering to meet ~5% capital requirement (% of UPB)

    o Intermediate flow = any capital injection (or releases) needed to meet capital requirements. This capital could be funded with debt or equity and we're only concerned with equity flows. Other constraints to model out are 1) keeping consolidated debt/capital at some target, 2) keep minimum holdco liquidity

    o Exit flow = earning * multiple (estimate 10-15x)

    Stocks: FNMA, FMCC
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Comments (3)
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  • Welt
    , contributor
    Comments (111) | Send Message
     
    Nice work, I like your return distribution calculations and table. Am I correct in assuming that the FNMA common has an even less favorable risk/return ratio than the preferred?

     

    I say this just because the preferred would have first dibs at the distributions/dividend...
    31 Mar, 12:53 PM Reply Like
  • Michael Spacey
    , contributor
    Comments (34) | Send Message
     
    Author’s reply » thanks, it's a different set of distributions and I think a worse one (at least for risk averse investors). Under this analysis the commons would only be worth something under scenario 1 (everything goes back to pre-crisis mode), and maybe negligible return under scenario 5 (gets diluted by preferreds)

     

    So you would have ~50% chance of losing -100%, ~20% chance of getting maybe single digit return, and ~30% chance of getting say a 400% return. Obviously the probabilities aren't anywhere precise but it's important to note that this is not a simple binary outcome like some people would suggest (for example "no 3rd amendment = 400% return, 3rd amendment get upheld = -100% return, 50/50 chance so expected value = +300%"). Instead, there's a range of outcomes in the middle that are quite mediocre which makes the overall distribution undesirable
    31 Mar, 10:55 PM Reply Like
  • Welt
    , contributor
    Comments (111) | Send Message
     
    Thank you for the response and your probabilities. It's such a tough scenario to even evaluate.
    1 Apr, 09:13 AM Reply Like
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