Part 1. The Straightforward Brilliance of Dr. Rossi's Restructuring Plan
Albert Einstein is credited with the following expression, which is based on a principle dating back to the 14th century:
"Everything should be made as simple as possible, but not simpler."
Many people call this Ockam's Razor and the dumbed-down version is "the simplest solution is usually the best one."
What is the future of the GSEs?
With most problems, you start with a series of inputs. Here are some facts.
Bailout Costs Paid Back
Taxpayers have been paid back on the Senior Preferred Stock Purchase Agreement. This is evidenced by the basic math. $187 billion cash paid out is offset by $218 billion cash received by Treasury.
The GSEs are profitable again. Fannie Mae's latest $3.7 billion quarterly profit amounts to an annualized amount close to $15 billion. Freddie Mac's recent profit of $1.9 billion means they are capable of about $8 billion in annualized profits. The Guarantee Fees created by the GSE Mortgage Backed Security (MBS) issuance are the biggest reason for the profitability and the $23 billion per year in combined profit represents a significant future cash flow with a high certainty of being collected.
In fact, Guarantee Fees are comparable to Mortgage Servicing Rights (MSRs), which companies are actually allowed to carry at fair value on their balance sheets. Each one is a small fee added on to each mortgage payment. Over a few years, these fees add up. In the case of MSRs, companies are allowed to carry them at fair value using a discounted cash flow model. The reason that Guarantee Fees cannot be carried at fair value is that they cannot be sold or transferred and they fulfill a different function than MSRs.
How Big is the Guarantee Fee Intangible Asset?
The Guarantee Fee is expressed in terms of basis points. A 10 basis point fee would amount to $200 in annualized fees on a $200,000 mortgage. If the average mortgage originated in the past few years remains in good standing with no prepayment or refinancing, then this amounts to $2,000 in fees over a ten-year period. Extrapolate this to a $5 trillion balance sheet and the fees expected over ten years will total $50 billion.
Mortgages originated since November 2012 have had a 38 basis point Guarantee Fee, of which 10 basis points went to the federal budget. So, the GSEs get to keep 28 basis points to compensate for default risk. If a 10 basis point fee equals a $50 billion intangible asset, the 28 basis points in fees will create a $140 billion intangible asset. Without a professionally built model, it's impossible to know the exact value of this intangible asset. In fact, if mortgages are refinanced through the GSEs themselves, this adds significant value to the future asset. When viewing capital adequacy of the GSEs, you must acknowledge the existence of this asset.
Significant Value Can Be Unlocked
Knowing that Guarantee Fees provide a stable future cash flow, a fair value can be calculated based on the current profitability. Using the current 30-year Treasury rate of 3.04% to discount future profits, with no growth in the $23 billion in annualized profits, a net present value of almost $200 billion is possible for the common equity under one type of limited model.
Going a step further, one could assume that GSE restructuring could actually be a permanent fix that restores the companies to soundness. In this case, the profits of the companies, without any growth could be valued based on a perpetuity model. The perpetuity formula is simple and mostly dependent upon the discount rate. There is no assumed growth in profits.
Using a moderate 8% discount rate, the calculation creates a $287.5 billion valuation for the equity. At a 10% discount rate, the perpetuity calculator provides a $230 billion valuation. If you are curious, then you should know that these valuations also correspond to 12.5 and 10 P/E multiples, well within value stock ranges.
Dr. Rossi's plan is as simple as the following:
"One approach to accelerating a recapitalization of the GSEs would be to cancel the Treasury's senior preferred stock by declaring it "paid back," re-characterizing past payments of the profit sweep (minus the 10% dividend sweep) as a paydown of principal. The value from that cancellation would flow up through to the remaining common stock, benefitting the Treasury as owner of 80% of the common stock through the warrants that it still would hold."
Click here to see Dr. Rossi presenting his plan to Senate staffers and investors at the Dirksen Senate Office Building in Washington, D.C.
How does this plan work exactly?
Simplicity is the key here. The FHFA will declare that the Senior Preferred stock is paid back and direct the GSEs to stop transferring their net worth to the Treasury. This eliminates the tremendous cost of paying back the bailout and begins to unlock the value for common stockholders (of which 79.9% of the shares are owned by taxpayers).
On the aggregate, 7.2 billion shares will be issued by execution of the existing warrants. This could create 9 billion total shares in these entities.
For Fannie Mae, the current stated diluted share count is 5.74 billion shares and this includes the government's warrants. As stated above, current earnings power of Fannie Mae is about $15 billion per year. Earnings would be about $2.61 per share. At a 12.5 times P/E multiple, the share price target would be about $33. The taxpayer's shares in Fannie Mae would be worth about $151 billion.
For Freddie Mac, the current stated diluted share count is 3.22 billion shares and this includes the government's warrants. As stated above, current earnings power of Freddie Mac is about $8 billion per year. Earnings would be about $2.48 per share. At a 12.5 times P/E multiple, the share price target would be about $31. The government's shares in Freddie Mac would be worth about $80 billion.
It is important to reiterate now that the GSEs' current solid book of business combined with the stability of cash flows from the guarantee fees represent a substantial intangible asset that fully supports the valuations.
Minimum Capital Standards
Dr. Rossi also addresses minimum capital standards required for release from conservatorship. In his plan he writes,
OFHEO imposed a set of statutory capital standards on both agencies defined as the greater of minimum capital standards or risk-based capital. The minimum capital standard was 2.5% of GSE assets plus .45% of outstanding MBS.
These capital requirements actually still exist today and estimates show that under these standards, the GSEs may actually have enough capital to be released from conservatorship. However, Dr. Rossi notes that OFHEO's standard may be a bit low.
This set the capital standards of the GSEs below those of commercial banks and thrifts and clearly was insufficient to cover losses that struck both companies during the crisis.
The plan also points out that HERA grants FHFA authority to establish capital requirements for the entities to be released from conservatorship. Current third-party estimates of capital requirements show a 5% capital buffer is optimal and this matches some of the plans created by Congress.
So, how could you go about raising this capital? You have multiple options.
FHFA might increase Guarantee Fees. This action would boost the rate at which capital builds on the balance sheet.
They could accelerate the wind-down of the retained portfolios. This might have two effects on capital. First, they may be able to sell retained portfolios at a profit, generating equity capital. Second, the overall size of the balance sheet would shrink reducing the capital needed.
These things would have a limited effect. Dr. Rossi estimates that the amount of core capital needed would be as follows:
As a starting point for simply assessing the gap needed by each company to re-emerge from conservatorship, the amount of core capital required would be $137.3B and $80.9B for Fannie and Freddie, respectively.
So, in summary, to be released from conservatorship, the GSEs need $218 billion in core capital. Dr. Rossi says it is up to the FHFA to create a strong recapitalization plan.
One-Step Further with the Plan
It is the author's view that there is a very simple solution to this problem for FHFA. Instead of issuing the warrants simply to dilute the stock, recreate the warrants with a strike price of $30. Treasury can then decide whether they want to issue the warrants themselves, or auction them to the private sector, over time.
Issuance of 7.2 billion share warrants with a strike price of $30 would provide $216 billion in capital. This is right on target with the amount of core capital needed. Based on the current profitability of the company, earnings could support a combined valuation of about $231 billion on those same warrants, meaning that the strike price is fair.
Conclusions on Dr. Rossi's Plan
FHFA should consider all options available, but the most elegant solution may be a simple one, such as ending the Net Worth Sweep and rebuilding capital. Significant value is waiting to be unlocked in the common stock, creating long-term valuations close to $30 per share.
Part 2. The AIG Takings Trial Related to the GSEs
One of the prevailing arguments being made in the AIG trial is that the bailout terms for AIG were not proportionate to bailout terms for other companies during the financial crisis. Essentially, AIG was charged rates of 12% or more on funds they were forced to borrow from the government. The government sponsored entities (GSEs), Fannie Mae and Freddie Mac, had a 10% dividend rate on their Senior Preferred Stock. (This rate eventually rose to 100% of their net worth.)
Meanwhile, large banks such as Citigroup (NYSE:C) and Bank of America (NYSE:BAC) were charged much lower rates on their borrowings. In the case of Citigroup, Bank of America, Morgan Stanley (NYSE:MS), Goldman Sachs (NYSE:GS), and other big banks, the Federal Reserve offered lending facilities as low as 0% for up to $9 trillion in overnight loans. And under the Capital Purchase Program, enacted by Congress, the borrowing rates for these banks was 5%, much lower than AIG or the GSEs.
The irony of the situation is that AIG and the GSEs were damaged due to triple-A ratings on mortgage securities that should never have been rated that highly. The banks that created these faulty mortgage securities were the very same ones getting better deals on their bailouts.
Wednesday's testimony by Tim Geithner under questioning from David Boies gets to the heart of this issue, which Tim Geithner eloquently calls a philosophical issue.
The vital questions that the plaintiffs are asking in the AIG trial appear to be:
During a crisis, does the government have the right to pick winners and losers? Or obligation to create the fairest deals possible?
Do they have the power to punish their enemies? And save their friends?
In the past few months, FHFA has sued and settled with many banks on behalf of the GSEs over Private Label Securities (PLS) for $18.2 billion. The $200 billion in PLS were mortgage securities issued by the banks, not the GSEs. These banks allegedly sold the GSEs and other consumers toxic trash that was full of fraud. The banks admitted no guilt, but paid up on the settlements regardless.
Some readers may be thinking, "but the GSEs were willing buyers." Maybe so, but in this country we typically don't blame the victims when they purchase a faulty product. We have implied warranties that cover consumers against loss when products don't hold up to their advertised quality.
By the way, the above settlements do not include the conforming loans sold to the GSEs that did not meet the conforming loan standards. Several years ago, a putback tsunami started that forced banks to buy back loans that did not meet conforming mortgage standards. Most of the big banks settled these claims as well. For instance, Bank of America paid $2.8 billion to the GSEs and several billion more to other parties. The total settlements with all the different parties add up (if anyone can point out a source that shows everything, that would be appreciated).
Still, Mr. Geithner and other regulators appear to be blaming the firms that bought these products.
We forced losses on shareholders proportionate to the mistakes of the firm. And we made clear in . . . AIG that they would be dismembered."
Mr Geithner said on Wednesday that AIG was in the group of firms whose shareholders took losses proportionate to their companies' mistakes, but he also included big banks, which were forced to raise capital and common equity as part of the stress tests and other programmes.
"There's this thing about hindsight and stuff," Mr Geithner said. "Many things that seemed prudent at the time turned out to be imprudent." - Financial Times
As we have seen the past few years, most of the bad behavior ended with lawsuits and prosecution through the legal system, as banks had to pay for their alleged bad behavior. This should, by itself, show that the proper place for punishment is actually in the court room, not during a back door deal to stabilize the system.
It's the Constitution, Stupid
Getting back to some of the core issues behind these shareholder lawsuits, let's go back in time.
The Fed seized AIG in September 2008. The job started to go down on the 16th, when Treasury Secretary Henry Paulson, Fed Chairman Ben Bernanke and other officials met with key members of Congress.
According to Paulson's own memoir, Sen. Chris Dodd twice asked "how the Fed had the authority to lend to an insurance company and seize control of it." Bernanke insisted the law allowed it in "unusual and exigent circumstances."
The congressional brass was skeptical. Sen. Harry Reid warned: "I want to be absolutely clear that Congress has not given you formal approval to take action. This is your responsibility and your decision."
Paulson was so nervous that, as they were walking out of the Capitol, he ducked behind a pillar and went into dry heaves - meaning, he tried to throw up. Defying the Constitution can do that to a man who's sworn to defend it. - NY Post
Shareholders were denied their rights. The companies were seized illegally. The companies' balance sheets were used to save the banks at the expense of the companies and their owners.
Paulson rejected a substantial offer from private investors?
With the AIG trial the bad news keeps coming. It may seem strange to many people that the shareholders thought they could save a company with such dire prospects. However, there is plenty of evidence to suggest that a private bailout was possible, including the fact that Chinese investors offered to invest "more than the total amount of money required" to save the company.
Similar conclusions were reached with Fannie Mae and Freddie Mac when it was learned that Warren Buffett made an offer to bailout Fannie Mae while meeting with the CEO, Franklin Raines, at the Omaha airport in 2004 and attempted to buy tax assets from the companies in 2009. In both cases, regulators squashed the deals for their own self interest.
Who has more money than Buffett? The Chinese, of course. We may soon learn that they also tried to bailout the GSEs.
Anyway, why would Paulson turn down these private investors when they made significant offers to help save these institutions? Its widely known that AIG's counter-parties were made whole on many of their interests, saving them from losses. And it is also known that millions of homeowners participated in mortgage modification and refinancing programs through the GSEs. Later, FHFA settled MBS claims with many of these banks for pennies on the dollar. These programs and settlements would not have been possible without complete government control.
Current AIG shareholders have little to gain from a court room win, but current GSE shareholders could gain from a legal precedent.
The GSEs still have about 19 court cases in progress and one in appeal. Perhaps one judge will agree with shareholders. Or, the government strikes a deal to include shareholders in the reform process and these issues are long forgotten.
On news that Bill Ackman has increased his GSE common position, investors can look to the price targets ($30 to $45) he set for the companies earlier this year when setting a long-term target price for the investment.
Disclosure: The author is long FNMA, FMCC.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
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