Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) are two Government Sponsored Entities in conservatorship that are currently in an agreement that sweeps over 100% of their quarterly profits on a quarterly basis to the U.S. Treasury. This agreement serves as an amendment to the original Senior Preferred Securities Purchase Agreement.
Bill Ackman recently wrote them up in his Quarterly Letter to investors:
While we remain confident in the prospects for Fannie and Freddie and believe our investment in their common shares will ultimately be worth a large multiple of current prices, the litigation is likely to continue for a protracted period before being resolved, unless the Administration, Treasury, Congress and other interested parties forge a consensual resolution.
Ackman has mapped the timeline out for Fannie Mae and Freddie Mac. According to Ackman's presentation slide 99, you will see that in the middle of 2017, the Takings occurs. Note how the dividends on treasury preferred share difference is exhausted that year and is almost exhausted in 2016. Right now by my calculations we will be at ~$40B on March of 2015.
AIG (NYSE:AIG) Makes This Interesting
If Judge Wheeler rules that the government cannot demand equity in exchange for a loan, then Sweeney can quote that to throw out the warrants. Judge Wheeler and Judge Sweeney are both in claims courts. This should happen sometime early next year.
Debt and Takings
A takings has not occurred in a debt security until the creditor has taken more than they lent plus interest. That has not yet happened. That will happen by 2017 according to Ackman's slide deck. The point is that soon there will be no doubt that a takings has occurred, but for now we operate in a gray area. Judge Lamberth can argue all day till he is blue in the face that a takings has not occurred by using this logic, but those days are numbered.
The sweep becomes illegal when the amount swept is easily understood as in excess of loan and expected interest payments.
FHFA Continues To Overlook Mandates
While the sweep at present may not technically be illegal, it is illegal for the FHFA to do anything that does not protect and conserve shareholder rights. That's where things get interesting in Sweeney's court. If it can be proven that the FHFA has been acting as an agent of the UST, then the agreement itself is illegal. I'm not sure if I'm being Mr. Obvious or not.
Why Is This Happening?
The government could not take shares or change their security because that would have been considered a purchase of a new security, for which the powers to do so expired years earlier. The sweep is an agreement to change the terms of the loan, not a new security, and is still therefore a loan, because the government can enact a fourth amendment.
What Is Going To Happen?
There are two main legal paths that I see as we count down from ~$40B.
- This will become a takings when the amount swept exceeds the original loan agreement. This is by the end of 2017. In this case, the warrants will be cancelled because exercising them is a takings. Stock is worth $115+ by Ackman's calculations. You need to multiply his numbers by 5 to get to undiluted values. $23 x 5 = $115.
- If it can be shown that the FHFA is breaking the law by not protecting shareholders, then the third amendment can be thrown out. This is what is going down in Sweeney's court.
Nevermind that I disagree with Lamberth's conclusions, the end is in sight, and the upside is enormous. Line your pockets before everyone else figures this out, because by the time they do, we'll be triple digits, not double digits. I don't know how long court cases take to play out but my understanding is that the Lamberth Appeal should be processed by the end of 2015. As a common shareholder, time is on your side. In the meanwhile, let's take a look at what Brown can do for you.
What can Brown do for you?
If waiting till the first part of 2017 seems too long, there are other ways that this may come sooner.
Sen. Sherrod Brown (D-Ohio), who is poised to become the panel's ranking member, said recently that he would push for a fresh effort and would avoid using the Johnson-Crapo bill as a foundation.
Brown wants to win provisions to help poor families get credit to buy homes.
So, there is a legislative solution here that would amount to the same thing. Will it happen? That's anybody's guess but I'm not counting on it. I am counting on Congress to do what it does best, nothing that means anything. Another way that this all could come to fruition sooner is if Fannie and Freddie release some of their reserves. I don't know a lot about the specifics there but it sounds to me like they are overreserved for future losses that aren't going to materialize.
Edward Demarco is the previous head of the FHFA. In his last speech he revealed that winding them down requires that they are re-chartered the way things are. He says that he expects that there is some legislative solution that will save the day and end the Enterprises. I don't understand what is so bad about two of the most profitable businesses in the world that help poor families get credit to buy homes in America. I don't understand what makes everyone so willing to sell their shares in these best-in-class businesses at less than one times what they make in one quarter. I do understand that people make mistakes and that money means business. That's what I'm counting on, just be where the money is going and it will find you.
Disclosure: The author is long FNMA, FMCC.
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