Valuing Freddie Mac And Fannie Mae's Common And Preferred Stocks

| About: Freddie Mac (FMCC)

Summary

FMCC and FNMA have near-term earnings that would justify impressive stock price valuations but for the net income sweep.

The net income sweep is a major impediment to realizing the potential valuations, but could be overturned by Treasury/FHFA, Congress, or the Courts.

A Court may, in the future, find that the net income sweep is inconsistent with the applicable statute, or a taking under the 5th Amendment.

Freddie Mac's (OTCQB: OTCQB:FMCC) expected near-term earnings of roughly $2.50 per share would imply a common stock valuation of $25.00 per share if a price/earnings ratio of 10 times is assumed. For Fannie Mae (OTCQB: OTCQB:FNMA), expected near-term earnings of roughly $1.80 per share would imply a stock price of $18 per share, again using a 10 times price/earnings ratio. These are impressive proposed valuations, which have gotten the attention of actual and potential investors in FMCC and FNMA in recent years.

These proposed valuations for the FMCC and FNMA common stocks assume that the U.S. Treasury warrants to own 79.9 percent of FMCC and FNMA are exercised. If they are not exercised, the assumed valuations for FMCC and FNMA would be about $125 and $90 per share, respectively.

The valuation issues for the Freddie Mac and Fannie Mae (together known as the government sponsored enterprises or GSEs) preferred stocks, including FMCKJ and FNMAS , are a bit simpler. GSE preferred dividend holders want to either have their dividends restored or their shares bought back at redemption value ($25 per share for FMCKJ and FNMAS). Given that FMCKJ and FNMAS are currently trading at about 15.62% of redemption value, preferred holders would see a more than six fold increase (more precisely, 6.40 times) relative to the current preferred stock price if they return to redemption value. In terms of percent return, this would be a 540% return, i.e., ($25.00 - $3.905) / $3.905 equals about 540%.

Economists talk about "factuals" and "counterfactuals" and analyze the differences between the two when analyzing the impacts of a government policy intervention. The factual situation is what actually happened. The counterfactual is what would have been the case "but for" the policy intervention.

For FMCC and FNMA, the current factual situation presents daunting obstacles to the realization of the proposed common stock valuations for FMCC and FNMA. This presents both a timing issue (how long will it take-if ever-to realize the proposed valuations?) and a "hero or zero" issue (what are the risks of the current factual situation staying in place indefinitely?). While earnings dilution from financial recapitalization would be another potential obstacle to the realization of the proposed common stock valuations, that issue will not be addressed in this article, but will instead be covered in a future Seeking Alpha article.

Similar but slightly less daunting obstacles exist to the realization of redemption value for the preferred stocks. The GSE preferred stocks are non-cumulative, which means that the Federal Housing Finance Agency (FHFA) (on behalf of the GSEs' investors, including holders of common, senior preferred stock, and preferred stock) has relatively weak incentives to restore the preferred dividends. I will provide a more specific discussion of the valuation issues related to the GSE preferred stocks in a subsequent article.

The purpose of this article is to briefly summarize the current factual situation facing GSE equity investors that currently prevents the realization of the proposed valuations, the counterfactual that would have been the case but for the 3rd Amendment, and what has to happen to overturn the 3rd Amendment.

What Actually Happened

A concise statement of what actually happened as a result of the relevant government policy interventions can focus on two dates, September 6, 2008 and August 17, 2012. The economic and financial consequences of the events that began on August 17, 2012 will be the focus of this article.

On September 6, 2008, Freddie Mac and Fannie Mae were placed in conservatorship by the director of the FHFA. The next day, the FHFA and the U.S. Treasury Department (Treasury) announced the signing of Senior Preferred Stock Purchase Agreements (SPSPAs) for the GSEs. These SPSPAs provide explicit support to the GSEs by the U.S. Treasury, but not an explicit government guarantee. In return for infusing senior preferred stock capital into Freddie Mac and Fannie Mae, the Treasury received a 10 percent senior preferred stock dividend (12 percent if the dividend was not paid in cash); in a formal sense, dividend payments are not considered a repayment of the senior preferred stock capital. Subsequent to the imposition of conservatorship on the GSEs, the FHFA and the GSEs took numerous actions to support the mortgage and real estate markets and to restore the profitability of the GSEs. Now, having largely worked through the legacy issues related to the 2004-2008 period, the GSEs are essentially public utilities, albeit supported by the SPSPAs rather than by their own book equity capitalization.

On August 17, 2012, a 3rd Amendment to the SPPSAs was approved by Treasury and FHFA. This 3rd Amendment, among other things, replaced the 10 percent dividend on senior preferred stock with a "net income sweep" to the Treasury-the required quarterly senior preferred stock dividend equals the amount, if any, by which the GSEs' net worth as of the end of the preceding quarter exceeds an applicable capital reserve amount. The 3rd Amendment also ensures that the GSEs will have no book equity capital on their balance sheets by the end of 2017.

As it turned out, the net income sweep had the effect of accelerating the repayment of the Treasury in terms of "net investment," i.e., outflows of cash to the GSEs versus inflows of cash to the Treasury. In terms of "net investment," the Treasury has now been more than fully repaid for its support of the GSEs during the financial crisis period.

Issues Raised by the 3rd Amendment

By August 17, 2012, the 2008-2009 financial crisis had been over for several years. A lot was going on during the financial crisis period and things have worked out fairly well so far. Thus, the actions of the FHFA and Treasury during the financial crisis are not the primary focus of this article.

The 3rd Amendment, however, stands out as a draconian policy intervention. By August 17, 2012, the financial crisis had been over for several years and the GSEs' profitability had been restored. The 3rd Amendment raises a number of questions including:

  1. Were the FHFA and Treasury actions related to the 3rd Amendment consistent with their authority under the Housing and Economic Recovery Act of 2008 (HERA)?
  2. Was there a "taking" in terms of the 5th Amendment to the Constitution ("nor shall private property be taken for public use, without just compensation")?
  3. Were the FHFA and Treasury actions consistent with the "due process" requirements of the 5th Amendment to the Constitution ("nor shall any person … be deprived of life, liberty, or property, without due process of law") and the Administrative Procedures Act of 1946?

In order to interpret the events that began on August 17, 2012 and which have aftershocks that continue to the present day, some of the economic and financial policy issues raised by the 3rd Amendment will be briefly discussed.

First, regulatory bodies are expected to act in a manner consistent with their statutory authority. HERA of 2008 specifically states that when the FHFA acts as conservator it may take such action as may be: (1) necessary to put the regulated entity in a sound and solvent condition; and (2) appropriate to carry on the business of the regulated entity and preserve and conserve the assets and property of the regulated entity. From an economic and financial standpoint, the 3rd Amendment is diametrically opposed to the requirements of HERA. After all, the 3rd Amendment takes the GSE's earnings and gives them to the Treasury and also ensures that the GSEs will have little or no book equity capital. This is fundamentally inconsistent with the economic, financial, and legal principle that common equity investors are entitled to receive the residual earnings and cash flows after the firm's other obligations are satisfied.

Second, the 3rd Amendment has the characteristics of expropriation and nationalization. The 3rd Amendment may or may not be direct expropriation (i.e., a taking of a company "lock, stock, and barrel"), but, in terms of its economic effect, the 3rd Amendment has displaced common equity investors' right to the residual earnings and cash flows after the other obligations of the GSEs are satisfied and thus constitutes an expropriation by the government from GSE investors. This "creeping expropriation" has its effect quarter by quarter as the GSEs' earnings are swept to the Treasury via the 3rd Amendment. Moreover, while the 3rd Amendment is de facto nationalization (not de jure nationalization) that only shows that the government was careful not to technically have rights to more than 80 percent of the GSE common stock in order to avoid triggering a requirement to put the GSEs' debt on the government's balance sheet. Thus, from an economic and financial perspective, the 3rd Amendment can be viewed as an expropriation from GSE common and preferred investors and as a nationalization of the GSEs. Given that there has been no "just compensation" to date, the 3rd Amendment would appear (from an economic and financial perspective) to meet the criteria of a taking without just compensation.

Third, from an administrative standpoint, due process has not been followed. Compared to public utility regulation, the administrative procedures used by the FHFA as regulator and conservator of the GSEs and by Treasury as a party to the SPSPAs are remarkably opaque and lack administrative justice. While FHFA as conservator has more discretion than a typical public utility regulator, this should not mean that the conservator can act in a manner diametrically inconsistent with its statutory authority. Moreover, FHFA should not be unduly influenced by the Treasury. HERA of 2008 states that FHFA "shall be an independent agency of the Federal Government" and, when acting as conservator or receiver, shall not "be subject to the direction or supervision of any other agency of the United States or any State in the exercise of the rights, powers, and privileges of the Agency." The requirement of "just compensation" means that governments can be required to bear the cost of takings, which would provide an incentive for governments to make sound decisions about whether to take property. This can also promote corrective justice because governments can be required to provide just compensation to the victims of takings.

These obstacles to the proposed valuations can be removed by: (1) joint action of the FHFA and Treasury to remove the 3rd Amendment to the SPSPAs; (2) Congressional action to remove the 3rd Amendment; or (3) a court decision overturning the 3rd Amendment. Given ongoing litigation before the U.S. District Court in Iowa, the U.S. Circuit Court of Appeals D.C. circuit, and the U.S. Court of Claims, it seems likely that the courts will decide this issue. Treasury/FHFA and/or Congress are unlikely to act while litigation is ongoing.

Going forward, it is possible that action by FHFA/Treasury, Congress, or the courts could unlock the proposed valuations.

The Economic and Financial Consequences of the 3rd Amendment for investors in Freddie Mac

The 3rd Amendment has had major financial consequences for Freddie Mac equity investors. I will first briefly summarize what actually happened, then I will discuss what would have happened but for the 3rd Amendment. Going forward, reversing the 3rd Amendment is important for common and preferred investors in terms of realizing the potential valuations of the GSE common and preferred stocks.

Because of the 3rd Amendment, the U.S. Treasury was repaid in terms of "net investment" more quickly than would otherwise have been the case. For Freddie Mac, Table 1 presents the cumulative outflows from the Treasury, the cumulative inflows to the Treasury, and the net effect. Governmental accounting is simple, focusing on inflows to the government (taxes and user fees) and outflows from the government (costs of government activities) with the goal of balancing outflows with inflows over time. Thus, "net investment" focuses on outflows from the Treasury and inflows to the Treasury. However, in a formal sense the GSEs are not currently allowed to reduce the amount of Senior Preferred Stock on the GSEs' balance sheets.

Table 1: Freddie Mac's Cumulative Outflows from the Treasury, Cumulative Inflows to the Treasury, and Net Investment pursuant to the 3rd Amendment

Quarter Year

Cumulative Outflows from Treasury ($million)

Cumulative Inflows to Treasury ($milllion)

Net Investment ($million)

Q1 2013

$71,336

$29,572

($41,764)

Q2 2013

$71,336

$36,543

($34,793)

Q3 2013

$71,336

$40,900

($30,436)

Q4 2013

$71,336

$71,336

-

Q1 2014

$71,336

$81,771

$10,435

Q2 2014

$71,336

$86,270

$14,934

Q3 2014

$71,336

$88,160

$16,824

Q4 2014

$71,336

$90,946

$19,610

Q1 2015

$71,336

$91,797

$20,461

Q2 2015

$71,336

$92,543

$21,207

Sources: FMCC 10-Qs, 10-Ks, and quarterly earnings releases

For Freddie Mac, Treasury was paid off only four quarters after the 3rd Amendment went into effect. Since then, the inflows to the Treasury from Freddie Mac have exceeded outflows from the Treasury to Freddie Mac by $21.207 billion. With the benefit of hindsight, Treasury's timing was excellent-senior preferred dividends have far exceeded what would have been the case if the 10% dividend had continued in effect.

But for the 3rd Amendment, the GSE common and preferred stockholders would have been in far better positions. For Freddie Mac, Table 2 presents the estimated cumulative outflows from the Treasury, the estimated cumulative inflows to the Treasury, the estimated incremental retained earnings for shareholders, and the estimated net investment for Treasury but for the 3rd Amendment.

Table 2: Freddie Mac's Estimated Cumulative Outflows from the Treasury, Estimated Cumulative Inflows to the Treasury, and Estimated Net Investment but for the 3rd Amendment

Quarter/Year

Estimated Cumulative Outflows from Treasury ($million)

Estimated Cumulative Inflows to Treasury ($milllion)

Estimated Incremental Retained Earnings for Shareholders

($millions)

Estimated Treasury Net Investment ($million)

Q1 2013

$71,336

$25,553

$4,019

($45,783)

Q2 2013

$71,336

$27,361

$9,182

($43,975)

Q3 2013

$71,336

$29,169

$11,731

($42,167)

Q4 2013

$71,336

$30,977

$40,359

($40,359)

Q1 2014

$71,336

$32,785

$48,986

($38,551)

Q2 2014

$71,336

$34,593

$51,677

($36,743)

Q3 2014

$71,336

$36,401

$51,759

($34,935)

Q4 2014

$71,336

$38,209

$52,737

($33,127)

Q1 2015

$72,293

$40,017

$51,780

($32,276)

Q2 2015

$73,379

$41,849

$50,694

($33,530)

Sources: FMCC 10-Ks, 10-Qs, and earnings releases, with adjustments and calculations by the author.

But for the 3rd Amendment, there would have been over $50 billion of retained earnings on Freddie Mac's balance sheet that could have eventually been used to pay dividends to common and preferred holders. Treasury's "net investment" would not have been paid off in full, but Treasury could (and still can) exercise the warrants to own 79.9 percent of Freddie Mac's common stock to recover more of their investment.

The GSEs would have been well on their way to financial recapitalization but for the 3rd Amendment. While draws on the Treasury of roughly $1 billion would have resulted in each of the first two quarters of 2015, this would have been manageable for Freddie Mac given the lack of draws during the previous two years.

With the benefit of hindsight and looking at the 3rd Amendment from the standpoint of GSE equity investors, the Treasury and FHFA can be said to have been fiendishly clever in their amendment of the SPSPAs in terms of maximizing proceeds to the Treasury while leaving GSE common and preferred investors high and dry.

Conclusion

The primary obstacle to realizing the potential valuations for the GSE common and preferred stocks is the 3rd Amendment to the SPSPAs. But for the 3rd Amendment, common investors would be entitled to the residual after the other obligations of the GSEs are met. Moreover, from the standpoint of the ability to raise new equity capital, but for the 3rd Amendment it would have make sense to restore the preferred stock dividends.

The removal of the 3rd Amendment to the SPSPAs would not necessarily eliminate all of the obstacles to the proposed valuations for the GSE common and preferred stocks, but it would be a giant step in the right direction.

Disclosure: I am/we are long FNMAS, FMCKJ, AND OTHER GSE PREFERRED STOCKS.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Mr. Olson is an economist, CFA, and CPA. Mr. Olson is not an attorney.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

About this article:

Expand
Author payment: $35 + $0.01/page view. Authors of PRO articles receive a minimum guaranteed payment of $150-500.
Tagged: , Savings & Loans,
Want to share your opinion on this article? Add a comment.
Disagree with this article? .
To report a factual error in this article, click here