Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) are two publicly traded Fortune 50 private companies that have worthless equity because the government is taking all the money for itself. Any positive value to accrue to the equity would require a change in course from the status quo. The best opportunity for change is legal rulings against the government's actions to circumvent the integrity of the GSE's capital structure. The biggest risk historically has been rulings against plaintiffs, and sure enough Judge Lamberth and Pratt both ruled in favor of the government, basically saying that the government can do whatever it wants. The purpose of this article is to lay out events in the past two weeks to show that support plaintiffs in their appeal for Perry Capital as well as the lawsuits in general against the GSE status quo.
Investment Opportunity In Brief: Right now, the practical valuation for GSE equities is a call option on the probability that a portion of their net income belongs to the companies themselves. As such, preferreds trade roughly at 20 cents on the dollar and common shares trade at around $2 when they used to trade over $50. To date, no lawsuit against the government accounting fraud, its taking of 100% for nothing and the conservatorship in general has made it past the motion to dismiss. If the government has its way and plaintiff lawsuits have no merit or are ruled collectively to have no merit, the GSEs are worthless, HERA undermines the constitution, and the FDIC should consider managing more conservatorships for its own benefit. Considering that at current G-Fees, the GSEs combined make $15B/annum to distribute to equity, valuations starting around $20 have been proposed by William Ackman and Richard X. Bove.
Hamish Hume Demonstrates FHFA And Treasury Arguments Collapse Under Own Weight
Hamish Hume represents the class plaintiffs. In a recent legal filing wrapping up the scheduled part of the Perry Capital Appeal, Hume decapitated the obfuscation inherent in the government's legal filings that Judge Sweeney classified as "schizophrenic" looking for a better explanation. First off, Hume shows that FHFA tells it how it is:
Instead, FHFA goes on and on rehashing an argument that Hamish points out lacks substance:
Second off, Hume demonstrates that Treasury is having difficulty having its cake and eating it too without taking separate sides to the same issue:
Plaintiffs have finally circled the government encampment in this lawsuit. The government was able to escape the original Lamberth ruling by submitting an incomplete subset of facts. Fairholme has recently done good work at exposing these facts.
Fairholme's CFC Discovery Exposes Falsifications
The most interesting part of all of this is that Lamberth ruled that it doesn't matter what the administrative record would be:
Nevertheless, plaintiffs have subsequently produced documents proving that the government lied:
Alright, so let's see what they allegedly lied about:
From the start of conservatorship, the government has been downplaying the true profitability of the GSEs, treating them as scapegoats and forcing them to report net losses even though they were cash flow machines making billions of dollars. These non-cash losses were due for reversal, but the purpose of them would have been completely undermined if the net worth sweep wasn't put into place to reclassify them as government revenue. Here comes the mic drop moment, FHFA and Treasury withheld information from court:
The government "found out" the GSEs were going to be forced to reverse their non-cash losses that the government forced them to take on to justify the imposition of conservatorship. Instead of reversing them and letting the earnings accrue to the capital structure, Treasury and FHFA conspired together to take them all. Plaintiffs say that this is in violation of the law. If the plaintiffs are able to find a judge who will rule in their favor the government's profit sweep will end. Notice how the defendants justified their actions years ago by referencing data that was inaccurate at the time the action was taken:
These facts were not known publicly at the time and the government was given the benefit of the doubt. Now that facts have come out in discovery proving the government's legal filings were incomplete and relied on inaccurate information, one would reasonably begin to think that judges would see more merit in plaintiff claims. After all, the money doesn't lie and the government has been in charge of where it has gone since conservatorship has begun and where it's gone is to those in charge. One feature of capital structure in corporations is to prevent management from stealing money from shareholders, not to mention the entire company, among other things.
Class Plaintiffs Respond to FDIC Surprise Last Words
For those unfamiliar, the FDIC filed an Amicus Brief saying that they could declare sovereign immunity under their statutory law and hoped that whatever happens in this court does not negatively impact that case law. The class plaintiffs have now responded:
Pre-empting out of existence pre-receivership obligations is not supported by the case law. As such, the forecasted impact of the FDIC's Amicus Brief that was filed after the court was in theory fully briefed is negligible.
How Did We Get Here
Hank Paulson wrote about it in his book. The planned takeover of Fannie Mae and Freddie Mac was to catch them by surprise and cut their heads off before they knew what was happening:
The book Too Big To Fail offers a little more insight into exactly how Paulson planned it all:
The plan was to take over the companies, write down their assets and issue themselves enough equity to eventually justify taking everything from the shareholders at the time.
From the vantage point of Treasury and officials, non-governmental shareholders were an issue because at the time the financial markets were crumbling and there was a possibility that some country could have tried to stir up a panic in the GSE debt market. By coming in and injecting itself into the capital structure, taking control, and effectively eliminating shareholder interests with the net worth sweep, the government has effectively turned them into government agencies. The latest push to build the CSS/CSP, do risk sharing transactions, and the like basically finish off that transformation. Unfortunately, these things take time and probably will get at least partially thrown away if the plaintiffs get a legal victory in the coming weeks.
Never before had the US Government been party to an agreement where it benefited through stock issuance by writing down the other party's assets. In this case, it was by design in preparation for the net worth sweep which has been in preparation for receivership and spinning off their core assets. Here's the problem, this plan has left them with little to no capital because it's all been taken by the government. Voiding the net worth sweep may or may not resolve that issue and as such conservatorship may persist for some time, which is odd because if the net worth sweep gets voided it would prove that FHFA and Treasury broke the law to take the GSEs money and in that line of reasoning it just feels odd to let FHFA keep controlling the GSEs. I'm not a lawyer so I don't know how exactly this plays out.
What I do know is that there are two bets you can take. The first is on the preferred equity. The terms of Fannie Mae preferred can be found here. The terms of Freddie Mac's preferred can be found here. What's really odd about this is that the government owns preferred stock but it's not listed on these websites. It's probably because it's not freely traded, but it's pretty clear that they don't want their preferred shares to get confused with our preferred shares. The government details the terms of its preferred shares on its own website here.
The second bet is on the common equity. The common equity has more exposure to the way that the government decides to handle resolving the conservatorships in the event the net worth sweep ends. In the AIG case, the common stock was further diluted beyond just the warrants. In the GSE case, I'm really looking forward to those BlackRock documents being produced in discovery and made public. Here's what the government says about why the public shouldn't see those:
The fact that Christopher H. Dickerson points out that these documents it doesn't want produced during discovery are 8 years old, still the subject of significant public interest, and would likely be the subject of intense publicity and public scrutiny can only logically be explained by their inclusion of projections aligned with the forensic accounting work by Adam Spittler.
In that case, it would undermine the government's narrative that conservatorship was warranted if they showed that the GSEs were not in crisis and they would be able to meet their obligations as they came due for the foreseeable future. Judge Sweeney has been fully briefed since June 10th and has had access to this information since May 27th. As far as timeline goes, I'd love to see more of these documents released before the Perry Capital Appeals ruling. Further, no dates have been set for the Delaware or the Kentucky lawsuits.
Summary and Conclusion
As of last week the Perry Capital Appeal is fully briefed, in theory. There is of course the possibility, albeit small, that the judges ask for further briefing. At this point in time, the plaintiffs have been able to run circles around the government's legal defense and supplement the record with facts proving that the government purposefully tried to mislead lower courts. I expect a ruling from Perry Capital in the next 4-6 weeks (before August 31).
As such, last week I accessed my last aspect of liquidity and pulled a 401k loan for around $11K that I'll be using to buy GSE preferreds. I anticipate that the Perry Capital ruling will at the very least vacate Judge Lamberth's dismissal and the preferreds should return to pre-Lamberth highs. It is possible and I think it is the likely scenario that his ruling is reversed instead of just vacated and sent back. My disposition comes from my interpretation that an agreement that guarantees insolvency when the law requires actions providing solvency is flatly illegal.
Even still, if the judges are unable to come to this conclusion at this point in time, the more that the legal system digs into this the less credible the government's defense should look and here's why. The cash doesn't lie. Since conservatorship was imposed, two companies at their highest capital levels in history have been bled to insolvency and over $100B has been siphoned from them to the government. If conservatorship was never imposed, the GSEs would never have run into the purported problems that they are accused of having. I expect the preferreds to eventually return to par.
I don't expect the government to shut down the GSEs (they make too much money). The plan wasn't ever to shut them down to begin with. From what I can deduce from Paulson's book and the government narrative, the number one goal of nationalizing them was simply to provide certainty to GSE debt markets. Years later, lessons have been learned and internally reform has been happening. The lawsuits have come a long way since they were originally filed and now legal rulings will have the benefit of recently produced discovery, some of which may still be produced before the Perry Capital Appeals ruling.
Disclosure: I am/we are long FMCCH,FMCCP,FMCCT,FMCKO,FMCKP,FNMA,FNMFN,FNMFO.
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.
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