Q1. What is the purpose of this Seeking Alpha article?
A1. This is the third in a series of articles that respond to frequently asked questions about investing in Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) common equity securities. My previous FAQs cover the basic fact situation here and the political and litigation risk is discussed here. The opportunities and risks remain about the same as described in my earlier FAQs.
I would, however, caution investors to do their own due diligence. Investors should think through the investment risks and opportunities for themselves.
In a formal sense, the Federal Housing Finance Agency (FHFA) is currently the independent regulator and conservator of the GSEs. I have previously characterized FHFA regulation of the GSEs as "regulation on steroids." Moreover, the argument can be made that the U.S. Treasury (Treasury) is effectively the co-regulator of the GSEs because of the Senior Preferred Stock Purchase Agreements (SPSPAs) and the related Senior Stock Certificates.
With respect to future amendments of the SPSPAs, FHFA Director Watt has stated that he will defer to the Treasury. "It's something that would have to be initiated by Treasury, not by me," Mr. Watt said. "In the short term I would rule it out, in the long term, I might not rule it out."
Fannie Mae and Freddie Mac are together known as the government-sponsored enterprises or GSEs. FNMA and FMCC have 1.158 billion and 0.650 billion outstanding common equity shares, respectively. The GSEs also report "fully diluted" shares, which assume that the U.S. Treasury (Treasury) will at some point exercise its warrants to own 79.9 percent of the GSEs' common stock shares. FNMA and FMCC traded at $1.79 per share and $1.65 per share, respectively, at the close on September 27, 2016.
The Shapiro-Kamarck report uses valuations of $10.34 per share in 2016, $12.51 per share in 2018, and $15.14 per share in 2020. Thus, the "upside" for FNMA and FMCC may be in the range of $8.62 per share to $13.42 per share. This suggests that the total "upside" for FNMA and FMCC investors as a whole may be as much as $24.26 billion by 2020.
Please note that I have not had the opportunity to analyze the Shapiro-Kamarck model in detail. Shapiro-Kamarck assume that the Treasury exercises its warrants to own 79.9 percent of Fannie Mae and Freddie Mac - if the Treasury surprises us all and does not eventually exercise some or all of its warrants, the upside for existing FNMA and FMCC shareholders would be much greater.
There are also roughly $31 billion (based on redemption value) of GSE preferred stocks trading at the present time, although they are currently trading at about 10 percent of redemption value. GSE preferred stock ticker symbols include FNMAS and FMCKJ. If the GSE preferred stocks were to trade at redemption value in the OTC market at some point in the future, then GSE preferred investors would be better off by about $28 billion.
Note also that the total preferred dividends would amount to about $1.86 billion per year assuming a six percent preferred dividend rate.
Q2. Is there any evidence that the GSEs would be paying dividends to common and junior preferred in the absence of the 3rd Amendment's net worth sweep?
A2. An interested reader comments as follows:
There is no evidence that the GSEs would be paying dividends to common and junior preferred in absence of the NWS. In fact, the balance sheet, regulatory capital, the regulator, and Treasury's SPSPA pretty much forecloses this possibility.
I would make three points. First, but for the net worth sweep, the GSEs would now have book equity capital of about $120.70 billion on their balance sheets ($74.24 billion for Fannie Mae and $46.46 billion for Freddie Mac). This assumes the payment of a 10 percent cash dividend instead of the net worth sweep, ceteris paribus.
I used data in this analysis, which is available here. [Note that I adjusted the 2013-2016 dividend payments to reverse out $2.4 billion of dividend payments for each company, which reduce the capital reserve amount to $0.6 billion for each company.] But for the 3rd Amendment, the GSEs' balance sheets and regulatory capital levels would not necessarily have prevented the GSEs from paying dividends on their common and preferred stocks.
With the benefit of 20-20 hindsight, it turns out that the GSEs paid over twice as much to Treasury in the nineteen quarters after the net worth sweep as they did in the 13 quarters before the net worth sweep. That is, they paid dividends of about $6.23 billion per quarter in the 19 quarters after the sweep, compared to dividends of about $2.80 billion per quarter in the 13 quarters before the net worth sweep began.
What makes this even more interesting is that documents released via "discovery" at the Court of Claims indicates that Treasury knew about the potential release of the DTA valuation allowance and the possibility of reductions in credit loss reserves before the 3rd Amendment was announced on August 17, 2012.
Thus, it seems more and more likely that Treasury did the sweep because it was good for Treasury (and not good for the GSEs) and FHFA went along with it because of the Acting Director's ideological opposition to the GSEs' continued existence because of the GSEs' flawed charters (as Dr. DeMarco discussed in his deposition). I discuss some related issues here and here.
Second, the regulator's own Final Rule on Conservatorship and Receivership states that:
"§ 1237.12 Capital distributions while in conservatorship.
A Except as provided in paragraph B of this section, a regulated entity shall make no capital distribution while in conservatorship.
The Director may authorize, or may delegate the authority to authorize, a capital distribution that would otherwise be prohibited by paragraph of this section if he or she determines that such capital distribution:
(1) Will enhance the ability of the regulated entity to meet the risk-based capital level and the minimum capital level for the regulated entity;
(2) Will contribute to the long-term financial safety and soundness of the regulated entity;
(3) Is otherwise in the interest of the regulated entity; or
(4) Is otherwise in the public interest.
B This section is intended to supplement and shall not replace or affect any other restriction on capital distributions imposed by statute or regulation."
Public utilities (and the GSEs are essentially public utilities) are normally expected to build and retain the book equity capital that is necessary to maintain the public utilities' ability to raise needed capital in good times and bad in order to meet utilities' obligation to serve their customers. Note also that dividends are paid out of retained earnings not out of income.
A dividend payout ratio of over 100 percent of earnings is not especially unusual for public utilities, although that situation wouldn't normally persist for a long period of time. Thus, it seems plausible that but for the net worth sweep the GSEs might have been able to pay dividends to investors on the $31 billion of investor-owned preferred stock during the 2013-2016 period and possibly the GSE common stocks, ceteris paribus. This would be the case even though the GSEs would also be paying a ten percent dividend to Treasury on the Senior Preferred Stock.
FHFA director Watt has already stated that:
The most serious risk and the one that has the most potential for escalating in the future is the Enterprises' lack of capital. FHFA suspended statutory capital classifications when the Enterprises were placed in conservatorship, and Fannie Mae and Freddie Mac are currently unable to build capital under the provisions of the PSPAs. The agreements require each Enterprise to pay out comprehensive income generated from business operations as dividends to the Treasury Department, and the amount of funds each Enterprise is allowed to retain is often referred to as the Enterprises' 'capital buffer.' This capital buffer is available to absorb potential losses, which reduces the need for the Enterprises to draw additional funding from the Treasury Department. However, based on the terms of the PSPAs, this capital buffer is reducing each year. And, we are now over halfway down a five-year path toward eliminating the buffer completely.
Starting January 1, 2018, the Enterprises will have no capital buffer and no ability to weather quarterly losses - such as the non-credit related loss incurred by Freddie Mac in the third quarter of last year - without making a draw against the remaining Treasury commitments under the PSPAs. There are a number of non-credit related factors that could lead to a loss and result in a draw on those commitments: interest rate volatility; accounting treatment of derivatives, which are used to hedge risk but can also produce significant earnings volatility; reduced income from the Enterprises' declining retained portfolios; and, the increasing volume of credit risk transfer transactions, which transfer both the risk of future credit losses as well as current revenues away from the Enterprises to the private sector. A disruption in the housing market or a period of economic distress could also lead to credit-related losses and trigger a draw.
As a financial analyst with experience in the regulation of public utilities, it is my belief that FHFA should be expected to allow the GSEs to pay dividends on GSE preferred stocks, e.g., FNMAS and FMCKJ, and GSE common stocks, i.e., FNMA and FMCC, if doing so would contribute to the GSE's ability to recapitalize, thereby reducing the likelihood of draws on the Treasury.
Third, the "Treasury's SPSPAs" are the binding constraint on the GSEs paying dividends on their common and preferred stocks. But for the 3rd Amendment, the GSEs would have been financially able to pay dividends as early as 2012 or 2013.
If the FHFA had decided to recapitalize the GSEs in the 2012-2013 period instead of accommodating the Treasury's desire for a 3rd Amendment (a careful reading of the unsealed discovery documents indicates that that is a reasonable characterization of the FHFA's role in the 3rd Amendment), then it is plausible that FHFA would have agreed to the resumption of GSE common and preferred dividends at that time.
Consistent with the FHFA's Final Rule on Conservatorship and Receivership, this would have supported the GSEs' ability to recapitalize to rebuild their book equity capitalization.
Note that this would have been lucrative for Treasury as it would have allowed Treasury to "monetize" the value of its warrants on GSE common stocks.
Paying dividends on the investor-owned preferred stocks and the common stocks could have been a proverbial win-win-win-win. Good for Treasury, good for GSE investors, good for homeowners with GSE supported mortgages, and good for the general economic health of the mortgage markets as a whole.
Instead, Treasury/FHFA are bogged down in litigation with the preferred stockholder plaintiffs. The GSEs have essentially no book equity capital and a "draw" on the Treasury is possible at some time in the future. Note that this (hypothetical, for now) draw would occur more than eight years after the GSEs were seized and put into conservatorship.
Recapitalization will need to be dealt with by Treasury and FHFA at some point. Note that Treasury and FHFA did the SPSPAs and the three amendments to the SPSPAs and there is no apparent reason why Treasury/FHFA couldn't do a 4th Amendment and begin the process of recapitalizing the GSEs.
Q3. Would any investor (including the government) stop measuring their investment based on receiving cash dividends (or interest) in excess of the original principal?
A3. Yes. A lender of last resort does not expect a large profit when it acts to stabilize the economy.
An interested reader points out that:
With the apparent exception of the Plaintiffs and pro-litigation writers, I am unaware of any investor (including the U.S. Government) that stops measuring their investment based on receiving cash dividends (or interest) in excess of the original principal. Return on investment is not the same as the return of capital.
A government acting as lender-of-last-resort doesn't ordinarily seek to earn "windfall profits" from doing so. I've discussed the special treatment of the GSEs here and here. Bagehot's dictum, as summarized by Paul Tucker, says that "central banks should make clear that they stand ready to lend early and freely (i.e. without limit), to sound firms, against good collateral, and at rates higher than those prevailing in normal market conditions."
The GSEs were arguably financially "sound" firms at the time that the SPSPAs were imposed by Treasury/FHFA. They also had "good collateral" - as long as a "public utility" has a high market share and can charge rates to customers that are "high enough," than the regulated firm can be judged as having "good collateral," i.e., security that the regulated firm will be able to repay the loan. [Note, however, that the GSEs are not allowed to repay the Senior Preferred Stock.] There were "high rates" as well, first 10 percent and then later the 3rd Amendment's net worth sweep.
With respect to TARP (the Troubled Asset Relief Program), Treasury has not been able to make a profit on its TARP programs as a whole, but it has more or less broken even. To date, about 97.8 percent of TARP funds have been recovered. Given that the U.S. economy has performed relatively well (compared to other countries' with their "austerity programs") in recent years, this should not be especially surprising.
TARP wasn't intended to make a profit, it was about stabilizing the U.S. economy. Here is an example of what has been said about TARP by Treasury.
TARP was always meant to be a temporary, emergency program and most of the programs have been wound down. The government should not be in the business of owning stakes in private companies for an indefinite period of time.
That's why, after we extinguished the immediate financial fire, we began moving to exit our investments and replace temporary government support with private capital. Making a return on the taxpayer investments was not the primary purpose of the program, but the prudent execution of the TARP has helped to achieve its first goal - stabilizing the American economy - while minimizing the cost of TARP programs to the taxpayer."
Treasury is a government entity. Government "fund accounting" is pretty simple, it's about inflows of cash and outflows of capital, and avoiding a budget deficit. [I still remember the fund accounting class I took in college during the late 1970s.] The "net investment" calculation makes sense for a government entity. Treasury should try to at least break-even on its investment in the GSEs, but it shouldn't expect to do better than that.
Treasury has already recovered more than net investment, and it is safe to assume that Treasury will exercise its warrants to own 79.9 percent of the GSEs. But at some point enough has to be enough.
The Shapiro-Kamarck plan would shift ownership of 79.9 percent of the GSEs from Treasury to two affordable housing trust funds. Treasury would exercise its warrants and sell GSE common stock in the market, but then the Senior Preferred Stock would (somehow) go away.
That seems fair to me. Treasury would do far better financially than it did on TARP, but there would be an exit plan that is fair to Treasury, fair to GSE common stockholders, and fair to GSE preferred stock owners. More important, it is fair to American taxpayers and homeowners.
Q4. How would you respond to the comments of an interested reader as set forth below?
A4. An interested reader writes as follows:
…few observations: (1) Bagehot's dictum is not a law or policy of the U.S. Government or a right of investors. Treasury's involvement would not have been possible without an Act of Congress and the Fed would not have participated without Treasury's authority being exercised. (2) Regardless of the amount of dividends paid to Treasury over their original 10% terms, the GSEs would have negative regulatory capital and unable to operate in the financial markets without the support of Treasury and the Federal Reserve. (3) For the reasons stated in (2), no dividends would have been paid nor would the regulator permit them, even if they weren't already prohibited by the SPSPAs.
I would respond as follows:
1. Bagehot's dictum is considered "best practice" in the context of lender of last resort type lending. Thanks go to Treasury and the Fed for their efforts, but that doesn't mean that existing GSE common and preferred holders should be punished.
2. As set forth above, the GSEs would not have negative regulatory capital under the original 10 percent terms. The SPSPAs are currently a necessary replacement for the "implicit guarantee" that supported the GSEs prior to September 6-7, 2008, but financial recapitalization of the GSEs would reduce the GSEs' dependence on the SPSPAs.
3. I disagree about whether the GSEs would have received dividends in 2012-2013 but for the 3rd Amendment's net worth sweep. It's really all about the SPSPAs at this point. But for the 3rd Amendment and the SPSPAs, the GSEs could have significantly rebuilt their financial capitalization by now. Paying dividends beginning in 2012-2013 would have supported financial recapitalization via the issuance of additional common equity.
But for the 3rd Amendment, Treasury, FHFA, and the GSEs would have been much further along in decreasing reliance on the support provided by the SPSPAs, ceteris paribus. That would have been good for American taxpayers and ratepayers, including those taxpayers and ratepayers that have investments in the GSE equity securities.
Q5. Does this conclude this article?
A5. Yes. However, I want to note that I plan to continue my FAQ series, responding to comments from interested readers.
Disclosure: I am/we are long VARIOUS FANNIE MAE AND FREDDIE MAC PREFERRED STOCKS, INCLUDING FNMAS AND FMCKJ.
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: I am a consulting economist on economic, financial, and accounting issues related to the public utility industries.
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.