Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) are two companies that are being stripped of their profits every three months as part of a government run conservatorship. The first three to four years of conservatorship were defined by writing down Fannie and Freddie's assets and the more recent years were defined by reversing those writedowns. If that sounds like accounting fraud, you may be surprised to know that PricewaterhouseCoopers recently settled a lawsuit alleging accounting fraud. The status quo leaves both the common and some of the preferred shares worthless. Basically, if you can own it, it's worthless. If the government owns it, it takes everything.
Investment Thesis: The Obama administration is soon to be replaced by a new president, Donald J Trump. When Trump won the election, the publicly traded shares that you and I can own soared and when he announced the new Treasury Secretary Steven Mnuchin shares soared even further. Preferred shares now trade between 20 and 30 cents on the dollar. Depending on your perspective the common shares have more or less upside than preferred shares. It has now been 138 days since July 20th, 2016. There are a handful of legal rulings left from the last informal term at the DC District Court of Appeals. I figure a legal ruling that is remand or reverse will send shares soaring yet again. Eventually the hope is to bring an end to the net worth sweep, which the government argues in court that it can put into place without justification.
The Net Worth Sweep: An Aberration
HERA was passed into law in 2008 and it governs FHFA. FHFA argues in court that they have no fiduciary duty to shareholders. How is it that a company can be taken over without payment by any entity that claims no fiduciary duty? In America we are protected by the Fifth Amendment to the Constitution which prevents confiscation without just compensation. In this particular instance the government flouts confiscation for $0 compensation. So far, lots of legal rulings have fallen in favor of the government's interpretation of the law. Judge Lamberth gave the government a pass saying that the government could effectively do whatever they wanted to based on his read.
If true, HERA would be unconstitutional. Plaintiffs in one case suggested that this permits the conservator to take Fannie and Freddie's money and buy itself a fleet of yachts. The irony is strong.
STACRs/CAS - Where GSE Money Goes To Die
Instead of FHFA and government leadership going out and buying yachts, they've handed out GSE money to institutions as part of what they call risk sharing transactions. These so called risk sharing deals are risk sharing to the extent that they help share the risk of legal consequences surrounding the implementation of anti-GSE policies within the government. By giving away Fannie and Freddie's money, it makes the two look less profitable than they actually are and this helps put a lid on investor claims that the net worth sweep is illegal.
Let's Make A Deal
Obama has on a net basis drained over $100B out of Fannie and Freddie since they were placed into conservatorship. This figure looks at only the cash flow to and from the GSEs. When they were placed into conservatorship they had their highest levels of capital in history and now they are at their lowest. This is despite the fact that throughout this period the two companies continued to produce cash profits. In effect, the government basically forced the two companies to take money they didn't need in order to justify taking them over and could only do so by taking accounting control and declaring valuable assets as worthless.
That was then. This is now. After 8 years of trying to crush the living daylights out of Fannie Mae and Freddie Mac we have an incoming Treasury Secretary who thinks that it's time to make a deal. When it comes to making a deal, the two companies have by design been bled dry of all capital. Either the government needs to give back some of the capital it has taken or the companies need to be able to raise capital on their own from their current state of affairs. I am not betting on the government giving back a dime of what it's taken from Fannie and Freddie although it has taken by my count a trillion dimes across eight years making this arguably the largest theft in world history with the fewest moving pieces. I mean face it, in order to steal that much in the past, it would have taken armies, not a few accountants and signatures.
Second to capital comes all the other stuff. How does the government exit its position. Does it allow itself to be bought out? Does Mnuchin say that the senior preferreds have been paid back? If so, does he exercise any of the warrants? Some shareholders claim that doing so is illegal suggesting they are invalid. I'm not a lawyer but from a fairness perspective doing so meets my criteria of the government taking something for nothing and I think that on principle they shouldn't. These are all questions that I wouldn't have asked a few months ago when the main course of resolution would have strictly been through the courts.
At what level do they set G-fees when the government isn't either taking them all or isn't passing them out like candy via STACR/CAS transactions? I figure G-fees return to their historical level of around 30 basis points. Prior CFO Timothy J Howard suggested that 7 basis points was the watermark for sustainability.
Summary and Conclusion
No matter how I look at it, it still looks like the government is in the drivers seat for how Fannie Mae and Freddie Mac are handled with the exception that preferred shareholders seem to have a fairly strong breach of contract claim. That's why I own preferreds. I have also moved my mother and her mom both into preferreds, too.
I have 4050 shares of FMCCH, 9340 shares of FMCCP, 9714 shares of FMCCT, 2600 shares of FMCKI, 1025 shares of FMCKO, 6585 shares of FMCKP, 27225 shares of FNMFN and 5 shares of FNMFO.
I am not sure if the next big shoe to drop is a legal ruling or an administrative action. I also am not sure with regards to how long it takes the two companies to be put back onto solid footing. There are lots of binary decisions that need to be made by those in charge that will determine how this plays out for shareholders. I figure that it's not but a few months until we get some wild swings and I'm all strapped into this rocket. I've examined the rocket, done my rocket science and calculated my trajectory to the moon and am pretty sure I'm not going to blow up at this point since we're already on our way. Out with the old. In with the new. That's what's happening.
Disclosure: I am/we are long FNMFN, FMCKO, FMCKI, FMCCP, FMCCT, FMCCH, FNFMO, FMCKP.
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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