These are interesting times for investors in Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC), which are together known as the government sponsored enterprises or GSEs. U.S. Treasury Secretary nominee Stephen T. Mnuchin had encouraging things to say about the GSEs last week.
It makes no sense that these are owned by the government and have been controlled by the government for as long as they have.... In many cases this displaces private lending in the mortgage markets and we need these entities that will be safe. So let me just be clear- we'll make sure that when they're restructured they're absolutely safe and they don't get taken over again. But we gotta get them out of government control.
In this article, I will explain that:
-A simple solution to the status quo situation for GSE common and preferred equity investors can be found.
-Implementing this simple solution will not be easy.
-Under the "call it even" plan, the U.S. Treasury (Treasury) would have the equivalent of a "golden share."
-Treasury would acknowledge that it has been reimbursed in full for the draws on the Treasury during the financial crisis period, the net worth sweep would be eliminated, the senior preferred stocks would be cancelled, and the warrants to own 79.9 percent of the GSEs' common equity would be cancelled.
Given the tangled mess that the structure of the Senior Preferred Stock Purchase Agreements (SPSPAs) and the related Senior Preferred Stock certificates presents, the restructuring of the GSEs will face a number of financial, economic, and legal challenges.
While there have been encouraging developments for GSE equity investors in the past week or so, uncertainties and risks remain. Thus, GSE equity investors should continue to do their own due diligence.
A simple solution such as the one laid out in this article could provide a catalyst to a rapid resolution of the ongoing litigation, providing a solution that is in the public interest while being fair to GSE common and preferred equity investors. This would have important implications for GSE equity investors.
1. A simple solution to the current quagmire can be found.
The Treasury government would get a "golden share," meaning that it would have veto power if it believes that one or both of the GSE Boards of Directors had announced major steps that would be inconsistent with the public interest. Except for the powers provided by the golden share, Treasury would allow the Federal Housing Finance Agency or FHFA to be the sole regulator of the GSEs, consistent with the Housing and Economic Reform Act of 2008. In exchange for the golden share, Treasury would "call it even."
Rather than solve the issues in "one fell swoop," I would suggest that Treasury and the FHFA address the issues in a sequential manner.
I would suggest the following sequential steps:
-A 4th Amendment would end the net worth sweep and lower the senior preferred stock dividend rate from 10 percent to five percent.
-The GSE common and preferred stocks would be re-listed on the NYSE.
-Treasury would acknowledge that it has been fully repaid and the Senior Preferred Stock certificates and the warrants would be cancelled. In exchange, Treasury would get a golden share, giving it veto power in certain corporate situations.
-There would be a collateral-based line of credit going forward from Treasury to the GSEs, with an interest rate of (perhaps) 50 basis points above the Treasury Bill rate plus a commitment fee of perhaps 50 basis points. Note that this would not be an explicit or implicit "guarantee," but merely a collateral-based line of credit.
-Financial recapitalization of the GSEs' would begin, subject to regulation by the FHFA.
-To facilitate the attraction of new common stock investors, the dividends on GSE preferred stocks would be restored and a small common stock dividend would be established.
-Once the financial recapitalization has been accomplished, the conservatorships and the SPSPAs would end, replaced by the golden share and the collateral-based line of credit.
None of this would require action in Congress. I would argue that this solution is consistent with the public interest while also treating existing GSE common and preferred holders fairly.
This simple solution would support the financial recapitalization of the GSEs thereby restoring the GSEs' financial integrity, meaning that it would, going forward, be able to raise new equity capital at favorable terms in both good markets and bad without the support provided by the SPSPAs.
3. A "golden share" is sometimes used to give a government veto powers
A golden share gives a government the right of decisive vote, thus it can outvote all other shares in a shareholder meeting. This gives a government veto powers over major corporate actions of a company's board of directors, such as the sale of a company or a major asset or subsidiary of the company. More generally, it can be used to prevent the GSEs from doing something that Treasury believes is not in the public interest.
In Europe, courts have criticized golden shares as inconsistent with the principle of free circulation of capital within the European Union. Golden shares can block the ability of other direct investors to establish economic links with a company.
It is my understanding that the courts have ruled that golden shares do not violate the EC Treaty per se. Thus, European governments have some ability to retail their golden shares, subject to the legal criteria established by the court.
In the context of privatization, a golden share can usually be retained only for a defined period of time to allow the privatized company to adjust to operating as a private company in an industry that is "affected with the public interest," e.g., public utilities and other infrastructure providers.
Golden shares are rarely used in the U.S. However, in the merger between National Grid plc and KeySpan, the New York State Public Service Commission (NYSPSC) ordered that a golden share be used by Niagara Mohawk to "ringfence" a bankruptcy of National Grid or an affiliate from Niagara. Thus:
As directed by the Commission, the Company has modified its certificate of incorporation to establish a "golden share" intended to prevent a bankruptcy of National Grid plc, National Grid or any affiliate from automatically triggering a bankruptcy of Niagara Mohawk without the approval of the holder of the golden share, a trustee charged with acting in accordance with the best interests of New York. The protections also prohibit the Company from paying common dividends without Commission approval if its or National Grid plc's bond rating on their least secure form of debt falls below investment grade as determined by one or more U.S. nationally recognized rating agencies, or either entity's bond rating falls to the lowest investment grade rating and is on negative watch or review for a further downgrade. Finally, no debt associated with the KeySpan merger may be reflected as an obligation of Niagara Mohawk on its regulatory or US GAAP books and records. Niagara Mohawk also has pending before the Commission certain Rate Plan Provisions (filed January 31, 2012 in Case 10-E-0050) in which it has agreed that the Company would be prohibited from paying dividends if its average total debt exceeds 57% for both the most recent three- and six- month periods until the average total debt is reduced to 55% or less over the most recent six months ending at the end of a quarter.
Jones, Megginson, Nash, and Netter, in their article "Share issue privatizations as financial means to political and economic ends" (Journal of Financial Economics 53, 1999, 217-253) point out that:
We also find that governments almost always insert control restrictions in the charters of privatized firms, or retain golden shares, which are designed to ensure that the privatized firm will not be fully controlled by foreigners or successfully targeted for hostile takeover... One method of maintaining ultimate governmental control ... is the golden share, which is especially popular in the U.K. (90% of the U.K. firms have golden shares). A golden share is a special share retained by the government that enables it to veto mergers, liquidations, asset sales, and other major corporate events. Privatisation International often reports whether a firm has a golden share but no other information about the post-privatization control structure. The government can also directly insert similar control restrictions into the corporate charter. ... In spite of the pervasiveness of golden shares, we know of only two cases in which a government has threatened to trigger the share.
While the GSEs have never been explicitly nationalized and the GSEs' common and preferred stocks have never been explicitly expropriated, there is a sense in which the GSEs will be privatized via the end of the 3rd Amendment, the cancellation of the senior preferred stocks and the warrants, financial recapitalization of the GSEs, and the end of conservatorship.
On balance, it may be in the public interest for Treasury to retain some control over the GSEs via the golden share and a collateral-based line of credit to the GSEs, so long as the punitive aspects of the SPSPAs are eliminated.
Disclosure: I am/we are long VARIOUS FANNIE MAE AND FREDDIE MAC PREFERRED STOCKS, INCLUDING FMCKJ AND FNMAS.
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: Economic consultant, no an attorney.
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