Chances are anyone reading this article is already familiar with Glen Bradford's work chronicling the fate of the Government Sponsored Entities, (GSE) Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC). As my profile points out I have no formal financial or accounting training, I am self taught. While I do have some understanding of the basics of valuing stocks I rely on the work of others in addition to my own checks to evaluate an investment. With that said I've relied on Glen's work and the work of the many intelligent followers commenting on his articles to get an understanding of what's going on with these investments.
I'm not going to rehash the history of the GSE's conservatorship and the legal battle of investors to regain their investment. Anyone not familiar with the story can read through Glen's articles I linked above. There are two interesting pieces of information I picked up along the way that I am going to expound upon for this article. The first is a valuation of the GSE's common stock provided by Bill Ackman of ~$20.00/ share. I do recall this valuation assumed the government would exercise the warrants which would dilute existing shareholders stake to just 20%. The second piece of information is that most of the institutional interest in the GSE's was through their preferred stock and not their common stock.
Backtracking a bit, while I appreciate Glen's work chronicling the fate of the GSE's, I was skeptical of his article of faith belief that the legal system would return the GSE's to shareholders even after the government went 5 for 5 in court rulings predicated on the assumption that the GSE's had been affectively nationalized. A good part of my skepticism derived from the fact that both sides of the political aisle were in favor of the government's argument that the GSE's now belong to tax payers although for polar opposite reasons. In short, the left wants to incorporate the GSE's functions into a government run service. The right see's the implied government backstop of the GSE's as an abomination of the free market and wants their functions doled out to pure private banks with no government guarantees.
With only a couple of "greedy" hedge fund managers as the spokespeople on behalf of GSE investors (until Trump's win) I had no interest in betting against the government in court as the downside was a complete loss. However the Treasury Secretary to be Stephen Mnuchin's recent proclamation that getting the government out of ownership of the GSE's is a top priority changed all of that for me. While a massive run up in the GSE's common stock would suggest this is great news for the common stock my gut was telling me it's time to figure out why the smart investors are betting on the preferred shares.
As a self taught investor there are holes in my knowledge base. I feel pretty comfortable valuing common stock, however, I don't have a great understanding of other types of investments and thus I tend to stick to just common stocks outside of mutual funds. I understood in general what a preferred stock was but I lacked a more detailed understanding of this type of investment. I did notice from Glen's articles that getting back to "Par" value was a key assumption behind investing in preferred stock and I finally decided to look into this. Par Value is also referred to as Liquidation Value and it is the price preferred shareholder will receive if the stock is liquidated. It effectively acts as a kind of fair value for preferred shares. Looking at the charts of a couple of preferred stocks pre great recession confirmed they tend to trade near liquidation value in normal times.
Glen provides a list of a number of preferred stocks at the ends of his articles that he's invested in and he has stated that he's piggy backing the investments of the hedge funds fighting the government in court. In looking into these preferred stocks they all currently trade for about 25% of their liquidation value although they've run up since Trump's win and Mnuchin's announcement. The common stock on the other hand currently trades for about 18% of Ackman's fair value. While the common stock would seem to have more upside I believe there is a key factor missing from Ackman's valuation that has been eluded to in some recent commentary that the institutional investors choosing the preferred shares likely figured out.
Here is a news alert regarding a KBW analyst note that recapitalization of the GSE's would likely result in their stock being worthless. This recent SA article brings the same issue up although in a more measured tone. The S.A. article points out that the GSE's currently sport $1.2B in capital, however, GSE loyal followers know their capital base has been intentionally run down and is set to hit zero in 2018. The author notes that while the GSE's are wards of the state their capital level is not a concern as Uncle Sam will back them up. As privatized entities they'll need a whole lot more capital. The article mentions current government guarantees over $100B each. With market caps in the low single digit billions; if they need to raise 10's of billions or worse via equity in order to recapitalize upon returning to privatization it will dilute common shares into oblivion.
I believe this is what the KBW analysts are getting at and it has precedent with the TBTF banks. They were forced to take TARP money to resolve a liquidity crisis in the banking system and once the crisis was resolved they were pressured to repay TARP ASAP via secondary stock placements with all TBTF banks repaying in full with interest in less than a year resulting in varying degrees of dilution. Citi's shareholders were effectively wiped out while Well's and JP Morgan shareholders were left relatively unscathed. Banks were also forced to raise cash via secondary offerings if they failed the annual stress tests that got tougher each year for the first few years. Since the banks were scapegoated with responsibility for the entire crisis and recession an element of "punishment" to avoid "moral hazard" was also part of the rationalization of forcing common stock holders to bear the brunt of bolstering the banks against a future crisis.
I know Glen and his followers feel the GSE's never needed assistance to begin with and will point to the fact that the capital shortfall was at least in part by design and therefore common shareholders should not be forced to bear the brunt of the recapitalization, however, the smart money doesn't seem to be betting that way. In Glen's defense he also switched to all preferred, however, as I recall it was due to piggy backing institutional investors. Maybe he also understood the recapitalization risk as well, however, I don't recall him discussing this risk and so I figured I'd bring it up for the consideration of non accountant types like myself.
One last point on "privatization". Mnuchin did not specify how he would like to see the GSE's privatized. The run up in the common stock after his announcement assumed they would be returned to existing shareholders. Hard core "free market" right wingers want to see their services doled out to pure free market banks. Another option would be to wipe out current shareholders and start over with new shareholders as in a bankruptcy restructuring. This is something I've been considering and have come to the conclusion that returning the GSE to current shareholders but punishing them with massive dilution (that will not affect preferred shares) is the most likely scenario.
From what I understand of the "pure free market" argument the GSE's artificially prop up property values which forces owners to pay out too much of their income over time and that if free market forces were allowed to dictate prices, property values would plummet and home owners would ultimately benefit from spending less total money on their mortgage. This point of view probably makes sense if we were at a time before the GSE's came into being, however, as the recent "great recession" proved plummeting property values would wreak havoc on the economy in the short to midterm and is not a realistic option at this point in history.
Just as Trump is beating a hasty retreat from his most controversial campaign promises now that the reality of the responsibility on his shoulders is setting in, I'm fairly sure Mnuchin understands the repercussions of an ideologically pure privatization of the GSE's and will steer the process to the more realistic return to almost private status, with a higher capital level requirement that will be borne on the backs of common shareholders to avoid the "moral hazard" of having "bailed them out".
IMO This will be the grand compromise that will have something for everyone. Democrats get to influence the "government" sponsored entities, hard core free marketers get a pound of flesh and higher capital and the middle gets to maintain the status quo in the housing market. For this reason I avoid the common stock and stick to the preferred with one caveat. The preferred are extremely illiquid so if you are gaming short term events the common are the way to go. If you are gaming the ultimate resolution of the GSE's IMO the preferred shares are the safe bet. In regard to which preferred shares I looked at the current discount to liquidation value and found they all traded near 25% of liquidation value. As it turns out there was an article on the subject published today that can handle this better than I can if you are looking for a more nuanced explanation.
Disclosure: I am/we are long FMCCH.
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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