Trump Administration - Valuing The Potential Outcomes For Freddie Mac And Fannie Mae Common And Preferred Stock Investors

| About: Fannie Mae (FNMA)

Summary

Fannie Mae and Freddie Mac (F&F) are in conservatorship and currently have very little common stock equity on their balance sheet.

Freddie Mac currently has $72.3 billion of Treasury Senior Preferred Stock outstanding and standing in priority of the common stock. Freddie Mac also has $14.1 billion of non-Treasury preferred stock.

President-elect Trump and comments from incoming Treasury Secretary Steven Mnuchin have recently driven up the price of Fannie Mae and Freddie Mac’s common and preferred stock securities.

The increase in F&F preferred/common stock prices is based on the belief that either a judicial or executive branch change to the Treasury agreements will be favorable to investors.

This article lists potential outcomes, assigns my probability to those outcomes, and encourages the reader to do the same for the purpose of obtaining fair value for Freddie's preferred/common.

Much has been written about the initial bailout of Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC), the subsequent changes to the agreement, and the outstanding judicial challenges to these changes. Much has also been assumed about what a new Treasury Secretary and Administration will mean for Fannie and Freddie (F&F) common and preferred stock investors. The assumptions on Seeking Alpha in articles and comments generally assume very positive outcomes for investors and in relatively short order. Since applying capital to F&F is almost entirely predicated on political and judicial outcomes, this investment is speculative in nature and high risk since a total loss of investment remains a possibility, especially for the common stock. A prudent investor, who wishes to invest with a margin of safety and a definitive edge, will want to examine all possible outcomes and assign conservative probabilities to those outcomes to verify whether indeed the security is undervalued and provides a positive expected net present value in excess of its current price. This article will use Freddie Mac and its related non-Treasury preferred stock securities and assign a value based on what I believe to be reasonable probabilities of the possible outcomes. You are welcome to add outcomes and change the outcome probabilities to match your opinion.

Freddie Mac currently has negative retained earnings, or an accumulated deficit, of $80 billion dollars. This is due to accounting losses during and after the Great Recession, which were plugged by the 2008 Senior Preferred Preferred Stock Purchase Agreement and draws against that agreement. The 10% dividend rate in the original 2008 Treasury Senior Preferred Stock agreement was changed in 2012 in what is known as the net worth sweep, or Third Amendment to the Senior Preferred stock agreement. The Third Amendment took all accounting income above a small token amount and swept it to the Treasury right as accounting profits, and thus payments to Treasury, became substantial. Treasury also currently owns warrants to purchase 79.9% of Freddie Mac at an exercise price of $0.00001 per share. In summary, the current state for Freddie Mac is that it has negative retained earnings, is required to send nearly all of its net worth to the United States Treasury, has a highly dilutive warrant outstanding, and potentially needs to raise a large amount of capital. To make matters worse, Freddie Mac's business consists of bundling packages of mortgages into securities that are given a guarantee of repayment (with an implied guarantee from the Treasury) and the primary customer of the business is the New York Fed. In addition, this business is funded with agency liabilities that also have an implied guarantee from the Treasury. So what is to like about an investment in Freddie Mac you ask?

Against the negative balance sheet and operational realities are the following positives. By the end of 2016, Freddie Mac will have made cumulative payments of $101.4 billion to Treasury against draws of $71.3 billion. Freddie Mac has historically operated with a very low level of capital in relation to its assets relative to other financial institutions. In addition, and most importantly, where before there was little political appetite to release these institutions from their current conservatorship state, recent comments by the incoming Treasury Secretary Mnuchin indicate they will be put back in private hands in a reasonably quick time frame. There are also judicial challenges to the net worth sweep and other aspects of the Treasury's investment in F&F that could see positive outcomes for investors.

First, let us get some basic information on Freddie Mac with respect to its financial condition.

Here is a balance sheet of Freddie Mac from its most recent 10-Q:

Source: Page 70 from FREDDIE MAC CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED) from Form 10-Q Filed: November 01, 2016 (period: September 30, 2016)

Next, let us get a working estimate of Freddie Mac's Treasury Senior preferred stock dividends required under a 10% dividend instead of the net worth sweep.

  • Approximate Freddie Mac Annual Dividends on Treasury Senior Preferred @10% are $7.2 billion.

Let us also get a working estimate of the non-Treasury preferred stock dividends. Here is the Freddie Mac Non-Treasury Preferred Stock Outstanding:

FMCC Preferreds.png

  • For simplicity's sake, let's take 6% as an average dividend against the $14.1 billion of non-Treasury preferred stocks outstanding to arrive at $.85 billion in annual dividends.

Now, let us see how much income has been available over the last three years to pay the preferred dividends and retain as earnings for common stockholders.

Last 3 Year Income.png

In 2013 through 2015, you can see comprehensive income of $48.7 billion, $9.4 billion, and $5.7 billion, respectively. The positive 'other income' numbers in 2013 and 2014 are non-agency mortgage-related securities settlements that are not typical and should be ignored. Furthermore, the large tax benefit in 2013 is a one-off as well. Let us use a conservative income available to the preferred and common shareholders of $5 billion dollars in a typical year.

  • Assume $5 billion in normalized annual income available to preferred and common stockholders.

Net Worth Sweep Removed/Treasury Senior Preferred Remain Outstanding

Assuming the net worth sweep is removed but the outstanding Treasury Senior preferred shares remain outstanding in full, we draw the following conclusion. Since this $5 billion does not cover the Treasury Senior preferred dividend obligations, we immediately see that without growth in earnings, the non-Treasury preferred stock and common stock have little possibility of receiving cash flows or having much of any value. This is even more so the case if the warrants were not cancelled.

Net Worth Sweep Removed/Treasury Senior Preferred Considered Paid in Full

On the other hand, what if we assume the net worth sweep is removed and the outstanding Treasury Senior preferred shares are considered paid in full. Since this $5 billion covers the non-Treasury preferred dividend obligations of $.85 billion, we see this level of earnings allows $4.15 billion to be retained annually on average. Take an earnings multiple of 10 times and we see a valuation of $41.5 billion for the common shareholders. If the Treasury warrants are exercised or sold to private investors, this leaves 20% of this value with existing shareholders, or $8.3 billion, and the rest with the warrant holders.

Net Worth Sweep Removed/Treasury Senior Preferred Considered Paid in Full/Capital Raise

Due to the net worth sweep, since Freddie Mac currently has almost no common stock equity ($1.2 billion) to support about $2 trillion dollars in assets, it is likely a capital raise of between $50 billion and $100 billion will be necessary to insure public funds are not required in the future. Or as Treasury Secretary Mnuchin said on Fox Business with Maria Bartiromo "...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." While $50 billion, or 2.5%, is an incredibly thin layer of capital to absorb losses, let us take that optimistic view. A capital raise of $50 billion would dilute the existing common shareholders to perhaps 5% if the warrants are cancelled and 1% if they are not. Assume a post transaction market capitalization of $55 billion due to the enhanced capital cushion and a 4.5% discount for new investors to incentivize the deal, this gives values of approximately $2.75 billion and $.555, respectively to the existing common shareholders.

Net Worth Sweep Removed/Treasury Senior Preferred Considered Paid in Full/Capital Raise in Form of Preferred Stock Exchange

The common stock equity raise could also come in the form of preferred and/or subordinated debt exchange offer. Since there is not much subordinated debt and it is very unlikely anything further up the capital structure will assume any haircut, only the preferred would likely be part of any exchange offer. With only $14 billion in face value of non-Treasury preferred stock outstanding, and non-Treasury preferred stock trading at about 25% of redemption value, an offer for shares representing common stock at, say, $7 billion (50% of redemption value), or 100% over current prices could attract some interest. However, even with the unrealistic assumption that every non-Treasury preferred shareholder tendered into the exchange offer, this would only provide an additional common stock capital cushion of $7 billion, not really making them 'safe'. Putting that aside for a moment, if $7 billion and perhaps $3 billion in existing common equity were allowed to stand without a capital raise, converted preferred shareholders would own about 17% of the common stock and existing common shareholders would own 83%, or $7 billion and $34.5 billion, respectively without warrant dilution. With warrant dilution, and assuming the preferred exchange is not diluted, common stock ownership becomes 17% for preferred exchange holders, 66.4% for warrant holders, and 16.6% for existing common shareholders, or $7.055 billion, $27.556 billion, $6.889 billion, respectively. I suspect this is an unlikely event for two reasons. Preferred shareholders would be giving up 50% upside to redemption value and as previously stated, the common stock capital cushion established is not sufficient.

Net Worth Sweep Removed/Treasury Senior Preferred Considered Paid in Full/Capital Raise in Form of Preferred Stock Exchange/Balance in Capital Raise

If in the exchange scenario, $43 billion is still required to get to a $50 billion capital cushion, and it is raised in a secondary common stock offering, the following valuations result. Assume once again a post transaction market capitalization of $55 billion due to the enhanced capital cushion and a 4.5% discount for new investors to incentivize the deal, and the ownership percentages are 81.7% for new investors, 12.7% for preferred exchangers, and 5.6% for existing common stockholders, or approximately $44.92 billion, $7 billion, and $3.08 billion, respectively if the warrants are cancelled. If the warrants were not cancelled, they would only affect the value of the existing common stock and the value would be $.616 billion.

Methodology

Since the primary driver of Freddie Mac security values are political and judicial outcomes, why not simply use a probability-based outcome valuation model. Using this model to determine whether Freddie Mac's common or preferred have value above their current state, we need to do the following for each individual security:

1) List the possible outcomes. (Outcomes)

2) Assign a probability to each of these outcomes. (Outcome Probability)

3) Assign a security valuation to each of the outcomes. (Outcome Value)

4) Multiple each outcome probability by the security valuation assigned to each of these outcomes (Outcome Value Weighting)

5) Sum all the outcome valuations (Estimated Future Security Value)

6) Discount Estimated Future Security Value by the Estimated Time to Outcome (Estimated Current Security Value)

7) Compare Estimated Current Security Value to the Current Price

Probability Based Analysis on Freddie Mac Common and Preferred

Outcomes

Outcome

Probability

Common Shares

Market Value

Common Share

Price

(Outcome Value)

Weighted Price

(Outcome

Value Weighting)

Preferred Share

Price

Assume $25

Redemption Value

Preferred

Weighted Price

Status Quo

5%

$650,000,000.00

$1.00

$0.05

10% of redemption Value

0.1

$2.50

$0.13

Net Worth Sweep Removed/

Treasury Senior Preferred Remain Outstanding/

Warrants Cancelled/

No Common Stock Capital Raise Required

5%

$1,950,000,000.00

$3.00

$0.15

20% of redemption value

0.2

$5.00

$0.25

Net Worth Sweep Removed/

Treasury Senior Preferred Remain Outstanding/

Warrants Remain/

No Common Stock Capital Raise Required

10%

$390,000,000.00

$1.67

$0.17

20% of redemption value

0.2

$5.00

$0.50

Net Worth Sweep Removed/

Treasury Senior Preferred Considered Paid in Full/

Warrants Cancelled/

No Common Stock Capital Raise Required

5%

$41,500,000,000.00

$63.85

$3.19

100% of redemption value

1

$25.00

$1.25

Net Worth Sweep Removed/

Treasury Senior Preferred Considered Paid in Full/

Warrants Remain/

No Common Stock Capital Raise Required

5%

$8,300,000,000.00

$12.77

$0.64

100% of redemption value

1

$25.00

$1.25

Net Worth Sweep Removed/

Treasury Senior Preferred Considered Paid in Full/

Warrants Cancelled/

Common Stock Capital Raise Required

20%

$2,750,000,000.00

$4.23

$0.85

100% of redemption value

1

$25.00

$5.00

Net Worth Sweep Removed/

Treasury Senior Preferred Considered Paid in Full/

Warrants Remain/

Common Stock Capital Raise Required

20%

$555,000,000.00

$0.85

$0.17

100% of redemption value

1

$25.00

$5.00

Net Worth Sweep Removed/

Treasury Senior Preferred Considered Paid in Full/

Warrants Cancelled/

Common Stock Capital Raise

In Form of Preferred Exchange Only

5%

$34,500,000,000.00

$53.08

$2.65

50% of redemption value

0.5

$12.50

$0.63

Net Worth Sweep Removed/

Treasury Senior Preferred Considered Paid in Full/

Warrants Remain/

Common Stock Capital Raise

In Form of Preferred Exchange Only

5%

$6,889,000,000.00

$10.60

$0.53

50% of redemption value

0.5

$12.50

$0.63

Net Worth Sweep Removed/

Treasury Senior Preferred Considered Paid in Full/

Warrants Cancelled/

Common Stock Capital Raise

In Form of Preferred Exchange and New Issue

10%

$3,630,000,000.00

$5.58

$0.56

50% of redemption value

0.5

$12.50

$1.25

Net Worth Sweep Removed/

Treasury Senior Preferred Considered Paid in Full/

Warrants Remain/

Common Stock Capital Raise

In Form of Preferred Exchange and New Issue

10%

$726,000,000.00

$1.12

$0.11

50% of redemption value

0.5

$12.50

$1.25

Sum of Probabilities:

100%

FMCC (Estimated Future Security Value)

$9.07

FMCC Preferred Stocks (Estimated Future Security Value)

$17.13

Discount 1 year at 10%:

$8.24

Discount 1 year at 7%:

$16.00

FMCC Price as of Close on 12/14/16:

4.01

6.5

Discount to Models Value:

48.64%

Discount to Models Value:

40.61%

Return to Models Value:

105.58%

Return to Models Value:

146.23%

Conclusions:

Of course, the above is just one of many possible value results one might get as they apply their own probabilities. In addition, I have ignored some possibilities such as that the Treasury Senior Preferred Stock redemptions are determined by the actual draws from and payments to Treasury and the original 10% rate agreed upon. Some may also wish to consider the outcome that the common stock, or even the non-Treasury preferred for that matter, is extinguished entirely in a pre-packaged bankruptcy like reorganization, given the lack of equity available for existing common and preferred stockholders if previous payments do not end up being considered redemptions. However, these results can largely be derived by applying a large probability to the status quo outcome and/or changing that outcome's price. For status quo, the prices picked were simply the trading prices, albeit with a discount to the pre-election results/Mnuchin comment events.

Please note that the Freddie Mac common stock value is strongly determined by whether a common stock capital raise will occur. I have assigned a 70% probability to that occurring. A bet on the common over the preferred is mostly predicated on the belief that F&F will be allowed to rebuild capital over time through retained earnings versus a capital raise or reorganization event. Given Mnuchin's comments to make them 'safe', I read this as insuring an adequate capital buffer will be required so that the markets will never doubt their ability to make good on their liabilities during good times and bad. Agency mortgage bond traders, of which Steven Mnuchin was one, and the wealthy insurance companies, banks, asset management firms, and pension funds that are their customers, can make for a far more powerful lobbying group than the remaining F&F preferred and common stockholders. These large and powerful institutions depend on the trillions of dollars of outstanding and new issue agency liabilities being good as Treasuries. And should things go awry again, they do not want to count on the American public supporting these institutions again for their livelihood. Therefore, my opinion is that a recapitalization is likely part of any deal to remove the net worth sweep and consider the Treasury Senior Preferred Stock redeemed. The Treasury warrants being cancelled in addition to all of the above, would certainly make the common stock a home run. Perhaps as much as 10 times current market prices. However, I see this outcome as unlikely. If you want to swing for the fences, go for the common stock, but the preferred stock looks like a much better risk-adjusted investment. With a reasonably likely return to redemption value, or four times current market prices, my bet is on the preferreds.

Disclosure: I am/we are long FMCCL, FMCCN.

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: Do your own research, make your own investment decisions, and own those choices.

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.

About this article:

Expand
Author payment: $35 + $0.01/page view. Authors of PRO articles receive a minimum guaranteed payment of $150-500.
Want to share your opinion on this article? Add a comment.
Disagree with this article? .
To report a factual error in this article, click here