Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) are two companies (GSEs) that have been forced by their conservator to hand the US Treasury all of their money in a series of payments stringing back to the beginning of conservatorship. The payments started innocently enough as the government forced Fannie and Freddie to write down hundreds of billions of dollars of assets in the early years of conservatorship. The intent of these writedowns was to choke off the existing equity holders by inserting enough senior preferreds between existing equity and creditors so that the government could justify zeroing out existing equity. The government's slow-roll nationalization has banked on evading statutes of limitations and shareholders sleeping at the wheel. Unfortunately for the government, they didn't act soon enough.
Investment Thesis: The really big problem here is that the government did not effectively close the door. The government waited till after they were forced to report profitability to implement the Net Worth Sweep. After the GSEs started reporting profits, the government implemented the Net Worth Sweep. The government fell asleep at the wheel of the largest heist in history and that's just one reason why they're not going to get away with everything. That being said, one worst case scenario is that they're able to get away with $100B+. The incoming administration has expressed an interest in changing the course of history of Fannie Mae and Freddie Mac, whereas the current administration has all but assured their demise. The lawsuits against the government action have not only been buffered by the fact that the government fell asleep at the wheel but also left a long trail of evidence, some of which has been produced publicly as part of the discovery process that was used to show the government lied in its earlier court arguments in Perry Capital which is now fully briefed on appeal and we all are awaiting a ruling. There are different pieces of the conservatorship that are being contested in court:
- The conservatorship (2008)
- The accounting fraud (2008-2012)
- The net worth sweep (2012)
Any change to the status quo where the government siphons off the profits of Fannie Mae and Freddie Mac would begin rebuilding their capital buffers. The preferred shares would initially participate in the early equity build after which the common shares would likely retain some claim on residual earnings.
The conservatorship began with the government issuing itself 79.9% warrant coverage and issuing itself a senior preferred security with some peculiar terms. Instead of terms designed around liquidity needs, the terms were designed around discretionary accounting adjustments that FHFA was to decide in the future. Washington Federal is a lawsuit that contests the conservatorship. It is my understanding that it is the only one at present, but that as discovery is produced in the Court of Claims it is possible for lawsuits that were filed within the appropriate statute of limitations to be amended. I'm not expecting this and I'm not a lawyer.
The Accounting Fraud
One of the accounting fraud lawsuits was settled. Both Fannie Mae and Freddie Mac's auditors were sued by investors for signing off and the bigger lawsuit of the two remains outstanding. In so far as a financial restatement is concerned, it would appear that a financial restatement where the accounting fraud was reversed would put $100B of liquidation style cash transfers back to the companies.
As far as incentives go, the SEC is the government agency that would force this and I'm not expecting them to do the right thing. Generally speaking, accounting fraud is one of those things that the SEC would hunt down and resolve over time but in this instance doing so would not be in the government's best interest although it would be in the best interest of transparency.
The Net Worth Sweep
The net worth sweep was put into place in 2012 in order to officially vacate the capital buffers of Fannie Mae and Freddie Mac. The government argued that the net worth sweep was necessary to protect the two companies from losing even more money, but this argument has lost credibility due to evidence produced by discovery.
There are many technical legal arguments as to why the net worth sweep is illegal, but none of them have found friendly rulings that have ended it yet and several judges have dismissed such cases. Judge Lamberth originally dismissed in 2014 and judges around America have joined Lamberth's chorus. The most recent member of the dismissal chorus was the Voacolo dismissal. Lamberth's dismissal is fully briefed on appeal and is one of less than five cases that have not been ruled on from last term that are still outstanding. In other words, keep your eyes peeled on the website Tuesdays and Fridays around 10 am.
The most recent Perry Capital skirmish was a back and forth regarding the interpretation of a somewhat related case. The government filed its notice first. Plaintiff lawyers filed their two-page response swiftly:
The plaintiffs are suggesting that the government is incorrectly interpreting what is actually happening. Given the series of events and the fact that I've read literally every legal filing thus far, to me it's self-evident that the government chose to take a series of designed-in-advance actions that effectively nationalized Fannie Mae and Freddie Mac. The off-balance sheet accounting treatment that was used to sweep their earnings to Treasury while zeroing out shareholders has by some accounts put taxpayers at risk.
The government argues that it doesn't put taxpayers at risk and frankly I think the way most people say stuff doesn't seem to make any sense so I like saying it right. The government is the tax collector and the rest of us including Fannie Mae and Freddie Mac are tax payers. The conservatorship has been a vehicle for the government to convert Fannie and Freddie into tax collectors but it's either running out of gas or off a cliff. If the government succeeds with its current plan of action the taxpayers that are buying and selling GSE securities that are senior to equity shareholders would be put at risk. This is in contrast to the practical intent of the conservatorship which was to provide stability to agency mortgage-backed securities. Since conservatorship has been put into place the government has elected to dividend to itself the net worth of the GSEs winding their capital to zero. The money that should have been preserved to make these credits whole has instead been swept to Treasury.
For most of the equity universe, an investor doesn't have to worry about the government unilaterally nationalizing their property. In this particular case, that's what's happened and the path to pay dirt is the timeline for getting any of it back. In this particular instance, we've got an incoming administration that has expressed interest in preserving two entities that the outgoing administration has scapegoated. I'm not particularly sure whether or not Corker's GSE Jumpstart prevents the self-destruction of the SPSPA, but I do believe it permits some sort of amendment that permits the GSEs to build capital instead of shovel it off to Treasury. I'm not a lawyer but I believe in the government's ability to do what it wants and to settle the lawsuits and fix this mess if the tide truly is turning.
Summary & Conclusion
The most contested and frankly unusual piece of all of this is the possibility that the government might be able to get away with a lot of the shenanigans that have transpired under its watch so far. I don't think that the warrants should be exercised but that's because I took an ethics course at university.
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, 27269 shares of FNMFN and 5 shares of FNMFO.
I don't own common shares because I am unable to predict the future capital structure of Fannie Mae and Freddie Mac. Further, I'm not able to reason why the government wouldn't lower guarantee fees to historical norms when they are no longer net worth sweeping them all.
At this point I'm willing to admit that maybe I'm jaded. I'm willing to admit that I'm kind of expecting the government to close out of this chapter by exacting as much damage as possible which may not necessarily be the case. Maybe the incoming administration goes out of its way to expose the current administration's wrongdoing by publicly releasing all of the 11,292 documents that plaintiffs have fought for, for years, and even had a judge rule that the government has improperly withheld.
Needless to say, even that is locked up as we head into 2017 but eventually courts will rule on the Writ. I have no idea, I'm not a lawyer. I do think that it's becoming obvious that the fate of Fannie Mae and Freddie Mac is going to be decided in 2017 and I'm betting my life savings that they will survive and thrive.
Disclosure: I am/we are long FNMFN,FNMFO,FMCKO,FMCKI,FMCKP,FMCCT,FMCCP,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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