Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) are two companies in a conservatorship run by the Federal Housing Finance Agency (FHFA). Under the Obama administration, every nickel of net worth less a small and depleting capital buffer that Fannie and Freddie have made has been transferred to FHFA's sister agency the US Treasury. The net effect is that the two companies are being run as if they are off-balance sheet government agencies that are privately owned. Since the government has placed Fannie and Freddie into conservatorship the fees they charge to insure pools of mortgages (g-fees) have increased to generate additional government revenue.
Investment Thesis: The government regulates Fannie Mae and Freddie Mac regardless of if they are in conservatorship or not. Further, I presume that the lawsuits would need to get resolved somehow. The lawsuits primarily concern events surrounding the imposition of the net worth sweep in 2012. In 2014 a judge ruled that the government could do whatever they want and many other judges have echoed similar opinions. I don't own the common shares and I own the preferred shares. The only investment I have is in GSE preferred shares and I have borrowed over $200,000 in addition to contributing all of my capital. In retrospect, I did a fair job given the circumstances and choices I made across time. If I had known that it would be taking this long, I'd like to think that I would have structured my life so that it wouldn't have felt like I was waiting forever. Because I think that resolving the lawsuits is necessary as part of any recapitalization or outcome, I own preferreds. The government's handling of AIG kept me awake at night worrying when I held commons previously.
Mnuchin Senate Finance Committee Hearing
Thursday January 19 Mnuchin will have his hearing. Democrats can't stop him but they are working to increase the public's awareness of their story of events surrounding his past dealings. This is just the committee. Assuming he survives the committee he gets his confirmation vote at the full Senate which has yet to be scheduled but I guess could be as early as the following day but may take longer.
Mnuchin's November 30th remarks effectively changes the course of history if he becomes Treasury Secretary. Instead of treating Fannie and Freddie as if they are the scourge of the earth and a barren wasteland, it sounds like they'll be getting a more fair shake.
Fannie and Freddie were placed into conservatorship in 2008 and an agreement was structured such that the government could transfer wealth to itself by discretionarily writing down GSE assets. Investors didn't really discover that this was happening until well after accounting rules forced the companies to report profits and the net worth sweep was put into place. The government at the time and in earlier legal filings declared that the purpose of the net worth sweep was to protect the companies. Now, their legal argument has been backed into saying that they had the discretionary authority to do whatever they want, which if true makes you wonder why they didn't just do that from the beginning of conservatorship.
My perspective is that a quick analysis of the cash flow supports a historical forensic accounting analysis that suggests the conservatorship is a joke on the American people. I'm not a lawyer but unfortunately there are statutes of limitations that seem to apply in this case where it's taken us so long to realize we've been wronged.
Coming Full Circle
The government is in charge of pretty much everything. They regulate the business and the profits of Fannie and Freddie and therefore the eventual profitability and earnings attributable to common shareholders. The normalized cost to operate is 7 bps and historically the companies charged 25 bps and right now they are charging double that. Ackman's slide deck forecasts seem to me to be more wrong than right in numerous ways.
Assuming a 're-privatization', what are the capital requirements and how do we get there? Some accounts suggest that the documents will prove that the government has been lying about everything and that this will unwind the entire conservatorship sending the entire capital structure through the roof. Although I agree that this is what should happen from an ethical and moral perspective with the facts considered and put out into the open, I'm not betting on it or I would own common shares. Instead, I'm betting that the companies get recapped by issuing new equity. I don't think it's reasonable to expect the government to give up anything, but who knows. Maybe Mnuchin sees the fraud for what it is and goes to Donald and they use this to expose how corrupt the current administration's handling of Fannie and Freddie has been to date.
Prior GSE Detractor Stegman
Historically Stegman has been one of the administration's mouth pieces and has basically been a supporter of taking all of Fannie Mae and Freddie Mac's money away from them. More recently, Stegman seems more open to the future of the twins:
I am not sure if they have all the pieces in place to effectively take care of everything at this point or not. Do shareholders need legislation or a legal ruling to prevail? I don't know, but what I do know is that Mulvaney wrote something up last week.
Mulvaney's New Legislation
Mick Mulvaney drafted HR 491 for the 115th Congress.
- To provide for the repayment of amounts borrowed by Fannie Mae and Freddie Mac from the Treasury of the United States, together with interest, over a 30-year period, and for other purposes.
Mulvaney is the Trump nominee for Director, Office of Management and Budget (OMB). He's also openly criticized the actions of FHFA for getting around the law.
Watt On GSE Capital
Director of FHFA Melvin Watt has given a speech where he labeled the declining capital buffers of the GSEs as the most serious risk:
Enterprises' declining capital buffers. The most serious risk and the one that has the most potential for escalating in the future is the Enterprises' lack of capital. FHFA suspended statutory capital classifications when the Enterprises were placed in conservatorship, and Fannie Mae and Freddie Mac are currently unable to build capital under the provisions of the PSPAs. The agreements require each Enterprise to pay out comprehensive income generated from business operations as dividends to the Treasury Department, and the amount of funds each Enterprise is allowed to retain is often referred to as the Enterprises' "capital buffer." This capital buffer is available to absorb potential losses, which reduces the need for the Enterprises to draw additional funding from the Treasury Department. However, based on the terms of the PSPAs, this capital buffer is reducing each year. And, we are now over halfway down a five-year path toward eliminating the buffer completely.
Logic would dictate that if Mnuchin wants to amend the SPSPA to permit the build of capital or the end of the net worth sweep, Watt would support that.
AIG Part Deux?
If you look at the AIG recapitalization plan:
When AIG is paying off the New York Fed, transactions involving the Treasury Department will cause the department's stake in AIG to increase to 92.1% of the company's common stock, from 79.8% today.
I believe that dilution for that plan came from exercising the warrants and converting preferred stock to common. I know that some estimates suggest that the senior preferreds if the NWS is reversed would still have an outstanding balance making that part of how that played out potentially interesting in how this may play out. I don't think that the government played fair with AIG, GM, Chrysler, etc. With history as a guide I prefer to play as defensive as possible and simply bet on a recapitalization, the mechanics of which are still unknown to me but we all have our guesses.
Summary & Conclusion
I own 4050 shares of FMCCH, 9340 shares of FMCCP, 10127 shares of FMCCT, 2600 shares of FMCKI, 1341 shares of FMCKO, 6585 shares of FMCKP, 26876 shares of FNMFN and 5 shares of FNMFO. I own these shares because I am simply betting everything I have that I can't lose money by owning them. The legal cases against the net worth sweep have strong breach of contract claims, the accounting fraud is as clear as day in conjunction with a third grade analysis of the cash flows, and now we have an incoming administration that appears to be GSE friendly.
My only regret is that I wish I could have more. Martin Luther King Junior was a man who supported equal opportunity and Fannie Mae and Freddie Mac support equal opportunity affordable housing. These are not just good companies, they are two of the best companies in America and are Fortune 50 companies. Great people work for them and they continue to meet the needs of millions of Americans. I have a dream and that dream is quickly becoming reality.
Disclosure: I am/we are long FMCCH,FMCCP,FMCCT,FMCKI,FMCKO,FMCKP,FNMFN,FNMFO.
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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