Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) are two companies that are being stripped naked of their capital as part of a government plan to leave their existing non-governmental equity shareholders with nothing and put their non-governmental debt stakeholders at risk. The government's stake in the equity via Treasury combined with their conservatorship control via FHFA has made for a case of the "what's yours is now nationalized" that was earlier justified by a deliberately punative accounting agreement and a batch of temporary accounting losses 2008-2011. Subsequently, the justification has become, "we can do whatever we want" and last week a three judge panel ruled 2-1 that, yes, the government can do whatever they want, but that when they step into the shoes of the board of directors and violate contracts there are consequences and that this needs to be further explored in lower court.
Investment Thesis: Any intellectually honest observer would note that the cash flows do not lie, but the accounting often does. In this case, on a net basis no matter how you do the math billions upon billions of dollars have been transferred to the government and it should be no surprise that the government orchestrated it all from their position of power but it should be a surprise that they have laced the path of getting answers with booby traps. We are now years into multiple litigation strategies attacking the government's actions from multiple angles and while the DOJ sandbags the cases by pulling every trick in the book, the new Treasury Secretary plans for some sort of reform. Before this past week, one might expect that based on prior statements Secretary Steven T. Mnuchin would fix the GSEs very early this year but he threw cold water on that notion saying that tax reform comes first. This change of pace is likely due to the Perry Capital legal ruling. I own GSE preferred shares and I think that at some point I will get paid. The question that I will attempt to address in this article is the potential mechanics of how. I don't know how exactly the government would politically justify putting the enterprises into receivership based on a DTA technicality when the companies aren't actually struggling at all financially and I'm not saying that they will. I'm just saying that it looks like it is on the table if nothing changes, and for all I know maybe that's what they're going for. There are potentially alarming implications to different stakeholders if the receivership route continues to materialize.
Jacobs and Hindes
It has been ruled that the plaintiffs can amend their filing:
As you may recall this lawsuit centers around state claims. The claims this lawsuit centers around are very similar to the ones that the Perry Capital ruling seemed to remand. My guess is that the Perry Capital ruling put this lawsuit into a great position. Yes the government can do whatever it wants as FHFA, but can they violate state contract law? Perry Capital seems to suggest that they cannot and remanded back to district court with further instructions.
Ginsburg & Millett vs. Brown - Perry Capital
The ruling in effect on a 2-1 split decision says that the government can do whatever they want, but that when they violate contracts, those claims are valid:
Brown dissented from the Perry Capital legal ruling. I found the dissent very instructive. First it is clear that Brown finds that FHFA engaged in ultra vires conduct:
Brown interprets FHFA's actions as those outside the scope of what a conservator can do (aka ultra vires):
The fact Fannie and Freddie were liquidating their cash to Treasury was not lost on Brown. Paying out the net worth of a company during conservatorship puts senior claims (aka debt) at risk:
Judge Brown finds the net worth sweep to fundamentally transform the relationship between the companies and Treasury:
The irony is that if you look at the cash transfers on a net basis from the GSEs to Treasury so far, you're over $100B:
Brown points out that Ginsburg and Millett's interpretation of FHFA's actions as conservator leaves them outside the established historical norms for what a conservator is:
This leads to a fundamental lack of conserving assets during conservatorships, increasing the risk of owning distressed companies:
Judge Brown then categorizes FHFA's actions as inside a banana republic:
Judge Brown even provides guidance on the may vs shall debate:
Lastly, the court has provided on its own motion 7 days for a timely petition for rehearing or en banc:
Although Millett and Ginsburg (at least one of them) seemed to agree that FHFA cannot strip contractual rights away from shareholders, they do not seem to have a problem with a conservator that simply takes over an adequately capitalized company, commits accounting malfeasance to transfer cash out the back door, and then proceeds to transfer the net worth of the company to itself. It is as if the context of the government being proven to lie that was submitted to the court fell on deaf ears.
I don't know if this goes en banc. The Perry Capital ruling permits a conservator to transfer unto itself at its discretion to whatever extent it feels like it the assets of any company in conservatorship. This uniquely depletes the intensive purpose behind what a capital structure is supposed to be. Investors of the future should not have to fight the government for contract claims if the government decides to take over and obfuscate shareholder interests by transferring cash to itself. On top of that, the government has created a labyrinth of privilege claims.
Judge Sweeney - Court of Federal Claims - "Quick Peek" Procedure
After overcoming their first motion to compel that revealed that the majority of the documents withheld were unsurprisingly improperly withheld plaintiffs have proposed the court impose the "quick peek" procedure:
The government insists that each of the documents that they asserted privilege over needs to be reviewed on a "document-by-document basis":
If this were school, Plaintiffs would have gotten an A-, which suggests that the government's privilege assertions were far too broad:
The timeline to resolving discovery is still months away. The final result of which will be the filing of amended complaints. The courts are extremely slow, which is why the politics are where things get interesting.
Mnuchin, Mnuchin, Mnuchin
Secretary Treasury Steven T. Mnuchin came into office with the attitude that the GSEs could be handled fairly quickly as a top priority. In the most recent video interviews on Fox and CNBC, it sounded more like this issue will be tackled after tax reform.
As a GSE investor, tax reform would likely lead to DTA impairments which would force a draw from the Senior Preferred Stock Purchase Agreement (SPSPA). This would be the first draw in years and if it were to take place, it would do so simply by design not unlike the earlier draws 2008-2011. It raises the question: does Mnuchin really plan to deal with the GSEs after tax reform? Does he mean after tax reform is complete or after he comes up with a plan for tax reform? Does this put GSE creditors at risk and do the GSEs get put into receivership? Is that how this ends for Fannie and Freddie? Are the GSE operational assets packed into new capital structures and released to new investors while the old investors muddle around in courts too slow to catch up with the political machinery?
These questions have yet to be answered. If words have meaning, it would seem that Mnuchin's potential brinksmanship isn't for the faint hearted. Prior Fannie Mae CFO Timothy J. Howard has speculated that only when this draw actually happens will Mnuchin take action to seek a private solution to Fannie and Freddie. I'm personally not sure. My vantage point is binary. Either Mnuchin wants to pursue a solution with lots of capital and it's best to get started earlier than later so that the GSEs can support equal opportunity affordable housing better and more effectively as soon as possible or it would seem more likely that brinksmanship isn't really brinksmanship but a plan to push the GSEs into receivership.
I don't subscribe to the notion of in-betweens. Fannie Mae and Freddie Mac put out 10-K press releases from last year that seemed to change the dividend language and we are led to believe that this was after Treasury's Mnuchin met with FHFA's Melvin Watt.
Now, I can appreciate Mnuchin's priority is tax reform and that maybe he doesn't want to administratively resolve the GSEs because he may need all the support he can get on tax reform. That said, it sure seems like the $15B that the government is taking out of the GSEs pales in comparison to the benefits of exiting government control and sweeps. The companies could better enable minority home lending, decrease inequality and jumpstart economic growth which would likely create more tax revenue indirectly than the sweep.
Dialing Into What A Receivership Could Mean
If receivership is where this is going, GSE debtholders might be concerned to learn that prior to receivership the government dividended itself on a cash basis over $250B and that is only so far. In the event that FHFA writes up the value of GSE assets in the short term and they are later marked down this year due to DTA revaluations on the new tax plan then perhaps people operating in the GSE debt markets would not be made whole while the government as an equity holder has made off with what should have been theirs not unlike Madoff. Maybe then the STACR/CAS profit redistribution transactions would attract increased scrutiny but once the money is gone it is generally too late.
This receivership scenario would have a destabilizing effect on the markets and may impact mortgage market liquidity later this year, something Mnuchin has said he had planned to avoid. It remains to be seen how exactly GSE reform comes after tax reform, but that's what Mnuchin said his priorities were. What this scenario is, however, is simply forecasting out where things are headed if nothing changes. Could this be the first receivership in history that was preceded by a conservator that put receivership assets at risk by draining the net worth?
Inquiring minds want to know but we're not there yet and we still don't know if a DTA revaluation with the imposition of a new tax plan would lead to a receivership or merely a massive one-time SPSPA drawdown. The problem is that the SPSPA forces cash draws not based on cash needs but based on accounting, which is how they forced Fannie and Freddie to take all that money 2008-2011 in the first place. That was money that on a cash basis they never needed and as far as I can tell if you don't need cash and someone forces you to take it at an interest rate of their choosing, how do you gauge risk and provide loans to creditworthy borrowers?
This is the problem Fannie and Freddie have faced during conservatorship and the resolution that has been identified by Mnuchin is one of capital and the exit of government ownership. What we have here is point A which is now and point B which is that some point in the future where this is fixed and how you get from A to be is what will determine the value of the publicly traded equity and debt shares of Fannie and Freddie.
One thing that we can count on for certain is that the Senior Preferred Shareholder is going to get paid because they've already gotten more out than they've put in. What we can't say is that the minority interests will get the same treatment as the Senior Preferred Shareholder continues to argue in court that it gets everything until it says stop to the immediate and perpetual exclusion of other equity shareholders. Creditors don't seem too worried yet, but we could be looking at less than a year to a point where they might start worrying if receivership is where this is going. If it isn't and neither is the never-ending perpetual conservatorship that treats the GSEs as off-balance sheet government agencies then non-governmental equity claims will have residual value starting as soon as capital requirements are imposed or the SPSPA is modified to change the mechanics of the net worth sweep.
Summary & Conclusion
I own 4050 shares of FMCCH, 23088 shares of FMCCP, 7370 shares of FMCCT, 1341 shares of FMCKO, 13485 shares of FMCKP, 12788 shares of FNMFN, and 5 shares of FNMFO. Needless to say last week I lost roughly $400K or so due to devaluation. My father has suggested selling and has advised me on his birthday that he has lost the opportunity to buy a home in Florida. Happy birthday dad. The irony is that last week we got further than we've ever been. An appeals court ruled that my preferred share contract claims are not necessarily eviscerated and remanded back to Lamberth.
As far as Mnuchin's words go, nothing seems to make sense to me. I'm not really a subscriber to Hollywood style 'moonshot' analogies where you have to shoot and accelerate around the moon to get back to earth. I think Mnuchin is either going to deplete the GSEs of capital or stop the depletion of their capital. I don't think that it is reasonable to argue that he'll deplete them of capital for a few more quarters and then right before they are by his own tax plan's design forced to take a draw suddenly fixed so that it doesn't happen. As a preferred shareholder I don't really care either way. I'm going to get paid, it's just a matter of how and when. That's how I see it.
I'd prefer the government to get out of its own way and help equal opportunity affordable housing by allowing its two primary cornerstones to retain capital and reverse the policy of taking money away from those who deserve it most.
Disclosure: I am/we are long FMCCH,FMCCP,FMCCT,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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