What would you do if I told you that the courts have consistently ruled the government can put the largest companies in America into conservatorship where it forces them to hand over all of their money for nearly a decade? The two companies in question serve as countercyclical sources of capital that support equal opportunity affordable housing in America and are commonly referred to as Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC). Richard A. Epstein is a legal genius who has recently penned a piece that has inspired this article. Earlier in the week Hamish Hume was on a call discussing the implications of the ruling.
Investment Hypothesis: If you fool me once, shame on you. If you fool me twice, shame on me. I was wrong about Lamberth. I was wrong about Millett and Ginsburg. With Mnuchin in play, one has to wonder if one can be wrong about him too since he has previously said capital is part of any solution. At face value that would seem to me to be the payday musical finale for a preferred shareholder like myself. Despite the fact that the government has been proven to lie about the events surrounding conservatorship that has led to it being transferred the GSE's net worth quarterly, Millett and Ginsburg sported their view that they can do whatever they want in a fascinating legal filing that amounts to a case study of, "How to justify ruling that a conservator can seize the net worth of two Fortune 50 companies without judicial review." Where the law is interpreted to not confine the behavior of FHFA, I can't be the only one wondering what the difference between carte blanche and HERA is. One plausible explanation is that FHFA didn't fully appreciate their powers as conservator early on in conservatorship because I suspect that if they truly believed they could have arranged the net worth sweep without judicial review, then perhaps they would have Day 1.
Outside of that, in order to reach the foregone conclusion that the government can do whatever it wants, the legal opinion had to conveniently overlook pretty much all of the plaintiff arguments and simply rule on an interpretation of HERA that seems to defeat the purpose of having it altogether. This is scary stuff, no doubt about it. Although I am frightened by the fact that the words in HERA still don't restrict the actions FHFA can take as conservator or receiver, I remain enthusiastic about my long term prospects as a preferred shareholder with Mnuchin being Treasury Secretary. Previously, I was looking forward to a quicker path to victory with a Perry Capital legal ruling being the driving force. The road may have gotten longer but the destination I think is effectively the same. I own preferred shares because I think any solution requires capital, not unlike Mnuchin. As Treasury Secretary, he's got preferred shares and so too do I. Treasury's are senior and mine are junior but preferred shares are preferred shares.
They May But They Don't Have To
It's a pretty obnoxious thing to say that FHFA may or may not do any of these things as conservator or receiver:
If they may or may not, what is the meaning of the words above? I am led to believe that their existence serves no practical purpose based on the recent Perry Capital majority ruling. Consider that, for instance, the FIRREA law that HERA was based on has been interpreted to restrict the operations of a conservator to the aforementioned actions. Nevertheless, where there is a will, there is a way and it has been ruled that the government can do whatever it wants, including provide its own ex post facto interpretations of how the law is supposed to be interpreted despite the fact that the law it was originally based on is interpreted differently.
When Lamberth originally ruled, evidence had not yet been produced disproving Ugoletti's sworn and written testimony. That was no longer the case for the appeals ruling in February. While it is true that it never says that a conservator has to conserve and preserve the assets of a regulated enterprise, to suggest otherwise would make the unsuspecting wonder why they're called a conservator in the first place. This confusion draws on the fact that HERA is a law that only seems to apply to FHFA as conservator and that interpreting it incorrectly may have limited repercussions.
One thing that I find to be interesting is that if this becomes settled law it would seem that amending a contract from taking a fixed dividend to the entire net worth quarterly would no longer qualify as a purchase of securities in at least this case where the economics of the situation changed in effect from preferred to common. As far as destabilizing the stock market goes, common shareholders beware as the company could issue preferred stock to its board members and simply amend them during a temporary period of accounting distress to take everything.
Treasury Purchasing Authority
Treasury's own purchasing authority limitations is very interesting. Again, the fact that the SPSPA was based on accounting fraud draws and not cash needs was not yet mainstream Fanniegate at the time the original Perry Capital lawsuit was filed. Thus far, the actions have protected tax collectors, not taxpayers. Draining the net worth of taxpayers Fannie Mae and Freddie Mac at the expense of their shareholders puts taxpayers at risk:
Since the imposition of conservatorship, the Treasury has dividended itself with the help of FHFA over $250B dilutes the liquidation preference of creditors. Paying out junior stakeholders in effect is a breach of the liquidation rights based on FHFA's accounting adjustments. Who is to say that the imposition of the net worth sweep wasn't followed by unsustainable and overly optimistic net income projections that release money to Treasury that should have gone to creditors who are taxpayers? The net worth sweep effectively converts the senior preferred stock to that of a common security that takes 100% of everything. Only by technicality are Fannie and Freddie still private companies as they are really treated as 100% owned and operated off-balance sheet government agencies.
Paying cash dividends when they could have paid 12% PIK non-cash dividends has been putting taxpayers who are GSE creditors at risk. No one is complaining yet because they're still getting paid, but no one is paying attention to the fact that their principle could be being raided by a junior stakeholder. This act of paying cash dividends was not addressed by Perry Capital. According to the judges, neither was the constitutionality of HERA.
Looking For Not Near Term Bipartisan Solution
Because of the Perry Capital ruling, Mnuchin resolving this issue is no longer near term:
Ironically, the man who previously has proposed that capital is part of any solution still has the rest of this month to see to it:
The net worth sweep without proper capital levels imposed by FHFA seems to be going in the opposite direction. That said, it doesn't seem like anything is going to change this month even though it is possible for Mnuchin to make that change happen. Instead, Mnuchin has other priorities. As a preferred shareholder, I pretty much own shares at this point because I believe Mnuchin will get around to fixing this situation by allowing Fannie Mae and Freddie Mac to retain capital. How soon that starts is anybody's guess but the next sweep is later this month. The mechanics of which and timing of which are unclear and may or may not have to do with any legal ruling. I must say that it is disappointing to see that the government continues to fight against the release of documents surrounding events in the Court of Claims.
Taking The Long View
I operate from the frame of reference that when you're fighting the government that the government effectively always is considered to be a credible source of information. In this particular case, even though plaintiffs proved that the government's earlier arguments were outright falsities, the judges begrudgingly wrote a legal ruling that completely ignores many plaintiff claims as it overwhelmingly aligns itself with the government's narrative. Part of this is due to how things came to be. From the beginning, no one that I knew except maybe John Hempton were smart enough to really see that the government had issued itself a security that's value was dependent on its ability to drive maximum accounting losses at Fannie Mae and Freddie Mac. Early into the conservatorship Hempton realized that the mortgages themselves were never really risky. The risk here was that the government had taken control and was leveraging its control to separate existing shareholders from the companies' earnings power by injecting itself between equity and debt and inflating like a balloon or perhaps forcibly separating the two like the jaws of life would separate a car door from a vehicle to save a car crash victim.
All of this has been taking place over years. The government claims that it stepped up to save the day but the cash flow suggests that the government stepped up to nationalize two companies that didn't need a bailout in the first place. A recent article suggests a linkage between the net worth sweep and the funding of Obamacare. I'm not well-versed enough to determine if there is causation there or if it is simply correlation. What I can say is that at the time of the net worth sweep, both companies had returned to printing profits because FHFA was no longer able to generate accounting losses. The massive temporary writedowns were soon to be reversed and the SPSPA needed to be amended if these writedowns were to be permanent in order to exclude public shareholders from participating in the future of Fannie Mae and Freddie Mac.
Lawsuits have been filed and many judges have decided that the government was at liberty to act this way. Even today I still find it hard to believe that the Perry Capital ruling and the Appeals ruling went as they did, but what can you do? This is not a complex issue. The cash does not lie. Cashflow always tells the truth. Fannie Mae and Freddie Mac are the victims and are being run as tax collectors by tax collectors at the expense of taxpayers. Since they've been placed into conservatorship they've increased their guarantee fees that they charge at the expense of taxpayers who want to own a home in America but cannot afford to buy one without a mortgage. I figure the biggest loss has been born to those who were simply not invited to know better.
Further, their lack of capital has made it more difficult for them to support equal opportunity affordable housing. The SPSPA is not capital. The new capital paradigm that FHFA and Treasury have paraded around in court is really a lack of capital paradigm, after all if you are being treated as a government agency - what is the purpose of capital anyway? They don't need capital, they need a budget unless they're a source of revenue at which point they're a tax collecting agency. The sooner that we can lower the cost of equal opportunity affordable housing in America the better, and right now the best and fastest way to do that is to reprivatize Fannie Mae and Freddie Mac.
Capital Classifications? The Sweep?
Melvin L. Watt previously raised the concern of the enterprises' declining capital buffers around this time last year:
FHFA Director Watt has stated that he will defer to the Treasury. We know Mnuchin met with Watt already. We know that the earnings releases of Fannie Mae and Freddie Mac had language changes that drew into question the March payments. GSE shareholder Adam Spittler, who put together the accounting fraud thesis that generated lawsuits against the auditors, put his thoughts on what might happen next into a image that he posted on Twitter. Spittler proposed that FHFA set appropriate capital levels or the net worth sweep gets eliminated or suspended and talked about the pros and cons of each.
Many Of Them Know Mnuchin Quite Well
Prior Fannie Mae CFO Timothy J Howard was recently asked in the comments of his blog about what he can do to raise awareness among key players. In general it seems that he thinks that the key players already have established opinions on the topic at hand that are unlikely to be easily swayed:
It remains to be seen if Mnuchin will be calling for a meeting with Tim Howard. What we do know is that Mnuchin is having a meeting with Bright, DeMarco and Parrott this week. DeMarco is the man who implemented the net worth sweep:
Tim Howard addressed the fatal flaws of these so called risk-sharing securities that intrinsically share no risk and simply hand out money to people who know how to buy them. It does not look like there will be pro GSE people attending that meeting who might be able to call attention to the fatal flaws of the proposals that may be put in front of Mnuchin this week.
Summary and Conclusion
I own 4050 shares of FMCCH, 23088 shares of FMCCP, 7370 shares of FMCCT, 1341 shares of FMCKO, 13185 shares of FMCKP, 12788 shares of FNMFN, and 5 shares of FNMFO. I figure I'm down something like $400K or so from the Perry Capital ruling and I don't have confidence in the market valuations stabilizing, going down, or going up across the near term. The ruling was 'devastating' to short timelines, if you will. From a practical standpoint, however, I simply do not think it makes that much of a difference. Further, for those of you paying attention to my share counts, I had to sell 300 shares to meet rent/interest obligations this month.
I think that the net worth sweep will stop eventually and this is why I own preferreds. I think that if the net worth sweep stops by process of elimination the only option left is recapitalization. If you're looking into recapitalization scenarios, I still am unable to come up with one where the preferreds are not taken care of.
I'm not entirely sure that receivership is a feasible option at this point because it would likely lead to even more lawsuits. Eventually things have to start simplifying, but we're not there yet. I can't imagine that this is a scenario where the government steamrolls equity shareholders for nearly a decade and then proceeds to steamroll creditors while simultaneously declaring that it can do whatever it wants as well as having the courts rule in its favor.
Does the Collins lawsuit that touches on the constitutionality get past a Perry Capital style ruling? Perhaps. Eventually one has to think that words have meaning and that it is in the judiciary's best interest to support the notion that words in HERA actually restrict the powers that FHFA has to operate if it comes to that. I just don't think that they are going to have to. It didn't have to be this way but I think Mnuchin will beat them to it. One thing we do know is that Obama owns the net worth sweep and all of its proceeds so far, and if they do sweep this month then Trump is going to start owning part of that legacy, too.
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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