By Parke Shall
A new Reuters article out this morning makes it look to us as though recapitalization is now the primary objective for both Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC). Today we wanted to analyze this new piece of journalism as well as offer our independent analysis of why we believe owning preferred shares of both entities is an investment that will be able to return multiples of capital invested. We also wanted to make a comment about why we don't own common stock and what the timeline for a recapitalization could be.
Much of the focus this week was on Mark Calabria's comments at the ABA Government Relations Summit, where he spoke about both Fannie Mae and Freddie Mac not having enough retained capital to position them safely in the event of any type of future crisis. He commented that a set of principles for a recap situation would likely be on the way in coming months,
Overhauling Fannie Mae and Freddie Mac is a financial regulation priority for the Trump administration, Vice President Mike Pence's chief economist said Tuesday, adding that "a set of principles" will likely emerge in the coming months.
Mark Calabria told participants at the American Bankers Association Government Relations Summit in Washington that the administration is examining mortgage finance policy to "try to figure out, really, what should the best approach be?"
This morning's article from Reuters seems to touch on the very same topic, indicating that not only have discussions been ongoing about retained capital, but also that this is the obvious route to a recapitalization. It seems as though they are even past recapitalization talks and are now zeroing in on dividend transfers. Reuters reported,
Instead, investors' focus is shifting to how Mnuchin and Federal Housing Finance Agency Director Mel Watt, an Obama Administration holdover, will manage the dividends transfers.
Analysts expect the two institutions to make a full $10 billion dividend payment for the fourth quarter on March 31. But investors will be looking for any indication from Watt or Mnuchin about whether they plan to allow the mortgage firms to retain profits later on and begin the slow recapitalization process.
Though rebuilding an adequate capital buffer would take years - as long as two to three presidential administrations, according to one analyst - it would eventually allow Fannie and Freddie to leave government conservatorship, returning value to their investors.
This is astounding. We believe we are now past the point of wondering whether or not recapitalization is front and center on the agenda of the Trump administration. It is.
While we would have done a better job of naming this Reuters article ("Fannie, Freddie revamp plan unlikely this year" doesn't allude to the optimistic content for Fannie and Freddie investors), the content speaks volumes regardless. It makes it very clear to us that ongoing discussions are already taking place on how best to remove Fannie and Freddie from government control.
The litigation that has driven down the stocks of both Fannie and Freddie over the last couple of months essentially becomes irrelevant if the government simply decides that they want to push forward with the recapitalization.
On top of this, the Reuters article notes that dividends are in focus, leading us to believe that there will likely be negotiations for current preferred shareholders to have access to the dividends that they were once entitled to. We continue to own preferred shares here and believe them to be a substantially better bet than the common. There was nothing in the Reuters article that stated to us that the common shareholders are going to get wiped out completely, but in any recapitalization process, owning the securities that are senior in the capital structure increases your chance of them being made whole again.
We don't really see the point to owning the common, when the return on preferreds would likely be only slightly less in a best case scenario. Our advice to common shareholders would be to liquidate their positions and move into preferred shares. Again, this is just a move for safety and isn't indicative of any concrete evidence that we have the common shareholders will get wiped out.
While the article states that action may not be taken until next year, that is really only several quarters away at this point. We will know if the government is serious about whether or not they want to follow through with this plan of retaining capital by the end of this month, when it is clarified as to whether or not they intend to keep the net worth sweep in place. If the government elects to allow Fannie and Freddie to retain capital this quarter or next quarter, it is a sure fire sign that the companies are at the beginning stages of the route to recapitalization.
The Reuters article is correct in stating that retaining capital as a safe haven by simply using the company's profit streams could take more than a year. However, if new securities are to be issued in conjunction with ending the net worth sweep, it is not difficult to believe that an entire recapitalization process could be over and done with within the next 24 months. We remain long preferred shares of both entities.
Disclosure: I am/we are long FNMA AND FMCC PREFERRED STOCK. 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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