Any Solution Will Be Dependent Upon The GSEs Being Capitalized

About: Freddie Mac (FMCC), FNMA
by: Glen Bradford

Mnuchin wrote that "any solution will be dependent upon the GSEs being capitalized properly and other such controls that eliminate risk to taxpayers."

The net worth sweep could be suspended unilaterally by FHFA Director Watt who has recently advocated for some sort of capital buffer.

The net worth sweep could be altered by an agreement between Treasury's Mnuchin and Watt.

Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) have been in an unprecedented conservatorship governed by HERA which was passed into law in 2008. On a net basis, the government has taken billions out of the two companies while it simultaneously claims that it is owed their future net worth, too. As with any companies that are unable to retain any sort of equity capital buffer due to a controlling shareholder taking out the net worth in cash dividend payments by design so that there will be none left next year, the companies are not only at risk, but their creditors are at risk. Fannie and Freddie securities represent more than half the mortgage market in America, so putting their creditors at risk by taking all of their money puts all sorts of investments at risk. If Treasury were to decide to push the plunger and force a draw via Tax Reform later this year and edge Fannie and Freddie into receivership, maybe not just equityholders would be claiming the government broke the law by taking all of the money but creditors would be on deck. The danger here is that FHFA can do whatever it wants and most recently has claimed that the value of the security doesn't entirely transfer when you buy and sell in the public trading markets.

Investment Thesis: If this sounds unusual it's because it is. Fortunately, the people in charge, Watt and Mnuchin, have spoken a public narrative that results in establishing a capital buffer and getting the two companies out of government control. With this in mind, we can review outstanding reform proposals and determine whether they are a solution or not. Not everyone has proposed a solution and what's ironic is that those that haven't seem to have the most to say these days. There is one solution that stands out as workable and tractable and in fact was proposed by a Trump advisor, a man who Trump invested in, and a man who worked with Mnuchin to save a company in the mortgage business knowing full well Mnuchin is an expert on the business from his days at Goldman Sachs. This man is John Paulson and his plan is the Moelis plan and it is the best plan I've seen. Another man by the name of William Ackman has put together a proposal, but it takes too long and seems to have assumptions built into it that I think might need some double counting. That said, these two plans are workable plans. The rest of the plans I've seen simply do not fit with Watt's and Mnuchin's framework. The plans that work result in higher share prices in the preferred securities. There of course could be other sets of assumptions that result in preferreds doing better than common. If you completely ignore the fact that the administration has set the stage for action later this year, you might think that the only route to victory is a legal victory and might be hanging your hat on the Perry remand breach of contract claims.

Moelis / Ackman / Other

Moelis pushes for higher guarantee fees, more capital than they've ever had, and raises that capital from private markets and monetizes the government's warrants and senior preferred. The preferreds shake out around par in this plan sometime in the next 12 months.

The Ackman plan pushes for raising guarantee fees even more and raising capital organically over a period of years. It also monetizes the government's warrants. This plan doesn't capitalize the companies as quickly as it could. This is something the Moelis plan improved upon.

Other plans may result in the continuation of current or historical guarantee fees. The Ackman and Moelis plan both provide for an implicit government guarantee. The implicit guarantee is at the enterprise level.

Peter J Wallison / AEI / MBA / Ed Demarco

In general, the TBTF banks are lobbying to provide for an explicit guarantee. David H Stevens runs Mortgage Banker Association. He put together a plan but hasn't read the Moelis plan according to prior CFO of Fannie Mae Timothy J Howard. This explicit guarantee could be put on the enterprise level or the security level. At the enterprise level the two companies are in effect nationalized and their shareholders get what they get in the courts. At the security level, the GSEs could be split up after they spin off their operational assets via the CSS/CSP.

Specifically, these plans are more of lobbyist plans and it is more about selling the plan than it is about actually trying to understand what works best and how can we make the best of the future given what we've got today.

These plans don't fit into Mnuchin's and Watt's framework and are therefore not a solution.

Summary and Conclusion

There's a difference between a plan and a solution. There's great reason to advocate to somehow get a piece of the billions of dollars that Fannie and Freddie make supporting equal opportunity affordable housing. With the lobbyist plans, it is tough to say how exactly the equal opportunity affordable housing initiatives are treated on a forward basis. There is a lot of downside as these plans would in effect continue to undermine good logic. Industry veterans like Josh Rosner have been attempting to debate MBA on the facts for years, but doing so has proved impossible because MBA's platform simply doesn't permit.

I own 4050 shares of FMCCH, 21988 shares of FMCCP, 7370 shares of FMCCT, 1341 shares of FMCKO, 12885 shares of FMCKP, 12788 shares of FNMFN and 5 shares of FNMFO. Unfortunately, that's simply as much as I've been able to procure. If I would have been smart enough to know that the plaintiffs would lose the Perry capital ruling earlier this year, I could have more, but I don't and that's that. Mnuchin said that the second half of 2017 was when housing reform would be a priority. I'm speculating that the reason for that is because the light at the end of the tunnel is the expiration of GSE Jumpstart Reform early 2018. GSE Jumpstart actually retards housing reform as opposed to promoting it as it restricts what the administration can do until next year.

I expect Treasury to come out with some sort of plan like Moelis. I can't say whether or not there will be some sort of explicit guarantee or not. I can't say what guarantee fees or capital requirements are going to be. I can say that the guy backing this solution is John Paulson, who is the man with the plan.

I guess the bottom line is that if you take Mnuchin and Watt seriously, Fannie and Freddie survive and are recapitalized. There simply isn't another way. Congress can and will pass some sort of ride-a-long thing that makes it look like they did something but the something to expect is simply regulating Fannie and Freddie in some way shape or form. If the TBTF banks win, they get the explicit guarantee. At Moelis capital requirements, that's not really necessary. Note that right now the SPSPA isn't an explicit guarantee and is also not capital. We are in the second half of 2017 and I am taking Mnuchin and Watt seriously since they're in charge.

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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