Reviewing GSE Recapitalization Mechanics And Potential Outcomes

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About: Fannie Mae (FNMA), FMCC
by: Glen Bradford
Summary

Fannie and Freddie have remained in conservatorship for nearly a decade where all their money has gone to the US Treasury.

There was a bailout earlier this year after FHFA and Treasury established a token capital buffer that wasn't enough to prevent a tax reform bailout late last year.

Watt's recent remark concerning a future proposal in the near term for risk-based capital standards sets the table for an administrative recapitalization solution.

Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) are two companies that were placed into conservatorship via a board vote in 2008. Back then, Dan Jester worked with Hank Paulson to reconstruct the record and planned to ensure that the mortgage market crisis would not take down Fannie and Freddie, for example if the Chinese would have dumped their holdings exacerbating a market panic. Once the two companies were placed into conservatorship, an agreement based on the accounting now known as the Senior Preferred Securities Purchase Agreement was put into place to prevent the companies from having a negative net worth. The Federal Housing Finance Agency, during conservatorship, used its discretionary accounting authority immediately after the imposition of conservatorship to regularly justify the conservatorship by writing off GSE assets. By writing down the value of these assets, Treasury was forced to contribute capital per the terms of the agreement and this made Fannie Mae and Freddie Mac look like they were in serious trouble. Investors have raised concern regarding these accounting transactions and filed lawsuits in court, one of which was settled and one of which was dismissed. Further, there have been many lawsuits filing or APA claims saying that the net worth sweep is illegal but so far none of those have turned out favorably for shareholders. Instead, the rulings to date basically support the notion that the government could have implemented the net worth sweep on the first day of conservatorship because the law provides that the government can do whatever it wants and that instead this claim would be sorted out in the Federal Court of Claims.

Investment Thesis: The next major legal ruling that I'm hearing about is the Collins case in Houston. According to the court website we should have expected a ruling issued 60 days after oral arguments, but are now overdue. Mnuchin most recently punted housing reform into 2019, but Watt says that FHFA's going to come out with risk-based capital standards. This would be in addition to the capital buffer that was implemented late last year. Mnuchin in the past said, "any solution will be dependent upon the GSEs being capitalized properly and other such controls that eliminate risk to taxpayers." In this article I will explore two competing recapitalization plans that outline how this might play out. In both scenarios, the publicly trading preferred securities seem to do well, one gets par, one does not. In one scenario, the commons do well and in the other they do not.

Scenario Characteristics

In both scenarios, things happen and then the companies need to go out to the public market to raise capital by selling new common and preferred shares to meet the capital requirements that are mostly agreed to be determined. In both scenarios, the companies raise over $100B.

In the first scenario, the government's main driver of value is the conversion of senior preferred to common where the warrant value is small in comparison. In the second scenario the government's main driver of value is the exercising of the warrants because the senior preferred are declared to be paid off.

The mechanics of this first scenario:

  1. The government exercises its warrants.
  2. The government converts its senior preferred to common.
  3. The junior preferred shares convert to common.
  4. New capital is raised.

The fully diluted end state share count here is ballparked at over 200B shares for the combined enterprises.

The mechanics of the second scenario:

  1. The government declares senior preferred are paid back.
  2. The government exercises its warrants.
  3. The junior preferred shares optionally convert to common.
  4. New capital is raised.

The fully diluted end state share count here is ballparked at 20B shares for the combined enterprises.

Note that with a 10x difference in share count, you'd expect there to be roughly a 10x difference in price for the common shares and that looks to be about right. In the first scenario, the commons are worth less ($0.80) than they can be bought for today and the junior preferred are not worth par (50% of par perhaps) . In the second scenario, preferred get par and common trade near $8.

Summary & Conclusion

I own 4050 FMCCH, 8394 FMCCI, 10141 FMCCL, 400 FMCCN, 12608 FMCCP, 5042 FMCCT, 9085 FMCKP, 11132 FNMFN and 5 FNMFO. This whole thing is largely disappointing when reviewing the facts. The facts can be observed by a forensic accounting analysis of the cash flows between the government and the companies during conservatorship. The government appears to have used control to its advantage and unfortunately for shareholders, the government has continued to prevail inside the court room. The government's current track record sets a path for any company to amend its preferred securities to take all of the income from common equity if it is at the hands of the government. It also enables the government to do that the first day a company is placed into conservatorship despite the business fundamentals. These sorts of legal rulings would seemingly exacerbate market corrections because as the price of equity goes down, if conservatorship is threatened, one would expect the price to collapse as fears grow that the government would seize the income stream in perpetuity after it seizes control with no recourse.

In this case, based on Mnuchin's commentary alone, recapitalization is a foregone conclusion. Watt seems to be stepping up to the plate with risk-based capital requirements after forcing Mnuchin's hand late last year on a capital buffer. Mnuchin most recently punted to 2019 for another push for legislative reform and so the time frame for administrative action seems to be delayed yet again. The question remains if recapitalization will be done before the end of Trump's first term or if it will only just be started by then. A recapitalization of this magnitude takes time and with the legislative calendar closing for midterm elections, the time is ripe to take action now if the administration believes the action to be in the best interest of the elections.

The question remains if preferred shareholders like John Paulson and Bruce Berkowitz are okay with taking a haircut or will refuse to settle for anything less than par. My understanding is that there are two parts to this equation and everyone seems to be forgetting that over $100B needs to be raised and the real question is where is that coming from and for those people, are they already involved and if so, what do they own? If you are contributing new money and you just saw 10 years of questionable accounting based net worth sweeps after seizing two companies that arguably didn't need it themselves but in the context of preventing a market collapse I guess needed to be "bagged and tagged," how do you feel about contributing new money if the commons get wiped out and that's what you're supposed to be buying and the preferreds are forced to take a massive loss when the companies were remarkably profitable during the whole conservatorship? So profitable, in fact, that they paid back more than what they originally were forced to take by their conservator at a punative interest rate that was seemingly designed to bankrupt them in advance, but as the facts show and the law supports, the net worth sweep could have been implemented day one.

$100B is a lot of money and I guess I doubt that new money would be interested in contributing it if the government isn't interested in saying that it's been paid back, when for all practical intensive purposes it has. Because I have a tendency of being wrong, I own preferred just in case I'm wrong.

Disclosure: I am/we are long FMCCH,FMCCI,FMCCL,FMCCN,FMCCP,FMCCT,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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