Steven Schwarzman and John Paulson, two Trump insiders, hired Ken Moelis's firm, another Trump insider, to assemble a recapitalization plan. After meeting with FHFA they created an updated version.
This updated plan generates $100-$125B of profit for the government from the warrants up from $75B-$100B in the prior plan.
I am a preferred shareholder, but I used to be a common shareholder, and this plan makes me wonder if the grass is greener on the other side.
The purpose of this article is to take a look at this updated plan and see how it compares to their last plan.
This plan was put out immediately after elections. Congress is now divided, so if legislation couldn't happen before, the odds of meaningful legislation are worse now.
Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) are two private companies in conservatorship that currently give all of their money to the government and are run by the government. They're treated like off balance sheet government agencies. The way the equity is currently structured is that the United States Treasury has 79% warrants and Senior Preferred stock. The Senior Preferred stock takes 100% of the net worth of the companies quarterly in excess of a token capital buffer that was put in place late last year to prevent normal course business fluctuations from forcing draws from Treasury depleting the amount that can be drawn. Consider for instance that Treasury has invested $191.5B into Fannie and Freddie and all payments from Fannie and Freddie to Treasury haven't reduced liquidation preference, the government effectively holds all the power and gets all the money. Shareholders have sued the government for all sorts of reasons, but have largely lost so far as the companies remain in conservatorship with the government taking all of their money. Judge Lamberth has recently changed his mind on one of the claims, but the claim is not injunctive and instead is for damages. No major ruling will happen there for at least a year or two.
Investment Thesis: The previous administration ignored capital completely. Earlier this year FHFA issued a proposed rule on Enterprise Capital. All comments are due by November 16th. Moelis met with FHFA and submitted its comments and proposes this plan that is in compliance with the proposed capital rule:
The $125B Treasury Proceeds version makes Fannie Mae and Freddie Mac a 10-bagger next year:
The timeline for the plan has steps where this quarter the net worth sweep is stopped:
There's a lot of value in these two companies and this plan is one way to recapitalize two companies into 10% ROE utilities.
Moelis Argues Against Receivership
A conservatorship can end in one of two ways. One way is the two companies become adequately capitalized and are released from conservatorship and conservatorship ends or the two companies are placed into receivership. In the past, receivership makes sense for a lot of companies. A general rule of thumb is to ask if the companies are making money. In this case, if you back out the accounting that FHFA did to force draws early in conservatorship that it later reversed after implementing the net worth sweep so that it could harvest them for itself as cash payments you see that not only have the companes been constitently making money since the net worth sweep but also they made money during the years where they were forced to generate losses due to FHFA's discretionary accounting authority. Critics advocating for receivership suggest it as a way to eliminate the charters, but this doesn't really happen in receivership:
The Moelis plan goes on for an entire page outlining the problems with receivership but here's the summary:
Receivership tends to work where you have situations of isolated disaster, where companies are losing money, have no chance of making money, and there are lots of parties with the budget able to buy the assets in liquidation. In this case, receivership of a duopoly simply disrupts the mortgage market in a big way, lowers the value of the assets, and makes it more difficult to raise new capital. In a receivership, it's hard to say how debt would be handled and the GSEs have over $5T in assets that creditors would be fighting over. Note that their capital buffers are $3B a piece:
A small fluctuation in asset value would lead to some of the most complex litigation in history, especially after how the GSE lawsuits have gone to date. If anyone would oppose receivership, I would think the top two candidates would be creditors and mortgage brokers. Creditors would wonder why two companies that have been making money for years are being placed into a statutory process for companies that don't make money after the Treasury has been taking all of their money for 10 years and counting. Needless to say, if you do think this is a receivership, then you're basically saying that the only value to publicly traded equity is litigation based. In that case, I'm not sure about the value for common shares, but preferred shares have a clear liquidation preference and dividend terms and those are going to trial in Judge Lamberth's court for breach of implied covenant of good faith claims.
The 10% Moment?
Moelis points out that Alex Pollock says the GSEs have reached the 10% moment:
What's interesting here is that Moelis also points out that Fannie Mae, by their calculations, hasn't yet reached that point on page 7:
SPS principal is reduced to $0 at Freddie Mac, reflecting amortization of past payments in excess of a 10% annualized rate. SPS principal balance at Fannie Mae, reflecting amortization of dividends paid in excess of a 10% annualized rate through Sep 30, 2018, is equal to $276 million – which is assumed to be converted into common equity in connection with the relisting offering
Moelis envisions converting that remaining balance to common. One could argue that the government may instead opt to take another quarter of cash dividend and keep the change. Moelis does say that now is the time for action and identifies the next three steps for the administration to take:
That answers my previous question of how do you raise capital with the net worth sweep in place. Moelis says that the net worth sweep must be stopped and declared paid down before you direct the GSEs to submit capital restoration plans.
Mortgage Bankers Association Wants Security Level Guarantee
When the revised Moelis plan came out, MBA Mortgage said that they believe reform must come before recapitalization and legislation is needed for a security level guarantee. It is important to note that the Safety and Soundness Blueprint was specifically designed to be compatible with a securities-based guarantee if Congress were to go in that direction. Advocating to hold Fannie and Freddie in conservatorship as undercapitalized hostages in order to force legislation for a security level guarantee is a plan with a problem.
The problem is that we just had elections. Republicans controlled the House, Senate, and Presidency. Congress is now divided and it's borderline unreasonable to expect a now divided Congress to do something when an undivided Congress couldn't do anything but talk for years. Talk is cheap but I wasn't born yesterday. Conservatorship is 10 years old and we've seen every reform plan come and go, but only one works, while aligning with FHFA and Treasury:
Insisting on such legislation will continue to put taxpayers at risk by not restoring safety and soundness to Fannie and Freddie. If such legislation were passed, investors in GSE MBS would benefit from substantial regulatory and capital relief advantages as a result. That's what the Mortgage Bankers Association is really after - better treatment of GSE MBS for the balance sheets of large TBTF banks:
Any potential legislative action should no longer delay critical actions by Treasury and FHFA to rebuild capital at the GSEs. The TBTF banking lobby hasn't come up with a solution that senators and legislators could pass into law and that was before Congress was divided. Housingwire agrees:
GSE reform isn’t happening this Congress. Not that there was much traction previously on this issue, but the divided Congress will only make it that much more difficult to find consensus on such monumental legislation. Any non-legislative changes that come to the GSEs would likely be minor and focused on reducing the government’s footprint in the market.
Without any major legislation, there's really only one direction to go if receivership is off the table. Moelis trumpets its own plan in the context of there being no other pragmatic and tractable plan: The Moelis plan adds up. It also discusses every other plan that has been proposed to compare and contrast. I recommend you look at all the reasoning in the updated proposal. The key point to be made is we are now moving to a divided Congress so good luck passing meaningful reform legislation.
MBA's Prior CEO David H Stevens has weighed in, in his new blog. He starts his blog by saying that you should be skeptical of the Moelis plan because it is bought and paid for:
The team from Moelis has unveiled a new and somewhat improved version of their plan to return the Government Sponsored Enterprises to the shareholders. Before turning to the substance, much of which is quite good, it’s important to note up front that they have the interests of their clients, who are major shareholders in the GSEs, foremost in mind here. This is not a criticism of Moelis, which is doing what it is being paid to do, and admirably I must say, but something to keep in mind in understanding the effort, as some key features only make sense in that light.
David goes on to support a lot of the narrative that the updated Moelis plan shoots holes in. David supports the multi-guarantor model. He is against the GSE duopoly. He thinks Moelis isn't fair in their characterizations of Ginnie Mae. He argues that over time the GSEs regulator will relax standards and we'll basically have a 2008 all over again. David effectively proposes the status quo until legislation happens:
The conservatorship has lasted too long and ending it will take political will that thus far we just haven’t had. The alternative presented by Moelis is tantamount to giving up, putting Fannie and Freddie on a path to re-privatization.
I wasn't aware that recapitalizing a company in conservatorship was an act of giving up. My understanding has been that the purpose of conservatorships was to rehabilitate the companies that are put into them if possible. David H Stevens has told me personally that the rule of law is tired and old with respect to Fannie and Freddie. So far he has been right. The courts haven't forced an accounting restatement or provided injunctive relief. Prior CFO of Fannie Mae Timothy J Howard comments on why the MBA wants legislative reform:
For at least the past two decades, the MBA has insisted that there are “bright lines” that separate the origination, servicing and secondary market financing functions. In fact there are not, at least not legally. When I was at Fannie, we followed the principle in English law that “everything not forbidden [by our charter] is permitted” in furtherance of our goal of lowering the cost and increasing the availability of mortgages for the low- moderate- and middle-income homebuyers we were chartered to serve. That included developing and making available technology that reduced the cost of originating mortgages, which the MBA and its larger members bitterly opposed. But once we were doing this it was hard to reverse; the MBA essentially had to say to Congress, “Stop Fannie and Freddie from lowering homebuyers’ costs, because those costs are our revenues.” That’s not an easy sell (and it wasn’t successful).
David H Stevens continues to advocate for a route that simply has no political support but by definition requires it. I do appreciate the points he makes, but one of the key points to the updated Moelis plan is that it was built on FHFA's proposed capital rule. This rule was designed around if 2008 happened all over again, Fannie and Freddie wouldn't need to be placed into conservatorship. It basically forces them to hold so much capital that FHFA's discretionary accounting authority would have a hard time finding enough assets to write down in order to retroactively justify another conservatorship.
This isn't just a recapitalization. Many internal reforms have been made and the amount of capital they are being forced to hold with FHFA's proposed capital rule makes it so that they won't need a bailout. At the end of the day, it's been 10 years of the government taking all of the GSEs money. David advocates for more waiting for legislation. Moelis offers a practical plan to resolve the conservatorships that aligns with the administration's goals.
Moelis Income Projections Then Vs. Now
Note that the income forecast numbers played a key role on the Market Value of Equity difference. In the first Moelis used 2021 Earnings of $14.6B. In the updated version Moelis is forecasting 2022 Earnings of $21.2B.
Here is the original income forecast:
Moelis forecasts income levels higher now:
Valuation Ranges Then Vs. Now
Moelis originally forecasted an MVE between $205B and $238B:
Now they are forecasting MVE between $234B and $266B:
To me, what is interesting is that the valuation ranges for both the plans seem to be on the high side for Publicly Traded N.A. Mortgage Insurers. What's interesting to me is that the plan also readily admits that the GSEs are basically insurers in the mortgage guarantee business:
In both scenarios, I would say that the valuation looks to be on the high side, but the market will decide all of this later. Realistically, what you are coming out of the gate with is two way overcapitalized companies that produce income in the most predictable, recurring way, on a growth trajectory, basically an inflation hedge. As you'll notice the dividend discount valuation range for both the plans is the largest range, so it's really up to interpretation and market appetite.
Prior CFO of Fannie Mae Timothy J. Howard's Remarks
Prior CFO of Fannie Mae commented on the updated plan:
I was very pleased to see the Moelis team directly address the main proposed alternatives to their plan. In the section titled “The 2019 Outlook and State of the Debate” Moelis gives their analysis of and opinion about five proposed alternative objectives of or paths to reform: (1) Revoking Fannie and Freddie’s statutory charters; (2) Chartering new credit guarantors to compete with Fannie and Freddie; (3) Having the government change from a posture of backstopping credit guarantors to explicitly guaranteeing their securities; (4) Having Ginnie Mae effectively replace Fannie and Freddie, and (5) Running Fannie and Freddie through receivership. Moelis summarizes by saying, “All of these concepts risk substantial negative side effects, which should be weighed carefully by the government in assessing whether or not to support them,” and then goes on to give detailed and practical critiques of each.
I agree with Moelis on all of these points, and think it’s an important step for them to have made the critiques in such a clear and straightforward way. I believe all of these alternative ideas have been given currency and kept on the list of possibilities only because they have been advanced by prominent individuals or interest groups. The fact that they are impractical, unworkable, unwise or all three is known to most secondary mortgage market insiders and professionals, but not to those engaged in the political aspects of the reform debate. Having Moelis spell out the weakness and dangers of these ideas in this document hopefully will convince more people to focus their attention and effort on an administrative approach to reform that has a much greater promise of success and a much lower risk of going off the rails.
The one edge that Moelis has on all the other plans or proposals out there is that it works and is practical. The rest of the proposals seem to begin with the premise that Fannie and Freddie deserve to be dismantled and their shareholders deserve $0 and work backwards towards how to best argue that. Moelis addressed all of these points and Moelis so far has been the only proposal that has been created that aligns with FHFA's proposed capital rule.
Bloomberg Intelligence Concurs With Updated Moelis Plan
Bloomberg believes that FHFA's proposed capital rule sets the stage for exiting conservatorship:
The proposal implicitly prepares Fannie and Freddie to exit conservatorship, despite FHFA's assertions to the contrary.
Bloomberg also points out that the way the proposed rule is structured, it poises Fannie and Freddie for growth if they are released from conservatorship.
Fairholme's latest update Also Concurs With Updated Moelis Plan
Bruce Berkowitz's Fairholme sees Judge Lamberth's recent ruling as instrumental towards advancing the re-IPO of Fannie and Freddie:
Bruce's commentary is interesting as he now is arguing that not only was the net worth sweep not needed, but also the entire conservatorship was not needed. He argues that Fairholme can sue FHFA for money damages for breach of the implied covenant of good faith and fair dealings. Fairholme has been reducing exposure to its GSE preferred securities the past few years as the assets under management of the firm has decreased. Fairholme is often seen as one of the primary litigants in this battle for shareholder rights.
In the AIG re-IPO, the government converted some of its preferred to common, and it sounds like Bruce is expecting something similar here.
The Wall Street Journal Agrees Split Congress Bad For Legislation
The Wall Street Journal has weighed in on the split Congress:
Getting Fannie and Freddie out of government conservatorship is the largest piece of unfinished business from the crisis era. While lawmakers have said overhauling the companies is a priority, they disagree on how to do it. The split in Congress come January means there is likely even less of a chance that legislation affecting Fannie and Freddie will become law.
While top leaders in both parties promise a fresh attempt in 2019, tackling the matter remains a tall order because lawmakers have divergent views on what to do.
Divergent views with a split Congress is a recipe for not being able to pass major legislation. The Wall Street Journal goes on to point out that the choice of the next FHFA Director is coming later this year or early next:
In the coming weeks, the Trump administration is expected to signal its intentions for the companies when it nominates a successor to current FHFA Director Mel Watt. Mr. Watt is due to step down in early January when his five-year term expires. A nominee is expected around that time.
When the last director was replaced in a similar situation, it was about 5 days before the term expired when the replacement was announced. Mnuchin has previously said that he was looking for a director with similar priorities as the administration to take next steps with. That may mean that nothing is going to happen until next year.
Summary and Conclusion
I have 4050 FMCCH, 8094 FMCCI, 9856 FMCCL, 400 FMCCN, 12608 FMCCP, 1210 FMCCS, 5042 FMCCT, 9085 FMCKP 11132 FNMFN and 5 FNMFO. These are all preferred shares in both of Fannie Mae and Freddie Mac. Moelis envisions some type of settlement of the lawsuits before new capital can be raised in a secondary/IPO. I don't know if existing preferred shareholders engaged in the lawsuits would settle for less than par, or even par for that matter. The government prevented them from having dividends since 2012, and since 2008 if you are serious about the accounting. At this point, the accounting restatement is off the table, but Lamberth's ruling squarely puts 2012-present damages on the table. If the administration stops the net worth sweep and announces that it is going to begin to recapitalize the companies, things get interesting in the settlement department for preferred shareholders.
For common shareholders, the risks include forcing a recapitalization that happens faster, the market not supporting such a high valuation, alternative hypothetical recapitalization plans, etc. The theory here is that the government aligns itself with common shareholders via the warrants so it should want to maximize the value of its warrants. In this style of a recapitalization, retaining a few years of earnings helps boost that value.
Downside to all shareholders would be the continuation of favorable market conditions. Moelis believes that the government should operate under a sense of urgency if it is to maximize the value of its warrants:
The updated plan envisions that preferred/common dividends would resume at the end of 2021. Combined the companies are forecasted to earn $22B that year and have 15-16B shares outstanding. Consider that income is forecasted to continue to increase from there, the potential for dividends exceeds $1.36/share per year. That's greater than the current market price to buy a share. This kind of reminds me of the last time I wrote about an American insurance company that looked like the P/E was less than 1. At that time, I put in $5000. Roughly 10 years later, I'm in 100x deeper but the feeling is the same. I originally pushed to title that article, "There's no risk with Conseco," but no sane financial journalist would ever say something is riskless. Let's just say I'm not trying to be a journalist. I didn't mean to write volumes of books on Fannie Mae and Freddie Mac. I'm writing this stuff because there's a void in coverage that's easy for me to fill. This is like showing up to a buffet with sandwich baggies in my pockets.
The next step is November 16th, 2018. That's when the comment period ends for the proposed capital rule. FHFA plans to have this rule finalized in the next year, which to me means by the end of September 2019 (government year's end). The director of FHFA Melvin Watt's term expires January 6th. Mnuchin said he wants someone running FHFA who shares the administration's plan. According to Moelis, we would think that an announcement could be coming very soon, as soon as before the end of this year, regarding the net worth sweep being turned off. With midterm elections out of the way, it will be interesting to see how quickly the administration does anything with GSE reform.
The government's legal team did just lose a major intermediate ruling in Lamberth's court, and so we can assume that loss and its long term implications and potential cash damages liability would have to be reported back to Mnuchin. It's not every day you get to choose between the risk of losing a lawsuit and having to pay $100B or settling and collecting $100B. It will be interesting to see if modeling for how the Lamberth's court lawsuit would be expected to pay out factors into some sort of settlement terms.
If the NWS is stopped and the SPSPA is declared paid down, it would seem that litigants would have the upper hand in determining a conversion scenario. The way I see it, this plan was designed for government officials and shows how much the warrants could be. What do you think about their normalized earnings going forward and IPO valuation? Share below.
Disclosure: I am/we are long fmcch,fmcci,fmccl,fmccn,fmccp,fmccs,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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