Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) are two companies commonly referred to as the Government Sponsored Enterprises, or GSEs. They are in conservatorship where the government has structured senior preferred stock that takes the net worth of the companies quarterly above a token capital buffer. Since before the Trump administration came into office, its officials have been talking about getting Fannie and Freddie out of conservatorship. The stocks soared and nothing happened and eventually the stocks crashed when investors lost another major battle in their quest for injunctive relief. The government has largely won the narrative that it can do whatever it wants, and so it has. It used accounting to justify taking all of the GSEs money when court rulings indicate that it could have just taken it. What this does is it supports the notion that the Federal Housing Finance Agency (FHFA) is one of the most powerful government agencies, at least while the GSEs are in conservatorship.
The investment thesis here is twofold. The first aspect is that eventually a legal victory will yield either monetary payment to shareholders, in some cases like Washington Federal, class shareholders who owned pre-conservatorship. The second aspect is that the administration will begin to recapitalize the companies and lead them to exit conservatorship. The first aspect is buoyed by a claim in Judge Lamberth's court that is going to trial. The second aspect is buoyed by the fact administration officials have repeatedly called for the privatization of Fannie and Freddie. If they are privatized in accordance with the latest version of the proposed capital rule, the companies would need to raise an unprecedented amount of capital from private markets. Recapitalization plans have been floated that support this kind of capital raise that result in both junior preferred and common stock valuations exploding higher by over 100% each. Mnuchin has previously said that switching out FHFA directors in order to have one that has interests aligned with the current administration is important. This seems to suggest that Watt has been delaying administrative recapitalization as an Obama holdover.
Coming Soon: New Director Of FHFA
Mnuchin has said that housing finance reform would be a priority and pushed it back for a few years but now Inside Mortgage Finance Publications and others are reporting that the White House will make an announcement soon regarding the interim director of FHFA:
I previously predicted Joseph Otting here 2 months ago. Joseph Otting previously worked with Mnuchin so it seemed like the most natural pick. January 6 is the deadline, but if you ask me, the White House is most likely to announce this after Congress goes home this year, so in at least two weeks. Various recapitalization plans have been floated around, some where commons go down and preferred get a fraction of par, and some where commons and preferred both go up a good amount. The former tend to have junior preferred converting before the warrants are exercised and the latter after. I am a preferred shareholder because I'm a worst case scenario kind of investor. That said, I am sympathetic to common shareholders pleas for a fair deal. I just think that the government is going to try to maximize the value of its warrants in a recapitalization.
John Carney's "Hedge Funds Looting Fannie and Freddie" Narrative
John Carney has historically been more accurate than I have as far as history has actually played out and I must applaud his recent article. He claims that the administration is warming up to recapitalizing Fannie and Freddie via the Moelis plan that is backed by Trump insiders. For those of you new to the game, the Moelis plan was built on top of the excellent work done by Josh Rosner. In the article by John, he talks about Mick Mulvaney being a supporter of a recapitalization plan:
John attempts to make a few points as to why hedge funds are looting Fannie and Freddie. The first is that the earnings are now lower than they were as they were recovering:
That's a great argument, but it's only possible because FHFA used its discretionary accounting authority to drive the GSEs deeply into the red in the early years of conservatorship. These post net worth sweep massive dividends highlight the fact that the government knew the GSEs were about to report substantial profits and decided to take them instead of permit recapitalization. John's argument casts shade on the wrong part. It continues to blame Fannie and Freddie for not being able to spread out the reversals of the unnecessary accounting losses. That doesn't seem right to me. Nevertheless, Carney makes the point that the courts largely have ruled in the government's favor and he's right:
What he's missing though is that the breach of implied covenant claims actually are going to trial in Lamberth's court and all the claims in Judge Sweeney's court are yet to receive their first ruling because the discovery process took years due to government procedural delays as it belatedly produced incriminating documents.
Carney then goes on to say that because investors have lost in court, they've moved to try their hand in politics:
What Carney is missing here is that the hedge funds are proposing a settlement where the government basically gets to claim no fault but reverses the impact of the net worth sweep. It is impossible to recapitalize the companies with the net worth sweep in place. Secondly, the government needs to go to private markets to raise $100B+ in new capital. No new investor is going to put up money for these companies if existing shareholders have had all their money taken via government accounting and unilateral transactions in companies that are operated in conservatorship under a statute that courts interpret to give FHFA the power to take all their money unilaterally. Hence, these recapitalization plans that have been floated by shareholders are basically what it takes to attract new capital.
Carney makes the twitter point online that 100% is greater than 80%, meaning that the senior preferred stock that takes 100% of the net earnings of the companies is greater than the value of the warrants. I agree with his assessment there, but I don't find it convincing as taking 100% makes it impossible to raise new capital. It's worth noting that prior MBA Mortgage CEO David H. Stevens supports Carney's narrative. Carney goes on:
So, it's worth noting that in return the companies would be able to raise $100B from private markets for respecting shareholder rights by basically undoing the net worth sweep. Without being able to raise $100B of new capital, it basically makes restoring the GSEs as private companies a decade long process if not longer.
In fact, if housing markets take a turn south and FHFA were consistent in using its discretionary accounting authority to aggressively write down assets during rough times then we'd expect Treasury to have to inject more money into the GSEs which are really just being run as off balance sheet government agencies. I would assume that FHFA in a second housing crisis the way things are currently structured would likely not be interested in massive one-time charge offs like last time because there no longer is the need to retroactively justify the imposition of conservatorship.
Nevertheless, Carney closes strong:
He challenges the President of the United States to getting a better deal. The problem is, I don't think there is one. How do you recapitalize two of the largest most profitable companies in the world when you're taking all of their money and left shareholders so far with nothing except pending legal rulings?
I can tell you this, it would look worse if Donald Trump doesn't settle the lawsuits, housing turns south and he's forced to bail out the GSEs with hundreds of billions and then the administration is forced to pay shareholders billions of dollars for contract and takings claims that continue to persist in court. Carney pretends that shareholders have no chance in winning anything in his own words and does an A+ job of telling the worst possible narrative possible. I think he completely omits that the administration has repeatedly said publicly that resolving the conservatorships of Fannie and Freddie is a priority and it intends to re-privatize them.
I was on a call with a shareholder recently when I talked about how great of a job I thought Carney did at telling his story. The shareholder asked me if I thought Carney was right. I don't think his narrative is right, but I think it's the best you can do if you specifically pick out points along the way to tell the story that way. That's why I think that it's worth the read, not because it is compelling, but because it's the best set of arguments the opposing side can make.
Craig Phillips Updates David H. Stevens
Craig Phillips is the Counselor to the Secretary US Department of the Treasury. He's basically Mnuchin's man in charge of Housing Finance Reform. He's said that this is now on the top of Mnuchin's docket and recently educated David H. Stevens about the loan limits increases made by the FHFA Director appointed by President Obama:
David H. Stevens has been publicly outspoken against the various recapitalization initiatives while he was the CEO of MBA Mortgage. From a recapitalization standpoint, it's great to see a Trump administration official point out that the problems David is complaining about are directly related to officials that are going to be replaced next month.
How Did We Get Here?
It's been a long journey. This has been the longest and perhaps the largest conservatorship in American history at over 10 years and over $5,000,000,000,000 in assets. Some people say that the conservatorship was never necessary. If you look at the cash flow of Fannie and Freddie, it's true that they basically didn't need a bailout. Their capital reserves coming into conservatorship would have permitted them to survive without having to raise additional funds. What happened here was more of a situation of National Security.
If you study the narrative of prior Treasury Secretary Hank Paulson, he was concerned about the market not being able to differentiate between agency mortgage backed securities. In 2008, real estate prices were crashing and private label mortgage backed securities were basically priced like they were high quality when the reality was that they were mostly a house of cards. The movie The Big Short does an excellent job of telling this story.
David Fiderer wrote the book, "The Plot to Destroy Fannie Mae: Anatomy of a Power Grab", which goes into great depth to talk about how this all played out. Long story short, Hank Paulson justified the imposition of conservatorship in the name of preventing a run on agency mortgage backed securities.
The problem I have with what transpired isn't really with the conservatorship. Conservatorships in history have done wonders. They provide an orderly process where otherwise things would get ugly. In this case, however, the government came in and took over adequately capitalized companies by forcing a board vote. Gary E. Hindes talks about the board vote in the context of the recently filed redacted Washington Federal complaint. Note that he has an active lawsuit against the government where the government so far has been winning the legal rulings:
After the board vote and the official imposition of conservatorship, the government unilaterally entered into an agreement where it could decide how much money to inject into Fannie and Freddie. The next three years, the government systematically wrote down GSE assets in excess of their cash income in order to produce net losses that triggered additional Treasury investment. Eventually, however, accounting rules kicked in and it became time to reverse course and write these assets back up. In the process, the government implemented the net worth sweep and got all of its money back.
The kicker is that conservatorship has been used as a heads the government wins, tails you lose. Historically conservatorships have never been operated this way but court rulings around America have ruled in favor of the government who says that it can do whatever it wants.
What's interesting to me is what can be learned from all of this. I'm not a lawyer, but I don't think you need to be to read HERA and understand what it is supposed to mean and how it is supposed to be interpreted in court. My interpretation of the law has been inconsistent with the prevailing court rulings. I thought that the court system would have declared what the government did here to be illegal, but it has been a fascinating experience to see how wrong I can be. My friends point out that I am the boy who cried wolf these days and perhaps no one has been as wrong as I have for as long as I have been. I agree in part and disagree in part. It's true that I have been outperformed and lapped by nearly everyone else. I've watched life pass me by.
I'm still trying to figure out what this all means, but it doesn't subtract from my conviction that this is a recapitalization that starts in the not too distant future. The moral of that story is there is no realistic alternative. Alternative proposals have been floated but they not only are not realistic, but the administration has signaled that the companies are going to be re-privatized.
The question for me is not really if, but when and using what mechanics. I believe that the government wants to recapitalize the two companies to the extent that they never would have needed a bailout in the first place, which is kind of odd because in my opinion they technically didn't. That said, the government continues to run this show and be in complete control. As such, the new FHFA proposed capital rule has been set so high that according to the government it would have prevented Fannie and Freddie from needing a bailout. Since the imposition of conservatorship, guarantee fees have been raised in order to support a recapitalization of such a magnitude.
What's ironic to me is that you'd expect that higher guarantee fees would require that the GSEs hold less capital because their recurring income is higher to offset any losses. But, that's all water under the bridge now. The tide is turning and even Hank Paulson came out recently and said that the biggest problem with the GSEs was really just inadequate capital.
MarketWatch's Andrea Riquier has been covering Fannie and Freddie for years, so it was interesting to see her allege that the net worth sweep was apparently a directive of Congress:
I think what she's referring to is changes to the Senior Preferred Securities purchase agreement. Those changes were made by FHFA and Treasury. Perhaps she didn't notice that Mel Watt wasn't an active congressman in 2012. I'm not sure, but if there was a directive from Congress to take all of the money from Fannie and Freddie in 2012, I haven't seen it. Andrea does hat tip to Joseph Otting:
Lastly, Prior CFO of Fannie Mae Timothy J. Howard said that he is planning to put up a blog post of how the time frame for a final capital rule impacts the pace of administrative reform:
To add to Tim Howard's point, they can't be recapitalized with the net worth sweep in place.
Summary and Conclusion
I own 4050 shares of FMCCH, 8094 shares of FMCCI, 9856 shares of FMCCL, 400 shares of FMCCN, 12608 shares of FMCCP, 1210 shares of FMCCS, 5042 shares of FMCCT, 9085 shares of FMCKP, 11132 shares of FNMFN, and 5 shares of FNMFO. These are preferred shares. I don't own any common shares because I think that all but one of the lawsuits can get settled by declaring the net worth sweep as paid back. That remaining lawsuit only includes claims for shares held pre-conservatorship.
In the event the net worth sweep is declared paid back, I think that it is possible to recapitalize the companies without there being material upside for common shareholders. It is for this reason I recommend buying preferred shares and why I have put more than my net worth into them by borrowing via personal loans. I will say that I've held these personal loans for so long and the interest rates are in some cases over 30% that I'm not sure if I would have been better off to simply just buy without the debt at this point? I think that breakeven is probably in a year or two, but what you don't take into consideration is how it impacts your daily life. For me, not diversifying enough has likely negatively impacted my day to day for years now and has forced short-sightedness on innumerable occasions.
At these prices, the potential upside to common shareholders if a Moelis style plan is adopted is roughly 2-3x that of preferreds. I just don't know what sort of recapitalization plan is going to be adopted and I urge caution because honestly if you own shares in these companies you generally feel that the government hasn't been doing the right thing for over 10 years. And so, the question as I see it is when you own shares and are sitting on the perspective that things haven't quite gone how they should, it generally seems unreasonable to me to expect some type of bonanza for shareholders if the government can get away without one. In a Moelis style outcome, where 50% of the preferred convert to common at the first offering and 50% either keep their existing preferred or convert to a new class of preferred it would seem that the preferred would not pay dividends until the companies are capitalized and exit conservatorship, so those likely would trade at a discount if that's how this goes. There are lots of mechanics that are TBD in this recapitalization, but we have a general amount of capital that needs to be raised, 2.5%-3.25%. Certain people out there have proposed more capital but that's impossible without raising guarantee fees and the cost of home ownership in America.
I have literally written over 150 articles on Fannie and Freddie for Seeking Alpha since the middle of 2014. I've probably been read over 500,000 unique times. This has probably been the biggest thing I've ever done in my entire life. If you're reading this, thank you for taking the time to filter through these ideas. Everything I've done here wouldn't have been possible without you and everyone like you that has decided to investigate what on earth is going on here, because it's nuts. It's absolutely nuts what's happened here and frankly what's about to happen is practically unbelievable at this point.
My friends say Mnuchin will keep doing what he's been doing, that he'll keep pushing back and delaying any meaningful legislative/administrative reform just like he has been. I'm never going to be in the business of I told you so, it's a lousy business. Instead, on a forward basis, as this plays out, if you have investment ideas that you're invested in that you think you'd like my thoughts on, feel free to reach out and let me know. Before I got into this, I have basically priced out the entire S&P 500. I look forward to actually getting back into company specific valuation analysis instead of investments that are so political in nature. I never have any idea what it is that I'm going to be doing next and I'm open to suggestions. I know Thanksgiving is over but in the spirit of Thanksgiving, thanks again.
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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