Time To Get Reform Done With Fannie And Freddie

Summary

• Treasury's point man on housing reform says it's time to get reform done.
• The en banc Collins v. Mnuchin oral argument went well, and it sounds like plaintiffs expect to win that in 4-6 months (if admin doesn't settle lawsuits first).
• I own preferred shares, but commons may have more upside for those willing to accept more risk.

Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) [often referred to as the government sponsored enterprises (GSEs)] are two companies in conservatorship because an agreement between their regulator, the Federal Housing Finance Agency (FHFA), and the United States Treasury has been taking all of their money since they were placed into conservatorship. Craig Phillips, the point man at Treasury for GSE reform, tweeted on housing reform, "Challenge accepted. Time to get reform done!!!!" Two weeks ago, FHFA's new director, Joseph Otting, was quoted by Politico saying that in the next two to four weeks FHFA employees should expect to see some communication coming out of the White House and Treasury that sets the direction for the future of housing and FHFA's part in setting the course.

Investment Thesis

On the recent Investors Unite conference call, lead plaintiff lawyer David Thompson talked about how reversing the effects of the net worth sweep would put junior preferred ($34 billion between Fannie and Freddie) at the top of the capital structure and then commons would participate on top of that. I own junior preferred but figure in any scenario where commons are not diluted before the warrants are exercised, there is upside there, perhaps more upside than in the junior preferred. Preferred trade at 40 cents on the dollar or less, and that's enough upside for me.

Craig Phillips: Challenge Accepted

This kind of reminds me of the Leeroy Jenkins video that went viral a few years back. What you have here is the #1 person in charge of housing finance reform from the Treasury side coming out enthusiastically saying it's time to get reform done:

One of the next major steps in the process of recapitalization would be for Treasury to announce that it has hired an investment banking firm to explore the options of exiting its position in Fannie Mae and Freddie Mac.

Investors Unite Conference Call

Investors Unite represents a GSE investor advocacy group put together by Tim Pagliara. They host calls, seminars, meetings with congress, and the leading public document database for documents produced by discovery - all relating to the rights of GSE shareholders. In this case, they held a call and have outlined ten big takeaways from oral arguments. The biggest takeaway is that the majority of the judges need to agree before even holding an en banc that an en banc is warranted. That's at least 9 out of 16. Secondly, oral arguments seemed overwhelmingly to favor plaintiffs. It sounds like after losing pretty much everything else so far, we finally have a winner. That said, administrative reform can - and I expect it to - happen sooner. Treasury's Craig Phillips seems to be kicking it into overdrive.

Crapo Legislative Plan

Crapo put out a plan. We've heard it all before. It's not news, except that he basically put it out again. Prior CFO of Fannie Mae says that it's a hybrid of the MBA's and the Milken Institute's plans:

Housing finance reform will be led by the administration. Congress will have its opportunity to contribute, and it may contribute such things as guard rails or an explicit guarantee at the security level.

Fairholme Update

Fairholme has reduced its GSE exposure in favor of cash, but has positive commentary:

What's interesting here is that Fairholme seems to differentiate between redemption values and realistic future outcomes. It would be interesting if they got into more granular detail about the realistic future outcomes, but doing so may impact their outcomes in a settlement.

Summary and Conclusion

The real story here is that FHFA is going to use its authority to establish historic capital requirements that would have prevented Fannie and Freddie from "having to be taken into conservatorship" in the first place. I put that in quotes because I think conservatorship harmed them. That said, it may have provided stability in their agency mortgage-backed securities, which was an administrative priority at the time.

These next two weeks will be interesting. Joseph Otting telegraphed the pass, and it looks like Craig Phillips is getting ready to throw the ball. I own preferred shares because they are the least risky bet on this being a recapitalization, which I think is a foregone conclusion at this point in time.

Fannie and Freddie will not immediately exit conservatorship when the net worth sweep is reversed. They need to raise enough capital such that FHFA deems them adequately capitalized. After stopping the sweep, their regulator will have to have Fannie and Freddie submit to FHFA capital restoration plans, which it accepts. The recapitalization process will take months to years. It sounds like the vast majority of the post-recapitalized companies will be new shareholders, whether they bought their shares from the company directly or from the government liquidating its position.

Analyst’s Disclosure: I am/we are long FMCCH, FMCCI, FMCCL, FMCCN, FMCCP, FMCCS, FMCCT, FMCKP, FNMAM, 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.