GSE Reform: More Thoughts Based On Reader Comments

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The Other Street
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Summary

  • On September 6, some inaccurate media reports knocked down the GSE's stocks. Since then, Fannie Mae common shares are up some 50%, and its T Preferred shares (FNMAT) are up 20%.
  • The trigger was an unexpected reversal of a District Court’s opinion by the 5th Circuit Court of Appeals, which declared FHFA unconstitutionally structured, by a vote of 12 to 4.
  • On September 19, FNMA was down 7% intraday, but recovered by the close. Preferred shares were flat. It was the same story: a misleading snippet from an otherwise good Bloomberg interview.
  • On September 13, I argued for an easy double (and then some, depending on the recapitalization terms) in both FNMA and FNMAT. I still do, with the common at $3.95 and preferred T at $13.

My recent article on Fannie drew many high-caliber comments. Based on these, here as some more thoughts to follow up.

Bear in mind that I am not attorney; this is a volatile, multi-event-driven story; and some of the people behind these comments are the real thing -- i.e., plaintiffs -- and they know much more than I do.

First, the September 18 Bloomberg TV interview, as published by DSNews. The snippet was:

According to Calabria, Fannie and Freddie won’t go to market until the end of 2020.

Anathema, right, especially for those shareholders who have been patiently waiting since Fannie and Freddie repaid their debt in 2014. To add insult to injury, Calabria actually said it could even reach into early 2021.

But this barely captioned the substance of the interview, and he knew Bloomberg was out to catch him. Whereas his focus was, rightly so, on the need for seed equity in order to be able to go to market, no question was asked about the potential shareholders’ remedies from the 5th Circuit.

As readers know, the 9 to 7 majority opinion led by Judge Willett was a prospective Net Worth Sweep cancellation. But his 7 to 9 minority opinion was a pure and simple vacatur of the NWS, meaning a retrospective cancellation. Read the reimbursement to Fannie and Freddie of the amount they paid Treasury in excess of the amount they borrowed. In Willett’s writing, the numbers were $250 billion repaid at the time of the suit, against $187 billion borrowed. Actually, as of Q2, 2019, the amount repaid was a total of $306 billion, for an excess of $120 billion.

Treasury is opposed to this, and argues that taxpayers, on whose accounts it acts, are entitled to compensation for lending the money in the first place. Makes sense, but my first reaction was to counter with the Trouble Asset Relief Program, aka TARP. To quote my 2009 book, Anatomy of The Meltdown:

TARP, introduced by Paulson and Bernanke on September 20, 2008. Originally a 5-page memo which called for Treasury to spend $700 billion on “toxic assets,” as mortgage and other asset-backed securities had become known, it ended up as a 551-page legislation, the Emergency Economic Stabilization Act. Within two week, on October 3r, it was signed by President Bush.” (page 133).

An Act of Congress, just a short month after FHFA’s Preferred Stock Purchase Agreement, aka the PSPA.

Speaking from memory, it seemed to me there was nothing in TARP that made Treasury as much money as Fannie and Freddie, so I took a second look. According to the March 2016 CBO report to Congress, TARP had disbursed $427 billion and lost $28 billion. Obviously no comparison with the gouging of Fannie and Freddie, $120 billion profit and counting, on a $187 billion financing.

Much like in this case, there was a taxpayer’s indemnification clause, in the form of warrants in exchange for TARP funds. However, there were two huge differences. One, the TARP recipients continued to operate as regular companies with a board of directors, even if there were a few strings attached such as a cap on officers’ compensation. Here, and this is a point of law raised by Willett, control was transferred to a single entity, the FHFA which, as it turns out, was unconstitutionally structured acted as a receiver instead of a conservator. And payments were made a single shareholder, Treasury. This is the main reason why there was no such things as the Third Amendment attached to TARP funds – this link to a 2014 Forbes article is an excellent summary.

The second difference is even more meaningful when it comes to explain the disparity in “taxpayers’ indemnification.” TARP recipients could all buy back the warrants or other instruments that had been issued in exchange for the loans and guarantees. And most banks did, out of retained earnings, or their own stock issuance. AIG, for its part:

In January 2011, AIG restructured its obligations under the program. As part of that restructuring, the Treasury agreed to exchange its existing preferred stock—with a total value of $48 billion—for approximately 1.1 billion shares of AIG common stock. In addition, AIG drew down more than $20 billion from the balance on its line of credit to purchase preferred shares in former AIG subsidiaries from the Federal Reserve Bank of New York; the remainder of the line of credit was canceled with $2 billion remaining undrawn. Since that time, AIG has fully exited the TARP; the company repaid its line of credit, and the Treasury recouped an additional $34 billion from the sale of its shares of AIG common stock at an average price of about $31— bringing the total amount repaid or recovered to $54 billion out of the $68 billion originally disbursed. The final net subsidy cost to the Treasury of the assistance that was provided to AIG through the TARP was $15 billion.” (page 6)

Not only the PSPA and the Third Amendment gouged the shareholders, but they prevented, and still prevent Fannie and Freddie from buying back the warrants. TARP cost taxpayers some change, Fannie and Freddie are making them big bucks.

Take Fannie. At the current price of $4, it would cost $18 billion to buy them – there are 1.15 billion shares outstanding (2019 10Q, page 53), the warrants cover an 80% ownership, meaning 4.5 billion additional shares, time $4 per share. Fannie earned $16 billion in 2018. QED.

Whichever way Treasury wants to cut it, in the end, Fannie and Freddie cannot be treated differently than the other entities involved in the 2008 crisis. Common sense oblige, backed up by Court’s opinion, and if need be, by the TARP-enabling legislation.

One could counter that HERA, aka the Housing and Economic Recovery Act, too was an Act of Congress. It was. The only problem, the FHFA it created was unconstitutional. How could that happen, I don’t know, but it did.

The fact is, Fannie and Freddie's $187 billion were fully repaid by Q4, 2013. Treasury could have made it easier by allowing them to retain earnings, and recapitalize on their own, but that was Geithner. Why didn’t FHFA DeMarco say something, I don’t know either. And then there was Mel Watt.

For those of you less familiar with these people, here is some background. Tim Geithner was appointed as Treasury Secretary by President Obama, who announced him in November 2008. Despite TARP, the market was unfazed and continued to swoon. Geithner had been the New York Fed President, supervising most of the US banks who had just failed under his watch. In my opinion, the combination of Geithner, Pelosi, Reid and a return to Keynesian economics was what broke the camel’s back.

DeMarco was a bureaucrat, leaning conservative, directing FHFA from 2009 to 2014. The Third Amendment was signed under his watch, and several bank suits were settled for not much. Don’t know why, maybe because of pressure from the Obama Administration.

That pressure to maintain the “receivership disguised as conservatorship” status became quite apparent under the next FHFA director, Mel Watt, North Carolina Senator, member of the Progressive Black Caucus, a close associate of President Obama.

Bottom line, with hindsight and reflecting on your comments, the story is quite simple.

The Courts are finally seeing through this. The Preferred may be capped by their call provision – not sure about, that since it will require money to call them at a time when Fannie and Freddie are trying to recapitalize - but the Commons have a hell of a ride to go. Best case, $16 billion divided by 1.15 billion shares times a PE multiple of 10 equals $140. Worse case, if warrants are indeed exercised - and I argue they won't be- $16 billion divided by 5.5 billion shared time 10 equals $29.

That leaves a lot of room from the current $4.

Which brings me to the next topic: Who’s the pilot? Clearly, President Trump. And what’s his course? The 2020 Elections. On that score, there are two camps on the September 13 thread, but surprisingly both are long GSEs. What they differ on is their level of patience, their investment horizon, and the trust they put – or don’t - on the president, Calabria, and Mnuchin, separately or as a group.

On the psychological side, I am not qualified, even if I knew the protagonists, which I don’t. But, like everyone else, I have an opinion. I view this as white-collar crime. It has been exposed, and finally ruled unconstitutional by the Appellate Court, 12 to 4. On the heels of this opinion, the DOJ, speaking on behalf of the Consumer Financial Protection Bureau, after years of wrangling, admitted last Tuesday September 17, that it too was unconstitutionally structured. For those who don't remember, the CFPB was created through the Dodd-Frank legislation in 2010:

In July 2010, the President signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), Pub. L. No. 111-203, 124 Stat. 1376. The legislation provided “a direct and comprehensive response to the financial crisis that nearly crippled the U.S. economy beginning in 2008.

Senator Chris Dodd, the #1 recipient of GSE's donations, retired from Congress in 2011. Congressman Barney Frank, also a large recipient of GSEs money, retired in 2013. They were the Democrat leaders of the 2008 Congress, and part and parcel of what led to the sub-prime mortgage and collateralized debt obligations crisis:

The fact is, people have killed themselves over what happened – Thierry de la Villehuchet in New York[1], Adolf Merkle[2] in Germany. The most recent victim was 41-years old David Kellerman, acting CFO of Freddie Mac, who committed suicide on April 21st, 2009. People went to jail - Bernie Madoff[1], Jeff Skilling, Andy Fastow and Ken Lay of Enron, Bernie Ebbers and Scott Sullivan of WorldCom, John and Timothy Rigas of Adelphia. Many others were on the short list.

Not to mention the Politicians who, for some, were supporters at best, deeply involved at worse – Jon Corzine, former head of Goldman Sachs then Senator and Governor of New Jersey, Congressmen Barney Frank, and all the other Fannie Mae players and the like – Penny Pritzker, former chairwoman of defunct Superior Bank of Chicago[2] and chair of President Obama’s 2008 campaign fund raising, Franklin Raines and Jim Johnson, former CEOs of Fannie Mae and advisors to then President-hopeful Obama, Congresswoman Maxine Waters, Senators Chris Dodd, Chuck Schumer and Kent Conrad, and even Senator Obama, the second largest recipient of Fannie Mae’s campaign donations. Just do a Google search - type their name and add Fannie Mae to it, you will be amazed – I was -, and this is an understatement. [Anatomy of The Meltdown, second edition]

But I digress, sort of.

I think Donald J. Trump followed this closely, then as private citizen, and now as President – this is Housing, 20% of the economy, and he is a populist. More voters on Main Street than on Wall Street.

For that simple reason, I do not think he will allow his people to challenge the Court’s 12 to 4 decision about FHFA unconstitutionality. Some say it was "partially unconstitutional." There is no such thing, it is constitutional or it is not.

Next, people worry about Mnuchin, mainly because of his past foreclosures history. Fair enough. My take is simple. He picked Jay Powell, and we know the President’s thoughts on that. Mnuchin needs to play to stay.

As for Marc Calabria, he knows FHFA inside out for having worked on the creation of its parent, the HERA legislation, and has long advocated for the GSEs to be taken out of conservatorship. Most people know he worked at the CATO Institute, characterized as libertarian, and for Senator Shelby. Few remember he was an economist for the National Association of Realtors, which suggests to me - I am also a Realtor - he has a pretty good idea of what works for real estate. And so does the President.

Which leaves us with the basic valuation question. I am on record for calling FNMA, $3.90, and FNAMT, $13, a double and then some. I am still on, and, except for volatility, I see no risk. Unconstitutionality requires remedy. Add to this malfeasance. At the end of the day, FNMA should make a normalized $10 to $14 billion, warrants should be cancelled, or allowed to be bought back, excess money reimbursed, and a modicum guarantee fee should be set. According to Marc Calabria, the taxpayer should not have been involved in the first place.

Repeating myself but he Preferred may be capped by their call provision – not sure about that since it will require money to call them, at a time when Fannie and Freddie are trying to recapitalize - but the Commons have a hell of a ride to go. Best case for Fannie, say $12 billion including an explicit government guarantee divided by 1.15 billion shares times a PE multiple of 10 equals $104. Worse case, if warrants are indeed exercised - and I argue they won't - $12 billion divided by 5.5 billion shared time 10 equals $22.

Going back to my favorite Earnings Yield, a PE of 10 means an EY of 10%. Comparing this to the market EY of less that 5%, that's a big risk premium. With an explicit Government guarantee, that would be a huge premium. $104 for FNMA may sound weird compared to the current $4, but FNMA sold at $70 pre-crisis, on a portfolio of $1.5 trillion when the EY was at 6%. It is now a $3.4 trillion portfolio. One and a half time the before-crisis valuation on a two and a quarter times larger portfolio does not sound that weird.

Whichever way we cut it, the final say is in the courtrooms, either in Collins, with Judge Atlas, or Sweeney, or some other case, or all the way to the USCC. You won't have to hold your breath much longer.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

This article was written by

The Other Street profile picture
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Going on forty years of salt mine experience as an institutional investment advisor, both on the Buy and Sell side. A graduate of Columbia Business School (MBA) and Chimie Paris Tech (MSChe), I started my Wall Street career with Brown Brothers Harriman & co, went West with Montgomery Securities and then founded my own advisory firm Capital Max in 1998, named after my first son. I could rename it "Max Brothers" but I am told to hold back. In 2009, with a second edition in 2011, I published my first adult book, titled "Anatomy of the Meltdown - 1998-2008. The Worst Decade in Stock Investing, or Was It?". Let me be clear: "Anatomy" has nothing to do with Sports Illustrated, except when the tide goes out. Published my second book in 2018, titled "Between Obama's Lines - How We Almost Lost The Middle East, The Cold War, and The Atlantic Alliance." This is serious stuff, you know - that's why they call us "The Other Street".
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Disclosure: I am/we are long FNMA, FNMAT, PHM, URI, IR. 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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