Fueling Up The Frannie Rocket Launch

Summary

• FHFA sounds like they are going to increase Fannie Mae and Freddie Mac guarantee fees, again.
• After years of disappointment in every branch of government, the final form of Fannie and Freddie as taken shape and the path out of conservatorship is simple but takes time.
• The purpose of conservatorship will largely be shifting how they are run from one of business economics to one of the economics of national security.
• People who own homes who have Fannie and Freddie mortgages will effectively have to pay larger guarantee fees to support keeping a mountain of money sitting idle on Fannie and Freddie balance sheets.
• The theory is that although they pay more in guarantee fees, perhaps this mountain of capital helps lower mortgage rates.

Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) are being set up to be the two most predictably profitable utilities in America. If there is anything institutional investors love it is predictable profitability. The problem with them right now is their capital structure. In the world of possible analogies, the one that best explains what is happening here is like a rocket getting ready to launch into orbit. The purpose of this article is to try to explain why I think it will pay to buy at these prices and wait for basically a bunch of incremental small things to happen for the next 6 months while they "fuel up the rocket for lift off" which I believe is scheduled to begin the countdown immediately after November elections. For me lift off is defined as the fourth amendment.

Investment Thesis: If 100% in 12 months sounds good to you, you might be interested in buying equity in Fannie Mae and Freddie Mac. Last year the companies were put on a path out of conservatorship that Trump's Treasury put together. Team Trump has always had housing finance reform as a priority on their agenda but they haven't been able to do much. After years of prior administration policy ruling the day because Obama holdover Melvin Watt was impeding progress, he was replaced as director of FHFA by Mark Calabria. Mark Calabria helped write the law that governs FHFA and in 2015 he wrote a paper saying that the conservatorships violate HERA and established insolvency principles. In other words, Team Trump has brought in the guy who wrote the law to ensure that FHFA follows the law, a novel concept for FHFA because up until Calabria was put in charge, FHFA simply did Treasury's bidding and as such Treasury has senior preferred and warrants. Treasury's senior preferred stock has a claim on all of the money the companies ever generate in perpetuity, arguably making every other part of the equity capital stack worth only what the intricate web of shareholder lawsuits that have been sewn as a blanket to try and stop the theft ends up being worth. So far, that's been a resounding nothing with the exception of an accounting fraud lawsuit that was settled by the auditor. The government, of course, was furious and tried to prevent settlement, but it doesn't take an accounting genius to see what has happened here. Long story boys and girls, here's what's in it for you. Based on forecasts that I've seen from Nomura, they are forecasting that common stock is worth $5 in a year and preferreds convert at an 80% discount to par as part of the legal settlement that is required to make these companies attractive to capital markets. As such, I figure commons will be at $3-4 and preferred at 60-70 cents on the dollar when the fourth amendment is made in 5-7 months. In the meanwhile, who the heck knows! The Dow Jones is over 27,000 again so buckle up and expect some turbulence because those valuations are stretched above historical averages.

Leading Up To Conservatorship

A long time ago, in a galaxy far, far away... okay, well actually in 1992 the Office of Federal Housing Enterprise Oversight (OFHEO) was established by the Federal Housing Enterprises Financial Safety and Soundness Act of 1992. OFHEO was largely a weak handed regulator. It was charged with ensuring the capital adequacy and financial safety and soundness of Fannie Mae and Freddie Mac.

In 2008, HERA was passed into law which converted OFHEO into the Federal Housing Finance Agency (FHFA). FHFA is much stronger than OFHEO. Casual reminder that current FHFA director Mark Calabria worked on HERA. Fannie and Freddie didn't meet any of the criteria to be placed into conservatorship, so Treasury worked on a plan that basically required threatening their boards of directors into agreement. The reality is that the boards of directors wanted to know the terms of conservatorship but Treasury wouldn't divulge those. Treasury's plan was based on the work by Dan Jester that leveraged FHFA's discretionary accounting authority over the enterprises to force them to systematically the conservatorship by declaring all sorts of assets were worthless.

If you're familiar with most accounting frauds, the game is usually to figure out ways to overstate assets like accounts receivable or understate liabilities or in Enron's case do off-balance sheet magic - all in the name of generating reported positive net income in line with or beating consensus estimates as a means of supporting stock prices or capital raises or whatever the goal is at the time. In this case, however, the goal was a hostile takeover, so if you can imagine you want to take over a company, instead of overstating the value of assets, you do the opposite. Treasury and FHFA worked hard to make Fannie Mae and Freddie Mac look worthless. The stocks themselves crashed in advance by design. Hank Paulson tipped of his hedge fund buddies at Eton Park that he was going to crash Fannie and Freddie to take them over.

Back To The Stone Age

So that's how they got into conservatorship in 2008. The three years that followed were simply plan execution. The companies reported consistent losses. Treasury looked like a hero coming in to save the day.

Frankly, I mean, I am not a smart man. In 2009, I remember reading John Hempton's analysis of what was going on here. I was not and still am not smart enough to detect that the government was committing accounting fraud against Fannie and Freddie in those earlier years. It's safe to say that if I was smart enough to figure that out, I am not even sure if I would have bet on their securities at that time. The thing about accounting fraud is that if good things are happening, in reality, you can only report bad things that are happening for so long. Treasury and FHFA ran out of accounting fraud that they could commit against Fannie and Freddie in 2011-2012 and all those writedowns that they made were going to be reversed, and quickly. Fannie Mae alone in 2013 made $84 billion dollars.

The thing was, however, that Treasury knew that Fannie and Freddie were going to make unprecedented amounts of money and they didn't want anyone else to have any. Treasury and FHFA did the third amendment net worth sweep in 2012 in order to ensure Treasury got everything. Lawsuits have subsequently been filed claiming that this was illegal for multiple reasons in multiple courts around America. For years, the courts have been an uphill battle against goliath, because apparently, you aren't cool if you are a judge and you rule against the government, especially in DC. The government got red carpet treatment. FHFA officials committed perjury but no one cares.

More recently, plaintiffs have won legal victories, but it hasn't stopped or fixed anything. I had no idea that courts were so slow and battles were so long and hard fought. It would seem to me that you can only fight 3-4 of these kinds of battles in a lifetime, and these are wars of attrition. The good guys who have fought the good fight here have fought longer and harder than I'm sure they ever thought they would have to. My thought early on was that as time passed it would be more apparent that Fannie and Freddie are here to stay and this would work out faster, but I never really anticipated the government doing what it has done. The goalposts keep moving.

The Space Race

When Trump won the presidency, Mnuchin came out guns a blazing saying that we had to get Fannie and Freddie out of government ownership. That was in 2016. Now it is 2020. I just lost 4 years. Has that ever happened to you? The courts haven't helped. Bob Corker's legislation didn't help, either. The Trump Administration didn't really start helping until last year when Melvin Watt left FHFA. Getting rid of Watt set of a chain of events. They put together a plan and started letting Fannie and Freddie keep their money instead of being forced to hand it over to Treasury. This was the first major step towards restructuring Fannie and Freddie since they were placed into conservatorship.

This about-face was not forced by the courts. In fact, I think if the government wasn't doing what it is doing these days, common shareholders might actually be better off in a few years when the courts actually get around to coming down hard on the administration. Imagine courts ruling on the APA claims to reverse the net worth sweep under the historical capital framework. The companies wouldn't need to raise nearly as much as they will need to now with their mafia-style capital requirements. Just saying, the Trump administration is taking the opportunity to solve this conundrum and take the W.

The end goal is basically to get Fannie and Freddie into orbit as dividend-paying utility companies with so much capital that there is never a run on agency mortgage-backed securities. Back in 2008, Hank Paulson got spooked by the Chinese into putting them into conservatorship because he knew his banker buddies couldn't handle a collapse in agency mortgage-backed securities prices and I guess people were considering dumping agency mortgage-backed securities. At the time, the solution was to sacrifice Fannie and Freddie to save the financial system by being creative with the law and hoping no one got in the way. To be fair, it's a small price to pay for what could have been a collapse worse than anyone alive has ever seen.

Assembling The Rocket

Throughout conservatorship, FHFA's favorite thing to do has been to raise guarantee fees, which are the fees that Fannie and Freddie charge homeowners for their services. These fees have boosted their profitability and robustness. For example, if you have the same company and on average if it makes $20B a per annum versus $10B per annum simply by doubling the fee that it charges, that income that it charges works to offset potential losses due to the business cycle. Absent accounting fraud, charging higher guarantee fees basically makes it that much more difficult to say the companies are insolvent. Further, having much larger guarantee fees sets the groundwork for having so much capital you can't possibly run through it all during times of stress.

FHFA's Calabria's favorite word since he's become director seems to be 'capital.' The amount of capital that he has proposed Fannie and Freddie hold seems to be based on the premise of forcing them to hold as much capital as they can instead of any analysis of how much capital they would need during a time of stress. In the past, Fannie and Freddie were treated like normal businesses. Going forward, Fannie and Freddie are being turned into matters of national security. Apparently, there needs to be a mountain so high of capital on their balance sheets that for them to work through it would take like an asteroid to wipe out an entire American city.

What's funny is that it's likely that behind all of this capital the remainder of the SPSPA borrowing capacity will be retained as a limited entity level guarantee that Fannie and Freddie pay for should they ever need it although with these guarantee fees and this amount of capital it literally would take an act of god and that's a scenario where who knows what anything is worth anyway.

Fueling The Rocket

This month, Fannie Mae and Freddie Mac are expected to hire financial advisors that will work with FHFA and investors to chart the path forward. I expect there to be lots of conversations about feasibility and what the market will bear and how to raise capital. The cheapest source of capital will be retained earnings and I assume the companies will try to minimize dilution by using as much of those as possible.

Buying stock now is like investing in private equity in what will be the largest most oversubscribed IPO in history. There is no business as predictably profitable as Fannie and Freddie and there is nothing institutions love more than being able to predict earnings with confidence.

Fannie and Freddie are scheduled to uplist to the NYSE later this year but I don't think that anything really happens until after the November elections. This whole process seems to have been designed around not getting any of the heavy lifting done in advance of the elections and then doing everything that matters and putting the twins on an irreversible path out of conservatorship between the elections and inauguration in January.

There are hints that stuff is being cleaned up over at Fannie Mae in preparation, like this filing. FHFA was run like a popsicle stand during the Obama administration and apparently, no one bothered to deregister securities that haven't existed since 2011 until this past week.

Launch Sequence Initiated

I figure you can really start counting down here after the elections this year. The companies can't raise any capital with the net worth sweep in place so that has got to go. The equity will get restructured in order to raise new money. These actions are all going to be decisions that are discussed across the next 5 months with these financial advisors that get hired this month for Fannie and Freddie.

The preferred shareholders in Lamberth's court have claims that need to be settled in order to raise capital but the vast majority of the lawsuits basically go away if they reverse the economic impact against the companies of the net worth sweep by writing down the liquidation preference and crediting the companies for the overages. So from these prices, you're looking at 100% return in about half a year. The stock market seems to be pricing in election risk, which doesn't really exist because for this plan it doesn't matter who gets elected. The current administration has mechanisms available to it to ensure that once launched, Fannie and Freddie get into orbit.

Life In Orbit

If you figure Fannie and Freddie raise money at $5 in a year, you can also figure that in a 2-4 years the companies will most likely be worth over $10. The companies will be wildly overcapitalized with more money than they'll ever need and they'll be dividend favorites. With interest rates this low, the sky is the limit.

Summary and Conclusion

I only own preferred shares but I figure commons have a pretty clear path forward from here, albeit with more risk. I figure the companies only raise as much money as they need to out of the gate and really try to focus on recapitalizing as much as possible from retained earnings. I figure the preferred legal claims are worth 140% of par so it will be interesting to see how that settlement works because a bird in the hand is worth two in the bush.

If you're new to this, welcome aboard. I figured I'd write this high level summary for all the people who I expect will start talking about this due to the financial advisors getting hired for Fannie and Freddie. You all are going to need to be able to quickly get up to speed with what is going to happen and in figuring that out it helps to know what has actually happened here and how we got here and why things are going the way they are and what that means going forward. Raising tens of billions of dollars doesn't happen overnight and with this entire process lining up now that we have an idea of how much capital the companies need, financial advisors incentivized to underwrite the capital raise process are going to be having lots of conversations to gauge investor interest at various prices.

Analyst’s Disclosure: I am/we are long FMCCG, FMCCH, FMCCI, FMCCL, FMCCM, 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.