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GSEs: The Hidden Shareholders' Capital The Government Can't Touch

|Includes: Freddie Mac (FMCC), FNMA
Summary

Due to an accounting rule, there is a hidden jewel in their balance-sheets.

The government can't touch this jewel.

The common shareholders have a fair claim over this jewel.

A jewel worth $16 pps.

Due to the 2012 amendment of the Agreement with Treasury, called Net Worth Sweep, now Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) basically funnel all the profits to Treasury, so they aren't allowed to retain earnings (TIER 1 Capital).

But there is a reserve set aside since Conservatorship began hidden in their balance-sheets that has gone unnoticed to investors and that the government can't touch.

FnF call Troubled Debt Restructurings (TDRs) to those loans where they have granted a concession to a borrower that is experiencing financial difficulties. Source: Freddie Mac 2016 Form 10-K. Page 248.

SEC filing here

After being classified as TDRs, they are individually impaired (different than the collective reserve for loan losses). The amount recorded as Allowance for Loan Losses is the concession granted to the borrower. Source: Freddie Mac 2016 Form 10-K. Page 21:

This Allowance of Loan Losses reduces the assets in the balance-sheet, so that the line item Freddie Mac reports as Asset is: "Mortgage loans held-for-investment (net of allowance for loan losses)".

Source: Freddie Mac 2016 Form 10-K. Page 216:

This is because when FnF issue a Mortgage-Backed Security (liability) formed by a pool of mortgages (assets), they call these mortgages as "mortgage loans held-for-investment" (held to become a MBS).

A MBS is a "pass-through security", because the revenues that FnF collect from the mortgages (assets), pass-through to the MBS investor (liability). This is why, when they grant a concession to a borrower, they impair that loan in the amount of the concession because they will receive less income and the payments to the MBS investors are the same than before. But receiving less income from a mortgage is not a loss, is less income, this is why this Allowance for Loan Losses will be fully recovered.

According to Freddie Mac 2016 Form 10-K. Page 115:

We expect our loan loss reserve associated with existing single-family TDR to decline over time as borrowers continue to make monthly payments under the modified terms and interest rate concessions are amortized into earnings.

In the page 21, Freddie Mac specifies that:

...is amortized into earnings each period and is recognized as a reduction in the provision for credit losses in the period in which the cash flows are received.

"Amortized into earnings"? "A reduction in the provision for credit losses in the period"? In this world that's called "reserve releases". Which means that the reserve set aside for TDRs, that is the "interest rate concession", will show up in "earnings" as the loans are "amortized", in other words, as the loans are paid off with the borrower's monthly payments.

I've read "earnings" in Freddie Mac's statement. Therefore, it's similar to a retained earnings account.

As of end of 2016, the Loan Loss Reserve associated with TDRs on accrual status was $10,295 million for Freddie.

Source: Freddie Mac 2016 Form 10-K. Page 116:

Assuming that the government's warrant won't be exercised, this amount represents $16 pps for 650.03 million common shares outstanding in the case of Freddie Mac.

This reserve for TDRs is ballooning the Total Loan Loss Reserve and if we add the effect of Charge-offs net (losses when a mortgage goes to foreclosure or is short sold) declining dramatically in 2016 ($1,441 mll. vs $4,354 mll. in 2015), the outcome is that the ratio of Total Loan Loss Reserve to Charge-offs net now stands at 10.5, the highest in history.

Excluding the reserve for TDRs, that ratio stands at just 3.9.

Source: Freddie Mac 2016 Form 10-K. Page 114:

BOTTOM LINE

This reserve for TDRs has been built up by the current common shareholders with sweat and tears (the provision set aside each year to fund these individually impaired loans translated into huge losses, then draw requests to Treasury and subsequent issuance of Senior Preferred Shares), thus the junior preferred shareholders and the government can't have any economic interest over this reserve.

That's why an imminent Housing Finance System overhaul announced by the Treasury Secretary can't impose a swap junior preferred shares for common shares or the government exercising its warrant representing 79.9% of the common shares.

This reserve is the common shareholders' hidden jewel.

Nobody can touch it.

Disclosure: I am/we are long FNMA, FMCC.