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How It All Is Going To End

|About: Freddie Mac (FMCC), FMCCP, FNMA, FNMAS
Summary

Dissecting the most probable outcome of the en banc decision.

A look at incentives.

Current fair value of the common and preferred shares.

Introduction:

This is my first post on SA. I am posting this because a) I want to give back to all the wonderful contributors who posted info on SA over the last years and b) to learn how I am WRONG. I would love to have a respectful, factual discussion in the comments so I could understand different points of view or different facts that I have not yet learned.

This post is about the Conservatorship of Fannie & Freddie, and I assume the readers will have a great background understanding of what has happened so far.

I am trying to add a little bit of research and thought here and hope some may find it useful. I am starting with a dissection of the 5th circuit court hearing and then continue by having a look at incentives of the people in power.

Dissecting the probable Outcome of the 5th circuit en banc court hearing:

I have been listening intently and numerous times to the full audio recording of the 5th circuit en banc hearing which was held in January 2019, in order to better being able to estimate the likely outcome of the upcoming ruling.

The first several times I just listened, trying to understand every word and detail that was spoken, and trying to fully grasp and follow every argument and every aspect that was discussed. From these listenings I came away with a very positive feeling for the plaintiffs. After listening several more times, I finally took the effort to categorize every voice and question and collect statistics in order to get a full, quantifiable picture. Here is what I learned:

Statistically speaking, the En Banc hearing has historically reversed a previous decision 13 out of 16 times. Since it takes a majority of the judges to vote in favor of taking any case en banc, the fact that they even held the hearing in the first place lets one assume a high probability (around 80%) of plaintiff success.

There are 16 Judges on the panel, not all of them asked questions during the hearing, so it is hard to estimate every single likely vote. But at least 9 out of the 16 judges need to hold for the plaintiffs if there is to be a reversal.

During the questioning of the Plaintiffs, 36% of the questions were positive towards the Plaintiffs, 42% were neutral, and only 22% of the questions had a somewhat negative feel to them. Only 6 Judges asked questions, of which 2 were clearly in favor of the plaintiffs, 2 were neutral and 2 were somewhat negatively oriented. So all in all, it was a fairly neutral endeavor.

During questioning of the FHFA, a whopping 82% of questions were clearly negative towards the FHFA, in fact FHFA’s lawyer was interrupted so frequently with negative questions that he was barely able to finish a sentence. Only 7% of the questions were positive, with the remaining questions neutral. There was clear hostility in the room towards the FHFA. It was possible by audio to distinguish 10 different judges asking questions, 8 of which clearly had a negative stance. 8 is not yet a majority. But interestingly, one judge who asked a very positive question towards Plaintiffs did not ask any question at all towards FHFA. If we put him in the anti-FHFA camp, it would be possible to assume that there was a majority (9) judges who had a clearly negative stance towards FHFA during the hearing. There was only one judge who was clearly trying to be positive towards FHFA, and another one asked a neutral question.

During questioning of Treasury, there were no positive questions and 83% of questions were negative, with 17% neutral. 6 Judges asked questions, 3 of which were negative and 3 of which were neutral. There was no positive judge towards treasury.

All in all, it was possible for me to distinguish 12 different judges by Audio, 9 of which were clearly on the shareholder side, 2 were neutral and 1 was clearly on the government’s side. The remaining 4 judges on the panel are anyone’s guess.

I will not discuss the contents of the discussion here as it would be far too long, but I would like to point out that the only clear argument raised by any judge in favour of the government was “we would not show respect towards the presidency if we ended the Net Worth Sweep.” To me, this argument is totally absurd and bogus. Is it the judicial system’s purpose to show respect to any president, or to uphold the law?

I clearly hope the latter.

As far as the above goes, I have a very high confidence that the previous opinion will not simply be upheld. I think there is ample chance that there will be some sort of revision and that this will go right for the plaintiffs.

Assuming the En Banc will hold for the shareholders of Fannie and Freddie, the question then becomes what is the correct remedy.

Basically, there are four possible outcomes:

1) The net worth Sweep (NWS) is stopped, overpayment (that is around 130 billion for the two companies combined) gets credited against the original PSPAs, eliminating them and leaving a small credit of 16 billion on the books as capital. This is the preferred option of the plaintiffs.

2) The NWS gets stopped, Overpayment is credited back in full and then sits on the balance sheet of the companies, basically recapping them but leaving both the original PSPAs and the Warrants in tact.

3) The question of what the remedy should be gets remanded to a lower court.

4) The NWS gets cancelled going forward, there is no backward relief.

In all three outcomes, the Warrants remain. This is because the plaintiffs do not ask for a cancellation of the Warrants, and they have nothing to do with the legality of the NWS. This is important going forward.

On option 4), I do not think this would make sense. If the NWS was illegal, it would be very strange to not have it reversed in full but only in the future. It would be like telling a murderer to not murder in the future but not punishing him for his past murder. It simply does not make sense but this is what Treasury’s Lawyer suggests as the correct solution if the court holds for the plaintiffs.

The beauty of option 1) is that there is no exchange of money, it is all just an accounting entry. However, there is a good reason to not credit illegal NWS payments of the 3rd amendment against a structure of the second amendment.

For shareholders, this option has great value because it basically completely removes the government from the capital structure and essentially sets the companies free. However the government would still have 80% of the common stock in form of Warrants. The problem is that, while it sets the companies free from conservatorship, it would leave them with very little capital and so necessitates an immediate capital raise.

The court seems to like this option because it does not lead to any cash exchange of money, just an accounting entry that does not impact the budget of the US. One judge asked specifically about that and seemed pleased with the answer.

So Option 2) is the cleanest option probably because it simply restores the companies to the situation they would be in if the NWS never happened but they would not have been allowed to pay back the original PSPAs.

It has the advantage of essentially recapitalizing the companies, but they would then still have to pay towards the original PSPAs, leaving very little, if anything, for shareholders for the foreseeable future except if a political resolution happens that somehow eliminates the PSPAs.

Option 3) would cause further delays but leaves everything on the table, and the issue might then get resolved by negotiating a settlement.

Option 4) would be unreasonable and certainly not acceptable by the plaintiffs, and I assume this issue would then be discussed in the supreme court. But at the very least, it would give political cover to end the conservatorship since a court has then decided against the government for the first time.

A look at incentives:

The great Charlie Munger has this to say about incentives:

"Well, I think I’ve been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it. And never a year passes but I get some surprise that pushes my limit a little farther."

"Never, ever, think about something else when you should be thinking about the power of incentives."

So I will do that here.

The people in the driver’s seat for an administrative solution are essentially Trump, Mnuchin and Calabria. From public records, we can draw a clear picture of their respective incentives to arrive at a good estimation of a likely outcome.

1) Trump: We know that Trump is close to John Paulson, who helped to fund his presidential campaign, and with whom he invested before assuming presidency. This is critical because John Paulson is one of the better known investors in Fannie & Freddie preferreds, and this is one of his biggest positions.

So, if preferreds get made whole, Trump, as an investor in paulson’s hedge fund, will be probably able to triple or quadruple his money. We know that Trump invested >100 Million in Hedge Funds prior to assuming office, although he spread that sum over several funds.

This is a very powerful incentive for Trump to act. But there is also another, more indirect, maybe even more powerful incentive: If Paulson is successful with his investments, he has the funds and the friendship and gratitude to fund Trump’s campaign for a second term.

Also, Trump is desperate to BUILD THAT WALL, but congress will never fund it. Getting F&F out of conservatorship would maybe, via the Warrants, provide a sudden windfall of 100-150 billion for the government. This is money that can help to fulfill his biggist campaign promise, helping Trump to get reelected.

2) Mnuchin: We also know that Mnuchin has invested with Paulson prior to assuming office, although it is unclear how much.

3) Calabria: The way I understand this guy, he is a strongly convinced libertarian, who has held and published strong views about Fannie & Freddie. It is unclear to me what is financial position is like, but I would be surprised if Calabria did not invest in a potential resolution of the GSEs.

What is clear is that Calabria absolutely wants to get the GSEs out of government control, believes the NWS is illegal, and wants to reform them to a more competitive landscape.

There is also one big disincentive for Trump and Mnuchin to act, which is precisely that their incentives and relationship with hedge funds are well published and well known. So it will be politically important, even critical for them not to appear to simply enrich themselves and their friends at taxpayer’s expense.

This let’s us predict the most probable unfolding of events:

1) Admin will most probably wait for a court ruling of the 5th circuit. Otting has already instructed the lawyers in the case to conceive that HERA is unconstitutionally structured, an event that was barely in the news but probably will have a huge impact on the ruling. This, together with the facts of the case, the letter of the law, the uncovering of documents, the way the hearing went (see above) should be enough to allow a ruling in favor of the shareholders. The ruling should be out by June or July or August at the latest. Any ruling in favor of the plaintiffs will be the perfect cover for the Admin to act, to negotiate a settlement with shareholders, to end the NWS and to put out and start a plan to end the conservatorship.

2) As hard as it may be for some shareholders, the warrants will be exercised, BUT at the most favorable price possible. Why? Look at the incentives. Trump needs money to spend for his last year of presidency before the election. Also, this serves beautifully to argue that the government (the taxpayers) got a great deal out of it, Trump can essentially claim to have made the best deal for the government ever. Why will the share price be as high as possible? Because this also maximizes the value of the warrants, and at least calms the shareholders somewhat. Any warrants will get exercised before any capital raise, because outstanding warrants will make it impossible for the GSEs to raise any money.

2a) The question, of course, is: Do they even have to raise money at all? Would it not be much nicer to not having to raise any money?

Capital proposals that are floating around are 100-150 billion for the GSEs combined. The GSEs have, during their conservatorship and the NWS, paid 130 billion MORE than they would have were there no NWS.

Bang, there you have your capital, smack in the middle of that range. Treasury simply refunds overpayment back to the companies, and bingo they are fully capitalized.

I think this possibility of a ruling was not yet discussed in full, but it may be the most elegant solution:

Treasury is ordered by law to refund the 130 billion of overpayment back to the companies, the government then cancels the PSPAs (at which point they are effectively released from conservatorship) and the government then exercises the warrants and sells its 80% of ownership over time, funding anything Trump wishes to build. Preferred shares may be converted to common @par value or kept and resume their dividend payments as the companies make profits.

This solution is elegant because it does not need any big money raising exercises or delays, it could effectively all be sorted out within days, and it leaves the maximum amount of value for the warrants and the shareholders.

Because the refunding of the 130 billion is ordered by court, there can not be any political discussion about it.

Also, this solution gives ample room for Calabria to mess around with the charters of the companies, because the government would at some point own 80% of the shares and so can basically operate the companies in any way it wants. The common shareholders at this point would have no real say and the preferreds will have converted at par or will resume their dividends.

2b) In case the courts rule that the 130billion are not refunded but simply do eliminate the PSPAs, (which is the preferred option by plaintiffs!) the companies would then have to raise a lot of money, and the outcome then is captured best by Moelis. However, in this case it may be hard for Calabria to dramatically change the laws around the GSEs, because doing so might impediment the future profitability of the GSEs and therefore might make a huge capital raise difficult.

3) In any case, I fully expect that this lawsuit will not land in front of the supreme court if the 5th circuit holds in favor of the shareholders. If it did, it would be fun to watch FHFA trying to argue for something that its own Director Calabria has argued at length is illegal.

Fair Value of the common and preferreds

The exact future outcome is impossible to predict, but there are several rather clear pathways that can be mapped out and where one can estimate probabilities. I have done so with the probabilities assigned to these outcomes as I understand them.

For the preferreds, I have assumed a maximum current value of 45 out of 50, in order to leave some discounting room as events unfold perhaps slowly over the coming 12 months. For the commons, I have relied on the great work by Special Situation Investing here on SA: "Trump Administration Valuing The Potential Outcomes For Freddie Mac And Fannie Mae Common And Preferred Stock Investors"

As things stand currently, I think the preferreds are worth around 29 out of 50 and the commons should trade around 7 USD. Clearly the market thinks very differently than me. Where am I wrong?

I will be able to adjust probabilities more and more clearly as events unfold.

Disclosure: I am/we are long FNMA, FMCCP, FMCCH, FNMAG, FNMAO, FMCCL, FMCCK, FMCKK.