GSE Accounting Center Of Plan To Nationalize Housing – Fannie …

Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) are two companies that were placed into conservatorship in 2008 because government official Hank Paulson threatened their boards of directors that they would experience adverse consequences if they didn’t acquiesce and that there would be no consequences if they agreed. Some members of the board of directors asked about the terms of the government deal but were rebuked and thus were kept in the dark on purpose, likely because they wouldn’t have agreed so easily if they knew what was coming. This is especially true because, at the onset of conservatorship, the two had their highest levels of capital in history. The government installed the Senior Preferred Securities Purchase Agreement (SPSPA) and gave itself rights to 79.9% of the company in the form of warrants. The idea was to make these warrants worthless by making the SPSPA take all the earnings forever after proving the companies were worthless, a tall order for two companies that have the most consistent profitability. A plan was hatched pre-conservatorship that was put into place day one. The premise was to use the Federal Housing Finance Agency’s post conservatorship accounting authority to force Fannie and Freddie to retroactively justify their conservatorships by having accounting losses so great that they looked like they were struggling. Since then, the rest is a history of shady dealings, but there is hope in multiple forms, some more swifter than others.

Investment Thesis:

Lawsuits have been working through the legal channels for years and will still take some time to win. Administrative reform, however, could happen as soon as FHFA’s Melvin Watt and Treasury’s Steven Mnuchin sit down and sign the requisite paperwork. Ever since FHFA ran out of fake accounting losses, the two companies have been officially stripped of their earnings while their earnings have been enormous and consistently positive. Making lots of money sounds like the opposite of a flawed business model and so the government is finding it increasingly difficult to justify throwing the businesses in the waste bin. Nevertheless, the companies are by design scheduled next year to hold $0 capital, because it all gets transferred to the government these days. Senator Bob Corker’s success at GSE Jumpstart expires early next year after which the Trump administration can start closing out of its position and in effect reprivatize Fannie Mae and Freddie Mac. In a reprivatization event, the government would need to settle the lawsuits. I own preferred shares and am hoping for par but not counting my chickens until they hatch. If a recapitalization plan like Moelis is put into place, common shares are worth more than they trade for today as well by more than 100%.

Breach Of Contract Claims

These are the claims that have been remanded back to the DC District Court:

The premise here is that when the government entered into the net worth sweep in 2012, it breached the junior preferred shareholders’ contractual rights. Plaintiffs have so far argued unsuccessfully that the government couldn’t enter into the net worth sweep. Courts ruled that the government could enter into the net worth sweep but that doing so could still be a “breach of contract and breach of implied covenant of good faith and fair dealing regarding the liquidation preferences and the claim for breach of the implied covenant with respect to dividend rights.” These claims were remanded back to district court. This depressing defeat happened earlier this year. The key snip from the opinion seems to outline the deficiency in plaintiff pleadings, merely that they didn’t argue that Treasury and FHFA’s interpretation of HERA was unconstitutional:

Legal vs. Admin Timeline

Lawsuits have subsequently been filed that address these constitutional shortcomings. The problem is one of timeline. Mnuchin said that the second half of this year was the time frame to consider resolving this. The end of this year will come much sooner than any final legal challenge, and here’s why:

If you look how Obama lost in court regarding how he was funding Obamacare and how it didn’t matter because he just appealed the loss and kept funding Obamacare, you quickly realize that until we get to the supreme court, it would appear that no ruling is going to stop the government from doing what it wants to do. If the government wants to carve up Fannie and Freddie and go along with a plan like MBA Mortgage has proposed, then that could happen well before any courts stop it. Plaintiffs would be left with damages.

The light at the end of the tunnel is when GSE Jumpstart expires (early next year). At that point, a capital restoration plan will likely be put into place. Fannie and Freddie support equal opportunity affordable housing. Before Fannie and Freddie were put into existence, people had to get loans to buy homes from banks, and it was a known but unspoken practice where many banks would provide loans for certain neighborhoods based on skin color. Fannie and Freddie helped us as a society to get past that and have continued to act as a countercyclical source of liquidity. In fact, since the financial crisis of 2008, the private label mortgage backed security market has basically collapsed into no longer existing while Fannie and Freddie securities filled the early void and continue to prosper today.

Capital “Requirements”

The Federal Housing Finance Agency Office of Inspector General put out a paper on the Existing Statutory Capital Requirements for Fannie Mae and Freddie Mac this past month. Not surprisingly, FHFA’s net worth sweep has prevented Fannie Mae and Freddie Mac from meeting their statutory minimum capital requirements. To provide context, Mick Mulvaney previously asked Watt how an agreement between two agencies trumps the law:

Fannie Mae reported that, as of December 31, 2016, it calculated the statutory minimum capital requirement to be $24.4 billion. Because Fannie Mae’s 2016 capital reserve pursuant to the PSPAs stood at $1.2 billion, its capital was $23.2 billion below its minimum statutory capital requirement.

Freddie Mac calculated the minimum capital required by statute to be $18.9 billion. Because Freddie Mac’s 2016 capital reserve pursuant to the PSPAs stood at $1.2 billion, its capital was $17.7 billion below its statutory minimum capital requirement.

More recently, Senator Bob Corker ridiculed Watt saying “It’s one of the most baseless arguments I’ve ever heard” with regards to Watt saying that Fannie and Freddie need a non-zero capital buffer since FHFA has a statutory obligation to prevent market volatility. Corker chided Watt to take $10B that was not needed just to pull a stunt:

“I don’t need to.” – Watt

“Do it anyway.” – Corker

Corker previously passed GSE reform inhibiting legislation more commonly referred to as GSE Jumpstart. He also went on live television and recommended shorting Fannie and Freddie. Unsurprisingly, he profited from shorting them himself. Fortunately, for GSE stakeholders, Corker’s GSE Jumpstart expires early next year at which point the administration can put into place a recapitalization plan and begin closing out of its position.

Reprivatization Timeline

The House put together a budget involving the privatization of Fannie and Freddie. It reads “(t)aking these steps in the financial services sector will help rein in the Obama regulatory regime, prevent taxpayer-funded bailouts, and encourage private sector lending for American small businesses”:

Paulson’s Merger Arbitrage Fund highlighted this in its most recent quarterly research note:

The language changed from the month prior to include “or early 2018.” It remains to be seen when exactly the government stops taking all of Fannie and Freddie’s money. I would argue that whether they take the next payment at the end of this month, it doesn’t really change that much. Do the government officials who are deciding this outcome need Q4 to figure out a recapitalization plan? Does stopping the sweep now make that easier to do? I can’t pretend to know. What I can do is look at things from the perspective of the government and assume that its goal is to take as much as possible. The best way for it to do that is to take as many sweeps as possible and sell out its stake as quickly as possible. Since it can’t sell until next year and there are two more sweeps this year, those both seem up for grabs to me.

Now, what I don’t know is if there is some reason that putting a plan in place would help with these budget discussions later this month as we rush into the annual budget ceiling standoff. That being said, it does seem reasonable to think that if they don’t take this next sweep, it would give them three months time to all agree to the best recapitalization plan until GSE Jumpstart reform expires.

Summary And Conclusion

I don’t know when the last sweep is or was. I don’t think that I need to. The price of the junior preferred securities is what you’d expect. They’re trading at around 20-30% of par as the market tends to overdiscount uncertainty. In this case, in particular, the availability of these securities is enormous, given there is $34B in par value out there. There just isn’t enough demand at any given price to offset the palpable timeline uncertainty. I was able to refinance my 401K loan this last month, so I was able to add a month’s worth of shares for those of you keeping track of my share counts. I own 4,050 shares of FMCCH, 29188 FMCCP, 7370 FMCCT, 741 FMCKO, 12885 FMCKP, 13135 FNMFN, and 5 FNMFO. I think the law was broken, but that this will end in a settlement. I am hoping for par but not betting on it. I’m betting on more.

I don’t own common shares, but as part of the Moelis plan, the government monetizes its warrants as common shares, which is a change of pace from saying that they are worthless. I think the entire conservatorship is a sham transaction and should be voided entirely, the accounting fraud unwound, and money stolen be returned; but the courts are too slow. The government has the upper hand here. The government is going to call the shots, and if it wanted to, it could keep holding Fannie out back and put a bullet in her, so to speak. Contract rights would be honored, but the courts would be too late in that instance to save the GSEs. I’d much rather see Fannie and Freddie returned as soon as possible to help make equal opportunity housing more affordable to more deserving borrowers in America. This has been a huge learning experience in how the courts don’t always rule in line with how the law reads even though we all know they should. I think at the end of the day, the premise is that the court system is designed to protect defendants as best it can as we are all innocent until proven guilty here in America. Plaintiff lawyers simply didn’t foreclose on the constitutional challenges early enough, and the government got lucky, but I’m not sure that it would have changed the outcome as much as timing if at all. Remember that even if plaintiffs had won earlier rulings, the government could have just appealed them anyway and kept taking the net worth sweep payments. The cookie doesn’t always crumble the way you want it to, but it’s still a pretty good cookie.

Disclosure: I am/we are long FMCCH,FMCCP,FMCCT,FMCKO,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.

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