GSE Capital: Buffer Vs. Recapitalization

Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) are two private companies that the government placed into conservatorship via forced board vote in 2008 despite the fact that the companies had their highest levels of capital in history. There are two types of equity shares: common and preferred. There are two types of shareholders: private and public. In the case of Fannie and Freddie, private investors have suffered the loss of all net income to the public investor US Treasury, which has taken it all via the net worth sweep. In effect, as long as nothing changes, equity shares that are publicly available on the open market have no intrinsic value.

Public gains and private losses is the story if you simply look at the cash flow and who gets what these days. There’s more to this story than meets the eye, and considering that I see this whole thing wrapping up in the next 12 months, I wanted to touch on a few other aspects of this story that I previously haven’t while it is still timely.

Investment Thesis

The only reason to own shares is because you think they are worth more than what they trade for today. In this case, the shares trade like a reasonably expensive call option on the possibility of either a court victory or an administrative/congressional action that leads to a conservatorship that doesn’t end in receivership. One of the keys to this is the accounting fraud lawsuits against Deloitte and PwC. These lawsuits and increased scrutiny have people watching for the type of FHFA accounting that we saw 2008-2011. Mel Watt delineates the difference between GSE reform and housing reform. A few plans have been floated that recapitalize Fannie and Freddie, and the one that seems to have Republican support is the Moelis plan. The commons would be worth over 100% more, and the government would make billions off the warrants. The preferreds sound like they’d get converted to common or resume dividends in a few years, when the companies are adequately capitalized. Mel Watt recently suggested 2-3% was an adequate amount of capital for Fannie and Freddie. The Moelis plan gets Fannie and Freddie to that level by 2020.

The Government Narrative

According to the government, it came in, put up lots of money and saved two businesses on the brink of failure. The government injected billions of dollars into them to keep them solvent, and implemented the net worth sweep to solve the problem of their dividends exceeding the income of Fannie and Freddie on a forward basis. The original purpose of the net worth sweep was part of a winding up of the GSEs.

FHFA’s Melvin Watt says any action he takes with the capital buffer should not be confused with recapitalization, but that he is working with Treasury’s Mnuchin. Watt has said the capital buffer dropping to $0 at the end of the year is a problem that he will step in front of to implement some sort of buffer. Considering that he can act unilaterally, what this does is makes you wonder what sort of “working together” Watt and Mnuchin are up to these days.

Forensic Accounting Narrative

Adam Spittler and Mike Ciklin published an analysis on HousingWire a few years ago that suggested the conservatorship was put into place not to save the GSEs from the brink of disaster, but simply to seize accounting control and sign a deal with the government based on this accounting control. In the early years of conservatorship, Fannie and Freddie were forced by FHFA to write down assets, among other things, to force draws against the SPSPA. Ironically, the nature of these draws shows how they aren’t based on any urgent need for money, as they come through 15 days after the end of the reported period, which would be at least 45 days after the shortfall and even more on a weighted average basis if you figure they were bleeding throughout the quarter instead of end-of-quarter FHFA writedown goal-seek type calculations:

Since 2012’s net worth sweep was put into effect, dividends get paid roughly 90 days after they are calculated, since they are payable before the end of the following quarter for the preceding quarter’s net worth less the capital buffer:

This information can be used to challenge the government narrative. The first takeaway is that the “zero capital buffer” that starts next year really is more of a “one quarter capital buffer,” because the payment gets made 90 days after the relevant quarter ends. The second is that the SPSPA was never designed around timely money transfers in the first place.

For those of you who have followed me and agree that the US Treasury is a tax collector and Fannie and Freddie and likely you and I are taxpayers, please excuse my following deviation back to the government narrative.

From 2008 to 2011, what the government did was put taxpayer dollars at risk – but how much risk, one has to wonder. If you study the accounting, it looks like they simply over-reserved for losses to the extreme and forced Fannie Mae and Freddie Mac to take over a hundred billion dollars by alleging that Fannie and Freddie were riskier than they actually were. In 2011-2012, therefore, the two were at their highest levels of capital in history. Since then, the government arranged the net worth sweep and has taken all that money back and then some by simply resuming normal accounting practices.

Legal Narrative

Judge Sweeney recently ordered the use of the quick peek procedure for 1500 more documents that the government hasn’t handed over for over a year, and instead, has hidden behind a blanket of privileges. The odds are that this order will get appealed. The story here is that multiple lawsuits have worked their way through multiple courts, and so far nothing has stopped the net worth sweep. To the novice, it is easily explainable that the government can do whatever it wants.

That’s not entirely true, but when you’re dealing with litigation concerning new, previously undisputed law, what I’ve learned is that you can’t just argue what the law reads, but you must also simultaneously argue that misleading interpretations of it violate the constitutional non-delegation doctrine. Another possible takeaway is that it is the judge’s job to provide all deference to defendants, unless plaintiffs can assemble an open-shut case. Maybe that means I’m naive for coming into this thinking that judges would read both sides to the story and then the law, and then rule based on what seems the most reasonable. Maybe I’m naive for thinking the discovery that proves that the government has been lying in its briefs about why it did what it did is somehow relevant to the possibility that it is also lying about how to interpret the prevailing law.

Regardless, it would seem to me that any positive legal ruling in any currently pending case in a court would result in a simple government appeal that would permit the net worth sweep to continue for at least a while longer. That’s why I believe the correct place to focus in the near term is administrative/congressional reform. That said, more documents being made public demonstrating that the government’s narrative is more false than we’ve already seen certainly couldn’t hurt.

Summary and Conclusion

Fannie Mae and Freddie Mac are two private companies that have shareholders even though they are currently being run by the government not unlike government agencies. This arrangement exploits a technical loophole that prevents the two companies from being consolidated on the government’s balance sheet, even though for all technical purposes IRS guidelines would dictate otherwise. However, who is going to enforce this when the government is incentivized to look the other way?

I own 4050 shares of FMCCH, 21688 FMCCP, 7370 FMCCT, 741 FMCKO, 12885 FMCKP, 13135 FNMFN, and 5 FNMFO. At the end of the day, I think that there is a lot of upside in the next six months as GSE Jumpstart expires. At that point, a plan like Moelis can be put to good use. Further, when you look at this whole thing holistically, assuming a plan like that is where this goes, from 2008 plan implemented, the companies would in effect be forced to hold significantly more capital, as well as required to be significantly more regulated. Capital comes at a cost, and the cost would be footed by American homeowners – and that’s kind of a bummer. That said, this added cost would provide for something that we previously didn’t have – which is a significantly better capitalized housing system. I’m not sure we really need a better capitalized housing system than we had in 2008, because the real source of financial problems at Fannie and Freddie can be traced to FHFA’s accounting control. Without accounting control, this conservatorship would have appeared much less necessary.

What more capital does get us, however, is the perception of less risk in the next housing crisis. Perhaps with a significantly larger amount of capital than they held in 2008 when they were adequately capitalized, the people running the companies will be less willing to hand them over to be scapegoated and run by the government for the government. Seems plausible. Leave your comments below.

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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