FNMA and FMCC preferreds. In search of the elusive 10 bagger.

[muscleman]

Judge Sweeney yesterday ruled against USA's motion to stay 5th Amendment cases in the Court of Claims.  We now have two different legal arguments in two different courts, either of which could provide a favorable ruling and a subsequent windfall to the private preferreds.

 

1)  Court of Federal Claims.  Fairholme and more than three other cases have been filed and some may be consolidated.  These cases argue that the Third Amendment to the Senior Preferred Stock Agreement (the Sweep) is an uncompensated taking under the 5th Amendment to the US Constitution.  Next key date:  11/7/2013, government response due on all cases.

 

2)  US District Court.  Fairholme and Perry Capital have each filed cases that are largely the same.  Both argue the validity of the Third Amendment to the Senior Preferred Stock Agreement (the sweep) under the Administrative Procedures Act.  Basically they argue that the Treasury and FHFA exceeded their statutory authority as conservator by agreeing to the Sweep.  Next key date:  10/28/2013, deadline for Treasury and FHFA motions (likely for summary judgment).

 

Thank you!

Just to clarify, what do you mean by "Judge Sweeney yesterday ruled against USA's motion to stay 5th Amendment cases in the Court of Claims."?

I think Fairholme sued USA for violation of the 5th amendment, but if this is a favorable ruling, it should be that the judge ruled against USA's motion to stay away from 5th amendment?

 

"Stay" is legal parlance for putting something on hold.  The US wanted all the Court of Claims cases (those claiming an illegal taking under the 5th Amendment) to be put on hold until the completion of the District Court cases (those cases that question the validity of the Sweep).  This could have resulted in years of delay.  The judge correctly ruled (IMO) that the 5th Amdendment cases are not path dependent on the DC cases.  In other words,  the judge implicitly agreed that even if the Sweep is ruled to be valid (the USA wins in DC court), the plaintiffs can still successfully claim an uncompensated taking under the 5th Amendment in the Court of Claims.

 

Got it! Thank you! I think this is great.  :)

[muscleman]

 

Ericopoly: 1. the state of being able to  retire comfortably in one's 30's; to own a Tesla.

 

I really envy him and would like to be the same if possible, but I know that is not easy.

 

Well, on the second thought, if you have 6% position in this, and it becomes a 6 begger, your total portfolio return is 30%. So are you just 30% away from pulling an Ericopoly right now?

[Mephistopheles]

Hi valuecfa, a couple questions for you.

 

You are saying that there is less of a likelihood of them paying the dividends then there is of the ruling to be in the investors favor, in which case the shares should jump up to par, correct? I have no experience investing in preferred stock, so I am wondering why would the stock go up that much without them paying a dividend? Are they convertible shares?

 

Also, since the dividends are non-cumulative, is there an interest rate risk with this investment? Let's say the litigation takes several years, the Fed's money printing takes into affect, and rates jump substantially. Aside from the variable rate preferreds, wouldn't this put a damper on the price?

 

Thanks

[muscleman]

Hi valuecfa, a couple questions for you.

 

You are saying that there is less of a likelihood of them paying the dividends then there is of the ruling to be in the investors favor, in which case the shares should jump up to par, correct? I have no experience investing in preferred stock, so I am wondering why would the stock go up that much without them paying a dividend? Are they convertible shares?

 

Also, since the dividends are non-cumulative, is there an interest rate risk with this investment? Let's say the litigation takes several years, the Fed's money printing takes into affect, and rates jump substantially. Aside from the variable rate preferreds, wouldn't this put a damper on the price?

 

Thanks

 

I think there is the interest rate risk, but that is not big enough to be a concern here. If your upside is 20% less, so what? Do you care about that, or do you care more about winning the case?

 

You can think of preferred stocks as bonds, but at the lowest rank. The par value is $25. If the government wants to shutdown the companies, they have to pay at least the par to buy out the preferred holders.

[CorpRaider]

I might have to get some exposure to this through Fairholme.  This seems like the kind of thing where I want someone in the room for me.  Cooper and Kirk?  I'm not familiar with them, but I suppose Perry has Ted Olson.

[valuecfa]

 

Ericopoly: 1. the state of being able to  retire comfortably in one's 30's; to own a Tesla.

 

I really envy him and would like to be the same if possible, but I know that is not easy.

 

Well, on the second thought, if you have 6% position in this, and it becomes a 6 begger, your total portfolio return is 30%. So are you just 30% away from pulling an Ericopoly right now?

 

Reread the thread. I initially took a 6% position, that has changed.

[valuecfa]

Hi valuecfa, a couple questions for you.

 

You are saying that there is less of a likelihood of them paying the dividends then there is of the ruling to be in the investors favor, in which case the shares should jump up to par, correct? I have no experience investing in preferred stock, so I am wondering why would the stock go up that much without them paying a dividend? Are they convertible shares?

 

Also, since the dividends are non-cumulative, is there an interest rate risk with this investment? Let's say the litigation takes several years, the Fed's money printing takes into affect, and rates jump substantially. Aside from the variable rate preferreds, wouldn't this put a damper on the price?

 

Thanks

 

Interest rate risk is the last thing i would worry about in this investment.

 

The higher coupons could go well above par if the dividends are paid. It is up to the issuer whether or not they redeem them for par (at any time, in which case they are all worth par), or continue to pay the dividends in which case the majority are worth more than par.

[dowfin1]

valuecfa,

 

Shrinking mortgage assets to $250B over time will reduce earnings for capital build, even if some of the illegal sweep is applied to principal on the senior preferred upon successful litigation.  With a prolonged litigation, I worry that a liquidation at the end is insufficient to pay the preferreds at par or even close.  How do you think about this?  Thanks.

[valuecfa]

valuecfa,

 

Shrinking mortgage assets to $250B over time will reduce earnings for capital build, even if some of the illegal sweep is applied to principal on the senior preferred upon successful litigation.  With a prolonged litigation, I worry that a liquidation at the end is insufficient to pay the preferreds at par or even close.  How do you think about this?  Thanks.

 

They are on track to repay by 2014.

 

I don't see the argument that the government will pull back so far (or private capital will step in so much) that Fannie runs unprofitably or at a level that is insufficient to pay the dividends.

[Mephistopheles]

Hi valuecfa, a couple questions for you.

 

You are saying that there is less of a likelihood of them paying the dividends then there is of the ruling to be in the investors favor, in which case the shares should jump up to par, correct? I have no experience investing in preferred stock, so I am wondering why would the stock go up that much without them paying a dividend? Are they convertible shares?

 

Also, since the dividends are non-cumulative, is there an interest rate risk with this investment? Let's say the litigation takes several years, the Fed's money printing takes into affect, and rates jump substantially. Aside from the variable rate preferreds, wouldn't this put a damper on the price?

 

Thanks

 

Interest rate risk is the last thing i would worry about in this investment.

 

The higher coupons could go well above par if the dividends are paid. It is up to the issuer whether or not they redeem them for par (at any time, in which case they are all worth par), or continue to pay the dividends in which case the majority are worth more than par.

 

What if they don't redeem them, and they don't pay the dividends either? Since the dividends are non-cumulative, why would they trade anywhere near par in that case? I guess my question is a general one for perpetual non-cumulative preferreds.

[muscleman]

 

Ericopoly: 1. the state of being able to  retire comfortably in one's 30's; to own a Tesla.

 

I really envy him and would like to be the same if possible, but I know that is not easy.

 

Well, on the second thought, if you have 6% position in this, and it becomes a 6 begger, your total portfolio return is 30%. So are you just 30% away from pulling an Ericopoly right now?

 

Reread the thread. I initially took a 6% position, that has changed.

 

I apologize! You said in page 23 that you built a much larger position than the initial 6% purchase. I misread that and thought you increased your position to a meaningful 6%. :)

I truly admire you! You and Ericopoly run such a concentrated portfolio!

[JRH]

What if they don't redeem them, and they don't pay the dividends either? Since the dividends are non-cumulative, why would they trade anywhere near par in that case? I guess my question is a general one for perpetual non-cumulative preferreds.

 

Suspension of the dividends is only allowed when there isn't profit to pay them - it isn't optional (although I need to see how the terms enforce that exactly).

 

To address a concern stated earlier, I would suggest that successful litigation, combined with run-off of the entities, yes, could result in less than full repayment on the preferreds (and nothing for common), although on that "branch" of the tree you then have to start asking questions like, what does the economy do, what is the nature and speed of the run off, etc...

[nkp007]

I like to think it's all about incentives and that with a growing pie, all sides can win.

 

Even if the government "loses" and the entities continue to exist, guess who owns 79.99% of the common of an incredibly valuable enterprise?

[muscleman]

I like to think it's all about incentives and that with a growing pie, all sides can win.

 

Even if the government "loses" and the entities continue to exist, guess who owns 79.99% of the common of an incredibly valuable enterprise?

 

That is right. It is either a win-win situation if they keep the GSEs, or it is a lose-lose situation.

Their reason to close these GSEs isn't rational either. If they completely give the mortgage market to the private sector, do they think they don't need to bailout them when these private companies fail? I think they always have to prepare for a bailout in a bad time no matter what they do.

[merkhet]

http://online.wsj.com/article/SB10001424127887324807704579087072063293460.html?mod=WSJ_hp_LEFTWhatsNewsCollection

[colinwalt]

Do not know enough about this to comment - leaving that to those more knowledgeable than me...

 

http://www.bloomberg.com/news/2013-09-26/fannie-woos-investors-as-regulators-embrace-risk-sharing.html

 

...

 

"The risk-sharing transactions resemble provisions included in legislation introduced this year by Republican Senator Bob Corker of Tennessee and Democratic Senator Mark Warner of Virginia, and endorsed by President Barack Obama. The proposal would create an agency to replace Fannie Mae (FNMA) and Freddie Mac that would bear catastrophic mortgage losses, after private firms take the first 10 percent."

 

....

 

"Fannie Mae and Freddie Mac may not want to do too well at luring bond investors to their risk-sharing deals, according to Sanders, the former bond analyst and professor.

“I think that they’re nervous about succeeding, because if they succeed that gives a lot of people in Congress the ability to say, ‘Well, we don’t need them after all do we?’” he said."

[valuecfa]

Video on Fannie/Freddie: http://www.law.nyu.edu/news/Fannie-Freddie-conference-CLI

[Grenville]

Video on Fannie/Freddie: http://www.law.nyu.edu/news/Fannie-Freddie-conference-CLI

 

Thanks! Will be interesting to watch.

[valuecfa]

Plaintiffs for the prefs ought to hire professor Richard Epstein. The guy is an intriguing and convincing orator. Supposedly, he is advising several hedge funds on the matter.

[twacowfca]

Here's my two cents worth about the future value of the public's preferreds.

 

The margin of safety continues to be the same as outlined in the original post and subsequent posts.  There are powerful reasons why F&F will not be completely taken over by the US or replaced with a new scheme, not the least being the bad appearance of taking their liabilities onto the official balance sheet.  Therefore, they should eventually be able to earn their way out of the hole using the strength of their franchise.  Recent results suggest that this may happen sooner than later.

 

I agree with the consensus that the original takeover and conservator ship very likely will not be deemed a "taking" by the US Court of Claims.  But, It's hard to imagine that the recent expropriation of all these GSE's profits would not eventually be ruled an impermissible  "taking" by the courts.

 

Those who are interested in investigating the strength of the claim may want to study the various US Court rulings involving litigation tracking warrants issued to S&L shareholders in the 90's and 00's for the purpose of  spinning off claims against the US that were valued at zero by Mr. Market. (Disregard Chapter11 rulings, bankruptcy courts are inferior courts that make all sorts of strange rulings that are ignored by higher courts).

 

In the 1980's the US wanted solvent S&L's and other regulated Thrifts to take over insolvent Thrifts.  Therefore, their regulators allowed goodwill to be counted toward regulatory capital, contrary to previous practice.  About 1989, Congress passed a law that goodwill would no longer be allowed to count as regulatory capital. 

 

This caused no end of distress among institutions that had taken over the insolvent thrifts at their regulator's urging. They suffered balance sheet losses, had to raise very expensive capital and lost out on M&A deals that would have helped their shareholders.  The loss of economic value was deep for these savings institutions.  The marketplace gave no allowance for the possible value of these claims, and this affected the economic value of these businesses as well as their stock prices.

 

Some of these claims worked their way through the US courts, eventually being judged by the US Court of Claims with the logic of those rulings affirmed by the US Court of Appeals.    The final rulings were liberal to the claimants. In a particular case, the appeals court suggested to the US Court of Claims that it should go even farther and award even more damages to the claimant than it had.  This is a big plus for the value of the claims F&F preferred shareholders have as a consequence of last year's taking.  However, the earlier Thrifts'  claims, that originated with the US's reneging on their pledge about how regulatory capital would be determined, took more than a decade to work their way through the courts.

 

In short, there seems to be light at the end of the tunnel, but the tunnel may be a long one.  :)

[onyx1]

However, the claims that originated with the reneging on the pledge about how regulatory capital would be determined took more than a decade to work their way through the courts.

 

The good news for us as investors in the private preferred is that with greater than 4:1 odds, we will have lots of entry and exit opportunities over the long time period it takes to work through the court system.

[twacowfca]

However, the claims that originated with the reneging on the pledge about how regulatory capital would be determined took more than a decade to work their way through the courts.

 

The good news for us as investors in the private preferred is that with greater than 4:1 odds, we will have lots of entry and exit opportunities over the long time period it takes to work through the court system.

 

Yes, as mentioned, we have had three multibagger round trips in these since the US takeover, plus numerous trades arbitraging the differences in prices of the various issues. :)

 

Interestingly, our most highly successful type of investment over the years has been buying the common of increasingly solvent businesses in Cpt 11.  F&F  are not unlike those companies. Simply think of "conservatorship" as being like "Chapter 11 protection".  :)

[muscleman]

Interestingly, our most highly successful type of investment over the years has been buying the common of increasingly solvent businesses in Cpt 11.

 

Could you please give some examples? Does that include American airline?

[nkp007]

Tone changing?

 

http://mobile.businessweek.com/news/2013-10-15/fannie-mae-survival-back-on-table-as-lawmakers-sketch-new-system

[Guest Dazel]

 

Laidlaw, USG.

 

Were big winners...

 

But GGP was the biggest.

 

Dazel.