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

[onyx1]

Richard Epstein Op Ed:

 

http://www.restorefanniemae.us/bonanza

 

Nice site full of important links, thanks for posting.

[constructive]

"Armed with these extensive powers, FHFA promptly entered into a sweetheart deal with Treasury whereby Treasury purchased a new issue of senior preferred stock from Fannie and Freddie for about $188 billion, which carried with it a 10 percent dividend, and an option that allowed Treasury to acquire some 79.9 percent of the common stock for the nominal price of $0.00001 per share."

 

It was the opposite of a sweetheart deal. Besides the US Treasury, no other entity in the world was willing and able to provide financing to Freddie and Fannie on any terms. Buffett got a 10% coupon from relatively healthy GE and GS - the going rate for insolvent Fannie and Freddie might have been 20%.

 

"A conservatorship requires the conservator to act in the best interest of its beneficiaries—here the shareholders of Fannie and Freddie at the time the conservatorship was imposed."

 

Based on what? Nothing in HERA or FHEFSSA or the PSPA or public statements by FHFA. The beneficiary of the conservatorship is the US Treasury, not public shareholders.

[Guest qanary]

Thanks for posting ValueCFA.  Per my comments, the response was a bunch of procedural silliness and an otherwise toothless argument.

 

Richard Epstein Op Ed:

 

http://www.restorefanniemae.us/bonanza

[Guest qanary]

Buffett did not receive 79.9% of GE or GS in warrants.

 

The obligations of conservatorship do not require external positive assertion of their duties in any acts or statements in addition to what is already encoded in law.

 

It was the opposite of a sweetheart deal. Besides the US Treasury, no other entity in the world was willing and able to provide financing to Freddie and Fannie on any terms. Buffett got a 10% coupon from relatively healthy GE and GS - the going rate for insolvent Fannie and Freddie might have been 20%.

 

"A conservatorship requires the conservator to act in the best interest of its beneficiaries—here the shareholders of Fannie and Freddie at the time the conservatorship was imposed."

 

Based on what? Nothing in HERA or FHEFSSA or the PSPA or public statements by FHFA. The beneficiary of the conservatorship is the US Treasury, not public shareholders.

[constructive]

Buffett did not receive 79.9% of GE or GS in warrants.

 

The obligations of conservatorship do not require external positive assertion of their duties in any acts or statements in addition to what is already encoded in law.

 

Right, which law was that?

 

The best analysis at the time suggested that the 80% warrants were worthless since the equity was most likely worthless.

[merkhet]

I'm curious to hear the analysis of some of the other lawyers on the board.  I feel like a lot of people are glossing over the government's response, and it's driven by a feeling of inequity as opposed to a legal analysis of the case.  I agree that what was done to Fannie & Freddie was wrong, but it does not necessarily follow that there will be a legal remedy for it.

 

Issues:

 

(1) Jurisdiction - I agree that this procedural aspect is at worst a nuisance. A refiling elsewhere with the correct jurisdiction will take care of these issues. This is "procedural silliness" as qanary has pointed out...

 

(2) Standing - This actually worries me. It's possible that none of the currently filed cases can go forward because the plaintiffs might lack standing to bring a case (directly and/or derivatively) against the U.S. government / FHFA / Treasury.  Professor Epstein's response to this is not compelling to me.  When you have to step back and rely on "general legal maxims" and/or "the broad unconstitutionality" of a legal statute, you are probably in trouble. Notice that he does not cite case law for any of this stuff...

 

The developed case law on this matter, which directly points to the statute in question, says that HERA transfers all rights to the FHFA. Here's the relevant quote from Kellmer v. Raines:

 

 

HERA provides that FHFA “shall, as conservator or receiver, and by operation of law, immediately succeed to . . . all rights, titles, powers, and privileges . . . of any stockholder.” 12 U.S.C. § 4617(b)(2)(A). This language plainly transfers shareholders’ ability to bring derivative suits—a “right[], title[], power[], [or] privilege[]”—to FHFA. The Fourth Circuit has reached the same conclusion, La. Mun. Police Emps. Ret. Sys. v. FHFA, 434 F. App’x 188, 191 (4th Cir. 2011) (per curiam), as have all three circuits to have interpreted HERA’s predecessor, the Financial Institutions Reform Recovery and Enforcement Act of 1989 (FIRREA), which contains virtually identical language, see 12 U.S.C. § 1821(d)(2)(A) (FDIC “shall, as conservator or receiver, and by operation of law, succeed to . . . all rights, titles, powers, and privileges . . . of any stockholder”). All of these courts have found that, absent a manifest conflict of interest by the conservator not at issue here, the statutory language bars shareholder derivative actions. See Lubin v. Skow, 382 F. App’x 866, 871 (11th Cir. 2010) (per curiam); Pareto v. FDIC, 139 F.3d 696, 700–01 (9th Cir. 1998); see also First Hartford Corp. Pension Plan & Trust v. United States, 194 F.3d 1279, 1295 (Fed. Cir. 1999) (“as a general proposition, the FDIC’s statutory receivership authority [under FIRREA] includes the right to control the prosecution of legal claims on behalf of the insured depository institution now in its receivership”).

 

 

There is an exception for situations where there is a manifest conflict of interest.  In First Hartford Corp. Pension Plan & Trust v. United States, the FDIC made a regulatory change in how it counts capital for solvency purposes, and as a result of that regulatory change, they had to seize Dollar Dry Dock Bank of New York (of which First Hartford was a shareholder).  First Hartford:

 

 

Our conclusion that circumstances here warrant standing is premised not only upon the FDIC's de facto refusal to sue, but also, and most significantly, upon the conflict of interest faced by the FDIC in determining whether to bring suit.   Indeed, in the circumstances presented in this case, the FDIC was asked to decide on behalf of the depository institution in receivership whether it should sue the federal government based upon a breach of contract, which, if proven, was caused by the FDIC itself.  

 

 

Notably, the exception has nothing to do with the idea that the "[government institution] has acted in violation of the duty of loyalty to [shareholders]" as espoused by Professor Epstein. Instead, the exception has to do with whether FHFA can be expected to sue itself for a wrong it committed. It is not entirely clear that the wrong that was committed here comes from the FHFA rather than from Treasury -- mostly because I'm not sure you can impute to FHFA a duty to stockholders during conservatorship. 

 

The analysis would then shift to whether shareholders can have derivative standing because the two institutions are closely related based off Delta Savings Bank v. United States:

 

 

The government responds that the FDIC is independent from the OTS and cites statutes and cases that supposedly attest to their independence from one another. We disagree. These are not two disengaged bodies on the opposite ends of an organizational chart; these are closely related entities. The Director of the OTS is, by statute, a member of the Board of Directors of the FDIC. 12 U.S.C. § 1812(a)(1)(B). Until the RTC ceased to exist, the Director of the OTS was also a member of the Thrift Depositor Protection Oversight Board, which had oversight over the RTC. 12 U.S.C. § 1441a(a)(3)(A). An employee of the OTS can simultaneously serve as a deputy or assistant to a member of the Board of Directors of the FDIC, and in such cases, he or she is considered an "employee of the FDIC" under Title 12. 12 U.S.C. § 1812(f)(2). The FDIC and OTS jointly publish regulations, issue reports, and conduct cooperative investigations. The OTS and RTC even share a common genesis, both having been created in FIRREA.

 

 

I don't believe that FHFA & Treasury would fall under this test the way that FDIC & OTS did.  Then the analysis is whether the FDIC then has a duty to sue Treasury on its own -- not necessarily due to damage to holders of private securities but rather whether they must sue Treasury because of damage done to FHFA.  Again, I don't believe that's clear cut.

 

(3) Takings Claim: The case law seems to directly engage with this as well.  In California Housing Securities, Inc. v. United States stated:

 

 

The RTC's occupation and seizure of Saratoga, and its subsequent liquidation of Saratoga's assets, cannot constitute a physical fifth amendment taking because neither Saratoga nor CHS could have developed a historically rooted expectation of compensation for such a seizure. Saratoga did not possess the most valued property right in the bundle of property rights, the right to exclusive possession, or stated conversely the right to exclude others, at the time of the alleged taking in this case. The power to exclude is an essential element of property ownership. It "has traditionally been considered one of the most treasured strands in an owner's bundle of property rights." Loretto, 458 U.S. at 435-36, 102 S.Ct. at 3175-76 (citing Kaiser Aetna v. United States, 444 U.S. 164, 179-80, 100 S.Ct. 383, 392-93, 62 L.Ed.2d 332 (1979) and Restatement of Property § 7 (1936)). See also Nollan v. California Coastal Comm'n, 483 U.S. 825, 831, 107 S.Ct. 3141, 3145, 97 L.Ed.2d 677 (1987), quoting Loretto, 458 U.S. at 433, 102 S.Ct. at 3175, quoting Kaiser Aetna, 444 U.S. at 176, 100 S.Ct. at 391 ("We have repeatedly held that, as to property reserved by its owner for private use, 'the right to exclude [others is] "one of the most essential sticks in the bundle of rights that are commonly characterized as property." ' "); Kaiser Aetna, 444 U.S. at 179-80, 100 S.Ct. at 392-93 ("In this case, we hold that the 'right to exclude,' so universally held to be a fundamental element of the property right, falls within this category of interests that the Government cannot take without compensation.") Hendler v. United States, 952 F.2d 1364, 1377 (Fed.Cir.1991). Saratoga lacked the fundamental right to exclude the government from its property at those times when the government could legally impose a conservatorship or receivership on Saratoga.

 

 

Again, I'd note that Professor Epstein's response does not engage any case law in his response.  There is a question as to whether the government could legally impose a conservatorship on Fannie & Freddie, and that would be an area of attack -- though I think that it would fall under a Chevron analysis of whether they had a rational basis for such a move.

 

(4) Exaction Claim: I feel like this was a throwaway claim from the plaintiffs, and I agree with the government response to this.  I believe that the "money in its pocket" thing is actually a requirement of exaction claims, but I'm not 100% sure.

 

As a side note, the fact that the HERA statute says "no court may take any action to restrain or affect the exercise of powers or functions of the Agency as a conservator or receiver" also bothers me.

 

Anyway, those are my immediate thoughts after having read the response a few times.

 

Are there other lawyers and/or former lawyers who want to weigh in here?

[gfp]

http://www.cnbc.com/id/101193820

[bmichaud]

Endless debate for months on end about the legal side of F&F, yet zero discussion thus far regarding one of the largest potential restructurings ever!!!

 

FT said there are various documents floating around regarding the investor group's proposal. Anyone come across anything?

 

This whole situation makes far more sense IMO if in fact this is what Berkowitz had in mind the whole time - i.e. private capital coming in to restructure F&F. Why else would he take such a large stake in something that has a legitimate possibility of going to zero?

 

 

[merkhet]

 

Endless debate for months on end about the legal side of F&F, yet zero discussion thus far regarding one of the largest potential restructurings ever!!!

 

FT said there are various documents floating around regarding the investor group's proposal. Anyone come across anything?

 

This whole situation makes far more sense IMO if in fact this is what Berkowitz had in mind the whole time - i.e. private capital coming in to restructure F&F. Why else would he take such a large stake in something that has a legitimate possibility of going to zero?

 

 

That's probably because the legal side is happening whereas the restructuring side might happen.

 

Treasury owns 79.9% of the equity of the company through warrants. Why would they agree to forego that ownership and turn over ownership to the private preferred shares?

[Guest Dazel]

https://www.moodys.com:443/research/Moodys-GSEs-profitability-continues-to-improve-but-long-term-reform--PR_286526?WT.mc_id=NLTITLE_YYYYMMDD_PR_286526

[Guest Dazel]

http://www.ft.com/intl/cms/s/0/b6ff63c6-4bb7-11e3-8203-00144feabdc0.html#axzz2kXTJzRmT

[bmichaud]

 

Endless debate for months on end about the legal side of F&F, yet zero discussion thus far regarding one of the largest potential restructurings ever!!!

 

FT said there are various documents floating around regarding the investor group's proposal. Anyone come across anything?

 

This whole situation makes far more sense IMO if in fact this is what Berkowitz had in mind the whole time - i.e. private capital coming in to restructure F&F. Why else would he take such a large stake in something that has a legitimate possibility of going to zero?

 

 

That's probably because the legal side is happening whereas the restructuring side might happen.

 

Treasury owns 79.9% of the equity of the company through warrants. Why would they agree to forego that ownership and turn over ownership to the private preferred shares?

 

My point was that when I woke up this morning to this news I came on here expecting 5 new pages of analysis. I understand why the legal analysis is happening  ;D

[bmichaud]

The deal would see the investor group take control of Fannie and Freddie’s core businesses of guaranteeing mortgage-backed securities, in two newly-capitalised insurance companies.

 

This could potentially be massive, along the lines of what BB has talked about AIG moving into. I wonder if BB doesn't have plans for AIG to become part of this in some way shape or form....

 

The group proposes to capitalise the new insurers by converting their preferred securities into common equity and then carrying out a $17.3bn rights issue, according to a presentation document seen by the Financial Times.

 

Fannie and Freddie’s portfolio of previously-written guarantees and mortgage holdings would stay in government hands to be wound down, potentially at considerable profit to taxpayers. A common securitisation platform, used to standardise mortgage-backed securities, would also stay in public hands.

 

So the Treasury's cash cow would remain in place.

[nkp007]

"Hedge funds take over F+F at massive profits...American voters go ballistic"

 

Not politically palatable, but it shows the investors are at least putting some pressure on the process. Not that Congress is capable of reacting.

 

The underlying note in this news: par is a thing of the past. The biggest holders are fighting for a MULTIPLE of par.

[Guest Dazel]

 

It's a bluff.

To get the government to try to take the equity and make the prefs whole.

 

Who is on the line for $5trillion in debt?

[Guest Dazel]

 

 

There is no incentive for the government to do anything but rake in the profits from the most profitable company in history....and they have the tax payers behind them.

 

The best scenario for everyone in the world is for the status quo except for the pref holders and the common holders who own 20%. These r flees....

 

The bond holders dwarf everyone and they do not want anything to happen at all...

 

I expect a recap after another year or two...to the same company...however it is very possible that the prefs are made whole because of the massive profits that will occur in this time.

 

Dazel.

[bmichaud]

How is this not the best of both worlds? 

 

1. The status quo remains the same for the current business (i.e. current bond holders have the backing of the USG) while Treasury gets to keep its cash cow

 

2. Private capital comes in to take over future MBS guarantees

 

The group is simply buying the future guarantee business with an instant 85% mkt share of all new mortgage issuance. Is it not?

[Guest wellmont]

"Hedge funds take over F+F at massive profits...American voters go ballistic"

 

Not politically palatable, but it shows the investors are at least putting some pressure on the process. Not that Congress is capable of reacting.

 

The underlying note in this news: par is a thing of the past. The biggest holders are fighting for a MULTIPLE of par.

 

american voters don't go ballistic as long as their internet connection works. vast majority don't even know what this is about, won't understand it, and won't care.

[nkp007]

"Hedge funds take over F+F at massive profits...American voters go ballistic"

 

Not politically palatable, but it shows the investors are at least putting some pressure on the process. Not that Congress is capable of reacting.

 

The underlying note in this news: par is a thing of the past. The biggest holders are fighting for a MULTIPLE of par.

 

american voters don't go ballistic as long as their internet connection works. vast majority don't even know what this is about, won't understand it, and won't care.

 

F+F create visceral reactions in voters, but maybe you're right.

 

They can hate them all they want, but as soon as you tell them the 30 year mortgage is at risk, you'll have a true revolt. Americans will wonder, why is everyone bailed out except the everyday American who has a 30 year mortgage.

 

The real estate industry has the American populace in its palm at virtually all times.

[Guest wellmont]

F+F create visceral reactions in voters, but maybe you're right.

 

They can hate them all they want, but as soon as you tell them the 30 year mortgage is at risk, you'll have a true revolt. Americans will wonder, why is everyone bailed out except the everyday American who has a 30 year mortgage.

 

The real estate industry has the American populace in its palm at virtually all times.

 

voters don't know what f&f are. they go to a bank they sign some papers and they get a check. they get their money from the bank not f&f.

 

what's in it for US GOV? There has to be something. I think the hedgies are going to be nuisance to US Gov. There is strength in numbers. Like really annoying dissident shareholders. They may not get everything they are asking for, but they may get something. US GOV wants to create wealth. That's their only plan. If they can create wealth they are interested. US GOV figured out they can't run anything. They want out of owning companies that should be private.

[merkhet]

Incentives matter.

 

I agree w/ wellmont... sort of.

 

What's the U.S. government's incentive to just turn over new issuances to the private preferred holders? If they can't win a legal battle, they have no leverage. Why doesn't FHFA split the company into two, run down the "old" F&F (while attaching the private preferrers to the old F&F) while spinning out the new F&F via a rights issue?

 

I don't think nuisance value cuts it...

[fareastwarriors]

Investors pitch to take over much of Fannie and Freddie

 

http://www.cnbc.com/id/101193820

[bmichaud]

I am curious how the prefs would convert into the new insurance cos. Say the $34.6B outstanding is trading at 36% of par, that's a market value of $12.5B. Under the investor group's plan, there would be a $17.3B rights offering.

 

Would the prefs convert at market value for total common equity post-rights offering of $29.8B? Or would the prefs convert at par....?

 

Assuming 20X leverage on $29.8B of starting capital, allowable assets would be $893B. Assuming a NIM of 3.5% and an expense ratio of 55%, PTPP would be $14.1B. If the investor group requires a 15% ROE, pre-tax income would have to $7.45B at a 40% tax rate, which implies an annual allowable loss rate of $6.65B. Also - I am not even including the guarantee fees....

 

What would a mid-cycle loss rate be for a guarantee business? 50bps? 100bps? At 100bps, this pro forma insurance co could support a $665B guarantee book, and at 50bps it would be $1.33T.

 

2012 FNMA/FMCC MBS issuance was $1.3T according to their 10Ks. I assume this is a decent proxy for the annual market NewCo would begin to guarantee.

 

The existing F&F guarantee book run off provides what I assume would be a huge growth runway. So what should NewCo be valued at? 20X earnings? 25X?

 

At 20X the required 15% ROE-derived net income of $4.47B, the NewCo fair value would be $89.4B. The current estimated market value of F&F prefs, or $12.5B, represents 42% of contributed capital....and 42% of the $89.4B fair value is $37.55B.

 

 

All that to say - the margin of safety part of this story is finally starting to shine through. Without a restructuring as outlined above or a legal victory, there is no margin of safety against the gov't pilfering 100% of F&F profits.

[Guest wellmont]

i would go in if and when they put conversion terms in place. convert pref to equity and participate in rights offering.

[fareastwarriors]

http://online.wsj.com/news/articles/SB10001424052702303460004579194333144295904?mod=WSJ_WSJ_US_News_5

 

Freddie Taps Reinsurer to Offset Loan Risks

 

Mortgage-Finance Firm Expands on Effort With Private Investors