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

[onyx1]

Fairholme GSE proposal attached

FAIRHOLME_CAPITAL_MANAGEMENT_ANNOUNCES_PROPOSAL_FOR_PURCHASE_OF_INSURANCE_BUSINESSES_FROM_FANNIE_MAE_AND_FREDDIE_MAC_0.pdf

[bmichaud]

Investor group pitch book:

 

http://ftalphaville.ft.com/2013/11/13/1694232/private-capital-now-say-hedge-funds-with-frannie-preferreds/

[vinod1]

Fairholme funds has case study on Fannie and Freddie. They have quite a few litigation documents also here. Apologies if this has already been referenced.

 

http://fairholmefunds.com/case-studies

 

Vinod

[bmichaud]

This seems like an extremely serious proposal by Fairholme and not the "bluff" Dazel was referring too. Perhaps I'm misreading the situation....

[merkhet]

Attached a copy of the investor group pitch book that has been rotated so it reads the right way...

 

[EDIT: I guess this is just a first draft of the Fairholme proposal...]

2013-11-13_Private_Equity_Proposal.pdf

[merkhet]

Still reading the proposal, but I'm already a little confused.

 

When they're saying $52 billion of private capital, isn't that a bit of a head fake? They've classified this as the following:

 

(1) $34.6 billion of restricted capital from conversion of the private preferred stock

(2) $17.3 billion in new cash raised in a rights offering

 

However, what they really seem to mean is the following:

 

(1) $34.6 billion of restricted capital paid from Fannie & Freddie's coffers (AKA government money)

(2) $17.3 billion in new cash raised in a rights offering

 

I'm still not entirely clear on what leverage the private preferrers have to force the government to make them whole...

[fareastwarriors]

fairholme letter to , FHFA head, Ed DeMarco

FairholmeLetter.pdf

[onyx1]

Still reading the proposal, but I'm already a little confused.

 

When they're saying $52 billion of private capital, isn't that a bit of a head fake? They've classified this as the following:

 

(1) $34.6 billion of restricted capital from conversion of the private preferred stock

(2) $17.3 billion in new cash raised in a rights offering

 

However, what they really seem to mean is the following:

 

(1) $34.6 billion of restricted capital paid from Fannie & Freddie's coffers (AKA government money)

(2) $17.3 billion in new cash raised in a rights offering

 

I'm still not entirely clear on what leverage the private preferrers have to force the government to make them whole...

 

A brilliant proposal by Fairholme, et al!

 

I read it as the private preferred would be made whole at par plus accrued dividends from the date of the Third Amendment Sweep, Aug 2012.  What is not clear to me is whether the UST writes a check for the par + accrued on the private preferred, or whether it is credited toward capital by the new state insurance regulators.  I suspect a check.

 

The leverage comes from the litigation threat and the deterioration of the infrastructure assets while waiting for a legal conclusion.

[mankap]

I agree, it is a brilliant proposal.It raises the stature of Fairholme fund and Berkowitz as a top tier fund in trying to pull a 52 B recap.

What i understood is that preferred shareholders get the equity in the new company and will not be paid by UST.

I am still reading and trying to understand the proposal.

[merkhet]

 

A brilliant proposal by Fairholme, et al!

 

I read it as the private preferred would be made whole at par plus accrued dividends from the date of the Third Amendment Sweep, Aug 2012.  What is not clear to me is whether the UST writes a check for the par + accrued on the private preferred, or whether it is credited toward capital by the new state insurance regulators.  I suspect a check.

 

The leverage comes from the litigation threat and the deterioration of the infrastructure assets while waiting for a legal conclusion.

 

 

I agree that it's a brilliant proposal. I'm just not sure whether it'll happen.

 

My sense is that Fannie & Freddie would have to provide $34.6 billion in cash to the NewCo. I'm not sure what you mean by "credited toward capital"...

 

In any case, I think we've covered the legal aspect of the case, and I think that there are significant hurdles for the private preferred holders. The leverage is not terribly strong IMHO...

 

 

What i understood is that preferred shareholders get the equity in the new company and will not be paid by UST.

 

 

Yes but someone has to provide the paid-in capital for the equity in the first place... it's not like they can just raise $17.4 billion in new equity and then split it as if they had $52 billion of paid in capital.

[Guest Dazel]

 

 

I sold my speculative position today in FNMAS 35% in a month. Thank you BB et all.  I Think this will have ups and downs as we head into the debt talks....

 

Good luck all.

 

Dazel.

[morningstar]

 

Yes but someone has to provide the paid-in capital for the equity in the first place... it's not like they can just raise $17.4 billion in new equity and then split it as if they had $52 billion of paid in capital.

 

Precisely... Fannie/Freddie contribute $34.6 billion in "corresponding assets" in exchange for the cancellation of the preferred shares. I assume that these assets would not be in cash but in securities, and would also include whatever operational assets the NewCo investors need for their planned business model. I think there are many challenges to implementing a plan like this, but it's an interesting idea.

[muscleman]

 

A brilliant proposal by Fairholme, et al!

 

I read it as the private preferred would be made whole at par plus accrued dividends from the date of the Third Amendment Sweep, Aug 2012.  What is not clear to me is whether the UST writes a check for the par + accrued on the private preferred, or whether it is credited toward capital by the new state insurance regulators.  I suspect a check.

 

The leverage comes from the litigation threat and the deterioration of the infrastructure assets while waiting for a legal conclusion.

 

 

I agree that it's a brilliant proposal. I'm just not sure whether it'll happen.

 

My sense is that Fannie & Freddie would have to provide $34.6 billion in cash to the NewCo. I'm not sure what you mean by "credited toward capital"...

 

In any case, I think we've covered the legal aspect of the case, and I think that there are significant hurdles for the private preferred holders. The leverage is not terribly strong IMHO...

 

 

What i understood is that preferred shareholders get the equity in the new company and will not be paid by UST.

 

 

Yes but someone has to provide the paid-in capital for the equity in the first place... it's not like they can just raise $17.4 billion in new equity and then split it as if they had $52 billion of paid in capital.

 

Yeah. This is what's confusing to me as well. Why should the government implement this proposal? Why not just keep the current Fannie and Freddie running and keep making $30 bn a quarter for the US government forever?

 

[bmichaud]

That's the brilliance of this plan - the govt keeps the cash cow while the future mortgage business is placed into private hands!!

 

Another interesting piece is the run off value that would accrue to the common. I assume that would not actually happen, but why not throw it in there!?

[bmichaud]

What are everyone's thoughts on the leverage that this company could handle to be AAA? Would 20x be too high?

 

What kind of a loss rate would guaranteeing 1-4 family mortgages have? 50bps? If the big banks are guiding to 100 mid cycle, I don't see why this would have to be more than 50.

[bmichaud]

Let's say it is levered 10x with debt costing 4%. Total assets are $520B, say with an average yield of 7%. So NIM on these assets would be 3%, or $15.6B in $ terms.

 

Say they guarantee $1T starting out at an annual premium of 50bps, exactly matching the estimated loss rate. So the guarantee fee and annual loss rate are a wash for income stmt purposes.

 

If the expense ratio is 40% (not sure off the top of my head what this looks like for AIG, but I would assume it would be lower than a bank that has an expansive physical footprint)  then Net income is $5.62B at a 40% tax rate. So ROE is just over 10%, a reasonable return for a utility-like business.

 

However, the incremental ROI on retained earnings is likely far higher than book roe as there is no need for incremental man power to manage an expanding base of float. And given the growth opportunity of this business, the FV PE on NewCo would be at least 15x I would think.

 

So NewCo FV at 15x 5.62 would be $84.3B. The prefs 66.5% share of this would be $56B versus the current market cap of around $13B.

 

Hopefully our brilliant Congressmen provide some attractive entry points over the next several months :)

 

 

Edit:

 

I miscalculated NIM by calculating it as if debt funded 100% of the assets. Required debt would be 468, and would cost 18.72 versus a 7% yield on 520 of assets, or 36.4. So NIM is 17.68 versus my 15.6 calc. Thus the estimated FV would be even higher....

[merkhet]

 

That's the brilliance of this plan - the govt keeps the cash cow while the future mortgage business is placed into private hands!!

 

Another interesting piece is the run off value that would accrue to the common. I assume that would not actually happen, but why not throw it in there!?

 

 

I'm afraid that I'm starting to sound like a broken record, but it seems like the government has two choices at the moment:

 

(1) Keep the run-off piece, and

(2) Provide $34.6 billion in cash/assets in exchange for private preferred + raise $17.4 billion in private capital for the mortgage insurance NewCo

 

OR

 

(1) Keep the run-off piece,

(2) Keep the $34.6 billion in cash/assets, and

(3) Raise the full $52 billion in private capital for the mortgage insurance NewCo

 

I don't know why they would choose the former and basically gift $34.6 billion to Fairholme et. al. There's practically no reason for it if, as I believe, the legal argument is looking weak. They can still put the new business in private hands by just raising the $52 billion outright. (Especially since I think bmichaud's analysis is roughly right in that the company will be worth significantly more than the $52 billion.)

[bmichaud]

And again - Bruce is virtually gifting AIG with a massive new business opportunity here. He made a comment about AIG eventually stepping into FF's shoes awhile back, but I would have never guessed he would orchestrate the change himself. Very very cool stuff.

[valuecfa]

It is a serious proposal that solves a lot of the hot button issues that other proposals fell short on. It will be interesting to see how much traction it gains.

 

 

[nkp007]

I think the real estate industry would be against this plan.

 

Lack of government guarantee will increase mortgage costs.

 

What's to say this entity doesn't MBIA itself and overextend while reducing underwriting standards at some point in its existence? If that's the case, we are back at square one.  Obviously this plan works well now that all new mortgages are pristine.

[Guest Dazel]

 

 

 

BB is on CNBC at 9:40 eastern time....

 

No way this can go through but it will get people thinking.

[valuecfa]

I think the real estate industry would be against this plan.

 

Lack of government guarantee will increase mortgage costs.

 

What's to say this entity doesn't MBIA itself and overextend while reducing underwriting standards at some point in its existence? If that's the case, we are back at square one.  Obviously this plan works well now that all new mortgages are pristine.

 

It's a bold step to do without a guarantee, and has been perceived as a far fetched goal of the politicians. A lack of guarantee will have large ramifications, but will please those (especially the politicians)  that prefer the government to not be on the hook when things go bad. The interested parties have not even gone so far as to definitively conclude whether or not they need/want a guarantee, or what form it will need to take if one remains. We are still in early innings on proposals, but this is one that goes the extra step.

[bmichaud]

 

That's the brilliance of this plan - the govt keeps the cash cow while the future mortgage business is placed into private hands!!

 

Another interesting piece is the run off value that would accrue to the common. I assume that would not actually happen, but why not throw it in there!?

 

 

I'm afraid that I'm starting to sound like a broken record, but it seems like the government has two choices at the moment:

 

(1) Keep the run-off piece, and

(2) Provide $34.6 billion in cash/assets in exchange for private preferred + raise $17.4 billion in private capital for the mortgage insurance NewCo

 

OR

 

(1) Keep the run-off piece,

(2) Keep the $34.6 billion in cash/assets, and

(3) Raise the full $52 billion in private capital for the mortgage insurance NewCo

 

I don't know why they would choose the former and basically gift $34.6 billion to Fairholme et. al. There's practically no reason for it if, as I believe, the legal argument is looking weak. They can still put the new business in private hands by just raising the $52 billion outright. (Especially since I think bmichaud's analysis is roughly right in that the company will be worth significantly more than the $52 billion.)

 

 

Great points. Could it be as simple as...with this proposal there is an automatic $52B already lined up ready to go, versus the govt somehow pitching to the private sector on its own why it should invest $52B on what would likely to be far worse terms than the current investor group would be getting by purchasing the prefs at a large discount to FV?

 

As BB says in his proposal, there must be a margin of safety in everything. Not that I would expect somebody like Nancy Pelosi to grasp such a concept, but the investor group has a large embedded MOS with the current set up in order to guard against the risk of taking a long-term stake (with a 5y lock-up) in an entirely new business venture.

 

Or perhaps you're right Merket, and the govt could simply raise the capital via a consortium of insurance companies??

[jay21]

Can someone please send me a link to the plan/letter that Buffett sent around during the financial crisis?  I can't remember if that was for F&F or more of a TARP type plan.

[dolce2think]

I understood this proposal differently:

Essentially the Value of Fannie and Freddie is split between the runoff and the ongoing/future business.

The preferred holders contribute 17 bio USD cash and the preferred stock will be converted into

"restricted capital" - which could be allowed to be counted as capital. Then, over 5 years the business

originates profits, which cannot be dividended out, until the restricted capital is paid up.

 

Please share your thoughts.