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

[Guest cherzeca]

i think both berkowitz and ackman have spoken (ackman more directly) to how a restructured fnma might look like.

 

either through court action or settlement, both believe that the excess dividends arising from nws should redound to the benefit of the public stockholders. that gets the treas pref down below $20B for fnma. one could easily see as part of any settlement retiring the treas pref with a new issue, as part of a release from conservatorship. as part of that release, i think you would see fnma become more like a utility, as per the real tim howard's work. see https://howardonmortgagefinance.com/

 

i havent heard either of them clamor for extinguishment of the treas warrants.

 

@seahug, i think you can raise capital over time so that the haircut you apply right up front may be too harsh.

 

my take on all of this is, if you are a value investor and are in fnma because of risk/reward, understanding that the margin of safety is more theoretical (berkowtiz:  fannie is necessary and cant be replaced) than financial, then you like the junior prefs.  if you like the risk/reward and are less concerned with having any margin of safety, then you like common.  owning both is a sensible position to take. all imho.

[Seahug]

 

So for FNMA, if you assume that NWS reversed and applied to 10% dividend payment, then 97.4bn remain that can be applied to repay the senior, bringing it down 18.7bn. There are 19.13bn of junior prefs outstanding (so call it 38bn in value to prefs). If you assume the business can sustainably make 10bn, at a 10x or 12x you get to your 100 - 120bn in value. Another way to calculate it would be 10bn - ca. 1.3 - 1.4bn of junior pref dividends (once senior repaid, which would take to about end 2019/20, if it can earn 11bn/year till then), so call that 8.5bn or so income attributable to common at that point ... apply a multiple to that. With warrants, unless they are restructured, you have 5.89bn shares outstanding, so that puts you into the $15 - $20 per share price range (after senior prefs are gone) for a 10x - 14x multiple.

 

Thanks! I was discussing this with a friend of mine and I actually was using your argument. His opinion was FNMA's capital is only $3bn (which is what's left after the sweep). FNMA would not be allowed by the regulators to function with almost no capital against a $3tn balance sheet. So capital would need to be raised. Unlike a normal business where the additional capital would allow you to expand and generate extra income, in this case the capital probably would not earn very much more (maybe $1bn in interest savings?). So the 120bn equity value would have to be shared between common SH (currently worth 18bn at $3), junior prefs (19bn), remaining unpaid senior (19bn), new common 50bn. So upside to common is much less. In ackman's presentation he assumes much higher profitability and I am not sure he assumes repayment of the senior pref principal.

 

Anyway I realize its all up in the air but I wanted to attempt to put some numbers to potential outcomes. I've common treated better than prefs in some european bank restructurings (Ireland for sure and I believe greece).

 

Thanks!

 

Any thoughts on FNMAT vs FNMAS?

 

 

[investorG]

will the mandamus ruling just pop out some time or is there a consistent tues - fri release window like the perry appeals court?

 

i am wondering if they will find a technicality and rule for the govt to avoid dragging obama and his staff through the mud since a new sheriff (trump) is in town to set future course of action. 

[Guest cherzeca]

will the mandamus ruling just pop out some time or is there a consistent tues - fri release window like the perry appeals court?

 

i am wondering if they will find a technicality and rule for the govt to avoid dragging obama and his staff through the mud since a new sheriff (trump) is in town to set future course of action.

 

different ct so no tues/fri sched for mandamus.  mandamus will be denied imo

[doughishere]

Summers basically admitted the problem with fannie and freddie in the crisis was the lack of capital. AxeFiles Podcast.

 

Not really worth the listen if you are going to it for just Fannie and Freddie.

 

http://politics.uchicago.edu/pages/axefiles

 

 

[investorG]

regarding mandamus, we don't know the 3 judges, if two of them are from the handful of Obama appointees, there should probably be more concern than currently discussed.

[Guest cherzeca]

regarding mandamus, we don't know the 3 judges, if two of them are from the handful of Obama appointees, there should probably be more concern than currently discussed.

 

govt has a very hard standard of review to satisfy, even if judges are a brother from another mother

[merkhet]

Transcript of Fairholme call

 

http://www.fairholmefundsinc.com/Documents/PublicConferenceCall20161118.pdf

[Seahug]

i think both berkowitz and ackman have spoken (ackman more directly) to how a restructured fnma might look like.

 

@seahug, i think you can raise capital over time so that the haircut you apply right up front may be too harsh.

 

my take on all of this is, if you are a value investor and are in fnma because of risk/reward, understanding that the margin of safety is more theoretical (berkowtiz:  fannie is necessary and cant be replaced) than financial, then you like the junior prefs.  if you like the risk/reward and are less concerned with having any margin of safety, then you like common.  owning both is a sensible position to take. all imho.

 

Thanks Cherzeca.

 

Ackman seems to be "talking his book"  and presents the best case for the common. He assumes a return of 75bn from Treasury (excess dividend by dec 2013) for FNMA alone, no dilution from the junior prefs (just reinstatement and payment of interest - which is ok w me btw). This results in minimal dilution from a capital raise going from 5.9bn to 9bn shares. He also presents further upside if the guarantee fee is increased to 60bps to 100bps so 23-47$/share. A significant guarantee fee bump will be unpopular because it will increase mortage interest. There's a bit of sophistry here as well as at $23, govt share = 108bn but actually it had to kick back $75bn so net gain to govt is only $33bn. Nice though if you can get it.

 

Berkowitz is for the AIG solution, which is ending the sweep, reinstatement of the jprefs. AIG repaid the bailout money + interest and also accepted the share dilution from the bailout. Again this ok w me but it's actually closer to the situation i described and benefits from precedent.

 

TBH I've not read through the timhoward site. I will check it out.

 

I can't also see the best case for the jprefs as realistic -  conversion  to common at par (meaning jpref would own more shares than the govt; 19bn for jpref, 18bn current mkt cap for govt + common) and then common doing 2-3x. A 10+ bagger for jpref. Nice also, but come on.

 

Still, absent a hugely pro-common decision, seems the prefs are a better risk reward in most reasonable scenarios.

 

This is not my favorite flavor of investment as it has too many moving parts, no defined process (like chap 11). I like that it's not market correlated. But, everything hinges on the legal outcomes, which I'm not comfortable with. If the courts don't go our way, what's next? I don't know if there would be enough impetus for settlement even with a new administration. Do you guys have the patience for another appeal? Funds that bought defaulted argentina debt made 4-10x their money back, but it took 13-15 years. In reality that's quite ok. But it would be a big mark to market hit, very illiquid, and what if it goes to the next administration?

 

However, here I am with some skin in the game. Expected value = 50% Loss (0.5) + 50% win (3x) = 1.75x from here so we should stay, right?  Cheers!

 

[Eye4Valu]

David Thompson sums up the difference between the preferred and the common quite well right here:

 

"As I indicated, under the terms of the contract, Fannie Mae and Freddie Mac are not permitted to pay dividends to common stockholders unless they have paid dividends to the preferred. So that’s an important distinction and candidly, if the common stock is worth a penny, then Fairholme’s preferred should be money good."

[doughishere]

David Thompson sums up the difference between the preferred and the common quite well right here:

 

"As I indicated, under the terms of the contract, Fannie Mae and Freddie Mac are not permitted to pay dividends to common stockholders unless they have paid dividends to the preferred. So that’s an important distinction and candidly, if the common stock is worth a penny, then Fairholme’s preferred should be money good."

 

Anyone who has taken a first year accounting course should know that.  It's not exactly news.

 

Edit: That was kinda rude,mea culpa.

 

[Seahug]

Some additional thoughts on the jprefs.

 

FNMA can't pay divs/jpref coupons until they have enough statutory capital and I believe retained earnings (though i think it's possible to restructure the balance sheet so the retained loss is eliminated and the company can build up retained earnings faster).

 

So a slower build up of capital (less dilution for common) is actually worse for the jprefs and better for the common.

 

 

[waynepolsonAtoZ]

Here is the language in the rule. http://www.ecfr.gov/cgi-bin/text-idx?SID=3fb97d0c7dc256cc0713f1cf7de76a96&mc=true&node=pt12.10.1237&rgn=div5#se12.10.1237_112

 

I suppose it's the chicken and egg question, but, to me, you have to restore the preferred dividends before you can sell new common equity. You probably also need to start a small common dividend before you can sell any new common equity.

 

I know that this may be optimistic.

 

§1237.12  Capital distributions while in conservatorship.

(a) Except as provided in paragraph (b) of this section, a regulated entity shall make no capital distribution while in conservatorship.

 

(b) The Director may authorize, or may delegate the authority to authorize, a capital distribution that would otherwise be prohibited by paragraph (a) of this section if he or she determines that such capital distribution:

 

(1) Will enhance the ability of the regulated entity to meet the risk-based capital level and the minimum capital level for the regulated entity;

 

(2) Will contribute to the long-term financial safety and soundness of the regulated entity;

 

(3) Is otherwise in the interest of the regulated entity; or

 

(4) Is otherwise in the public interest.

 

© This section is intended to supplement and shall not replace or affect any other restriction on capital distributions imposed by statute or regulation.

[doughishere]

Some additional thoughts on the jprefs.

 

FNMA can't pay divs/jpref coupons until they have enough statutory capital and I believe retained earnings (though i think it's possible to restructure the balance sheet so the retained loss is eliminated and the company can build up retained earnings faster).

 

So a slower build up of capital (less dilution tfor common) is actually worse for the jprefs and better for the common.

 

 

Sea, what's your estimate of pre-tax Noi?

[Sunrider]

Hi All

 

Perhaps it's more helpful to distinguish between longer term value in a steady-state income scenario (with senior prefs gone) and the likely reaction of share prices to various events. I think that is what Chris has been getting at ... if there's a favourable court outcome and the NWS is reversed, it's likely that the market will shortcut past the complexities of looking at how capital might be restored straight to 'holly crap, this is now worth something, I better get in'. The common is liquid and probably more easily understood (by average market joe) than the prefs, so they'll (hopefully) pop.

 

In the longer term, the common can only be worth anything if the prefs are also worth something (ignoring votes attached to shares). So it does matter how the GSEs are restored to capital health. Nothing wrong with 10x on prefs on conversion to common (as long as I can elect to receive cash instead :) - that's the whole point and the title of this thread. And why not? That's precisely Fairholme's point: they represent a contract and before GSE are able to give value to anyone else, they need to honour that contract.

C.

[Seahug]

Dough

 

I am from the "back of the envelope" school of investing  :) Well that's my excuse for not studying the profitability more closely.

 

I don't really have a solid estimate of net operating profit for FNMA. Ack estimates $17bn for FNMA & FMCC combined. 2015 i think net rev 20bn, 6bn exp, 14bn pre tax, 10 bn NPAT. 10bn on 3tn or 30bps. Some portion of this is from the spread/guarantee biz and some portion from owned portfolio which they are winding down. Also need to figure out earnings in good and bad times. Also most of recent NPAT are due to writebacks. So not sure but 10bn NPAT seems like an ok, not heroic type of number +/- 20%.

 

I find this is simpler though than the black box, big bank balance sheets w dozens of tn in derivatives - though I believe fnma also has interest rate derivs which i don't understand

 

 

 

 

 

 

 

[Guest cherzeca]

if corporate tax rate lowered with new administration, i cant think of a larger beneficiary than the GSEs.

[Guest cherzeca]

David Thompson sums up the difference between the preferred and the common quite well right here:

 

"As I indicated, under the terms of the contract, Fannie Mae and Freddie Mac are not permitted to pay dividends to common stockholders unless they have paid dividends to the preferred. So that’s an important distinction and candidly, if the common stock is worth a penny, then Fairholme’s preferred should be money good."

 

this was a stupid statement by thompson. it may be true in a liquidation scenario, but it is certainly not true of a going concern.

 

it is false both theoretically and empirically, because common is valued as an option on any future cash flows above those needed to satisfy the senior capital in a going concern situation. so you often see the junior stock with value and the senior stock valued at a discount. especially in situations where both classes of stock can benefit from a catalyst. 

 

this is even more so in the GSE case where the junior pref is noncumulative, so that omitted dividends are lost and no longer represent a claim that may be asserted by the pref.  the dividend pref is contractual and it has been breached, but as a matter of valuation, it is weak.

 

 

[investorG]

I'm not mr thompson but i believe he meant 'in the end' when making that statement, which would make it theoretically correct.  I doubt he meant 'during ongoing trading'.

[Guest wellmont]

The pref will get their money. It is just going to be a matter of how long it takes. If the current capital structure prevails, and I seriously doubt it will, the pref won't get a dime until the GSEs have a fortress balance sheet, and are making a ton of money every quarter. Until that point it makes no sense to ship precious capital out to holders of a security that represent capital that has vanished, that is gone, destroyed, or taken. The pref stock will not come close to par value until those dividends are turned on again. And unless there is a major recap, that could take years. I would study the case of the RBS preferred as an analogue. The pref languished for years because the dividends were turned off.

 

The hedge funds are not going to wait aground until GSEs build enough capital to start paying dividends on the pref. That is not their end game. Mom and pop might. But not Paulson and Perry. They will want an exit, liquidity, and an "event" that gives them a pop, and a good ROI on their original cost basis. They will be very open to a restructuring that allows them to exit the pref. They also might be very interested in getting a foothold as a common shareholder in a fully restructured, public, GSE.

 

The current capital structure of the GSE complex does not make any sense at all. It made sense in 2003. Not today. I believe you are going to see a massive, out of court financial restructuring, that could involve a merger of Fannie and Freddie, as well as a reduction of pref capital, and an increase of common equity. But tons of capital has been removed from the companies. Capital was destroyed in the great recession. And the GSEs need a much higher common equity ratio to move forward and become viable. And, after all that has transpired, that is why the current capital structures do not make sense.

 

Contracts are altered all the time in business when circumstances change. All the time. And they have radically changed here. The NWS was a prime example of a contract that was unilaterally altered. Proving that this isn't KANSAS anymore. So for the good of the GSEs and the country, contracts here will be altered. So that the GSEs can move forward with the correct balance sheet, contracts will be altered. I don't see how the GSEs move into the next phase with the existing cap structure.

[Eye4Valu]

David Thompson sums up the difference between the preferred and the common quite well right here:

 

"As I indicated, under the terms of the contract, Fannie Mae and Freddie Mac are not permitted to pay dividends to common stockholders unless they have paid dividends to the preferred. So that’s an important distinction and candidly, if the common stock is worth a penny, then Fairholme’s preferred should be money good."

 

Anyone who has taken a first year accounting course should know that.  It's not exactly news.

 

Edit: That was kinda rude,mea culpa.

 

Who said it was news? David Thompson obviously thinks it is an important distinction. I'm assuming there is a reason he is managing partner at Cooper & Kirk, and you "experts" are blogging on a stock forum. I wonder who gets paid more by the hour?

[Sunrider]

Right, though since the face value is what it is, I would expect pref holders to not accept common at a discount ... especially after all the contract rhetoric that Berkowitz has used.

Views?

 

The pref will get their money. It is just going to be a matter of how long it takes. If the current capital structure prevails, and I seriously doubt it will, the pref won't get a dime until the GSEs have a fortress balance sheet, and are making a ton of money every quarter. Until that point it makes no sense to ship precious capital out to holders of a security that represent capital that has vanished, that is gone, destroyed, or taken. The pref stock will not come close to par value until those dividends are turned on again. And unless there is a major recap, that could take years. I would study the case of the RBS preferred as an analogue. The pref languished for years because the dividends were turned off.

 

The hedge funds are not going to wait aground until GSEs build enough capital to start paying dividends on the pref. That is not their end game. Mom and pop might. But not Paulson and Perry. They will want an exit, liquidity, and an "event" that gives them a pop, and a good ROI on their original cost basis. They will be very open to a restructuring that allows them to exit the pref. They also might be very interested in getting a foothold as a common shareholder in a fully restructured, public, GSE.

 

The current capital structure of the GSE complex does not make any sense at all. It made sense in 2003. Not today. I believe you are going to see a massive, out of court financial restructuring, that could involve a merger of Fannie and Freddie, as well as a reduction of pref capital, and an increase of common equity. But tons of capital has been removed from the companies. Capital was destroyed in the great recession. And the GSEs need a much higher common equity ratio to move forward and become viable. And, after all that has transpired, that is why the current capital structures do not make sense.

 

Contracts are altered all the time in business when circumstances change. All the time. And they have radically changed here. The NWS was a prime example of a contract that was unilaterally altered. Proving that this isn't KANSAS anymore. So for the good of the GSEs and the country, contracts here will be altered. So that the GSEs can move forward with the correct balance sheet, contracts will be altered. I don't see how the GSEs move into the next phase with the existing cap structure.

[investorG]

if you expect a recapitalization, which may or may not happen, new investors won't likely pony up the necessary funds unless they see the existing preferred shareholders shown at least a little respect -- which would be accomplished thru dividends, a cash tender (perhaps at a discount to par but well above current prices), and/or a swap into common at some ratio (perhaps 2:1).

[Seahug]

RBS 7.763 2049 noncumulative preferreds issued 1997 traded as low as $3 in 2009 par is 25, current price is 25.76

 

Trades on NYSE ticker is NW-C

 

https://www.google.com/finance?q=NYSE%3ANW-C&ei=5tE0WMC7AcOB0ASkzIWIAg&ed=us

 

I do not believe these were restructured. Coupon paying since 2014. Also traded close to par a couple of years before coupons started.

 

Sorry, I don't mean to show you up. But I thought the best way to illustrate noncum value was to show an actual example.

 

 

 

[Guest wellmont]

RBS 7.763 2049 noncumulative preferreds issued 1997 traded as low as $3 in 2009 par is 25, current price is 25.76

 

Trades on NYSE ticker is NW-C

 

https://www.google.com/finance?q=NYSE%3ANW-C&ei=5tE0WMC7AcOB0ASkzIWIAg&ed=us

 

I do not believe these were restructured. Coupon paying since 2014. Also traded close to par a couple of years before coupons started.

 

Sorry, I don't mean to show you up. But I thought the best way to illustrate noncum value was to show an actual example.

yes I am aware they trade at par now. the point is the div is at the discretion of the BOD and they will decide when the dividend is paid. that could be a while in the case of the GSEs. I hope I am wrong about that.

 

Here is what gives me pause. I refer you to slide 109 of the ackman presentation of 2 years ago. Keep in mind that fannie and freddie have been systematically stripped of capital since this presentation.

 

"We estimate that the retention of the GSEs’ earnings will allow them to

become fully capitalized in no more than a decade. There are several

potential alternatives to capitalize them more quickly:"