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

[morningstar]

So in the case of AIG, the govt provided a massive loan and took an 80% fully diluted stake in the common. Existing common participated alongside govt, but just on a fully diluted basis. I don't remember what the preferred structure was, but to my knowledge, no securities were outright cancelled. No?

 

With GM, I don't remember specifically. Didn't the govt loan get converted into common? Or was most of the common stake obtained via warrant?

 

What is the upside to canceling the warrant and simply returning to the private sector?

 

Is it not in the govt's best interest to maximize the value of the warrant? Ya they can sit here and collect the profits, but given the 80% ownership, govt could capitalize 80% of those profits at 15 or 20 times, bringing forward years worth of net worth sweep proceeds. No?

 

What discount rate do you think the U.S. government should use? Bringing forward those earning replaces borrowing at 2-odd percent a year. Where's the logic in selling at just a five percent earnings yield? To say nothing of the fact that the net sweep produces more money than their share of common earnings, by a large margin.

[bmichaud]

Would there be alternative uses to simply paying down 2% debt?

 

Is the status quo of just collecting NWS proceeds forever a viable solution for the mortgage market?

[merkhet]

bmichaud,

 

AIG:

 

http://www.ny.frb.org/aboutthefed/aig/pdf/Recapitalization_Summary_Terms.pdf

http://phx.corporate-ir.net/phoenix.zhtml?c=76115&p=irol-newsArticle&ID=1477531&highlight=

 

No securities were outright cancelled. Various things were done to ensure that Treasury was repaid on its investment in the companies.

 

GM:

 

http://en.wikipedia.org/wiki/General_Motors_Chapter_11_reorganization#363_Sale_of_assets

 

The government loan was converted into 60% of the new common while the unsecured bondholders were converted into 10% of the new common. The original common stock was wiped out, that was because the company was insolvent at the time.

 

I think that it would be unprecedented for them to just wholesale cancel the existing capital structure absent exigency and/or insolvency.

 

If you believe Ackman's presentation (attached), the value of Treasury's warrants is between $165 billion to $342 billion based on various g-fees and a P/E between 12x and 16x.

 

---

 

morningstar,

 

The problem in my mind is that the way that the Third Amendment (http://1.usa.gov/1mSpE8u) is set up, they erode away the capital of the companies at the same time. In my opinion, this doesn't get enough play in the media.

 

For each Dividend Period from January 1, 2013, through and including December 31, 201 7, the "Dividend Amount" for a Dividend Period means the amount, if any, by which the Net Worth Amount at the end of the immediately preceding fiscal quarter, less the Applicable Capital Reserve Amount, exceeds zero. For each Dividend Period from January 1, 2018, the "Dividend Amount" for a Dividend Period means the amount, if any, by which the Net Worth Amount at the end of the immediately preceding fiscal quarter exceeds zero. In each case, "Net Worth Amount" means (i) the total assets o f the Company (such assets excluding the Commitment and any unfunded amounts thereof) as reflected on the balance sheet o f the Company as of the applicable date set forth in this Certificate, prepared in accordance with GAAP, less (ii) the total liabilities of the Company (such liabilities excluding any obligation in respect of any capital stock of the Company, including this Certificate), as reflected on the balance sheet of the Company as of the applicable date set forth in this Certificate, prepared in accordance with GAAP. "Applicable Capital Reserve Amount" means, as of any date of determination, for each Dividend Period from January 1, 2013, through and including December 31, 2013, $3,000,000,000; and for each Dividend Period occurring within each 12-month period thereafter, $3,000,000,000 reduced by an equal amount for each such 12-month period through and including December 31, 2017, so that for each Dividend Period from January 1, 2018, the Applicable Capital Reserve Amount shall be zero. For the avoidance ofdoubt, if the calculation of the Dividend Amount for a Dividend Period does not exceed zero, then no Dividend Amount shall accrue or be payable for such Dividend Period.

 

So yes, they are earning a significant amount due to their Net Sweep, but the Capital Erosion robs Peter to pay Paul, since the companies actually need a certain amount of capital to sustain the $5 trillion of existing guarantees on the Fannie & Freddie books. Again, if you believe Pershing Square, the companies require about $186 billion of capital as a reserve and, therefore, what Treasury is really doing is taking away $186 billion of capital and earning what amounts to about 10% return on that capital rather than profiting by taking $165 billion to $342 billion off the warrants and turning the market over to private insurers.

 

Since Congress (and just about everyone else) wants the government to get out of the mortgage business, it's difficult to see how that can happen while there's a near government monopoly on the mortgage market right now -- and it's still hard to see how they can (A) establish a completely new system and (B) entice private money since they've established that in times of crisis, that capital will be treated unfairly.

 

http://www.ft.com/intl/cms/s/0/ad13e938-4290-11e4-847d-00144feabdc0.html

 

Sales of private-label MBS total just $4.5bn so far this year, compared with $17bn sold last year. Some $726bn worth of private-label MBS was sold in 2007, at the height of the subprime mortgage bubble. But sales collapsed after heavy losses during the subprime crisis.

2014-05-05_Its_Time_to_Get_Off_Our_Fannie.pdf

[merkhet]

Additionally, let's not forget that the $200 billion that Treasury has received is only slightly more than the $189.5 billion that they put into the companies in the first place. So basically, Treasury is sitting here waiting to earn the full $186 billion of capital reserve $20 billion a year at a time -- so they're trying to earn back their return "of" capital rather than earn a return "on" capital at the moment, if that makes sense.

 

It's rather dumb. Berkowtiz is correct. There is a win for all constituencies. It's just a matter of when and whether all the parties end up seeing it this way.

[bmichaud]

So Merkhet, absent a favorable ruling, how are you handicapping the opportunity? Is there enough value there to incentivize the govt to restructure on private capital friendly terms?

 

There just has to be more to this thing. Berk doesn't put 15% of a mutual fund into these securities all for some horrendously reasoned ruling to just wipe it out. Gotta be more.

[merkhet]

So Merkhet, absent a favorable ruling, how are you handicapping the opportunity? Is there enough value there to incentivize the govt to restructure on private capital friendly terms?

 

There just has to be more to this thing. Berk doesn't put 15% of a mutual fund into these securities all for some horrendously reasoned ruling to just wipe it out. Gotta be more.

 

This is a difficult one to handicap.

 

And let's be absolutely clear up front, I thought there was a better than even chance that the Perry case was going to result in vacatur of the Third Amendment, and I think Judge Lamberth completely overreached in the opinion. So, you know, take my opinion with a grain of salt at this point.

 

Given that there's a win for all constituencies out there (either releasing Fannie & Freddie or Berkowitz's restructuring plan), I'm just at a loss as to what's taking so long.

 

I dunno if I would say that there has to be more purely because Fairholme placed 15% of his fund into this thing. He's certainly smarter and more experienced than I am, but it's possible for him to be wrong as well.

 

I think for him, he saw the opportunity as being pretty darn similar to the AIG situation. Possibly it was unfathomable that Treasury would find a way to release AIG into the wild and not Fannie & Freddie. One was a much worse actor than the other, and what they do is arguably equally systemically important.

[Mephistopheles]

Did Fairholme purchase a 15% position or did it rise to 15%? I thought it was the latter (in which case it would be 7-8% now).

[merkhet]

You're right. He purchased at prices rather below what they were when the preferred shares accounted for 15% of the fund, though I'd add that a non-sale is basically a purchase (ignoring taxes).

[bmichaud]

Not surprising to me it's taking so long given the Conservatorship. It's not like they own a private entity like GM or AIG where there seemed to be pretty good pressure to exit. But due to all of the lawsuits and the growing recognition that there is a win for everyone, it seems to make sense a reorg will take place within a few years. But who knows.

 

Not saying Berk can't be wrong. But just seems like he had to have had a worst case scenario in place. Who knows.

[merkhet]

I suppose it just flabbergasts me that everyone is clamoring for a private solution, but there's unlikely to be a private solution without some sort of reform that treats existing shareholders fairly.

 

Actually, now that I think about it, it doesn't seem like Congress is needed at all to figure this out. Treasury remains in full control over when and whether a deal is struck for reform.

[constructive]

I suppose it just flabbergasts me that everyone is clamoring for a private solution, but there's unlikely to be a private solution without some sort of reform that treats existing shareholders fairly.

 

Actually, now that I think about it, it doesn't seem like Congress is needed at all to figure this out. Treasury remains in full control over when and whether a deal is struck for reform.

 

Treasury's primary goal is simple: radically reducing the size of FNMA and FMCC. The status quo is achieving that goal.

 

They don't really care about how much money the government makes or whether the companies ought to be privately owned.

 

Treasury is a dead end, and gridlocked Congress isn't much better. The only likely source of reform continues to be the courts.

[bmichaud]

Do you think Treasury can shrink F&F via starvation and the private sector will just take up the slack over time?

[merkhet]

Or a better question is -- does Treasury think they can shrink F&F via starvation and the private sector will just take up the slack over time?

 

I suspect that even Treasury knows this isn't possible. Note the Financial Times article showing just how moribund the private sector is even though Treasury is trying its darnedest to get people interested...

[bmichaud]

Were you quoting my post? Lol I cant tell

[merkhet]

Sort of -- I was just rephrasing.

 

i.e. -- The question isn't whether any member of the CoBaFF forum thinks that Treasury can shrink F&F and just have the private sector -- the question is whether Treasury thinks that it can do that...

 

Moreover, can they do it by the end of 2017, since, by the very structure of the Third Amendment, the companies will have zero dollars of capital reserve left over -- so any losses will have to be absorbed by the federal government.

[bmichaud]

Got it. Sorry.

 

That's exactly what I was driving at. It's nonsensical that Treasury believes it can wind down the entire existing mtg mkt in this manner.

[merkhet]

Moreover, the Democratic administration will soon realize the following problem from that same article:

 

http://www.ft.com/cms/s/0/ad13e938-4290-11e4-847d-00144feabdc0.html#ixzz3EwrEdix5

 

Authorities are having to walk a fine line between encouraging private capital back into the mortgage market while ensuring availability of credit to less-than-pristine borrowers and simultaneously avoiding a repeat of the subprime bubble that brought the financial system to its knees in 2008.

 

Good luck doing that without at least some sort of financial backstop. Private markets will essentially perform an adverse selection issue for insurance -- the healthiest borrowers will get mortgages and everyone else will get nothing. I mean just look at how stringent the loan requirements are right now to get a mortgage. Pristine credit. Nothing else will do.

 

This administration literally just went over this with the Affordable Care Act. Same concept. In reverse.

[bmichaud]

And that's in a low rate environment. The leverage profile of the American homeowner can barely afford current levels, let alone another 100 bps for a private sector cushion plus higher rates in general.

 

One would assume logic will prevail here.

[constructive]

Americans were willing to pay 15-20% on mortgages just a few decades ago.

 

The economic system will adapt to whatever happens, even something much more extreme than Fannie and Freddie shrinking 50% and mortgage rates rising 1%. That's the beauty of "creative destruction".

[bmichaud]

'Course we'll adapt. But we are still "adapting" to lower levels of leverage and the economy is slow as a result. 20% down with 6% rates would slaughter housing prices if implemented quickly (i.e. 5 to 10 years).

[TwoCitiesCapital]

I've just read through the docs. I've written my understanding of what was decided below, the reasoning why, and my commentary at the end. Comments, corrections, and arguments are welcome. I'm trying to wrap my head around this whole thing and am looking for all the help I can get.

 

A. HERA Bars the Plaintiffs’ Prayers for Declaratory, Injunctive, and Other

Equitable Relief against FHFA and Treasury

"the question for this Court is whether the plaintiffs sufficiently plead that FHFA acted beyond the scope of its statutory “powers or functions . . . as a conservator” when the agency executed the Third Amendment to the PSPAs with Treasury"

 

1. Section 4617(f) Bars Claims of Arbitrary and Capricious Conduct, under APA § 706(2)(A), Which Seek Declaratory, Injunctive, or Other Equitable Relief

- TBH, I read through this section 3 times and still couldn't make much sense. I don't know why this was so hard for me to grasp but I just couldn't really understand what was being said. I'm not entirely certain this section is too important for other cases though.

 

2. Section 4617(f) Applies to Treasury’s Authority under HERA

"...such interdependent, contractual conduct is directly connected to FHFA’s activities as a conservator"

Essentially what I grasped from this is that the Treasury can't come under judicial review for actions taken as counterparty to the FHFA for the same reason the FHFA can't come under judicial review. Any judician review of counterparty actions, in these instances, would infringe on the FHFAs activities as Conersvator which is expressly prohibited by HERA. This actually makes sense to me, but it's appears to be hinged on the reasoning in Section 1 that I couldn't quite grasp.

 

3. Treasury’s Execution of the Third Amendment Does Not Constitute the Purchase of New Securities in Contravention of HERA

My understanding of the Judge's arguments: The government was able to "exercise any rights received in connection with" the GSEs without deadline. The government had a right to the dividend of 10% for it's contribution to its liquidation preference. This dividend was later replaced by the net worth sweep - therefor, replacing the dividend with the net worth sweep is just continuing to exercise a right and not a purchase of a new security. Furthermore, the  government received no additional shares or securities so it's clear that no purchase was made.

 

4. FHFA Acted within Its Statutory Authority

the question for this Court, simply, is whether the net worth sweep amendment represents conduct that exceeds FHFA’s authority under HERA—a statute of exceptional scope that gave immense discretion to FHFA as a conservator

My understanding of Judge's arguments: Plaintiffs failed to demonstrate how 3rd Amendment violated HERA. This was broken down further into two arguments:

 

4a. FHFA motives for entering the 3rd Amendment are irrelevant - FHFAs protection from judicial review means courts can only consider what the 3rd Amendment accomplishes and not the motives for entering it.

 

the Court will examine whether the Third Amendment actually resulted in a de facto receivership, infra; not what FHFA has publicly stated regarding any power it may or may not Case 1:13-cv-01025-RCL Document 51 Filed 09/30/14 Page 21 of 5222 have, as conservator, to prepare the GSEs for liquidation, see Individual Pls.’s Opp’n at 58-66. FHFA’s underlying motives or opinions—i.e., whether the net worth sweep would arrest a downward spiral of dividend payments (see also supra n.7), increase payments to Treasury, or keep the GSEs in a holding pattern, Individual Pls.’s Opp’n at 66-73—do not matter for the purposes of § 4617(f).

 

So I can agree that the FHFAs motives and reasoning don't matter, and that the FHFA will not be punished for making a poor decision, but I don't understand how the judge fails to see that the net worth sweep does result in a de facto liquidation of a large portion of the company every quarter and does prevent the rehabilitation of the co back to solvency.

 

4b. FHFA Has Not Viloated 12 U.S.C. § 4617(a)(7)

My understanding of the Judge's arguments:  Just because the Treasury developed the idea of the net worth sweep does not mean that the FHFA was "bound" to follow it or that it was under inappropriate influence to execute it. Therefor, the provision that provides that the Conservator "not be subject to the direction or supervision of any other agency of the United Sates...in the exercise of the rights, powers, and privileges of the Agency." Further, clearly the Conservator did it's job as the companies are now immensely profitable.

 

This actually makes a lot of sense to me. I agree with the judge that even though the Treasury clearly came up with the plan doesn't mean FHFA was under their influence in executing it. This was not something I had considered previously. The point on profitability seem to miss the point. Conservatorship is meant to rehabilitate a company back to independence and solvency, no? The net worth sweep makes this an impossibility which means that the FHFA acted in direct disregard of its duty as Conservator.

 

B. HERA Bars the Plaintiffs’ Derivative Claims against FHFA and Treasury

As the basis for its exception to the rule against shareholder derivative suits, the Federal Circuit

explained that “the very object of the derivative suit mechanism is to permit shareholders to file suit on behalf of a corporation when the managers or directors of the corporation, perhaps due to a conflict of interest, are unable or unwilling to do so, despite it being in the best interests of the corporation.” First Hartford, 194 F.3d at 1295; see also Class Pls.’s Opp’n at 32 (quoting the same). Yet the existence of a rule against shareholder derivative suits, § 4617(b)(2)(A)(i), indicates that courts cannot use the rationale for why derivative suits are available to shareholders as a legal tool—including the conflict of interest rationale—to carve out an exception to that prohibition.

 

My understanding of this is that the Judge is saying derivative suits exist to get around conflicts of interest. HERA bars derivative suits and it's not enough to call upon a conflict of interest to get around this bar as that is already implicit in a derivative suit which was barred. Furthermore, even if the suit was allowed, there does not appear to be a conflict of interest at the FHFA with the Treasury. This actually makes sense to me as well.

 

C. The Plaintiffs’ Breach of Contract and Breach of the Implied Covenant of

Good Faith and Fair Dealing Claims for Monetary Damages Must Also Be Dismissed

A claim is not ripe for adjudication if it rests upon ‘contingent future events that may not occur as anticipated, or indeed may not occur at all.

Essentially, since the companies haven't been placed into receivership, the preferred/common equity interests remain intact and no damage can be claimed. The Judge agrees that the FHFA had the authority to make the sweep as Conservator, and the worthlessness of the stock is a result of that sweep, so proposes this "injury" is ok as it was done by the Conservator in its regular course of duty. No other "injury" can yet be claimed and there is no preclusion of a 4th or 5th amendment that would undo even this prior "injury."

 

A lot what Lambeth says makes sense to me, but I think much of it misses the mark. It seems that Lamberth dismisses the claims that the FHFA was operating outside of it's role as Conservator by simply showing that the FHFA wasn't under undue influence of the Treasury AND that it succeeded in its Conservatorship role as evidenced by the immense profitability of the GSEs. I can agree with the validity of both of these, but they seem to be such narrow views of the questions. It's clear that the net worth sweep makes solvency and rehabilitation an impossibility which is in direct conflict with their role as Conservator (right?). This would open the FHFA (and the Treasury by extension) to judicial review for being outside of it's role. Does anyone here disagree with this or think that this was adequately refuted?

 

He also makes the case that no purchase occurred and that it was simply an exercise of rights - however, I disagree. It seems clear that there was an exchange that occurred between the two parties. The FHFA was received relief from the 10-12% dividend requirement in exchange for a 100% net worth sweep (in excess of an arbitrary amount that trends to 0). Even with no monetary remuneration or increase in the government securities, it seems clear to me that the result is that the government ended up with claims on a significantly greater portion of the economic value than it had before and that this was achieved through an exchange. How is this not considered a purchase of more securities when one of those securities was fundamentally changed to a greater value through an exchange of items by both parties? Does anyone believe this is incorrect or was adequately refuted. 

 

Lastly, the argument about no injury occurring because there is the possibility of a 4th or 5th amendment that could undo the prior injury doesn't make any sense. If I steal something, my ability to return it does not mean that no injury has occurred until a point in time where it is definitively clear that I will not be returning it. Did this strike anyone as reasonable? If so, why?

 

[merkhet]

'Course we'll adapt. But we are still "adapting" to lower levels of leverage and the economy is slow as a result. 20% down with 6% rates would slaughter housing prices if implemented quickly (i.e. 5 to 10 years).

 

Agreed. We would probably adapt to 15% to 20% rates on housing. However, between 4% rates and 20% rates is a destabilization of the economy and lower housing prices, which affects the average American household, which uses their home as a form of savings.

 

Zach, I think you're mostly right, and I'll provide my thoughts on the memorandum opinion tomorrow.

[constructive]

It's clear that the net worth sweep makes solvency and rehabilitation an impossibility which is in direct conflict with their role as Conservator (right?). This would open the FHFA (and the Treasury by extension) to judicial review for being outside of it's role. Does anyone here disagree with this or think that this was adequately refuted?

 

Yes, since 2008 and especially since the third amendment I have viewed the companies as being in de facto receivership.

 

No, I don't think there is a good foundation for the bullish argument about what conservatorship should involve. HERA, the senior preferred stock agreements, FNMA and FMCC filings, and FHFA reports do not state or imply that that shareholders will receive any value from the conservatorship.

 

When FHFA is tasked with putting Fannie Mae in "sound and solvent" condition, that refers to the company, not the securities. The way they put the company in solvent condition was by impairing the existing securities (subordinating them to $188B in government equity), kind of like how bankruptcy can put companies into solvent condition by impairing the existing securities.

 

Unlike bankruptcy or receivership, the case law on corporate conservatorship is almost nonexistent. In some cases (insolvent credit unions for example), the term has been used interchangeably with receivership. The assumption that conservatorship means the company's value will be "returned" to shareholders, or that the conservator is required to act for the benefit of shareholders, does not appear to have solid precedent.

[brker_guy]

Very interesting comments by Tim Howard today:

 

http://timhoward717.com/2014/10/02/honorable-maxine-waters-defends-the-rule-of-law-%D1%81%D1%83%D0%B4%D1%8C%D1%8F-%D0%BB%D0%B0%D0%BC%D0%B1%D0%B5%D1%80%D1%82-forever-stained/

 

I have resoundingly confirmed that судья Ламберт Soviet-style ruling has slammed the door on any notion that private capital will ever replace Fannie and Freddie.

[morningstar]

Moreover, the Democratic administration will soon realize the following problem from that same article:

 

http://www.ft.com/cms/s/0/ad13e938-4290-11e4-847d-00144feabdc0.html#ixzz3EwrEdix5

 

Authorities are having to walk a fine line between encouraging private capital back into the mortgage market while ensuring availability of credit to less-than-pristine borrowers and simultaneously avoiding a repeat of the subprime bubble that brought the financial system to its knees in 2008.

 

Good luck doing that without at least some sort of financial backstop. Private markets will essentially perform an adverse selection issue for insurance -- the healthiest borrowers will get mortgages and everyone else will get nothing. I mean just look at how stringent the loan requirements are right now to get a mortgage. Pristine credit. Nothing else will do.

 

This administration literally just went over this with the Affordable Care Act. Same concept. In reverse.

 

This problem will be addressed more in the choice of the next AG and less in how the GSEs are treated.

 

There's no lack of private capital ready to enter the mortgage market - existing portfolios have been bid up to monster levels, there is huge demand across all forms of ABS driven by the Fed's liquidity. Do you really believe we can do $100bn in CLOs and not $1tn in RMBS? Especially if gov't backstops on senior tranches lower their cost.

 

The problems are not on the demand side but on the supply and origination sides - demand is weak because borrowers are already overleveraged and the job market remains thin, and origination is not functioning properly because the administration has put the banks in a position where a sold loan that goes bad - where you made a few hundred bps gain on sale - can create more than its face value in eventual losses. With lawsuits, the CFPB, the QM rules, etc. they have made originating any but the cleanest loans unappealing - even if the bank would love to own the loan once issued. Those restrictions have left the mortgage market still tight while all other forms of credit are back to the 2007 peak. It has little to do with how the GSEs continue to operate, in my view.

 

I think mortgage market would function fine if we remain in the status quo, with Fannie/Freddie continuing to operate and effectively nationalized, and I think the market would adapt fine and probably quite eagerly to the Corker/Warner proposal. That said, any proposal involving private capital, while easy to fund now at the peak of the market, will be much more cyclical than the pure GSE model. Not clear to me if this is a big problem when you consider the availability of other cycle-dampening measures including a much more aggressive Fed.