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

[Seahug]

It's quite possible FMCCL even at a low interest rate of 5 year CMT will still need to be converted to equity or called together with the other prefs. (All the prefs have call features though like FNMAS it's every 5 years.)

 

Even if reinstated, it does not qualify as Tier 1 capital under Basel III (came out in 2010 whereas FMCCL was issued in 1999).

 

https://www.bis.org/publ/bcbs189.pdf

 

11. Instruments classified as liabilities for accounting purposes must have principal loss

absorption through either (i) conversion to common shares at an objective pre-specified

trigger point or (ii) a write-down mechanism which allocates losses to the instrument at

a pre-specified trigger point. The write-down will have the following effects:

a. Reduce the claim of the instrument in liquidation;

b. Reduce the amount re-paid when a call is exercised; and

c. Partially or fully reduce coupon/dividend payments on the instrument.

 

[Guest cherzeca]

what is the relevance of Basel to what calabria will propose in final rule?

[Seahug]

As I understand it US fed supports Basel III.

 

US implementation

The US Federal Reserve announced in December 2011 that it would implement substantially all of the Basel III rules.[24] It summarized them as follows, and made clear they would apply not only to banks but also to all institutions with more than US$50 billion in assets:

"Risk-based capital and leverage requirements" including first annual capital plans, conduct stress tests, and capital adequacy "including a tier one common risk-based capital ratio greater than 5 percent, under both expected and stressed conditions" – see scenario analysis on this. A risk-based capital surcharge...

 

....As of January 2014, the United States has been on track to implement many of the Basel III rules, despite differences in ratio requirements and calculations.[26]

 

Source: https://en.wikipedia.org/wiki/Basel_III

 

If you are going to have sub debt/prefs in your capital structure, you may as well make it count towards Tier 1 capital.  They can decide not to call/convert the low coupon prefs, but if you are doing it for most of the prefs, you may as well clean up the whole thing.

[Guest cherzeca]

what does the fed have to do with the fhfa director?

[Guest cherzeca]

oral argument at scotus on the ACA reimbursement case:  https://www.scotusblog.com/2019/12/argument-analysis-justices-appear-sympathetic-to-insurers-in-dispute-over-risk-corridor-compensation/

 

not a direct comparison to GSE situation, but this involves govt financial "trickery" involving billions of dollars that congress failed to appropriate that a prior congress said it "shall pay" to insurers.

[Seahug]

what does the fed have to do with the fhfa director?

 

Nothing direct and I am no expert...but the Fed funded the GSE initial bailout immediately prior to FHFA, had a consultative regulatory role and after provided some financial support.

 

Basel III is voluntary but the member central banks (fed is a member) push compliance to what's practicable. I have seen many tenders for noncompliant prefs - leading to some capital gain for holders, and reissuance of T1 compliant ones.

 

So in short it's a guess  :)

 

 

[Guest cherzeca]

@seahug

 

fhfa Director Calabria said that new proposed capital rule to be released early 2020Q1.  we shall see.  but as the regulator who is bound by his own organic statute (HERA) as opposed to Dodd/Frank, I dont think the fed or Basel or the OCC or anyone else other than fhfa is in the drivers seat. remember, GSEs are not a bank, but a monoline insurer.  now, there are rules that apply, such as only noncumulative preferred count towards capital, but I dont see these rules as Basel or fed/dodd frank based.  the new fhfa proposed capital rule should spell all this out

[Seahug]

thanks chris

 

i own a little bit of FMCCL, maybe 10+% of my position. thought about switching. but i bought at a discount to other series. to swap with the bid/offer spreads i thought it's not worth it, even if reinstated and ends up at a large discount to other series.

 

there's something similar for BIII for insu cos, i believe treatment of T1 is similar

 

anyway i hope this investment works out. i need a good year next year...

 

appreciate the very intelligent ongoing commentary you provide

 

cheers!

[Luke 532]

SCOTUS decision on whether or not to take Collins pushed to January 10, 2020.  Attached.

[allnatural]

Q1 should be fun... Off the top of my head we have

• Sweeney unsealed ruling should be released by Jan which will make for great press i'm sure
  
• SCOTUS decision to take case Jan 10 (with oral arguments in March/April if accepted)
  
• FA should be announced in Jan (with the FA road map looking to be delivered by end of Q1)
  
• Capital rule to be released Early Q1 (im guessing more like Feb/Mar after FA is on board and can review)
  

Meanwhile the GSEs continue to build $5b-$7b of capital every Q.

 

Entering 2020 GSE pfds are up ~70% (~15% off the highs), with 2020 being make it or break it for "irreversible" admin action, and SCOTUS/lambert/sweeney trials all on deck (imagine this time last year saying shareholders are favored in not one but three separate cases!).

[Guest cherzeca]

I am not sure whether it is "better" for scotus to take cases...probably prefer they put a hold on them until collins district court enters a final order.  I dont like the way Alioto was so antagonistic against insurance companies in ACA oral argument

[allnatural]

Walk through the scenarios. If SCOTUS declines to hear the case at this stage, admin probably can accelerate a settlement with proper cover (their own briefing says they cant proceed w/ housing reform with the litigation outstanding). If SCOTUS takes the case and shareholders win by the summer, admin has the cover to settle and accelerate the recap via a ~$30b tax credit for the overpayment. If shareholders lose SCOTUS i'm guessing worse case a) there is no overpayment credit and b) its possible (but unlikely in my mind) that the admin will try to monetize a portion of the snr pfds in settlement. My takeaway is I don't see a horrible outcome in any 3 of those variations for PFD shareholders, outcome would more materially alter the common valuation.

 

I am not sure whether it is "better" for scotus to take cases...probably prefer they put a hold on them until collins district court enters a final order.  I dont like the way Alioto was so antagonistic against insurance companies in ACA oral argument

[Guest cherzeca]

I agree with your scenario analysis and if scotus takes up APA claim I certainly hope they also take up constitutional claim/remedy.  I just think net net, a good enough and safe scenario would be a hold until district court order.

[Eye4Valu]

I agree with your scenario analysis and if scotus takes up APA claim I certainly hope they also take up constitutional claim/remedy.  I just think net net, a good enough and safe scenario would be a hold until district court order.

 

Agree. Moreover, looking out to the 2020 elections, if the economy holds, the stable genius is likely to get reelected. Fed is holding steady. A trade deal with China and clawback of tariffs needs to take place, and probably will in some form. This leads me to believe that reelection is likely, and that irreversible administrative action, while favorable, may not be a necessity.

[Guest cherzeca]

the additional thing to be noted is that even if there is a complete loss at scotus (which I wouldn't expect but which is nonetheless certainly possible) there would still be Sweeney and Lambert trials to take place. 

[Luke 532]

Rosner's post today...

Hon Sweeney recognized shareholders have deriv claim, direct claim is w GSEs. Does @MarkCalabria, as Chair of @FannieMae & @FreddieMac, know he has an obligation to demand, or sue @USTreasury @stevenmnuchin1 to write-down liquidation pref as per contracts. Think Goodwill suits

 

...and Pagliara's response.

That is incredible insight- and provides the legal basis for the independent regulator to write down the liquidation preference.

[Midas79]

Rosner's post today...

Hon Sweeney recognized shareholders have deriv claim, direct claim is w GSEs. Does @MarkCalabria, as Chair of @FannieMae & @FreddieMac, know he has an obligation to demand, or sue @USTreasury @stevenmnuchin1 to write-down liquidation pref as per contracts. Think Goodwill suits

 

...and Pagliara's response.

That is incredible insight- and provides the legal basis for the independent regulator to write down the liquidation preference.

 

By what I understand of the PSPAs, FnF never had the ability to pay down the seniors any time they wanted, even if they had the money to do so. The important parts are in section 3(a) and 8(b) of the senior pref stock certificate.

https://www.fhfa.gov/Conservatorship/Documents/Senior-Preferred-Stock-Agree/FNM/Stock-Cert/Third-Amend-FNM-Stock-Cert-as-amended_09-30-2019.pdf

 

3(a) excerpt: Prior to termination of the Commitment, and subject to any limitations which may be imposed by law and the provisions below, the Company may pay down the Liquidation Preference of all outstanding shares of the Senior Preferred Stock pro rata, at any time, out of funds legally available therefor, but only to the extent of (i) accrued and unpaid dividends previously added to the Liquidation Preference pursuant to Section 8 below and not repaid by any prior pay down of Liquidation Preference and (ii) Periodic Commitment Fees previously added to the Liquidation Preference pursuant to Section 8 below and not repaid by any prior pay down of Liquidation Preference.

 

(b) “Liquidation Preference” shall initially mean $1,000 per share and shall be:

(i) increased each time a Deficiency Amount (as defined in the Preferred Stock Purchase Agreement) is paid to the Company by an amount per share equal to the aggregate amount so paid to the Company divided by the number of shares of Senior Preferred Stock outstanding at the time of such payment;   

(ii) increased each time the Company does not pay the full Periodic Commitment Fee (as defined in the Preferred Stock Purchase Agreement) in cash by an amount per share equal to the amount of the Periodic Commitment Fee that is not paid in cash divided by the number of shares of Senior Preferred Stock outstanding at the time such payment is due;   

(iii) increased on the Dividend Payment Date if the Company fails to pay in full the dividend payable for the Dividend Period ending on such date by an amount per share equal to the aggregate amount of unpaid dividends divided by the number of shares of Senior Preferred Stock outstanding on such date; and     

(iv) decreased each time the Company pays down the Liquidation Preference pursuant to Section 3 or Section 4 of this Certificate by an amount per share equal to the aggregate amount of the pay down divided by the number of shares of Senior Preferred Stock outstanding at the time of such pay down.

 

The optional paydown while the funding commitment exists can only apply to (ii) and (iii) of 8(b), which pertain to missing or partial past commitment fee and dividend payments. By contrast, it is part (i) that ballooned the liquidation preference from $1B to $187B. Since the funding commitment never terminated, the implication that FnF (represented by FHFA) can demand Treasury to write off the seniors isn't correct because FnF never had the option to pay down the seniors, even if the NWS had never happened.

 

If I understand the contract correctly, FnF's only real path out of conservatorship (other than receivership) was to get to a point where they could sell $187B worth of stock and put that money into paying off the seniors. While technically possible, this was a near impossibility in practical terms. It's the PSPAs themselves, not just the NWS, that is the concrete life preserver.

 

The funding commitment is very important going forward because it provides the limited (entity-level) government guarantee that the administration wants without having to go through Congress. Thus there can be no attempt to retroactively (or even prospectively) terminate the funding commitment to allow the paydown.

 

The upshot: Treasury must agree to write down the liquidation preference of the seniors. If the contract didn't allow for it, a court isn't likely to mandate it. That would make the gist of Josh's tweet incorrect: FHFA can't plausibly sue Treasury to write off the seniors.

 

Josh's next tweet, where he said "The contract is for principal plus 10%. That has been satisfied.", is also incorrect because the seniors are not debt. Dividend payments do not reduce their balance. The contract has no terms for being satisfied if FnF were to (and did) pay back all the Treasury draws plus 10%. If I remember some of the unsealed Fairholme discovery documents correctly, the reason that Treasury chose equity and not debt was to keep FnF in conservatorship more or less permanently, at least until Congress could deal the killing blow.

 

This also goes to the very core of the remedy that Judge Atlas will prescribe, assuming that the case ever gets that far. I think this is very important, and if I am correct about this then Atlas will not be able to order the seniors extinguished because it would violate the terms of the contract while the other proposed remedy (Treasury returns all past quarterly payments that exceeded the 10% dividend and keeps the seniors) does not.

 

The $125B number floating around is that overage: the amount that FnF would have right now if they kept all past NWS payments and paid the 10% dividend instead. The Collins plaintiffs said $122B and one more NWS payment happened after that. Hoewver, this assumes a 0% interest rate. Taking the time value of money into account, it's $148B at 3% and $179B at 6%. If Treasury decides to convert the seniors into common (which both accomplishes the recap in conjunction with this payment and gives Treasury a way to recoup the expense), they will want enough commons to cover everything they send out and then some. That means the higher the interest rate used, the more commons Treasury will want. This is the basis of my worst case for the commons; they could go well under $1 if Treasury has to shell out $180B and wants nearly all the common equity in exchange. This solution should actually appeal to everyone other than existing common shareholders, incidentally.

[onyx1]

I am correct about this then Atlas will not be able to order the seniors extinguished because it would violate the terms of the contract while the other proposed remedy (Treasury returns all past quarterly payments that exceeded the 10% dividend and keeps the seniors) does not.

 

 

If you are correct, then common shareholders are in for a shock because the baseline belief I've heard over the last 6 years is that the Srs magically disappear with the NWS.  Converting Srs to common is a potential disaster many common shareholders don't appear to be considering.  With warrant exercise common could be diluted to near nothing.  Common shareholders may be pinning their hopes on the fairness of Treasury and not even realize it.  If there is a sound predictable investment case for the common I don't see it, especially when the preferred wins in either scenario and are still available at 35% of par.

[Guest cherzeca]

this is not the real world guys.  if atlas orders a remedy of a $XXXB payment from treasury to GSEs, and treasury says it is impractical to write the check, then atlas doesnt shrug and say, next case.  the parties settle and the seniors are eliminated by a stroke of the pen.  if no settlement I suppose the GSEs can place a lien on all of the gold in Fort Knox for starters....

[Midas79]

this is not the real world guys.  if atlas orders a remedy of a $XXXB payment from treasury to GSEs, and treasury says it is impractical to write the check, then atlas doesnt shrug and say, next case.  the parties settle and the seniors are eliminated by a stroke of the pen.  if no settlement I suppose the GSEs can place a lien on all of the gold in Fort Knox for starters....

 

This isn't my point. I'm saying that if Atlas orders Treasury to make that huge payment, Treasury could just say okay and convert the seniors into enough commons to pay for that and then some. It's no harder than an SPO, right? I think this could be even cleaner than the other remedy.

 

Is my read of the contract correct, at least? I'm just trying to figure out what happens if Treasury resists the idea of writing off the seniors. Josh seems to think that Calabria should move things along by suing Treasury for just that, and I'm saying that it isn't possible.

[Guest cherzeca]

"This isn't my point. I'm saying that if Atlas orders Treasury to make that huge payment, Treasury could just say okay and convert the seniors into enough commons to pay for that and then some."

 

ok, so you are saying treasury writes GSEs a check for $XXXB...which, lets assume, is enough to fully capitalize GSEs.  treasury and GSEs work out a deal by which treasury converts its senior prefs into common, and exercises its warrants to boot.

 

then everyone goes home.

 

I suppose that would be possible, and I suppose the common would be upset, though the juniors would be money good.

 

and I give this scenario about a 1% chance of occurring in the real world.  treasury will be rather long GSEs common with a huge overhang and would have to sell it off in drips and drabs over the next decade.

 

edit:  to summarize, I think this scenario only increases treasury's investment in GSEs rather than reduces it.

[allnatural]

Mnuchin has always said his main two priorities for housing finance reform is 1) reduce taxpayer risk and 2) preserve liquidity for the 30 year mortgage  Increasing taxpayers equity exposure contradicts #1

[WB_fan82]

Hi Midas,

 

I really appreciate your detail oriented and even-keeled analysis on this board.  Thank you!

 

In your scenario, the government would own > 80% of the common shares outstanding.  A lot has been written/speculated about why the government couldn't own > 80% of the common (hence why the warrant is limited to pro forma ownership of 79.9% of shares out at time of exercise).  Do you have any thoughts on whether there are real impediments to owning > 80%?

[Eye4Valu]

The bifurcation in views between preferred and common makes me laugh. Ackman thinks the common are the fulcrum security, while others view them as toilet paper. I guess we'll find out.

[Luke 532]

" No redactions requested. This is a sure sign of administration's commitment to reform, recap, relist and release. "

 

Bloomberg Intelligence attached...