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

[Wiggins]

there would seem to be some dynamic interactions going on behind the scenes. SM has right to consent to release from C under SPSA if there are SP outstanding. MC wants to do some kind of consent decree exit out of C before he gets canned. so if SM writes down SP, he gives MC free rein. why should SM care what MC does?  beats me. I personally think SM is getting around to doing what he wants to do when he wants to do it...it is a form of power.  if I had to bet, I would bet this gets done at last moment, because SM is feeling his oats on the way out

 

wrong. the case in front of SCOTUS will play out, so continued limbo until that ruling. (except allowing increase in retained capital with increase in liquidation preference of SPS)

this sentiment is similar to thinking SCOTUS was going to take the Texas suit against PA, WI, MI, GA

[typicalvalue]

 

Great slide deck summarizing the investment.

[Guest cherzeca]

 

Great slide deck summarizing the investment.

 

yes,, this is quite good. everyone on this thread could profit from reading this, even if it won't be news to many...very comprehensive.

[WB_fan82]

Yes, COBF.  I see a lot of wishful thinking on the boards.  But like Midas pointed out, what else would I expect?  It's just weird owning something and being surrounded by fellow holders that I think have several pairs of rosy glasses on...

 

On FHFA acting in its own interest, it's irrelevant whether we think it did.  All that matters is that FHFA could make a colorable case that they did.  And, unfortunately, they can.  It's their judgment, not ours.  It doesn't have to be a good or correct judgment either.  FHFA makes the call for what is in its interests, not us.  And perhaps not a judge, either.  Sad but true.

 

I also hate to be the bearer of bad news that the lawsuits are not a factor to SM.  Winning the lawsuit just means the TSY owes $120B back to the GSEs.  It's not even a bad thing to accelerate the recap in that way.  Nor is it a problem for new capital.  The lawsuits that would be a problem would be lawsuits where a plaintiff win would drain assets out of the GSEs, but Collins and others don't do that.  They are suing the government, not the GSEs.  The only problem the lawsuits really pose is that it makes a TSY exchange more difficult b/c if they get new common shares and therefore claim a bigger % of the $125B overage it's another nightmare of lawsuits about the TSY taking the economics of the overage through its additional ownership.

 

And eventually people will realize that no self respecting centimillionaire is going to abdicate his duties and do an embarrassing and pathetic forgiveness of the senior preferred.  It's just so weak sauce when the same objective could have been obtained with a few simple moves in a broader recap (settlement, exchange into common, etc)

 

I also think, sadly, that a jr pfd conversion into common is the final piece of the puzzle, not the first piece.

 

The investments still work.  I think even in a retained earnings scenario these guys are fully recapped with capital raises in 5 years if there is any sort of legislative stability.  The companies are simply far too valuable.

 

It just seems to me that the commons work better.  Basically the same downside by far greater upside.

 

Just sort of waiting and hoping for SM not to just remove the buffers.  Keeping the NWS in place or a cumulative 10% dividend makes it really, really hard to raise that external capital or makes the retained earnings train creep along at 3 mph.

[orthopa]

Yes, COBF.  I see a lot of wishful thinking on the boards.  But like Midas pointed out, what else would I expect?  It's just weird owning something and being surrounded by fellow holders that I think have several pairs of rosy glasses on...

 

On FHFA acting in its own interest, it's irrelevant whether we think it did.  All that matters is that FHFA could make a colorable case that they did.  And, unfortunately, they can.  It's their judgment, not ours.  It doesn't have to be a good or correct judgment either.  FHFA makes the call for what is in its interests, not us.  And perhaps not a judge, either.  Sad but true.

 

I also hate to be the bearer of bad news that the lawsuits are not a factor to SM.  Winning the lawsuit just means the TSY owes $120B back to the GSEs.  It's not even a bad thing to accelerate the recap in that way.  Nor is it a problem for new capital.  The lawsuits that would be a problem would be lawsuits where a plaintiff win would drain assets out of the GSEs, but Collins and others don't do that.  They are suing the government, not the GSEs.  The only problem the lawsuits really pose is that it makes a TSY exchange more difficult b/c if they get new common shares and therefore claim a bigger % of the $125B overage it's another nightmare of lawsuits about the TSY taking the economics of the overage through its additional ownership.

 

And eventually people will realize that no self respecting centimillionaire is going to abdicate his duties and do an embarrassing and pathetic forgiveness of the senior preferred.  It's just so weak sauce when the same objective could have been obtained with a few simple moves in a broader recap (settlement, exchange into common, etc)

 

I also think, sadly, that a jr pfd conversion into common is the final piece of the puzzle, not the first piece.

 

The investments still work.  I think even in a retained earnings scenario these guys are fully recapped with capital raises in 5 years if there is any sort of legislative stability.  The companies are simply far too valuable.

 

It just seems to me that the commons work better.  Basically the same downside by far greater upside.

 

Just sort of waiting and hoping for SM not to just remove the buffers.  Keeping the NWS in place or a cumulative 10% dividend makes it really, really hard to raise that external capital or makes the retained earnings train creep along at 3 mph.

 

Your not the bearer of bad news. Your driving blind and guessing yourself FWIW. As I mentioned before we are all allowed an opinion as we are each on the outside looking in on this. That being said major pieces of what you typed go against nearly everything those in charge, Mnuchin(phillips), Calabria, Otting etc have said. Like I said before if nearly everything they have said was a lie I would agree with nearly every one of your opinions. We are all still of course still waiting to see if those mentioned above spent 2-3 years lying. If so fuck me and fuck them I guess.

 

The one thing I still really dont understand is your thought that Jr Preferred get converted at the end. What's the purpose of that point and how do you get the 2/3rds majority to convert if not very favorable? Unless the GSEs retain capital exclusively for years capital will need to be raised which I think most agree with. New money may very well demand a dividend and I think the exclusions in the capital rule realize this. So how do you presumably raise new common with the very real possibility of a dividend for those issued shares but have a defaulted capital stack with no dividend paid on preferred? If your assumption is the preferred will get paid a dividend to not have a defaulted capital structure then assuredly they would trade at par or close if not higher with some at 7%+ rates in this environment. So if I have a preferred paying a div (because common will pay one to raise new $$$) that is trading over par, why the hell would I convert to common and lose a 20-30% div rate on cost?

 

My other question is assuming FnF are released on CD (maybe they wont and Calabria lied, Mnuchin lied to congress, the capital rule text is misleading/lied, and the FHFA/Treasury letter to congress earlier this year lied) then the financial advisors, the CEOs, boards etc are going to be incentivized to raise money ASAP and in large amounts. I dont see a slow recap high on the list of priorities for JPM, MS, the boards, and the CEOS. They are completely incentivized otherwise and frankly everyone is BESIDES the common holder. So anyway getting to my point JPM and MS no doubt see the preferred value counting towards capital once converted explicitly laid out in the capital rule and they just sit on it? 33B worth and they just sit on it for a couple years and then try to convince preferred holders close to if not getting a dividend to convert away from that?  And when exactly do they convert it then? When there is 33B left to get out of consent decree?

 

Id like to hear your opinion on why preferred get converted last? How you parse through the dividend discussion along the lines of what I describe above against the capital rule discussion of dividends?  What's your trigger at the end to convert? Waiting to need 33B to get out of consent decree? How do you incentivize or why would a preferred holder convert assuming divs are turned on? And if divs are not turned on at the end before conversion why? ie why not just sit tight and wait for your 20-30% on cost to turn on?

 

And to round it out how it makes any more sense then just doing it unannounced based on a previous 30 day trading range and completely avoiding the dividend discussion entirely and clearing the capital structure for new assumable convertible preferred?

[COBFInfinity]

I agree with Orthopa that preferred exchange makes no sense at the end of recap. It may not be at the start, but that just means the middle, not the end.

 

I'm not sure why the investment bankers' desire to get paid should influence how fast the GSE's raise capital. I'm sure they're persuasive, but GSE management needs to make those decisions.

[typicalvalue]

Mark Calabra interviewed in 1/2 weeks by Tim Rood On the hill. Good hint that things will happen before that interview

[WB_fan82]

The prefs go at the end for two very simple reasons.  First:  what they are replaced with, i.e. selling other prefs, can only happen at the end.  Second:  doing it early accomplishes nothing.

 

You should also consider how exchanges happened in C as a real world precedent.  There was a huge package of exchange offers across several security classes - preferred, and trust preferred --  to recapitalize into common equity in one huge corporate event.  That happens at the end, when the end product is clarity and certainty. 

 

For example, the GSEs could extend a similar exchange offer to hundreds of billions of agency corporate bonds issued at the same time it does for the prefs.  There are mountains of capital available in the stack.  It's just about getting TSY out of the picture.  That's why I love this investment.  But it does not happen in a weird series of one-offs.  Exchanging the pfd first in a vacuum accomplishes jack squat.  And the capital they need will not be done in one huge stock placement either - it's too big and see below --  so this idea that getting jr pfd out of the way first is a precondition to raising external common is bogus.  The jr pfd has no leverage and no say.  The board of dirs, outside of c-ship, would only consider minimizing common dilution not giving the jr pfd a nice IRR.  That's more ammo for it happening at the end, when the dilution is lower into common by virtue of retained earnings and reflexivity.

 

Before we get to the end, several areas of uncertainty need to be resolved:

 

1.  political and legislative certainty/stability re: the GSEs.  This includes what happens to the FHFA, and may span Constitutional ruling in Collins.

2.  earnings power post PSPSA amendment restrictions

 

 

 

[COBFInfinity]

The prefs go at the end for two very simple reasons.  First:  what they are replaced with, i.e. selling other prefs, can only happen at the end.  Second:  doing it early accomplishes nothing.

 

Your view appears to be that existing preferreds will be called with proceeds of new preferred sales.

 

I think this is very wrong for three very simple reasons.

 

First: The capital rule strongly encourages increasing common equity capital over preferred, so it makes sense to transfer preferred capital to common capital bucket.

 

Second: Since preferred has lower value in reaching capital targets, total preferred outstanding is likely to be lower post-recap than it is today. If true, your view means that additional common equity needs to be sold to redeem preferred stock. Why would the GSE's want to add additional amounts to raise in the market when they could just do an exchange?

 

Third: A couple of the largest preferred issues are not callable at will. For example, FNMA Series S (FNMAS) has a 7.75% dividend and can only be called every 5 years on 12/31. Today was a potential call date - the next won't be until 12/31/2025. This is a huge $7 billion issue and FNMA has no intention to every start paying 7.75% on these again. So unless these call dates magically align with other recap timing, they need to be removed from the capital structure well before dividends are turned back on.

[Midas79]

The prefs go at the end for two very simple reasons.  First:  what they are replaced with, i.e. selling other prefs, can only happen at the end.  Second:  doing it early accomplishes nothing.

 

You should also consider how exchanges happened in C as a real world precedent.  There was a huge package of exchange offers across several security classes - preferred, and trust preferred --  to recapitalize into common equity in one huge corporate event.  That happens at the end, when the end product is clarity and certainty. 

 

For example, the GSEs could extend a similar exchange offer to hundreds of billions of agency corporate bonds issued at the same time it does for the prefs.  There are mountains of capital available in the stack.  It's just about getting TSY out of the picture.  That's why I love this investment.  But it does not happen in a weird series of one-offs.  Exchanging the pfd first in a vacuum accomplishes jack squat.  And the capital they need will not be done in one huge stock placement either - it's too big and see below --  so this idea that getting jr pfd out of the way first is a precondition to raising external common is bogus.  The jr pfd has no leverage and no say.  The board of dirs, outside of c-ship, would only consider minimizing common dilution not giving the jr pfd a nice IRR.  That's more ammo for it happening at the end, when the dilution is lower into common by virtue of retained earnings and reflexivity.

 

Before we get to the end, several areas of uncertainty need to be resolved:

 

1.  political and legislative certainty/stability re: the GSEs.  This includes what happens to the FHFA, and may span Constitutional ruling in Collins.

2.  earnings power post PSPSA amendment restrictions

 

Do you think new commons can be issued while the juniors still exist but without turning dividends on?

 

Another argument: boiled down, the economic value of common shares comes from its liquidation and dividend preference. New commons would rather have less of each in front of them, so they should actually insist on the juniors being converted first, especially because it costs the companies no money. Otherwise they will pay less for their shares than without the conversion.

 

And another: the capital rule leaves no room for new pref issuance. That means if the juniors stay in place, all capital raises must be all common shares. If new investors buy commons while the juniors exist, they will know that if FnF want to raise capital later, it will either be more common shares (dilution) or via converting the juniors and issuing new prefs (dilution). That specter of future dilution will also serve to lower the offering price.

 

Note that Citi offered its pref stock exchange both for the express purpose of increasing tangible common equity (equivalent to CET1) and while it supposedly owed a fiduciary duty to the common shareholders. There is absolutely precedent for FnF doing something similar.

 

There are three things that can be done with the juniors: leave them as-is, redeem them for full par in cash, or convert them to commons. Redemption makes by far the least sense because it accomplishes the same capital stack-clearing goal as conversion but costs $33B more in cash at a time FnF need to be building capital. Redemption is completely off the table. Refinancing the juniors adds zero capital. Converting the juniors and then selling $33B of new ones adds $33B of capital.

 

CET1 capital requirements, along with the zero room for new prefs while the juniors exist, means that a debt-for-equity swap with the purpose of recapping FnF just results in as much dilution as a huge re-IPO would.

[Guest cherzeca]

"Third: A couple of the largest preferred issues are not callable at will. For example, FNMA Series S (FNMAS) has a 7.75% dividend and can only be called every 5 years on 12/31. Today was a potential call date - the next won't be until 12/31/2025. This is a huge $7 billion issue and FNMA has no intention to every start paying 7.75% on these again. So unless these call dates magically align with other recap timing, they need to be removed from the capital structure well before dividends are turned back on."

 

why FNMAS is a smart JP investment

[COBFInfinity]

"Third: A couple of the largest preferred issues are not callable at will. For example, FNMA Series S (FNMAS) has a 7.75% dividend and can only be called every 5 years on 12/31. Today was a potential call date - the next won't be until 12/31/2025. This is a huge $7 billion issue and FNMA has no intention to every start paying 7.75% on these again. So unless these call dates magically align with other recap timing, they need to be removed from the capital structure well before dividends are turned back on."

 

why FNMAS is a smart JP investment

 

Maybe, maybe not. I've never been willing to pay up for that feature as I'm not sure it does any better in an exchange offer than, say, FNMAG. FNMAG has a 5.38% dividend and trades 5% less in par value and 18% less in market price. Perhaps there are scenarios where FNMAS comes out better than FNMAG, but I just don't see it being worth that premium.

[COBFInfinity]

P.S. As I mentioned a few weeks back, I think it's CRAZY that the various preferred series that have floating rates sub 0.50% right now are trading at such modest discounts to the fixed rate preferreds. Absent a settlement with plaintiffs that requires an exchange offer on those series at comparable terms to the other series (which I no longer think is very likely), there is no economic argument for the GSEs to retire those. Post-recap, with dividends turned on, what will they trade at? Maybe 50-60% of par? Seems like a really bad bet to me vs. swapping into fixed rates.

[COBFInfinity]

P.S. As I mentioned a few weeks back, I think it's CRAZY that the various preferred series that have floating rates sub 0.50% right now are trading at such modest discounts to the fixed rate preferreds. Absent a settlement with plaintiffs that requires an exchange offer on those series at comparable terms to the other series (which I no longer think is very likely), there is no economic argument for the GSEs to retire those. Post-recap, with dividends turned on, what will they trade at? Maybe 50-60% of par? Seems like a really bad bet to me vs. swapping into fixed rates.

 

Quickly skimmed through the list of variables on QuantumOnline. FNMAO has the worst terms, paying 2-Year Tsy - 0.18%, which results in -0.06%, but luckily with a floor of 0%, of course. If FNMA preferreds were recapped and paying dividends right now, how much would you pay for this one? Yet, the most recent trades have been at the same level as other series with rates of 4.5-6.0%. I don't get it.

[Guest cherzeca]

I was interested in liquidity and potential for a favorable exchange offer.  FNMAS provides that, yes, at a premium

[WB_fan82]

To be clear, my view is that the jr pfd WILL be exchanged into common.  It's just that this will happen at the end, when the GSEs can go out and raise the equivalent in external preferred to replace them.  That last slug of new capital will be to get them fully capitalized.  Not as an early step in the road. 

 

And I do think the companies would be wise to extend a similar exchange offer to all the GSE bonds.  Accomplishes the exact same goal.  That would be done at the same time.  Just can't do this early when there isn't enough certainty on the value of the common vis a vis earnings power and, most importantly, political uncertainty.

 

It also has the benefit of minimizing dilution.  The stock prices of the GSEs after 1-2 years of truly retained earnings will be 100 - 300% or more higher than they are today.  That's not a primary objective of the GSE board, but it's a nice-to-have.

[WB_fan82]

Midas:

 

They certainly can.  I also think they _would_ in some circumstances, like to raise an amount of capital that would get them out of cship and qualify for a consent order.  Common shareholders do NOT need to receive a dividend for this to happen.  I can point to a hundred billion dollars raised in 2020 by companies that not only don't pay dividends but don't generate positive earnings.  Investors aren't dumb, it's all about the future.  No need for a dividend this minute.

 

Common shareholders don't care about liquidation preferences.  These are going concerns.  It's just about the earnings power and how much of that flows to the common.  With non-cum prefs, it's 100%.  Whether retained earnings or not, it's irrelevant.  Here's an example to show how little leverage the prefs have... The companies can retain earnings for a decade and pay nothing to the prefs.  Then after 10 years, they can turn on the pref dividends, and pay a 10 year special div to common.  Then turn off the pref divs and wait another 10 years.  Does this happen in the real world?  No.  But it just emphasizes the point that the prefs are along for the ride and someone else is driving the bus.

 

On dilution:  not really.  The earnings retention rate is so fast that it trumps dilution from the preferred.  And some of these preferred are big enough coupons that the dilution ends up being quite small, really.  This gets into reflexive math.  It's amazing how little dilution there can be when the common shares are $5, $10, $15 in 1 - 4 years.  It's a lot like GGP.  Once there is some certainty on the path up, look out above.  And it becomes a virtuous cycle, not a vicious one.  B/c there is no urgency to do those prefs early with the commons relatively low (at < 1x earnings ballpark), we won't see the vicious cycle.

 

Yes, I think FNF should do the C exchange on financial steroids.  Don't stop with the prefs.  Offer all the way to the bonds.  I forget if C went past the trust pfd into the actual corporate sub debt.  But remember, this big bang happens after earnings clarity, after political certainty, and at a point where the common are far higher than today.  Also remember that the common is trading at < 1 PE.  One year of retained earnings is a double to the stock.  And that's a halving of the dilution.  The dilution function falls really, really fast.  That's why it's really important when judging prefs vs common to think about the order of things.

 

 

[Midas79]

Midas:

 

They certainly can.  I also think they _would_ in some circumstances, like to raise an amount of capital that would get them out of cship and qualify for a consent order.  Common shareholders do NOT need to receive a dividend for this to happen.  I can point to a hundred billion dollars raised in 2020 by companies that not only don't pay dividends but don't generate positive earnings.  Investors aren't dumb, it's all about the future.  No need for a dividend this minute.

 

Common shareholders don't care about liquidation preferences.  These are going concerns.  It's just about the earnings power and how much of that flows to the common.  With non-cum prefs, it's 100%.  Whether retained earnings or not, it's irrelevant.  Here's an example to show how little leverage the prefs have... The companies can retain earnings for a decade and pay nothing to the prefs.  Then after 10 years, they can turn on the pref dividends, and pay a 10 year special div to common.  Then turn off the pref divs and wait another 10 years.  Does this happen in the real world?  No.  But it just emphasizes the point that the prefs are along for the ride and someone else is driving the bus.

 

On dilution:  not really.  The earnings retention rate is so fast that it trumps dilution from the preferred.  And some of these preferred are big enough coupons that the dilution ends up being quite small, really.  This gets into reflexive math.  It's amazing how little dilution there can be when the common shares are $5, $10, $15 in 1 - 4 years.  It's a lot like GGP.  Once there is some certainty on the path up, look out above.  And it becomes a virtuous cycle, not a vicious one.  B/c there is no urgency to do those prefs early with the commons relatively low (at < 1x earnings ballpark), we won't see the vicious cycle.

 

Yes, I think FNF should do the C exchange on financial steroids.  Don't stop with the prefs.  Offer all the way to the bonds.  I forget if C went past the trust pfd into the actual corporate sub debt.  But remember, this big bang happens after earnings clarity, after political certainty, and at a point where the common are far higher than today.  Also remember that the common is trading at < 1 PE.  One year of retained earnings is a double to the stock.  And that's a halving of the dilution.  The dilution function falls really, really fast.  That's why it's really important when judging prefs vs common to think about the order of things.

 

The no-div, no-earnings companies are completely inapposite comparisons to FnF because the former are high-growth companies, while FnF are closer to utilities. Utility investors primarily care about income. So in the end I just plain disagree on this point. I still think new investors will want immediate dividends.

 

Liquidation preference determines how much earnings power flows to the commons. If, hypothetically, there was $1T of liquidation preference ahead of the commons, they would trade at pennies.

 

The retained earnings rate really isn't that fast. By the end of the five-year period that Fannie and Freddie want for full compliance with the capital standards, the with-buffer minimum capital standard will be $300B ($265B in 2020 grossed up at 2.5% per year). In five years they will still be around $150B short of that with retained earnings. New investors putting in $150B of commons will want at the very least a controlling stake, and I think they will want more like 3/4 of the equity. That doesn't leave much for the existing commons, especially with Treasury's warrants taking up 4/5 of what new investors don't get.

 

I maintain that third-party capital must be raised, it will be raised in the next 12-18 months, and that the juniors will either have their divs turned back on or be offered a generous conversion to common at that time because it aligns with incentives for FHFA/UST/new investors and only harms existing commons (which nobody cares about). You evidently disagree with that, but at this point we seem to just be talking past each other regarding that.

 

And you're just making an assumption that the commons will explode later, which drives your "virtuous cycle". If the coming PSPA amendment says that FnF have to pay a commitment fee based on their capital levels, with the fee being large while capital levels are low (as they are now), then not only would retained earnings alone take multiple decades, it also incents FnF to perform larger capital raises rather than smaller, and sooner rather than later. That leads to a much lower offering price, and if the fee is high enough the commons could actually drop on the announcement. If I had a dollar for every future high common price prediction that didn't come true I could recap FnF myself.

 

I do think the commons will take off faster than the prefs once the PSPA amendment is finally announced, but how the terms affect the commons will quickly sink in. A good trading opportunity, perhaps, but we're talking long-term value here.

 

The P/E of the commons right now means nothing because the final share count is hard to estimate and will certainly be far higher than it is now. If one year of retained earnings should double the stock price, why hasn't it doubled in the last year when FnF have been retaining their earnings the whole time? It doesn't work that way.

[Guest cherzeca]

"I do think the commons will take off faster than the prefs once the PSPA amendment is finally announced, but how the terms affect the commons will quickly sink in. A good trading opportunity, perhaps, but we're talking long-term value here."

 

the robinhood effect will pump common for awhile, then off the robinhoobders go to their next escapade.  if you are nimble, there may very well be a trading opportunity there. not my style, not nimble

[WB_fan82]

Midas:

 

Re: divs.  Look at the wireless sector.  VZ and T pay divs.  TMUS pays zero divs.  Same businesses.  Large TMUS investors even placed a ton of stock into the market.  There are no dividends (or even buybacks) happening at TMUS.  Same with certain utilities.  That basically proves investors don't need a dividend to invest.

 

Re: liquidation preference, that's not true with going concerns.  The liquidation preference is irrelevant if/when the prefs are non-cumulative, which the jrs currently are and the srs are likely to be (imo) after a PSPA amendment.  I gave you the example to prove the point... don't pay a div for X years to the pfd, then turn it on for a quarter or two and pay a huge special div to the common, then turn them off again.  The liquidation preference doesn't mean anything when the value of a company is the present value of future cash flows AND being non-cum entitles the pfds to a very discretionary trickle of those cash flows.

 

The reason the common haven't doubled in the past year on retention is very simple!  There hasn't been retention.  As you know, the sr liquidation preference goes up b/c the sr pfd is cumulative and the dividend is still the entire net worth sweep.  Candidly, the entire notion of the GSEs "raising capital" this way seems fraudulent since the sr pfd doesn't count as capital and the higher liquidation preference isn't even on the equity statement in the SEC filings.  I have no idea how they are allowed to do that.  But the real economics of that are why the common are sitting here.  Now next year, assuming a PSPSA that means actual CET 1 economic capital retention, the common will quickly rise over time with earnings retention.

 

Yes, I do assume the commitment fees won't be absurd.  If they are anything like FDIC premiums, they should be reasonable.  A normal committed bank line for something like that would run < 1% per year on the undrawn amount.  That still leaves huge earnings retention.

 

The P/E of the common right now is just telling you how coiled the spring is.  At < 1x P/E, or 1.5x P/E with a tough backstop assumption, earnings start to recap very quickly.  And as the price of the common shares rise, the amount of shares to issue falls dramatically.  The spring is very coiled down here.

 

But it still comes down to Mnuchin.  I don't think any bad outcomes if we get real action, by which I mean simply TSY keeps the sr, goes back to 10%, makes it non-cumulative, passes consent decree approval to Calabria (perhaps requiring meeting at least statutory requirements first), adds a backstop, throws some other changes in based on the plan, and calls it a day.  Then barring Congress moving, the snowball has been pushed off and in 3 - 5 years earnings + external capital that snowball will be a snow moon.

 

 

[Midas79]

@WB_fan

 

[*]I don't buy the TMUS comparison. They aren't a utility the way FnF will be, and neither are VZ or T. Each of those has the potential for rapid growth with the right innovation and/or major mistake by competitors. Those can't happen with FnF, especially with the CSP in place. FnF are a duopoly with no realistic way to be threatened by a competitor, especially with Calabria's high capital standards. The specter of 2008 will also prevent them from getting to innovative because FHFA will be quick to step in. Calabria has already said he wants approval power over new products. These factors limit growth to roughly that of the housing market, which increases investor demand for income. And what exactly are the "certain utilities" you refer to? In my opinion, to be comparable to FnF these utilities need to be monopolies/duopolies and have relatively limited prospects for future growth.

[*]Even if dividends aren't offered immediately, the offering price will be lower without dividends than with. That means more dilution, so in the quest to deny value to the juniors, the existing commons would be cutting off their noses to spite their faces. Earlier capital raises also provide more stability to the housing market and taxpayer protection than later ones, so the idea that FnF could just build earnings and not raise capital until 2023 or later is, to me, just a fantasy. It works against the incentives of both FHFA and Treasury, even when they are led by Biden's picks.

[*]Of the economic value shares have, only liquidation preference and dividend preference vary with the health of the company as measured by the balance sheet. Take a company with essentially no going-concern problems like Apple. If they were to receive a $5B check then the stock price would go up, but the only real change would be an increase of liquidation preference attributable to common shareholders. A similar but opposite effect would happen if $5B suddenly disappeared. Liquidation preference absolutely matters outside of liquidation when it comes to stock value. You even agree with this: you argue that FnF's stock price should rise as they retain earnings. All the retention of retained earnings does is increase the liquidation preference of the commons.

[*]A much more relevant time when liquidation preference matters is in a restructuring of the capital structure. That is exactly what it going to happen with FnF.

[*]The idea of special dividends to common while trying to shaft the juniors (by not paying their dividends before or after the special dividend) is pure wishful thinking. It's possible in the sense that winning the Powerball is possible, and it doesn't prove any point at all. FnF could just as easily turn on junior dividends and keep common dividends off instead.

[*]Yes, there absolutely has been retention over the last year. Just look at the balance sheets. FnF haven't paid Treasury a dividend since September 2019. The liquidation preference increase to the seniors will be unwound when the seniors themselves are resolved (either by writing them off, converting to common, or some combination of both). That won't remove the retained equity from the balance sheet. What you appear to have missed is that the liquidation preference increases due to the retention of earnings don't show up on the balance sheet. Go look at the balance sheet from Q3 2019. The senior pref amount is the same as it is now. FnF's capital has been rising as they have retained earnings. And the stock price hasn't moved much.

[*]The increase in senior liquidation preference has nothing to do with their cumulative nature. It has to do with the wording of the PSPA and senior pref stock certificate contracts.

[*]The reason the senior pref balance on the balance sheet hasn't risen due to the letter agreements is because when it ballooned in 2008-2012, FnF was receiving cash from Treasury. That had to be accounted for somehow, and it was done by increasing the senior pref line on the balance sheet. This also undercuts your argument that liquidation preference only matters in a liquidation. If that were true, why would Treasury consider the liquidation preference increase to have any value at all? That's the consideration they received in return for allowing FnF to retain more earnings.

[*]As such, I think the current P/E reflects just how much uncertainty there is over the final share count, not the amount of capital FnF have (which really has been steadily rising for the last year, again, check the balance sheets). There are 1.8B shares out there for FnF combined, but I can easily see it expanding to 30B or more depending on warrants, junior conversion terms, and capital raise size/timing.

[*]If the seniors are converted to other shares it will have to be commons, not non-cumulative prefs. With that level of non-cumulative prefs on the balance sheet ($193B worth), capital raises will be impossible. That not only closes off common dividends in the immediate term, it does so until the seniors are gone, otherwise the senior dividends would eat up all of FnF's income. It's one thing to say that new common investors won't want immediate dividends. It's quite another to say that they will be okay not receiving one for a decade.

[*]The other reason the seniors would have to be converted to commons is the presence of a CET1 capital standard, and the fact that both buffers must be comprised entirely of CET1 capital. No prefs, not even non-cumulative ones, count towards that.

[*]The commitment fee might be absurdly high while FnF have low capital amounts. I also expect something reasonable (FDIC-like) once FnF are fully capitalized, but not necessarily before then. Also, once the seniors are gone FnF's credit lines will revert back to $200B per company, unless FHFA and Treasury negotiate a different amount (which might be even higher, and could be sized differently for each GSE). 1% of that per year is $2B per company, which represents a roughly 17% drop in earnings for Fannie and 25% for Freddie.

[*]As I explained above, I don't think converting the seniors to non-cumulative allows third-party capital to be raised. Mnuchin specifically mentioned third-party capital, so I can't see him taking some steps that would allow that to happen but not all of them.

[*]Why does the re-IPO price have to depend on the then-current market price of the commons at all? The new investors will have a good idea of FnF's earnings power (in fact they already should), and thus they will know how much of the equity they will demand in return for their money. For example, if they are asked for $100B and estimate the market cap to be $250B (both numbers FnF combined), they will demand 40% of the equity at a bare minimum, and in my opinion they will want a good bit more. None of that depends on the market price of the commons.

[Midas79]

To be clear, my view is that the jr pfd WILL be exchanged into common.  It's just that this will happen at the end, when the GSEs can go out and raise the equivalent in external preferred to replace them.  That last slug of new capital will be to get them fully capitalized.  Not as an early step in the road. 

 

And I do think the companies would be wise to extend a similar exchange offer to all the GSE bonds.  Accomplishes the exact same goal.  That would be done at the same time.  Just can't do this early when there isn't enough certainty on the value of the common vis a vis earnings power and, most importantly, political uncertainty.

 

It also has the benefit of minimizing dilution.  The stock prices of the GSEs after 1-2 years of truly retained earnings will be 100 - 300% or more higher than they are today.  That's not a primary objective of the GSE board, but it's a nice-to-have.

 

The $50-par fixed-div prefs trade at around $15.00, which represents a 6.25:1 ratio to the commons (give or take). That means if they are eventually converted at par and at the market price of the common, the commons will have to be at $8 ($50 / 6.25) at that time in order for owning commons now to be better. That would be a 233% gain from here, greater than the median of your range. So owning commons now requires an assumption that the top end of your range will be hit.

 

It also assumes both that the prefs won't get dividends between now and then (increasing the overall return of the prefs and their market price; 6% FnF prefs should trade above par) and that earlier capital raise participants won't insist on the juniors being converted first, which they have every reason to do because otherwise $33B more of commons would have to be raised later due to the CET1 capital standard.

 

In the end, nobody involved, not even the boards or UST, is going to take steps specifically to lower the amount of dilution. There's just no benefit to that other than to existing common shareholders, who truly have no voice or no say in this process.

[Midas79]

@WB_fan

 

One more thing. I do appreciate your continued posts, even though I disagree with much of the content. At the very least this allows me to crystallize my thinking by putting it in writing (as well as exposing it to outside criticism); I don't consider trying to change your mind to be a goal of mine.

 

In the end, the disagreement is motivated by differing opinions of whether the commons or juniors are a better investment from this point forward. You see similar downsides for both and more upside for the commons, while I see similar upsides for both and more downside for the commons. This is primarily fueled by disagreements over when capital will be raised and when dividends will resume (you say later, I say sooner). This summary is for those who don't feel like reading through my longer posts because I have always erred on the side of post length.

[COBFInfinity]

• If the seniors are converted to other shares it will have to be commons, not non-cumulative prefs.
  

 

Then Tsy owns more than 80% of common and GSE liabilities get added to U.S. Gov't debt. Is that a plausible scenario?

[Midas79]

• If the seniors are converted to other shares it will have to be commons, not non-cumulative prefs.
  

 

Then Tsy owns more than 80% of common and GSE liabilities get added to U.S. Gov't debt. Is that a plausible scenario?

 

Treasury can convert some of the seniors to get them to 79.9% ownership (the warrants become superfluous here) and the rest to non-cumulative zero-div prefs with a mandatory conversion to common upon sale to an outside party. The zero-div part is so Treasury doesn't just sit on them, and the mandatory conversion is for compliance with CET1 capital standards. Those would essentially be valued as commons (because they would become commons when sold) without actually being commons.

 

Also, if they can find immediate buyers for 7.2B shares (that would be 80% of the total) they can do a partial conversion for 7.2B shares, sell them, convert more seniors to get 28.8B more shares (80% of the new total), giving them de facto 96% of the pre-raise ownership while never having more than 80% at any one time. Naturally the buyers of the 7.2B shares would know about the later second conversion and price the shares accordingly. A third round of this could get them to 99.2%.

 

I could probably come up with more possibilities if I put my mind to it. Suffice to say, the 80% threshold is no bar. I think Treasury only picked that number for the warrants because that's the most they could do in a single transaction. Senior pref conversion is what opens the door to more, and is part of why I think the commons have much more downside potential than the juniors. When Treasury's incentives become opposed to those of the existing commons, it's no secret who will win. I consider it somewhat ironic that the one of the worst-case scenarios for the commons (huge senior pref cramdown) comes alongside recap and release.