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|Net Debt (in $M):||1||EBIT||0||0|
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The junior preferred stock of Fannie Mae and Freddie Mac ("F&F") offer compelling upside given underappreciated recent material events, practical constraints that must be recognized in solving for the future of F&F, incentive alignment between the government and existing shareholders, and strong consistent signaling of upcoming administrative reform which will result in the recapitalization and release of F&F. In this scenario, the junior preferred stock are worth ~par value (providing for ~100%-180% upside from current prices across the various junior preferred issues).
Material short-term catalysts are present - including the upcoming release of the governments reform plan expected to be published over the next ~1-8 weeks.
I recognize that these securities were recently pitched on VIC and I recommend reading the prior write-up, but given the near-term catalysts and overall misunderstanding/underappreciation of the situation for those not closely involved, I believe that there is incremental value in expanding on some of the core tenets of the thesis and providing further rationale for conviction in the eventual outcome.
Note: The ‘appendix’ section towards the bottom of this write-up includes a list of the various junior preferred securities available for purchase (differences between the specific jr prefs primarily relate to liquidity and interest rate attributes). Additionally, the write-up relies on a number of external quotes for which I’ve provided tickmarks (x) which make reference to sources listed in the ‘citations’ section towards the end of the write-up.
The current equity stack includes:
There are two key players who have full authority to modify the terms of the Senior Preferred Stock Agreement and allow the GSE’s to exit conservatorship:
Administrative Exit from Conservatorship
The investment thesis simple - UST and FHFA will take administrative actions to recapitalize and release F&F from conservatorship.
While this has been the thesis for many junior preferred shareholders for a while given the practical constraints involved, there are a number of significant events that have recently occurred which signal that execution of this path is imminent.
Practical constraints that must be solved for to exit conservatorship:
Any transition out of conservatorship must optimize for reducing transition risk given the GSE's significant size and role in the US economy
Releasing F&F from conservatorship requires recapitalization of the two entities
Recapitalization requires the government to end the “net worth sweep” (raising new private capital is not possible while the government takes all profits). Further, recapitalization requires the government to recognize the senior preferred stock as having been repaid, consistent with the original terms of the 2008 agreement (otherwise a $190bn overhang exists limiting ability to raise new private capital)
The government owns warrants for 79.9% of F&F common stock which are estimated to be worth ~$100-150bn in a recapitalization. To the extent these warrants have value, the junior preferred stock is worth par. In this sense, recapitalization provides a win/win scenario for both the government and shareholder
Significant recent events set the stage for administrative action:
o As described in the Background section above, the terms of the original preferred stock agreement in 2008 were such that the UST (on behalf of taxpayers) would receive 10% interest on the Senior Preferred. In 2012, the terms were amended to require F&F to instead sweep all quarterly profits to the UST in perpetuity
o The “10% moment” describes the moment for which the cumulative dividends paid by F&F to the UST have exceeded an IRR of 10% for the government. This moment was achieved in mid-2018 and as of today we are at roughly ~12% IRR. The implication is that taxpayers have been more than repaid under the terms of the original agreement (before accounting for the significant warrant value which remains available)
o Calabria was involved in drafting HERA, the current legislative statute which empowered FHFA to put F&F into conservatorship and empowers FHFA to release F&F from conservatorship
o Importantly, Calabria has publicly criticized the legality of the net worth sweep, as well as the prior administrations disregard for conservatorship principles in his co-authored paper titled “The Conservatorships of Fannie Mae and Freddie Mac: Actions Violate HERA and Established Insolvency Principles” (1)
o Since appointment, Calabria has been publicly signaling UST and FHFA intentions to administratively move forward on housing reform (see further below)
o Perceived delays on Mnuchin’s statement that he intends to privatize F&F (based on his early statements post-election) are misunderstood. Administrative reform could not occur until 2019 as the previous FHFA Director (Mel Watt) was adamant about not taking action until Congress did
What about legislative risk?
Strong consistent signaling from key players inform the future outcome:
With the various constraints and recent events described above in mind, I believe one significant reason for the current available arbitrage can be understood through the “boiling frog syndrome” metaphor, which basically states that small incremental changes tend to go unnoticed. Investors who have already passed on F&F junior preferreds are unlikely to be keeping detailed notes of the incremental signals communicated by the administration.
The cumulative signaling by various key players leads to one clear outcome:
The UST will announce its reform plan and it will lay out specific administrative actions to be taken to glide towards recapitalization and release from conservatorship. The plan will also include “recommendations” for Congress to enact legislatively which are compatible with, but not a requirement for, administrative reform.
· Amendment of the Senior Preferred Stock Agreement to:
· Eliminate the “net worth sweep”, allowing capital to be built through retained earnings
· Recognize the original terms of the Agreement by deeming the Sr Preferred repaid (10% moment described above)
· Require F&F to pay a commitment fee to the government in exchange for UST to maintain its existing $200bn current funding commitment under the existing Senior Preferred Stock Agreement as a catastrophic insurance pool only to be used in the extremely unlikely event the recapitalized entities deplete their capital. This will remain in place until Congress legislates a move toward an MBS level guarantee (or in perpetuity in the likely event Congress continues to not do anything)
· Request FHFA to finalize the proposed Capital Requirements (4)
· Request FHFA to submit a Capital Restoration Plan for recapitalizing the entities with clear milestones for achieving an exit from conservatorship.
· Grant FHFA authority to issue new GSE charters
· Establish explicit paid for catastrophic guarantee for any incumbent and future chartered GSEs
· Other legislative-required actions which are not significant to the investment thesis (such as changes to HUD and FHA organizations)
Whether or not the UST plan goes into specific details on the methods available to accelerate the recapitalization process, it is highly likely that recapitalization will be achieved through some combination of retained earnings, public and/or private common equity offerings, junior preferred stock conversions to common stock, and existing shareholder rights offerings. John Paulson and Blackstone hired Moelis (investment bank) to create a proposal for recapitalizing the entities and maximizing the value of the government’s common stock warrants – this is a must read for anyone interested in the investment as it includes a realistic path forward and touches on the use of the current funding commitment as an alternative to legislative-required explicit MBS guarantees (5)
The below is a collection of excerpts from statements made by key players either directly or indirectly through reporters etc. As described above, I believe it’s important to recognize the cumulative and consistent messaging that is publicly available when assessing the probabilities of the final outcome.
· Mark Calabria
o 4/25/2019 – ‘And although there are still some calls to wind down Fannie and Freddie completely or fold the mortgage giants into a replacement, Calabria, for one, says Fannie and Freddie aren’t disappearing anytime soon. “I certainly fully expect at the end of five years there still to be a company named Fannie Mae and a company named Freddie Mac,”’ (6)
o 5/10/2019 – “Calabria is currently waiting on a plan from the U.S. Treasury on reform for Fannie and Freddie, which he expects this summer. Then he will negotiate with Treasury and hopes to come to an agreement by the fall that would then allow them to stop Fannie and Freddie from sending all profits to Treasury later this year. That is, ending the so-called net sweep. By January, Calabria wants to start the capital-building process and thinks it’s possible an IPO could occur at the earliest in the first half of next year.” (7)
o 5/10/2019 – ‘If lawmakers aren’t able to pass something he will take action unilaterally. “Well I think I'm actually obligated to,” he says. “As far as I see it, I don't really have any choice but to fix them and get them out because that's what the statute demands.”’ (7)
o 5/14/2019 – ‘“One of the frustrations I often hear is this argument of, well, 'Congress must do something.' Well, the FDIC has never asked Congress to release a bank from conservatorship,” Calabria told an audience at the National Association of Realtors legislative conference. “What Congress decided in HERA was, if … Fannie or Freddie got in trouble, they enter conservatorship, we fix the problem and they move on,”’ (8)
o 5/14/2019 – ‘“I really would like to see Congress act,” he said. “Keep in mind, I’ve got two entities, I’ve got the current business model — I’m stuck with that. I can get them out of conservatorship, I can try to make sure they’re better capitalized, better regulated, but essentially, the model is the model”’ (8)
o 5/14/2019 – ‘McLean also asked Calabria about continuing shareholder litigation, which he brushed off. “I think if we can chart a path out of conservatorship … that that makes a lot of those issues go away,”’ (9)
o 5/20/2019 – ‘“Whether we can do some kind of conversion with [junior] preferreds, or whether they would get par, it’s way too early to figure that out.”’ (note this was highlighted in the prior VIC writeup but it is important to note again as Calabria brought it up unprovoked) (10)
o 5/20/2019 – ‘“Once that plan has been finalized, hopefully sometime this fall, I will sit down with my counterparts at Treasury to develop a responsible plan to end the conservatorships, with a clear road map and mile markers, and to adjust the Treasury share agreements accordingly. And by January 1 of next year, my hope and expectation is that we will be on the path to a new regime where the GSEs can start to build capital. At that point, the path out of the conservatorships will depend not on the calendar but on Fannie and Freddie meeting the mile markers we set out for them. It was insufficient capital that triggered the conservatorship, and it’s going to be sufficient capital that triggers an exit”’ (11)
o 6/11/2019 – “FHFA stands ready to assist Congress in furthering these legislative recommendations. In the meantime, I will work within my statutory authorities to address vulnerabilities in our current housing finance system where possible. Important post-crisis changes to the housing finance system and the Enterprises’ activities should be preserved. These include the recent implementation of the Uniform Mortgage Backed Security, continued use of credit risk transfers, and providing equitable access to lenders of all sizes to the Enterprises. Making sure FHFA’s regulated entities are well-capitalized, well-regulated, and well-managed remains a critical task, and it must be done to allow them to withstand any future downturn in the economy"(12)
o 6/12/2019 – ‘Mr. Calabria said his proposals would be consistent with a separate overhaul blueprint that the Treasury Department is crafting. That plan also is likely to include legislative proposals along with administrative steps the companies’ regulator can take, if Congress doesn’t enact a more fundamental overhaul. Both plans take into account the likelihood that Congress won’t take action, Mr. Calabria said. “A lot of what you’re going to see out of Treasury and a lot of what you’re going to see here is, how do we continue to make administrative actions that aren’t dependent on Congress,”’ (13)
· Steven Mnuchin
o 1/28/2017 – ‘Additionally, Mnuchin offered further details on his thoughts regarding housing finance reform, including the role of GSEs. Mnuchin wrote in response to questions from Senator Sherrod Brown that "any solution will be dependent upon the GSEs being capitalized properly and other such controls that eliminate risk to taxpayers."’ (14)
o 5/22/2019 – ‘Congressman: “How much of housing finance reform can be done with the administration?” Mnuchin: "I think a lot can be done administratively, we're working on that, we're also working on a report for the President. But I would also encourage there is an opportunity for congress on a bipartisan basis to make some significant reforms. These were not entities that were intended to be under government control forever and funded by taxpayer money forever so I hope that Congress would look at this with us but if not we will do things administratively ... this is a priority of ours."’ (15)
o 5/22/2019 – “Our fundamental view is that there should be risk capital in front the government’s money. And whether that’s a government guarantee on securities or treasury line, fundamentally there should be private risk capital that supports a a liquid 30 year mortgage market.” (15)
· Craig Phillips (Top Aide to Secretary Mnuchin who was responsible for the drafting of the imminent UST reform plan) -
o 5/16/2019 (skip to 33:54 min mark of the linked video) –
"Alex, my hero, he developed the concept of the 10% moment - and the 10% moment was when you had the GSE's in conservatorship and you had swept all of the dividend eventually you would have a 10% IRR for which we crossed I guess approximately when I got to Treasury, I think we're not at 12%. And it just shows that there is an opportunity here to protect the taxpayer, the taxpayer has actually been in some ways, many ways, has been repaid from the bailout of Fannie and Freddie, we've got to turn the page and fix it to move on" (16)
o 10/15/2018 – ‘“The administration advocates ending the conservatorship of Fannie Mae and Freddie Mac and returning them to private ownership,” Phillips said Monday. “Their charters should be removed from statute and their operations should be overseen by the primary regulator that has the authority to approve additional guarantors to introduce competition into the secondary mortgage market.” “Guarantors should have access to an explicit federal guarantee for MBS (mortgage-backed securities) that they issue which is on budget and fully paid for, designed for use only in exigent circumstances and designed and overseen in a manner that protects the interests of taxpayers by their primary regulator,”’ (17)
· David Dworkin (was part of the housing finance reform team under three secretaries and two presidencies – including working under the leadership of Craig Phillips) (18)
o 3/30/2019 – ‘“They’re really telling us that if Congress doesn’t act, the administration has enormous powers, but that it’s better if they act together,” Dworkin said. “We’re beginning to see, with the nomination of Mark Calabria as FHFA director, and the actions and statements made by acting FHFA Director Otting, the beginning of this process unfolding.” Dworkin envisions reform unfolding in what he calls a “dual-track” approach, with the Administration and Congress goading each other along. And he thinks the outline for what reform looks like is also pretty well established’ … Dworkin believes that the next iteration of housing finance is what he calls “HERA-plus.” The “plus” would involve an explicit paid-for government guarantee on mortgage bonds issued by Fannie and Freddie, and stronger powers for the regulator of the two enterprises. Still, as Dworkin put it, “HERA-plus is a good place to be. We don’t really appreciate the changes we made because the crisis evolved so fast. There are some things we missed but we’ve spent 10 years trying to come up with an alternative path to the 30-year fixed-rate mortgage that precludes the GSEs and we have not been able to do it. After 10 years, it’s not unreasonable to say we should go back to first principles, not back to the drawing board.”’ (19)
o 11/30/2018 – ‘“Leaving Fannie Mae and Freddie Mac in conservatorship is not the answer. The parts of our housing finance system that remain broken can be fixed without creating an entirely new system out of whole cloth that no one will capitalize. “If you build it, they will come,” is not a strategy for repairing nearly one-fifth of the world’s largest economy, it’s a tagline for a movie”’ (20)
o 7/17/2018 – ‘“An important first step is allowing Fannie Mae and Freddie Mac to exit conservatorship as private companies with access to a federal guarantee that is paid for rather than implied. … We need to fix what is broken in the current system, not tear it down and hope that if we build a new one it will work for everyone, or at all. Field of Dreams was a great movie, but it is not a viable economic theory; if we build a new system, they won’t come. If they would, investors would be filling the halls of the Capitol insisting on passage of legislation like the Corker-Warner bill that envisions five or more GSEs. It’s not happening .... Five years of working at Treasury with some of the smartest people I know has taught me this: Much of what we need in a new system already exists in Fannie Mae and Freddie Mac.”’ (18)
· Mick Mulvaney (current White House Chief of Staff) introduced legislation back in 2016 which is consistent with administrative recapitalization and release. Key sections of the proposed legislation are outlined below:
o The Housing Finance Restructuring Act of 2016 (21) Key sections:
§ (1) DEEMED REPAYMENT IN FULL.—Effective on the date of the date of the enactment of this Act, the liquidation preference on the Variable Liquidation Preference Senior Preferred Stocks of each enterprise is reduced to zero.
§ (c) Exercise Of Warrants For Common Stock.—Notwithstanding subsection (a)(2)(C) of this section, upon the enactment of this Act, the Department of the Treasury shall exercise the warrants for the purchase of common stock of the enterprises provided to the Department under the Senior Preferred Stock Purchase Agreements.
§ d) Capital Restoration Plan.—(1) REQUIREMENT.—Not later than the expiration of the 45-day period beginning on the date of the enactment of this Act, the Director shall prepare and submit to the Committee on Financial Services of the House of Representatives and the Committee on Banking, Housing, and Urban Affairs of the Senate a capital restoration plan for each enterprise that complies with section 1369C(a) of the Federal Housing Enterprises Financial Safety and Soundness Act of 1992 (12 U.S.C. 4622(a)).
§ (e) Termination Of Conservatorships.—The Director shall terminate the conservatorship of an enterprise under section 1367 of the Federal Housing Enterprises Financial Safety and Soundness Act of 1992 (12 U.S.C. 4617) at such time that the enterprise attains, as determined by the Director, an amount of capital that is equal to or exceeds 5 percent of the risk-weighted assets of the enterprise.
· Don Layton (Freddie Mac’s CEO through May 2018)
o May 2019 – ‘“At 50,000 feet, I agree: it'd be better to have more competition, but let me ask two questions. Number one: who's going to enter? Who's going to raise capital with the following investment thesis: I'm going to start from scratch, and to make it work, to be able to deliver into the single security, I need a nationwide footprint because otherwise it won't be accepted as fungible with the others (so that's a market requirement). And so I have to go big, fast, and I'm going to compete with two massively entrenched competitors, who have scale advantages and 100 percent market share against me. So what private equity firm is going to go, "I like that story"? So we sat there and go, "Who actually is going to enter?" I understand the theory that it'd be good if people would enter, but when you actually go and ask possible entrants, they go "It's just not a good deal." So I'm not talking theory, I'm talking about, will someone show up?”’ (22)
o WSJ 5/30/2019 – “The proposal, coming more than a decade after the government seized the firms to save them from collapse, would seek to put the companies on a sounder financial footing and then release them from government control, if Congress doesn’t enact a more fundamental overhaul, these people said … The proposal is expected to include a version of what has been called “recap and release,” which would ensure the firms have adequate capital to absorb loan losses in a future housing slump and thus avoid needing another taxpayer-backed bailout. If carried out, the companies could return to a status similar to how they operated before the financial crisis. Still, administration officials would prefer that Congress act on a more sweeping remake of housing finance, and their plan would also make a series of recommendations for lawmakers to consider” … “As part of the draft plan to return Fannie and Freddie to private hands, an existing Treasury backstop for the companies could remain in place. But the firms could begin paying a periodic “commitment” fee for the federal line of credit, the people said.” (23)
o Asset Backed Security Alert (institutional publication) 6/7/2019 – “Fannie and Freddie shareholders who spoke to FHFA head Mark Calabria this week said they are convinced the Trump Administration intends to conduct a $120 billion equity offering in late 2019 or early 2020. The move would bring the mortgage agencies out of conservatorship.” (24))
o Alex Pollock (Mortgage Finance Thinktank Author) and Mark Calabria 4/17/2015 – “What is required are practical steps forward, rather than designing the ideal but politically unachievable solution. We offer Congress the following suggestion as something that can be done now: simply take away all Fannie and Freddie’s special privileges” (25)
o Alex Pollock (the same Alex Pollock as the one referenced by Craig Phillips and the co-author of the April 2015 article w/ Calabria) 5/23/2019 – “What should happen next? The FHFA should set a 4% capital standard for Fannie and Freddie. The Financial Stability Oversight Council should designate Fannie and Freddie as the “systemically important financial institutions” they so obviously are, treating them the same as others of their size. The Treasury should exercise as a gain for the taxpayers its warrants for their common stock, removing any uncertainty about the warrants. When capital has become sufficient, the FHFA should end the conservatorships and implement regulation that ensures that Fannie and Freddie’s credit risk stays controlled and tracks how the more competitive, less GSE-centric mortgage system evolves. Congress does not have to do anything in this scenario. That is good, because it is highly unlikely that it will do anything” (26)
o Fox News 5/30/2019 – “In recent weeks, Wall Street bankers have spoken with Trump administration officials informally on the broad outlines of the stock deal that will finance the final leg of Fannie and Freddie’s recapitalization plan, according to financial executives and administration officials with knowledge of the matter” (27)
Why does this opportunity exist?
There are various reasons which have created an ability to arbitrage the upcoming recapitalization and release of F&F:
Note on Litigation
This thesis does not require success in the litigation space and is largely outside of my circle of competence.
Very briefly, it’s worth highlighting that the litigation within the 5th circuit (Collins case) is currently in an interesting situation. On July 16, 2018 rejected shareholder (plaintiff) claims in a 2-1 decision. Subsequently, the 5th circuit decided to rehear the case “en banc” which is a rare protocol applied to less than 1% of decisions, whereby the case is reheard before all judges of the court (rather than the 3-judge panel). The decision to rehear a case “en banc” alone is a positive signal as 13 of the previous 16 “en banc” hearings have resulted in a reversal in the initial decision.
In the event of a reversal, there are various potential remedies that all generally revolve around stopping the “net worth sweep” and potentially involve crediting for overpayment against the original Senior Preferred Stock Agreement terms. The situation is interesting as the “en banc” hearing was held in January 2019 and the courts decision is expected at any point. Presumably, the UST is aware of the potential for a reversal unwinding the net worth sweep and crediting the senior preferred stock for overpayment, and the imminent UST plan therefore is likely to be compatible with a reversal outcome.
Additionally, if recap/release is the plan, any banker would advise UST to settle outstanding litigation prior to asking for ~$100-200bn of new capital.
Note on Common Stock
The common stock carry significantly more risk of permanent capital loss given dilution risk. In a recapitalization scenario, it probable that the current common shareholders are diluted through either one of or a combination of the following:
· Conservatorship/Status Quo is maintained
· While the government currently receives all profits generated from F&F, under the current situation it is receiving those payments in consideration for exposure to a) contingent litigation liability and b) providing a $200bn+ line of credit to two entities with $5 trillion of exposure and effectively no capital. The government instead can recap/release which would generate a short-term windfall of $100-150bn, eliminate it’s contingent liability, and reduce the risk of needing to fund the $200bn+ line of credit.
· This would also directly contradict the significant consistent messaging outlined above
· Timing of recapitalization
· Recapitalization may take as long as 4-5 years. The most liquid junior preferreds (FNMAS) currently trade at a 108% upside to par value and have a floored coupon rate of 7.75% so potentially worth more than par. Even if value realization were to take 5 years and only par value is received, this would generate an attractive 15.8% CAGR at current prices.
· Public capital raise execution risk
· This is a massive equity raise – the entities will probably need to IPO $100bn+. For context, the largest IPO in history was Alibaba ($25bn) and the largest secondary offering was Petrobas ($70bn)
· Election Risk
· There is a risk that the current administration will no longer be calling the shots beginning January 2021. This risk is significantly reduced as it seems likely that an amendment to the Senior Preferred Stock Agreements will be executed in the near term, resulting in a capital build which increases the margin of safety for the junior preferreds.
· Release of UST Reform Plan in Q3 2019
· FHFA publishing Final Capital Requirements
· Amendments to the Senior Preferred Share Agreement to end the “net worth sweep”
· “En Banc” reversal of the 5th circuit appeals decision
· CECL - Due to the upcoming changes in accounting standards for expected loss reserves, it is probable that F&F will require an additional draw from the UST in Q1 2020. Allowing F&F to retain earnings (eliminating the net worth sweep) prior to Q1 2020 would eliminate this risk (28)
The below is a list of publicly traded junior preferred stock that I’m aware of. Please note that I compiled the volume/price data using scripts from yahoo finance and the security attributes using QuantumOnline so it may be worthwhile double-checking for accuracy.
16. https://vimeo.com/336717859#t=2004s - 33:54 mark
See "catalyst" section above
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