|Shares Out. (in M):||1,150||P/E||0.0x||0.0x|
|Market Cap (in $M):||4,600||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||0||EBIT||0||0|
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August 18, 2014
Recommendation: Federal National Mortgage Association (FNMA) common stock
As background information with respect to FNMA, the reader may wish to review Pershing Square’s presentation at the 19th Annual Sohn Conference with respect to FNMA. The slide deck associated with this presentation can be accessed here.
Essentially, Pershing Square presented a long-term thesis regarding FNMA at the Sohn conference. Pershing Square has disclosed that it owns almost 10% of the common stock of FNMA (and of Freddie Mac (FMCC)). I will present here a short-term thesis regarding FNMA.
Pershing Square assumed without supporting analysis in its Sohn slide deck that the 3rd A would be invalidated in court, and offered to show how FNMA could be valued at $23-$47 per share, assuming FNMA would begin to assess guarantee fees ranging from 60bps to 100bps. Pershing also argued that because (i) FNMA (and FMCC) were necessary for Congress to preserve as mortgage security guarantors in order for the US housing finance industry to continue to offer 30 year mortgages, and (ii) the private mortgage insurance industry could not build up in scale sufficient to fully replace FNMA and FMCC, any legislative proposal to wind down FNMA would not be implemented.
I will pick up not where Pershing Square left off, but rather where Pershing began but skipped over, and supply the supporting analysis to the conclusion that the 3rd A will be invalidated. This is a crucial threshold analysis since, given the terms of the 3rd A, FNMA common stock will have no value unless the 3rd A is invalidated. So, this essential first step of the valuation analysis is required before any FNMA investment is rationally contemplated.
I believe one can be agnostic about FNMA’s long-term prospects (which involve, among other things, a prediction of political and policy developments regarding housing finance over the next few years), but still have a very bullish view as to FNMA’s short-term prospects, given my view as to the likelihood that the 3rd A will be invalidated on the Perry motion for SJ, and the catalytic effect of the financial windfall from the 3rd A invalidation on FNMA’s common stock value.
In the event of invalidation of the 3rd A, I calculate the financial benefit to FNMA to be approximately $80 billion, with the result that the FNMA common stock “should” trade up from its current price of about $4 per share to almost $12 per share. This valuation estimate is supported by valuing FNMA’s “normalized” earning capacity, based upon FNMA’s reported results for Q2 2014.
There are two principal pieces of litigation affecting FNMA and the 3rd A: (i) the Fairholme litigation (Fairholme) in the DC Court of Claims before Judge Sweeney, in which a FNMA preferred stockholder seeks money damages (and ancillary relief) from FHFA and Treasury by alleging that the 3rd A constituted a taking of the plaintiff’s property, in violation of the Fifth Amendment to the US Constitution; and (ii) the Perry litigation in the DC Federal District Court before Judge Lamberth, in which a FNMA preferred stockholder seeks to vacate the 3rd A.
The Fairholme litigation is on a slow track and does not expressly call for the invalidation of the 3rd A, which is the financial windfall value catalyst for FNMA common stock. Fairholme has captured the bulk of the attention regarding FNMA litigation, even as Perry has the potential to be far more consequential, far more quickly, for FNMA common stock.
Indeed, a plaintiff victory in Fairholme arguably has no direct effect upon the FNMA common stock, as one of the threshold issues in Fairholme is whether a junior preferred stockholder had a valid investment expectation, such that a 5th amendment taking of anything of value occurred. Because a finding that a preferred stockholder had a valid investment expectation doesn’t necessarily imply that a common stockholder had a valid investment expectation, a common stockholder cannot use collateral estoppel to obtain damages based upon any preferred stockholder victory in Fairholme.
Indeed, because of this, Pershing Capital has recently commenced an action (Pershing Court of Claims) in the US Court of Claims that essentially duplicates Fairholme’s action, and an action (Pershing District Court) in the US District Court that essentially duplicates Perry’s action. These actions result in having FNMA common stock litigating essentially the same causes of action as the FNMA preferred stockholders, but ensures that the FNMA common stockholder is “at the table” should any settlement discussions ensue.
As opposed to the Fairholme action, the Perry litigation had been on a fast track, and the SJ motion by Perry to vacate the 3rd A has been fully briefed and had been scheduled for argument on June 23, 2014 by former District Court Judge Wilkins. When J. Wilkins was elevated to the DC Circuit Court of Appeals, former District Court Chief J. Lamberth (now a senior judge) was assigned the Perry case. The June 23, 2014 hearing date previously set for Perry conflicted with a prominent jury trial J. Lamberth is conducting (the trial of four Blackwater defendants for murder and manslaughter in Iraq, which began earlier in June), and the SJ motion hearing was postponed indefinitely until J Lamberth reschedules it. The Perry SJ motion hearing date has not been rescheduled yet, and likely won’t be rescheduled at least until the Blackwater trial goes to the jury. This may not happen for several weeks. However, since the Perry SJ motion has already been fully briefed, the SJ motion hearing should be held promptly once the Blackwater trial comes to a conclusion.
What is at stake with respect to the invalidation of the 3rd A?
By my calculation, approximately $80 billion of “net worth sweep” dividends, paid by FNMA to Treasury since the 3rd A was entered into, will have to be recharacterized as repayments of preferred principal in the event the Perry SJ is successful (this $80 billion excess dividend payment is corroborated in paragraphs 92 and 95 of the Pershing District Court action). That is, there were approximately $80 billion of purported dividends paid by FNMA to Treasury after the 3rd A that were in excess of the pre-3rd A obligation to pay dividends at a 10% rate. If the 3rd A is vacated, Perry can pursue various remedies, but the most obvious remedy would be to require that Treasury could retain the excess dividend payments only on the condition that such distributions are deemed repayments of principal. This would reduce the amount of FNMA preferred outstanding to Treasury from approximately $117 billion to approximately $37 billion.
It is not often that one comes across an investment opportunity involved in litigation at which $80 billion is at stake (and in which the litigation stakes are so large compared to the company’s common equity value).
FNMA has approximately $19 billion principal amount of public junior preferred outstanding, trading at approximately 35-50% of par, and 1.15 billion shares of common stock outstanding (subject to 80% dilution from Treasury’s common stock warrants). I will discuss the potential financial effect on FNMA common stock from a reduction in the amount of Treasury-owned preferred stock from $117 billion to $37 billion at the end of this memorandum.
The Perry briefs can be accessed as follows: (i) Perry Complaint; (ii) FHFA's Motion to Dismiss; (iii) Treasury's Motion to Dismiss (iv) Perry Cross Motion for SJ; (v) Treasury's Reply to Perry's Cross Motion for SJ; (vi) FHFA's Reply to Perry's Motion for SJ, and (vii) Perry's Reply Brief.
The two principal Perry arguments that the 3rd A should be vacated are:
I believe both Perry’s Securities Claim and the APA Claim will prevail on the merits. Because both claims are being asserted “on the papers,” requiring J. Lamberth only to construe and apply applicable law and facts not in dispute, the Perry SJ motion will be dispositive and result in the invalidation of the 3rd A.
The Stock Purchase Agreement (SPA) between FHFA as conservator and Treasury under which the bailout was effected resulted in the issuance of FNMA preferred stock to Treasury having a liquidation preference equal to the aggregate amount of draws made by FNMA from Treasury, less any repayments. Essentially, the SPA provided FNMA a line of credit from Treasury, but the obligation created was a preferred stock claim in order to be subordinated to, and therefore provide credit support for, FNMA’s over $3 trillion of debt securities. Dividends accrue at the rate of 10% if paid in cash, or 12% if paid in-kind. The principal balance outstanding under this FNMA preferred stock credit extension at the time the 3rd A was entered into was approximately $117 billion.
Pursuant to the 3rd A, FHFA and Treasury converted the dividend payable from a fixed cash or in-kind amount to a calculated amount equal to the total available net worth of FNMA at time of dividend payment (net worth sweep) (Treasury also agreed not to impose a commitment fee on the unused credit amount in connection with the 3rd A). The reason for this amendment, proffered by FHFA and Treasury during litigation, was to reassure the markets that the capped line of credit available to FNMA from Treasury would not be exhausted.
For purposes of the Securities Claim, it matters not whether this proffered justification for the 3rd A is plausible. The salient point made by Perry is that under HERA, it is clear that Treasury had authority to make purchases of FNMA securities only until the end of 2009, and the 3rd A was effected in 2012. After 2009 under HERA, Treasury only had the authority to exercise such rights as it had obtained in respect of the securities it had purchased under the SPA prior to the end of 2009. FHFA and Treasury do not dispute this statutory limitation.
The Securities Claim is a straight-forward application of conventional securities law. As Perry has pointed out in its briefing, whenever an issuer and a security holder enter into an amendment with respect to an outstanding security that fundamentally alters the rights and financial terms of the security, then for purposes of securities law as well as federal taxation law (which Treasury itself administers), the amendment has the effect of resulting in a new security issuance in exchange for the pre-existing security.
There can be no doubt that the 3rd A effected a fundamental (indeed, a huge) change in the terms of the Treasury-owned FNMA preferred stock, causing FHFA to pay Treasury $80 billion of dividends in excess of what would have been payable without the 3rd A. While Treasury’s briefs speak to Treasury’s expectation at the time of the 3rd A that it would not result in a radical economic change, it is clear that this securities and taxation law test is an objective, as opposed to subjective, test. In order to determine whether an amendment has given rise to the issuance of a new security, one looks to results, not intentions.
I believe there is little doubt that J. Lamberth will hold that the 3rd A constituted a securities exchange transaction which, post 2009, FHFA as conservator and Treasury did not have the statutory authority to enter into under HERA.
Treasury counters this argument by trying to assert that the 3rd A was only the permissible exercise of a right it had under the SPA, because the SPA contains the standard boilerplate that the parties may amend the agreement, but only by another writing.
As Perry correctly points out, Treasury only has a right under the SPA to the extent it permits Treasury to perform some action at its own election, without the concurrent consent of FHFA. An example would be the exercise of the FNMA warrants that Treasury received under the SPA; Treasury doesn’t require FHFA’s consent to exercise the warrants. Amendment of an agreement that requires mutual consent of the counterparty is not the exercise of one party’s contractual right received under the contract.
Treasury and FHFA will lose the Securities Claim and, because there is no factual dispute bearing upon the legal issues involved, the Perry SJ motion relating to the Securities Claim will be granted.
The APA requires a “federal agency” such as FHFA to compile an administrative record at the time of taking action in order to provide a reviewing court the basis to determine whether or not the agency acted in a reasonable, as opposed to arbitrary or capricious, manner. In any judicial review of administrative action, the agency must produce the administrative record of its deliberations at the time of the action, and not simply produce a litigation-generated post-hoc justification for the action in briefing. There is a “presumption of regularity” that courts often apply when reviewing federal agency action under an arbitrary and capricious standard, but the agency has the initial burden of producing the record of its deliberations at the time of the agency action to invoke this presumption of regularity.
In other words, the agency must present a record to show that it deliberated rationally at the time of acting, and not a court brief or affidavit to show, ex post, justification that can be demonstrated during litigation. While this “record rule” is an obligation of the federal agency, usually it often operates in the agency’s favor, as it can be used by the agency as a shield to preclude plaintiffs from seeking judicial review of agency action based upon exogenous facts that were not considered by the agency, as evidenced by the administrative record.
FHFA compiled no administrative record with respect to the 3rd A, and has stated so in the Perry litigation.
Rather, FHFA has tried to justify its entering into the 3rd A by arguing it was not arbitrary and capricious to agree to the net worth sweep, because the financial markets were worried that FHFA was simply drawing Treasury funds to pay owed dividends and would enter into a financial “death spiral.” The market needed assurance that Treasury’s bailout of FNMA would continue, and the net worth sweep would promote such confidence.
This is an ex post justification that is a day late, whether or not it is a dollar short.
This justification logically might have satisfied the low bar of an arbitrary and capricious standard had it been incorporated into the administrative record at the time of decision. However, as Perry correctly argues, this is really beside the point. While the arbitrary and capricious standard is an easy standard of review for FHFA to satisfy, FHFA must do so on the basis of the administrative record that it compiled at the time. FHFA cannot make this showing without an administrative record to introduce into evidence. Without making this showing, FHFA’s entering into the 3rd A is a violation of the APA.
Perry goes on to show that the net worth sweep was, in any event, arbitrary and capricious since FHFA had the authority under the SPA to pay dividends in kind, not requiring further cash draws upon Treasury’s credit line, which would have lessened any market concern that Treasury’s available credit line would become unavailable. Moreover, Perry argues that imposing the net worth sweep is contrary to FHFA’s obligation as conservator, which is to restore FNMA to a safe and sound financial condition.
While one may be confused at FHFA’s justification for the net worth sweep, which diminishes FHFA’s creditworthiness, in connection with the supposed justification to alleviate market concern regarding FHFA’s creditworthiness, one need not even get to this conundrum; FHFA cannot sustain the arbitrary and capricious standard in the case of its failure to produce any administrative record.
Finally, FHFA as conservator and Treasury were mandated under HERA to consider certain factors in connection with their actions, such as the extent to which such actions promoted the financial rehabilitation of FNMA and its ability to resume normal business operations. FHFA and Treasury considered these factors in connection with the first two amendments to the SPA, which expanded Treasury’s credit line (and, indeed, which were set forth in contemporaneous administrative records that FHFA was careful enough to compile in connection with those amendments). There is no evidence that FHFA and Treasury considered these factors in connection with the 3rd A. Indeed, there were contemporaneous public disclosures by FHFA that the 3rd A furthered the administration’s policy of winding down FNMA, which is not a relevant factor for FHFA to consider in its role as conservator.
FHFA/Treasury’s Argument that Perry is Jurisdictionally Barred under HERA from Seeking Judicial Review of the 3rd A
Because FHFA/Treasury’s positions with respect to the Securities Claim and the APA Claim are so weak, FHFA/Treasury place great reliance on a provision in HERA that purports to foreclose judicial review of FHFA’s actions, as conservator. If the District Court does not have jurisdiction to review the 3rd A, it cannot invalidate it.
HERA Section 4617(f), “Limitation on court action,” provides that “no court may take any action to restrain or affect the exercise of powers or functions of the Agency as a conservator.”
This is an audacious argument, seeking to stretch a provision, which is intended to prevent courts from enjoining before the fact the exercise of valid powers that the conservator may seek to exercise, into a provision that bars a court from determining after the fact whether the conservator had exceeded its authority and invalidly exercised its powers. The “restrain or affect the exercise of powers and functions” language is borrowed from FDIC statutory authority regarding conservators, and has not been construed to prevent judicial review of claims that the FDIC has exceeded its statutory authority. This is a statutory provision intended to prevent judicial second-guessing of conservator wisdom when acting within its scope of power, but not judicial review of conservator action alleged to be beyond its scope of power. Moreover, even if this provision was thought to insulate FHFA from judicial review, this HERA section by its terms would not preclude action against Treasury seeking to invalidate the 3rd A.
While we have no indication yet from J. Lamberth as to his view of this supposed jurisdictional bar under HERA, we already know from a recent opinion by Judge Sweeney in the Fairholme litigation how J. Sweeney regards this argument that courts are barred from reviewing actions by FHFA as conservator. J. Sweeney has ruled that Section 4617(f) does not insulate FHFA from judicial review of assertions that FHFA has breached its agreements or exceeded its authority.
FHFA/Treasury have also raised a standing argument, which is very weak. Because FHFA elected to act as conservator, not receiver, the legal rights and economic interests of FNMA shareholders were not extinguished or supplanted. In the event of FHFA action that adversely affects shareholders’ interests, FNMA shareholders maintain their economic interests and therefore have standing to present their claims for judicial review. (Indeed, shareholders would have standing to contest even FHFA actions as receiver, albeit under a separate statutory provision).
Judge Lamberth and Perry Counsel
It is worth noting that J. Lamberth is a former head of the Civil Division of the DC US Attorney’s Office. One might expect that he knows well when the US and its agencies have a strong case and when they have a weak case, having represented the US in both. Also, J. Lamberth is a Reagan appointee who has not been shy to invalidate Executive Branch action in the past. There are strong and weak judges for every case and, from Perry’s point of view, I would conclude that J. Lamberth is a strong judge.
It is also worth noting that Perry’s counsel is Gibson, Dunn & Crutcher, one of the preeminent litigation firms in the US generally, and one of the most successful firms in challenging US agency action under the APA out of its DC office, in particular. Perry’s briefs have been signed by Theodore Olson, a former US Solicitor General and one of the most experienced and respected attorneys in the US, and it may be expected that he will argue the SJ motion in front of J. Lamberth. There are strong and weak counsel for every case and, from Perry’s point of view, I would conclude that Gibson Dunn is strong counsel.
Financial Analysis of Effect on FNMA Common Stock of Invalidation of 3rd A
What is the financial effect upon FNMA common stock of the invalidation of the 3rd A and the consequent reduction of the FNMA outstanding preferred stock balance to Treasury from $117 billion to about $37 billion?
It can be assumed that since the Treasury preferred was subordinated in right of payment to all FNMA debt, and FNMA is not currently operating “in the zone of insolvency”, there would not be any absorption of value by the debt such as to leave no or little benefit for the equity. This is not the case where an insolvent issuer is made less insolvent or barely solvent, with all incremental benefit enjoyed by the debt. FNMA debt is not trading at a discount.
One possible effect would be to increase the value of the FNMA junior preferred without increasing the value of the FNMA common stock. However, the outstanding $19 billion of public junior preferred stock is trading at an aggregate market value of about $7 billion-$10 billion. Given that the preferred stock’s liquidation preference is capped and dividends are non-cumulative, there is no reason to think that the preferred stock will absorb more than $9 billion-$12 billion of the 3rd A invalidation windfall.
Assuming that the remaining $68 billion of 3rd A invalidation windfall doesn’t evaporate into the ether, it should redound to the benefit of the FNMA Common stock.
FNMA common stock currently trades at about $4 per share, but let’s assume that this trading value simply represents the market’s estimate of the expected value for 3rd A invalidation, and that the FNMA common stock has no independent financial value. After all, in the event the 3rd A is validated and the net worth sweep is upheld, it seems clear that FNMA common stock should be worthless. So, one can conclude that any value that FNMA common stock currently has reflects the market’s judgment as to the likelihood of 3rd A invalidation.
Starting from a value of zero for the common stock, the $68 billion remaining 3rd A invalidation windfall would suffer 80% dilution resulting from Treasury’s warrants, resulting in a net remaining benefit of $13.6 billion for the public outstanding FNMA common stock, which when divided by the 1.15 billion shares outstanding, results in a remaining net benefit of $11.82 per share.
This derived $11.82 per share value is a “snapshot” estimate of a rational market valuation resulting from the financial windfall of the invalidation of the 3rd A. One can proceed to ask whether this valuation is supported by the ongoing earnings capacity of FNMA.
FNMA’s earnings for 2013 were favorably impacted by (i) recoveries arising from representation and warranty litigation against banks which sold defective loans to FNMA, (ii) the reversal of FNMA’s loss reserves and (iii) the realization of the benefit of its deferred tax account. These extraordinary items will not recur in the future, and it is only with the most recent FNMA results for Q2 2014 that one can glean FNMA’s core earnings on a recurring basis going forward. As the FNMA CEO stated with respect to Q2 2104 earnings, “the second quarter's earnings gave a good sense of a normalized environment" for Fannie Mae. While these earnings will be favorably affected by a further increase in the guarantee fees (g-fees) charged by FNMA, which many expect FNMA to institute in the near future, the analysis set forth below assumes no such increase in g-fees.
FNMA recorded $3.7 billion of net income in Q2 2014, and it has experienced steadily improving credit quality and stable levels of net interest income over the past sequential quarters. As FNMA’s loan inventory declines, and its net income increasingly reflects g-fee income rather than an interest arbitrage spread on loan inventory, the volatility of FNMA’s income should decline.
Since Q2 2014 showed a restrained level of mortgage (especially refinancing) activity as compared with 2013, Q2 2014 serves as a relatively conservative base from which to project normalized earnings. Housing start activity is still historically low and, unless one posits a second recession soon, one can expect FNMA’s results over the next several quarters to approximate its Q2 2014 results.
The results for Q2 2014 imply annual net income for FNMA of $14.8 billion.
If one were to apply a 12x PE to this annual income projection (Pershing Capital uses PEs of 14x-16x (see slide 105 from the slide deck for the Sohn conference presentation), which I think is too high), this would result in a $177.6 billion equity valuation for FNMA. After giving effect to FNMA’s $37 billion Treasury preferred stock (post 3rd A invalidation) and the $19 billion public junior preferred stock outstanding, this leaves approximately $122 billion for FNMA common stock. Assuming 5.75 billion shares of FNMA common stock outstanding on a fully diluted basis, this results in a valuation of approximately $21 for the FNMA common stock on a going-forward basis.
It would be fair to point out that once the 3rd A is invalidated, FNMA’s capital structure would still be exposed to dilutive events arising from the need to (i) refinance the expensive Treasury preferred stock, and (ii) expand its equity base to increase its capital cushion as a financial guarantor. As well, there would remain policy risks regarding the timing of FNMA’s exit from conservatorship and potential congressional housing finance reform. These capital transactions and risks would likely cause the FNMA common stock value to come under pressure and trend downward towards the snapshot $11.82 estimated per share value from a potential $21 per share value.
Postscript: FNMA’s Low Signal to Noise Ratio
Value investment opportunities arise when there is a low signal to noise ratio, or when prevailing analysis of publicly available information improperly accounts for the inherent opportunities and risks posed by an investment opportunity. This is the case to an extraordinary degree with FNMA.
These failures of the financial analyst community and financial press to understand the opportunity presented by invalidation of the 3rd A only serves to depress FNMA’s common stock price and enhance the potential future financial return.
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