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

[dowfin1]

Zach, theres a good chart in note 14 of the FNMA 10-k

[merkhet]

There is also a list on the front page of each of the 10-Ks

[TwoCitiesCapital]

There is also a list on the front page of each of the 10-Ks

 

Thanks. Must have scrolled right past that previously as I don't recall having seen it. Appreciate the help.

[TwoCitiesCapital]

Been doing some thinking on this and what the possible outcomes are and the best ways to gain exposure. Most presentations shows the GSEs as a single entity with figures for the combined entity. I wanted to make sense of current securities so I separated this out for FNMA below.

 

 

Possible Outcomes:

[*]Injunction is denied. Government is found to have acted lawfully.

        i. Preferred mostly worthless

        ii. Common stock is worthless

[*]Injunction is approved. Government is found to have acted unlawfully

    A. Current excess sweep used to reduce the government's preferred outstanding. FNMA overpaid by about $76B in 2013 reducing government lending from $117B to $41B. This means that the gov was only owed 4.1B in dividends thus far in 2014 and has paid 9.4B further reducing government balance to 35.7B.

        i. Preferred stock totals ~55B between gov't and private holders. Definitely some value here with $15B in earnings enough to recapitalize and eventually cover anticipated dividends of ~5B in 7 years time. Expected return for preferreds is 14% per annum for this 7 year period.

        ii. Common stocks would eventually rally to catch up with the remaining $10B in earnings owed to them. A multiple of 10x puts the enterprise at $100B valuation meaning about common shares would be around $17.22 apiece with expect returns of 24% per annum.

      B. Fairholme proposal is executed. Past government sweep and any profits from wind down of business used to pay down government. Preferred holders would exchange shares for common shares of new entity to raise capital. $17B in warrants rights offering. About 57% of the company would belong to FNMA preferred holders.

        i. Based on Ackman presentation figures/margins, we can estimate that the co. could earn around $20B per yer and continue to capitalize up to 10% capital levels while charge 20 bps more in g-fees. A multiple of 10 puts the value of the combined co at $200B. FNMA common holders entitled to 57% resulting in value of 593% of face value to preferred holders or 64% per annum over 5 years.

        ii.Common shareholders wiped out.

    C. Ackman's proposal wins out. Preferred stocks are maintained, fees are raised, common remains in tact. 7 year recap.

        i.Preferred shareholders receive 2.5x current price for expected returns of 14% per annum over next 7 years.

        ii. Common holders receive somewhere between 10-15x current price (depending on future offerings to recap faster) resulting in nice profits no matter how  it's sliced.

    D. ???

 

Now let's handicap them.

 

I think the probability of government winning the case is low. So let's focus on the probabilities of a successful injunction.

 

Fairholme's plan makes sense for the government. Democrats get continued service that will keep costs of mortgages low and Republicans can claim a victory for small government and private enterprise. The gov would likely receive close to $200B in addition to current profits over the next 10 years of wind down ($51B from FIA business as estimated by Ackman, and $15B per year from legacy book) so it wouldn't be a total forfeiture of rights.

Only makes sense to own the preferred in this scenario as common shares are totally wiped out.

 

If either Ackman's solution is accepted, or some derivation of the first possibility of the sweep reducing current obligation to gov, then common shares are likely the way to go but preferred benefit too.

 

There's still unknown solutions that could surface that could affect one or both differently. It seems like the present solutions suggest that the majority of exposure should be held via preferred stock that will be worth something in every scenario (and worth a lot in Fairholme's scenario). An argument could be made for having 20-30% in common makes to boost returns in any other scenario but you don't want to end up with an absolute loss.

 

Does the board generally agree?

[merkhet]

A few running notes:

 

Scenario A:

 

I would agree with most of this -- except I have no idea where you get an expected return of 24% per annum. If the government preferred goes back to a 10% rate, then the preferreds basically go to par with the possibility of a discount based on whether there's an immediate appeal.

 

Same thought on the common stock -- though the equity build might put a slight hamper on the common.

 

Scenario B:

 

Basically agree though I think it's less likely they go this route.

 

Scenario C:

 

Same thought as Scenario A.

 

Additional Notes:

 

Let's not forget that Fannie has about $45 billion in DTAs that they might be able to strike a deal on w/ Treasury to further reduce the government preferreds. Any such deal would accrue directly to the common stockholders. An extra $3.5 billion a year is a 35% increase to the market cap.

 

Alternatively, let's remember they have pre-tax income of around $22.5 billion a year @ current g-fees, so the payback on the government preferred could be quite a bit faster than you think. (If they increased that by 20 bps, they'd have $30 billion in pre-tax income per year.)

 

Ackman's involvement here gives me a considerable amount of comfort since, as a 10% holder, my guess is that he's going to try and get on the board and make capital allocation decisions of this nature.

[morningstar]

A few running notes:

 

Scenario A:

 

I would agree with most of this -- except I have no idea where you get an expected return of 24% per annum. If the government preferred goes back to a 10% rate, then the preferreds basically go to par with the possibility of a discount based on whether there's an immediate appeal.

 

Same thought on the common stock -- though the equity build might put a slight hamper on the common.

 

In scenario A, worth pointing out the lower coupon older prefereds should still trade well below par for the foreseeable future, maybe forever. For instance if WFC 6% fixed-for-life prefs trade below par (rated investment grade, paying), so will these most likely, even 7 years hence. Especially if rates actually ever move wider.

 

That said, the higher coupons are the much bigger and liquid issues.

[merkhet]

A few running notes:

 

Scenario A:

 

I would agree with most of this -- except I have no idea where you get an expected return of 24% per annum. If the government preferred goes back to a 10% rate, then the preferreds basically go to par with the possibility of a discount based on whether there's an immediate appeal.

 

Same thought on the common stock -- though the equity build might put a slight hamper on the common.

 

In scenario A, worth pointing out the lower coupon older prefereds should still trade well below par for the foreseeable future, maybe forever. For instance if WFC 6% fixed-for-life prefs trade below par (rated investment grade, paying), so will these most likely, even 7 years hence. Especially if rates actually ever move wider.

 

That said, the higher coupons are the much bigger and liquid issues.

 

Two things to add to that:

 

(1) The Fannie Mae Series S has a floor of 7.75% and floats, so it's important to pick your spots.

 

(2) If we are talking about the injunction winning, then you will take your chances on a market rate. If we are talking about the Takings Clause winning, then you will get par.

[merkhet]

1.  Regan-appointed Judge Lamberth will invalidate the 3rd amendment (3A) via summary judgement in the Perry case soon after his current Blackwater murder trial goes to jury.

 

That case just went to jury a few days ago...

[bmichaud]

Market certainly doesn't like something going on behind the scenes....

[Yours Truly]

Ex-CFO and writer of TimHoward717.com joins Fairholm in suit against FNMA

 

http://www.valuewalk.com/2014/09/ex-cfo-fannie-mae-timothy-howard-joins-berkowitz-suit/

 

[merkhet]

Market certainly doesn't like something going on behind the scenes....

 

The theory has been that the Iowa case decision is bad for plaintiffs. I tend to disagree as it was just a jurisdictional issue for the Iowa plaintiffs.

 

Just landed in LA. I will type more later.

[merkhet]

Okay, so basically, as I understand it, there was a ruling in iowa where certain plaintiffs were denied additional discovery because the court said no additional discovery was needed in order to establish jurisdiction on whether the court could hear the case.

 

The big question was whether this could be then applied to the other cases before various courts, because, as I indicated earlier, discovery is critical to the establishment of a case that FHFA and Treasury had no authority to do what it did.

 

Now, the issue here is that in the case before Judge Sweeney, discovery actually IS needed because they need to be able to establish whether the court has Tucker jurisdiction based on whether FHFA was a government actor -- and/or a government actor acting in conjunction with Treasury.

 

Additionally, there is currently no discovery process before Judge Lamberth (there's merely a motion for summary judgment), so I don't see how the supplemental authority would matter here. And, personally, I think this is the more important near-term catalyst.

[onyx1]

 

What Happens if the Government Loses...

 

http://www.forbes.com/sites/richardepstein/2014/09/10/what-happens-if-the-government-loses-on-the-third-amendment-the-senior-preferred-stock-certificates-spell-nothing-but-trouble-for-the-government/

 

 

This is the first cogent explanation I have read on how & why the senior preferred would likely be retired in the event UST was forced to return 3rd Amendment excess distributions.  The longer the government delays, Epstein argues, the better off private shareholders will fare in the event of a favorable ruling as at some point 3rd Amendment dollars returned will exceed that required to retire all senior preferred plus coupon interest.  The excess dollars would have to be deemed capital, making it harder for FHFA to justify not retiring the senior preferred as allowed under Sections 3 & 4 of the senior preferred stock certificates.

[merkhet]

That's a good read. Thanks onyx1.

 

I'm certainly rather perplexed by the recent stock price movements over the last two weeks.

[valuecfa]

Swapped out some prefs for common today. Large decline is common's price is make it attractive again.

[merkhet]

Looks like the reason for the sell down yesterday was a ruling from Judge Jackson on derivative standing.

2014-09-19_Memorandum_Opinion_in_Sweeney_Estate_Marital_Trust_Case.pdf

[bmichaud]

http://investorshub.advfn.com/boards/read_msg.aspx?message_id=106453409

[bmichaud]

Page 6:

 

"But the Court finds that there is no disabling conflict here that would permit plaintiff to assume the Conservator’s function. Furthermore, the clear statement in HERA that “no court may take any action to restrain or affect the exercise of powers or functions” of the Conservator, 12 U.S.C. 4617(f), suggests that the Court may not be empowered to authorize plaintiff to pursue litigation that the Conservator has declined to pursue."

 

 

The Conservator did not pursue the litigation because FHFA is the Conservator and would not sue that which it is working with...i.e. Treasury.

 

No?

[merkhet]

Sorry that I posted and ran this morning -- I had an alumni thing that I was in charge of throwing.

 

Page 6:

 

"But the Court finds that there is no disabling conflict here that would permit plaintiff to assume the Conservator’s function. Furthermore, the clear statement in HERA that “no court may take any action to restrain or affect the exercise of powers or functions” of the Conservator, 12 U.S.C. 4617(f), suggests that the Court may not be empowered to authorize plaintiff to pursue litigation that the Conservator has declined to pursue."

 

The Conservator did not pursue the litigation because FHFA is the Conservator and would not sue that which it is working with...i.e. Treasury.

 

No?

 

So, I actually agree with the ruling here, but it doesn't matter for us.

 

The problem is that the plaintiffs are suing Treasury on behalf of Fannie Mae via a shareholder derivative lawsuit. (1) FHFA has already moved to stand in place of the shareholders in this lawsuit against Treasury. (2) The issue that the court ruled on was basically that just because FHFA was following the rules of the contract it struck does not mean that Treasury & FHFA are essentially the same entity.

 

Notably, this is differentiated from the Perry & Fairholme suits because (A) Perry is suing as a shareholder, not as Fannie Mae, and (2) Fairholme is suing FHFA directly. In neither case does the issue of shareholder derivative issue come up.

 

The wrinkle in the Perry case is that, while it might be possible that the FHFA would substitute itself as a plaintiff, it has made absolutely no indications that it is going to do so -- and what Perry is suing for is basically misconduct on the part of FHFA. On the Fairholme side, the FHFA cannot be expected to sue itself for actions it caused.

 

As for the anti-injunction provision of HERA, the court specifically states the following:

 

Every circuit court to consider the issue has held that this provision strips courts of jurisdiction to hear challenges to the “lawful exercise of FHFA’s power as conservator.”

...

Plaintiff does not argue that the FHFA’s failure to bring suit against Treasury over the LIHTC issue was outside the scope of the FHFA’s powers as the Conservator of Fannie Mae.

 

In both the Perry & Fairholme cases, that's exactly what they're suing for -- the fact that the FHFA exceeded its own powers as a conservator in executing the Third Amendment. Perry for procedural mishaps under the APA and exercising powers outside of those granted to a conservator. Fairholme for an illegal Taking w/o compensation.

[bmichaud]

Extremely helpful, Merkhet, thanks.

 

 

[Mephistopheles]

Thanks Merkhet. This also doesn't apply to the Ackman case, given that he is also suing the FHFA directly, and not on the behalf of FNMA/FMCC, correct?

[merkhet]

Basically, yes. In the Ackman case, he alleges similar things that Perry alleges but on behalf of the common. So, again, it's unreasonable to believe that the FHFA will sue itself.

[muscleman]

Swapped out some prefs for common today. Large decline is common's price is make it attractive again.

 

Do you know why Ackman bought 10% of FNMA but not more? Is there any law that prevents him from buying more?

[merkhet]

No -- but usually people buy 9.9% of a company to avoid triggering various filing requirements.

[nkp007]

Stumbled on some amazing back and forth on twitter. Robert King (apparently a value investor, maybe on this board) is engaging Carney in the most thoughtful way I've seen.

 

https://twitter.com/robertqking/with_replies

 

I'm impressed by the depth of Robert's knowledge on the F+F sweep documents.

 

Edit: LOL It's Merkhet.