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Fannie Mae: A Primer To Senior Preferred Shares And Warrants
Oct. 30, 2014 5:58 PM ET | 1 comment | About: Fannie Mae (FNMA)

Disclosure: The author is long FNMA. (More...)
Summary

The Fannie Mae conservatorship, and Treasury’s Senior Preferred Shares and Warrant, are governed by seven documents.
These documents are a credit to the legal scriveners’ art, making the moderately complex obscure to the lay reader.
This article will translate from the legalese the provisions that holders of Fannie stock will want to know.

This article comes out of a request by two readers for both a primer and a deep dive into the rights granted Treasury under the Senior Preferred Stock Purchase Agreement and related documents with regard to Fannie Mae (OTCQB:FNMA). As always, the goal is to translate the legalese into concepts any interested investor can follow.

The documents covered in this article will be:

Senior Preferred Stock Purchase Agreement dated September 7, 2008, (PSPA). (My thanks to the reader who sent me the link to this document.)

Senior Preferred Stock Certificate

Federal National Mortgage Association Warrant to Purchase Common Stock

Amended and Restated Senior Preferred Stock Purchase Agreement dated September 26, 2008, (Restated PSPA)

Amendment to Amended and Restated Senior Preferred Stock Purchase Agreement dated May 6, 2009, (1st Amendment).

Second Amendment to Amended and Restated Senior Preferred Stock Purchase Agreement dated December 24, 2008, (2nd Amendment).

Third Amendment to Amended and Restated Senior Preferred Stock Purchase Agreement dated August 17, 2012, (Sweep Amendment).

These documents are a credit to the legal scrivener's art, making the relatively complex completely obscure to the lay reader.

Essentially, there is an original Senior Preferred Stock Purchase Agreement which has been amended four times. The first amendment is titled with Amended and Restated. The next three amendments are numbered first, second and third. Each numbered amendment replaces specific paragraphs in the Restated PSPA. Subsequent amendments also replace paragraphs some of which were changed by prior amendments.

The correct way to do this is to restate the agreement and incorporate the new provisions with the old to produce one comprehensive document. This is what was done with the Restated PSPA. After that, the parties simply executed amendments. As a result, the reader must review the Restated PSPA and each of the three subsequent amendments to verify all the changes. I have seen worse, but it is still a mess.

For readers new to the Fannie saga, the factual background to these transactions is found in prior articles here and here.

Before going further, some basic stock concepts a reader requested: Preferred stock is stock which is has some feature which gives it a "preference" over common stock. The usual preferences are liquidation and dividends. A liquidation preference is a right, in the event the company is liquidated, to receive a fixed amount per share before the owners of the common receive anything. A dividend preference is a right to receive a fixed periodic dividend, again before the common receives any dividends. Common stock has a right to a dividend only if the Board of Directors of the company, in its discretion, elects to declare one. A warrant is a right to purchase stock of the company giving the warrant. The warrant will specific the type of stock which may be purchased, the number of shares which may be purchased, the price to be paid for the shares and the date by which the shares must be purchased. After that date, the warrant expires and becomes worthless. (I ask the indulgence of more experienced investors in only covering features which apply here.)

Under the Restated PSPA, Treasury agreed to make $100B available to Fannie (Commitment). The Commitment was increased to $200B in the 1st Amendment. In the 2nd Amendment the Commitment was increased to $200B plus any Deficiency Amounts (defined as the excess of Fannie's liabilities over Fannie's assets, excluding amounts due under the Senior Preferred Stock (SPS)).

In return for the Commitment, FHFA, as conservator of Fannie agreed to a number of things

1) To issue to Treasury 1M shares of SPS. The SPS has a dividend of 10% of the Liquidation Preference. Here, Liquidation Preference is defined to be:

a) $1,000 per share (1M shares X $1,000 per share = $1B); and

b) A prorated amount equal to each draw of the Commitment. Thus, the Liquidation Preference goes up with each draw on the Commitment and goes down with each re-payment of a draw on the Commitment. This is a critical point.

2) To issue the Warrant, which permits:

a) The purchase of that number of common shares to equal 79.9% of all outstanding common stock;

b) At a price per share of "one one-thousandth of a cent ($0.00001) per share;"

c) Expiring on September 7, 2028.

3) To pay a Periodic Commitment Fee "intended to fully compensate [Treasury] for the support provided by the ongoing Commitment."

a) The fee to be set each five years by agreement of FHFA and Treasury "subject to their reasonable discretion and in consultation with the Chairman of the Federal Reserve." Treasury has the right to annually waive the Periodic Commitment Fee "in its sole discretion based on adverse conditions in the United States mortgage market."

b) The fee is payable in cash or by adding the unpaid amount of the fee prorata to the Liquidation Preference of the SPS.

This brings us to the infamous, Third or Sweep Amendment. In the Sweep Amendment, the dividend of 10% of the Liquidation Preference was changed: Beginning January 1, 2013, "Dividend Amount shall be the "Net Worth Amount" minus "Capital Reserve". In more detail, and in equation form, this is:

Total Assets (not including the Commitment)

- Total Liabilities (not including any capital stock liabilities)

= Net Worth

- Capital Reserve

= Dividend

The Capital Reserve was $3B in 2013, but reduced annually ratably to be zero in 2018.

Bottom line: Under the Sweep Amendment, every quarter, all assets of Fannie over the Capital Reserve amount are transferred to Fannie. In 2018, the Capital Reserve goes to zero. At that point, every penny of Net Worth goes to Treasury every quarter.

On the other hand, so long as the Sweep is in place, the Periodic Commitment Fee does not accrue and is not payable. Very kind.

When does the Sweep end? Funny you should ask. This was the most indecipherable part of all seven documents.

There is no explicit provision which ends the Sweep. However, since the Sweep is the dividend to the SPS, the way to end the Sweep is to pay down the Liquidation Preference ($1B plus all the draws). Paying down the Liquidation Preference causes the SPS to be retired. Thereafter, no dividend is due.

Here's the rub: since the payments under the Sweep are "dividends" and not repayment of the Liquidation Preference, there is no way for Fannie to accumulate any funds to repay the Liquidation Preference. (There's a lot more, but that's the bottom line.)

Three more interesting provisions: First, §5.3 of the Restated PSPA forbids FHFA from terminating the conservatorship without Treasury's written consent. FHFA may, however, place Fannie into a receivership without Treasury consent.

Second, §5.7 of the Restated PSPA places a maximum limit on the amount of Mortgage Assets Fannie may own as a given date. It also requires that Fannie own no more than a defined percentage of the maximum each year thereafter. The final revision, in the Sweep Amendment, revises the maximum Mortgage Assets to be not more than $650B as of December 31, 2012, and each year thereafter to be not more than 85% of the previous year's maximum at each December 31. Fannie will not be required to own less than $250B. By my calculations, the $250B should be reached in 2018.

Third, §6.7 of the Restated PSPA provides that:

"If any order, injunction or decree is issued by any court of competent jurisdiction that vacates, modifies, amends, conditions, enjoins, stays or otherwise affects the appointment of Conservator as conservator of Seller or otherwise curtails Conservator's powers as such conservator (except in each case any order converting the conservatorship to a receivership) … [Treasury] may … declare this Agreement null and void, whereupon all transfers hereunder (including the issuance of the Senior Preferred Stock and the Warrant and any funding of the Commitment) shall be rescinded and unwound and all obligations of the parties (other than to effectuate such rescission and unwind) shall immediately and automatically terminate. (Emphasis added.)

Translation: if any court issues any order against FHFA which Treasury doesn't like, Treasury can unwind all the transactions discussed in this article "including the issuance of the [SPS] and the Warrant." Fannie would have to repay all the draws, of course. My speculation is that this was designed as a nuclear option to make any litigant fearful of having to repay the Commitment at Treasury's option. This is no longer a viable threat given Fannie's profitability but does reflect an interesting mindset.

With the documents outlined, let's talk about the implications.

First, the warrant: Did any reader earn a Gold Star by noticing the typo in the consideration for the warrant? The price per share of "one one-thousandth of a cent ($0.00001) per share" is wrong. "Thousandths" is three zeros to the right of the decimal, not four. I guess a $100B transaction just doesn't buy the same degree of proofreading it once did. Or, as my government employed friends would say: "Close enough for government work." The rule of construction is that in the event the numerals and written words differ, the written words govern. The difference in the exercise price is $90 and as a holder of Fannie common I want every penny.

On a more serious note, exercise of the warrants will increase the number of shares of common to the point that Treasury will own 79.9% of the outstanding common shares. The holders of the existing outstanding common shares will only represent 20.1% of Fannie. The exercise of the warrant will not cause the existing outstanding common to be eliminated or the current junior preferred to be converted into common.

The 79.9% number is not random. Under equity accounting rules, the owner of 80% or more of the common stock of an equity must consolidate the liabilities of that entity on the owner's books. Here, Treasury did not want to reflect Fannie's liabilities on Treasury's books. Thus, the Treasury warrant is only for 79.9% rather than 80% or more.

Second, the reduction of the maximum amount of the Mortgage Assets: At first blush this looks like part of a liquidation effort requiring Fannie to reduce its fixed income portfolio. Readers should review Bill Ackman's presentation on Fannie given in May 2014, if you have not already, to get the second blush. Ackman makes the point that Fannie has two business lines: buying, selling and holding fixed income securities, which makes money on interest spreads, and collecting guarantee fees.

Of the two business lines, the fixed income asset line is much riskier due to leverage and interest rate exposure while the guarantee fee line is more lucrative. On reflection, in the event Fannie is returned to the shareholders, reducing the mortgage assets and the associated risks, may not be a bad thing. On the other hand, I welcome any reader analysis of the relative cash flow and profit implications of the two lines.

Third, I think the reduction in the Capital Reserve is more nefarious than the portfolio reduction. Every company needs equity on the balance sheet. Reducing Fannie's equity to zero is an effective way of ensuring Fannie remains a ward of the Government, dependent on Government financing.

Fourth, in light of the legal arguments about whether Fannie has come under the control of Treasury, for what it's worth, in my opinion, the original PSPA was drafted by a Treasury attorney. Why do I say this? When an attorney prepares an agreement, he does so with his client's perspective. If the client is the seller, it's a sales contract. If the buyer is a purchaser, it's a purchase contract. Plus, it's usual, although not required, to name the seller first in a purchase and sale agreement. Review the first paragraph of the original PSPA. That paragraph lists the purchaser, i.e., Treasury, first. Very unusual, unless Treasury is your client and you view the world from Treasury's perspective. Does this have any legal bearing on the argument? Nope. But to a transactional attorney, it's telling.

Fifth, there's point about the original 10% dividend I haven't seen anywhere else. The literature about "lender of last resort" indicates that the interest rate should be "punitive" to literally punish poor business judgment. Yet, the rate should not be so high as to cripple the entity receiving the help or the purpose of the lender of last resort, to help stabilize entities, is defeated. The Government has argued that the Sweep Amendment was necessary because Fannie was unable to pay the 10% dividend. That would seem to me to be an argument that the initial 10% rate was far too much if it was so high the Government did not think Fannie could reasonably pay the dividend. The 10% interest rate smacks of ulterior motive.

Finally, in my career, I have helped raise the rent on farmers' elevators 6,000%, threatening to seize the livelihoods of entire farm communities (and been upheld by the 7th Circuit!), sold property where I knew my client had no title (quitclaim deeds), extracted 15 - 20 times the market value of a product when my client had a monopoly (free market), successfully fended off environmental agencies and finally, (arguably) cheated an order of nuns.

Yet, I'm a mere piker and stand in awe of the counsel who prepared the PSPA documents. To take every penny from the public shareholders and set up an economic servitude in perpetuity under the veil of rescue takes a special callousness which, so far, has been beyond me.

Request for reader help: I'm considering an article setting out the various Fannie suits in a chart, characterizing the approaches and discussing the high end strategies and end games for each approach as it relates to the common shares. Any reader help to forward links to complaints I don't already have would be appreciated. General articles have indicated that there are 19 or 20 Fannie Sweep or PSPA related suits. The only ones I have so far are:

Perry v. Lew, DC District Court (which includes the Fairholme suit also in the DC District Court)

Continental Western v. FHFA, Southern District of Iowa,

Fairholme v. FHFA, Court of Federal Claims

Rafter and Pershing Square v. USA, Court of Federal Claims

Washington Federal v. USA

Some of these, such as the ones before the Court of Federal Claims may be consolidated. Again, any help would be appreciated.

Editor's Note: This article discusses one or more securities that do not trade on a major exchange. Please be aware of the risks associated with these stocks.

http://seekingalpha.com/article/2620535-fannie-mae-a-primer-to-senior-preferred-shares-and-warrants