Fannie Mae-No Politics (FNMA)

[navycmdr]

Fannie Mae: Let's Return To The Settlement Negotiation Table

Dec. 14, 2016 9:56 AM ET| Charlie Harrison

..... Summary .....

-- Fannie preferred and common shares have risen with the nomination of Steven Mnuchin as Secretary of the Treasury and his enunciation that the privatization of Fannie as a Trump administration.

-- Subsequent blogosphere discussion has centered on how that privatization would look and whether it’s better to own preferred or common shares.


-- This article will set out my sense of how the litigation settlement process could work and the justification for owning FNMA common over the preferred.

The Federal National Mortgage Company (OTCQB:FNMA) has been mired in conservatorship since 2008 and litigation since 2012, when the terms of a Senior Preferred Stock Purchase Agreement (SPSPA) between the U.S. Treasury and the Federal Housing Finance Agency (FHFA), Fannie's conservator, were changed under the now infamous Net Worth Sweep (NWS) with preferred and common shareholders filing suit.

The details of the conservatorship, litigation background and the SPSPA have been extensively covered in Seeking Alpha, including my own articles, the most relevant one to this article is the one on the SPSPA, amendments and resulting documents here. The articles and tweets in the blogosphere seem to focus on valuation issues such as historic and likely future guarantee fees, the need, amount and process for Fannie to rebuild reserves drained by Treasury, whether the warrants for 79.9% of Fannie's common will be exercised or voided and how quickly the Trump administration can or will to move to privatize Fannie. While many important points have been made, a critical component has been missed: Fannie is the subject of 20+ suits. While the Trump administration can certainly take unilateral action, it will not be able to claim a clean win until the Fannie suits are substantially resolved.

This article will focus on what I think is the most likely scenario for the litigation settlement path. By way of background, in a prior life I was general counsel for a small publicly traded master limited partnership which was the successor to a reorganized railroad. As such, I negotiated or managed, what was for that company's size, mission critical litigation settlements.

Looking at the landscape for the potential settlement of the Fannie suits, an immediate point leaps out: If the Trump administration settles the suits reasonably soon after inauguration, any payment or government embarrassment can be blamed on prior administrations. Conversely, Trump's administration will own any litigation it does not settle. So it makes no sense for Trump to not settle any litigation his counsel tells him will eventually be lost. Moreover, of the three priorities Mnuchin recently enunciated: tax reform, Dodd-Frank reform and privatizing Fannie, only privatizing Fannie can be done by the executive branch without involving Congress and the legislative process. Thus, settling the Fannie suits as part of privatization is a potentially quick low hanging fruit to claim an early relatively easy accomplishment. For that reason, I see the main settlements happening in 2017.

Before talking about settlement, let's review the relevant points of the litigation. Over twenty suits have been filed. Although there are some outliers, for our purposes, the litigation falls into two broad categories.

The first is the consolidation of litigation in the federal circuit for the District of Columbia. For convenience, let's call it the "Perry Litigation" after Perry Capital, a lead plaintiff. Those suits were dismissed in September 2015, then appealed to the federal appellate court. After oral argument in April 2016, and subsequent briefing, they await what most expect to be an imminent decision. I've written about why I think the dismissal should be reversed here. After listening to the oral arguments, I agree with the commentators who speculate a 2-1 decision in favor of the plaintiffs. The basic claims here are that both FHFA and Treasury acted outside their authority, that both FHFA and Treasury violated the Administrative Procedures Act (NYSE:APA) in failing to maintain the appropriate administrative record in entering into the NWS and various other state law claims.

The second line of consolidated cases is before the Federal Court of Claims. For shorthand, this is the "Fairholme Litigation" after Bruce Berkowitz's Fairholme Funds. These cases essentially assert that the NWS is a taking of property for which the shareholders are entitled to compensation under the Fifth Amendment. I've written here about the issue that the person entitled to the recovery is the owner of the stock at the time of the taking, not the purchasers after the fact. More interesting, for our purposes, is the discovery issue.

In response to Treasury's and FHFA's motion to dismiss, Judge Sweeney in the Federal Court of Claims permitted what was termed "jurisdictional discovery" into the background of the SPSPA and the NWS. While Treasury and FHFA turned over 48,000+ documents, they claimed various privileges against disclosure on another 11,000+ documents. Judge Sweeney emphatically recently ruled on a selection of 56 of those documents that none of the asserted privileges applied in a ruling which was a not-too-subtle slap to FHFA and Treasury, then emphasized her displeasure by ordering FHFA and Treasury to file a memorandum explaining why they should not be ordered to pay Fairholme's costs and attorney's fees. This is judge-speak for "your arguments are frivolous and wasted my time."

This brings up a critical point: Treasury and FHFA fought very hard and asserted what the judge feels are frivolous arguments to delay turning over these documents. What, then, is in those documents that the Department of Justice was willing to alienate the judge using argument it knew would fail?

Let's back up a step to consider this. In litigation, it is not what you know, but what you can prove. A number of commentators have asserted that FHFA took over Fannie as a conservator not because Fannie was insolvent, but because FHFA and Treasury wanted to use Fannie as a backdoor bailout of the too-big-to-fail banks (TBTF) by requiring Fannie to purchase $50B per month of TBTF mortgage backed securities (MBS) at par, then marked them to market once on Fannie's books. This created book loses which required draws from Treasury which had to be repaid at 10% interest at a time of historic lower interest rates and when the government was bailing out Goldman, Morgan and Citigroup at interest rates not more than 2.2%. Also, the government never required warrants of Goldman, Morgan and Citigroup in exchange for their bailouts. The excellent Forensic Look at the Fannie Mae Bail Out explains in detail that Fannie never needed the Treasury bail out.

If this is true, why does no suit argue that the SPSPA was a fraud and the senior preferred stock and warrants should be voided and the entire indebtedness forgiven without applying the 10% NWS dividends? Every suit which is not alleging a taking, only asks that the NWS be voided and the payments to Treasury be considered a repayment of the Treasury draws. Several complaints, such as Washington Federal and Collins discuss the events surrounding the SPSPA as outlined above, but neither ask that the SPSPA be voided. Why not allege the SPSPA was a fraud? Answer: proof. Asking the NWS be voided only requires that the SPSPA documents be admitted, then argue that as a matter of law, the NWS should be void under the various legal theories in the complaints. Proving the SPSPA was a fraud to bail out the TBTF at the cost of Fannie's shareholders is simply too difficult to prove. Good luck getting directors to admit they violated their duty of loyalty, senior executives to commit professional suicide by challenging Treasury and FHFA and senior government officials to put their pensions at risk by admitting they helped perpetrate a fraud on public shareholders. In the absence of proof of the SPSPA fraud, a much better legal strategy is to make the easy and low-hanging-fruit NWS claim.

Here we move into speculation. Informed, I hope, but speculation none the less: FHFA, Treasury and the Department of Justice would not have asserted frivolous legal arguments unless the allegedly privileged documents were much more damaging than the documents plaintiffs already had. Plaintiffs can already show that Treasury was directing FHFA, that Treasury knew Fannie would be returning to book profitability shortly before entering into the NWS and that FHFA at least violated the APA. The only thing of the kind of magnitude to justify this degree of effort is that the withheld documents reflect the SPSPA as fraud on Fannie shareholders to bailout the TBTF banks.

With this landscape in mind, let's return to the settlement negotiation table.

Some would argue that Trump need not negotiate; he can take unilateral actions which would eviscerate the suits. True, but the appearances for a man with a reputation for toughness to maintain are unappealing: Trump can order Justice to no longer defend the suits and withdraw any active pleadings contesting the complaints, but this leaves the suits still winding through the courts resulting in default judgments. Default judgments, however, imply negligence or incompetence. Trump could also order Treasury to credit all NWS dividends to the draws and to forego all future dividends. This would have the effect of rendering the litigation moot, but without global settlements, has the appearance of giving something for nothing. Unilateral action without a settlement is unappealing.

Back again to the negotiating table. Consider first how this plays out on the Trump side. Trump will be told about the privilege issue documents, that this has only been a delaying action, what those documents contain and that the government will eventually lose and have to disclose. Let's again assume they contain very damaging evidence of the SPSPA as a fraud on the Fannie shareholders. If Trump settles now a suit his counsel tell him the Government will eventually lose, he can blame the prior administrations and claim to support the rule of law and the capital markets. Recall too that John Paulson, whose fund holds Fannie common is a part of Trump's transition team; that Bill Ackman of Pershing Square Capital already claims to have had his first meeting with Trump, presumably on this issue. That Carl Icahn and Bruce Berkowitz also hold shares. Trump has a "yuge" opportunity to do the right thing by shareholders, make friends with people well able to financially support his second run for president and pick up an easy quick win, all at the cost of casting dirt on prior administrations which have not treated him graciously. What's not to like?

There is the optics argument that the press will scream about a give away to greedy hedge fund speculators and Trump's billionaire buddies. But Trump has shown nothing but contempt for the press and can personalize the settlement with photo ops with the small shareholders and union pension funds which were raped by the SPSPA and handsomely compensated by his settlement. I don't think the optics issue will dissuade Trump.

There is also the public deficit argument that any payment to the plaintiffs comes out of the federal budget which will only increase the deficit under Trump's administration. As a matter of fiscal and monetary policy, I refer the reader to the excellent work of Cullen Roche on Modern Monetary Theory and not discuss the federal deficit argument further except to say that in light of the Obama record on deficits, I don't think deficits will trouble Trump.

Now let's look at settlement from the Perry plaintiff's perspective. By the time the Trump administration can prepare for a negotiation, the DC appellate court will have rendered its opinion for the plaintiffs and Justice will have appealed to the US Supreme Court. Bear in mind the Supreme Court only hears approximately 4% of the cases presented to it. Thus, the plaintiffs have a stronger hand on the NWS being voided and dividends being counted as repayment of the draw amounts.

But as plaintiff, you never settle until you get all the discovery documents. Here, plaintiffs will argue they are entitled to the withheld documents, that the court process will give it to them and that if the Trump administration will not furnish them it can only be because it damages the government case much more than the documents already disclosed. The plaintiffs will understand that while time hurts their IRRs, time also hurts Trump: if he defends even only part of the litigation in court, he owns the adverse result. Not appealing for Trump given his advantages in an early settlement.

Trump, however, has a reputation as a frequent litigator who is no doubt familiar with the settlement process and advised by the best lawyers the government can buy. He can be expected to take an initial tough position. His opening position would most likely be to tell the plaintiffs to accept the NWS voiding settlement, book your "yuge" gains and release the government from all other claims arising out of the conservatorship.

Turn now to the plaintiffs. Thought experiment: Are Bruce Berkowitz, Carl Icahn, Bill Ackman and John Paulson merely motivated by money or are they driven by it. Here's why it's important.

The plaintiffs will see that the NWS voiding as a won game. By settling now, they can book those gains. Trump can be expected to press for a release for all claims arising out of the conservatorship as part of the settlement. So if the plaintiffs settle now, they most likely have to give up any SPSPA fraud claims. Behavioral Finance and Prospect Theory (plus the experience of any investor looking at a handsome gain in a position) tells us that we become risk adverse when protecting a gain. If the plaintiffs focus only the NWS voiding gain, they will settle.

But while I have no personal experience with any of the plaintiff - investors, my experience with investment bankers and private equity players on a much smaller scale is that is that they are, deeply, deeply driven by money, not as money, but as the ultimate score keeper. This has to apply much more to men on the top of the industry. If so, they will not focus the NWS voiding gains, but on the gains from proving the SPSPA fraud.

So what would the upside be from proving the SPSPA fraud? Go back to the Forensic Look at the Fannie Mae Bail Out. Its authors assert that Fannie never needed a penny of bail out money. Also look at Tim Howard, the former Fannie CFO, post on December 9, 2016. He asserts that in 2008, Fannie had a $3.1T book with only a $47B reserve. Today, Fannie's book is still approximately $3.1T, but the credit quality is better. If Fannie never needed the bail out in 2008, and today it has a better book, then a $47B reserve is still appropriate. If the entire SPSPA is a fraud to bail out the TBTF banks and Fannie never needed any bail out money, then the entire SPSPA is unwound. Fannie's 2Q 2016 press release reflects total draws of $117.1B and dividends of $151.4B. If I'm representing the plaintiffs I'm arguing the draws are not only forgiven but paid to Fannie as damages, the dividends returned, plus the senior preferred stock and warrants are voided. Total the numbers, divide by 1.2B shares and like a private equity guy think "special dividend" to the common after paying a roughly 5-6% dividend to the $20B in non-cumulative preferred and setting aside $47B in reserves. The numbers are eye popping. Recall, too, this is in addition to Fannie's valuation as an operating entity.

My money, is that the plaintiffs who own the commons will focus on the once-in-a-century upside of proving the SPSPA fraud. If the plaintiffs anchor on the SPSPA fraud potential gains at the negotiating table, they will perceive not achieving those gains as a loss. Recall that Behavioral Finance and Prospect Theory also tell us that we become risk seeking to avoid a loss. If so, they will confront Trump and demand the withheld documents as a pre-condition to settlement.

So, in the great game at the negotiating table, the worse reasonable case for the plaintiffs is that Trump is willing to concede the NWS voiding but not the SPSPA fraud. The plaintiffs in turn argue for full disclosure of the withheld documents and in their absence assert the documents must bear on the SPSPA fraud and demand settlement assuming that fraud. Who wins?

My money, again, is on the investors getting the better position. Trump is not playing with his own money, can disclose the horrible things the prior administrations have done and claim to be draining the swamp and upholding the rule of law by settling. He also reaps the intangible benefits of billionaire friends for the future. Recall, too, that time works against Trump in that his Justice Department must continue to submit pleadings defending these actions. At some point, certainly before a year after the inauguration, he owns the litigation. If I'm counsel for the plaintiff, I advise them that the adverse affect of time on their IRRs is much more than offset by the potential increase over the NWS voiding value.

Go back to the eye popping SPSPA fraud upside number. Remember that this is a litigation settlement. In settlement, plaintiffs trade potential upside value for an immediate certain result, avoiding the uncertainty of litigation. The plaintiffs can only expect a percentage of that number, but a potentially very healthy percentage assuming the Perry appeal ruling favors the plaintiffs and depending on the extent the undisclosed documents support the SPSPA fraud argument. Another obvious split-the-baby-in-half point would be for the government to only forgive, instead of refund, the draws and repay the dividends, plus void the senior preferred and warrants. While a little less eye popping, the resulting number is still well worth negotiating for.

Releasing Fannie from conservatorship requires more than just settling the lawsuits, but those matters are almost administrative, with the exception of setting the guarantee fee. More important for immediate valuation is the litigation settlement paradigm.