Fannie Mae: Why I Increased My Commons Position By 33% After The Perry Decision
Charlie Harrison - Mar. 7, 2017 9:32 AM ET
..... Summary .....
• Fannie longs were stunned by the Perry appellate decision because we forgot the power of the narrative and became caught in our echo chamber.
• Mnuchin is still very encouraging about releasing Fannie from conservatorship.
• The documents withheld by FHFA/Treasury become even more critical to a successful resolution.
• Being a Fannie long still has a compelling upside.
As the Federal National Mortgage Association ("Fannie Mae") (OTCQB:FNMA) investment community knows, on February 21, 2017, the long awaited decision in Perry v. Mnuchin in the Appellate Court for the D.C. district was issued. To deviate from the professional for a moment, sometimes being a Fannie long just sucks. With that out of the way, let's talk about what we learn from the decision and the way forward for Fannie longs.
First take away: The background narrative matters. Court cases are not handed down in a vacuum. In World War II, the Supreme Court upheld the forcible location of 110,000 Japanese in the US, more than half of which were US citizens, because of the back ground fear of Japanese invasion following the attack on Pearl Harbor. The context of a controversy dramatically affects the judicial outcome.
Both the majority and dissenting opinions extensively reference the popular narrative that Fannie was on the edge of collapse before the benevolent Department of the Treasury stepped in to rescue Fannie and by extension the entire financial system, from ruin. Just two samples: "… the lender, who had single-handedly saved the Companies from collapse... " Decision at page 28. "That $200 billion-plus lifeline is what saved the Companies - none of the institutional stockholders were willing to infuse that kind of capital during desperate economic times …" Decision at page 34. (Note the thinly veiled contempt toward the vulture plaintiffs attempting to profit from Treasury's rescue of the failed private sector GSEs.)
Those in the Fannie investment community believe the facts to be different: Fannie did attempt to access other funds but members of the government intervened. The terms of the Amended Senior Preferred Stock Purchase Agreement ("SPSPA") with "draws" defined as preferred equity contributions which could never be repaid but earning a 10% coupon was far in excess of the low single digit interest required of other bailout recipients and was grossly punitive. No other company which received a mortgage related bailout was required to give warrants as part of the package. Regardless of mark-to-market reserve losses, Fannie was cash flow positive throughout the crisis. FHFA required Fannie to purchase $25B a month of non-performing mortgages from too-big-to-fail banks at par moving the losses from the banks' books to Fannie's as a backdoor bailout of the banks, causing more losses to the detriment of Fannie shareholders. And finally, that Fannie (and Freddy (OTCQB:FMCC)) did not cause the mortgage banking crisis.
The problem is that the "common knowledge" the Fannie investment community has shared in the blogs, online articles and Twitter circles was not asserted by the plaintiffs and was not common knowledge to the judiciary. We got caught in our own echo chamber. Hence, we were surprised by the decision. As a citizen, I share the general investing community's moral outrage at the Government's initial duplicity and subsequent denial. But emotions are the downfall of investors and we erred in not giving enough credit to the impact of the common knowledge of the background narrative.
Second take away: Whether or not we lose this whole thing in the courts will depend on which is more powerful: The narrative of the benevolent Treasury stepping in to save the feckless GSEs and the financial system, which deserves judicial support given the national crisis, or the need to uphold the rule of law enunciated very well by the dissent. In that context, let's explore the decision.
The single most important issue is whether FHFA acted within its authority. If FHFA acted within its authority, then under 12 USC §4617(f), the courts have no jurisdiction.
Section 4617(f) provides: "Except as provided in this section or at the request of the Director, no court may take any action to restrain or affect the exercise of powers or functions of the Agency as a conservator or a receiver."
I wrote a prior Seeking Alpha article which analyzed each of the case cited by the parties. The case law agrees with the Perry decision (expressed in the negative): if the FHFA acted outside its authority, its actions are subject to judicial challenge. So what actions did the plaintiffs challenge and were those actions outside FHFA's authority?
Here, the plaintiffs made a critical error. The plaintiffs only challenged the Third Amendment to the SPSPA ("Net Worth Sweep") or ("NWS"), not the SPSPA itself. I had previously speculated that this decision was probably due to proof issues. It is relatively easy to introduce the NWS documents, point to the lack of an administrative record, then allege a violation of the Administrative Procedures Act. It is also easy to point to the requirement to reduce Fannie's portfolio to $250M over time and the nature of the NWS taking all net assets for eternity, then allege that FHFA had morphed from a conservator, with a duty to preserve and conserve assets for the shareholders to a receiver with a duties to wind down the GSEs with a primary duty to creditors and only a secondary duty to shareholders. In contrast, it would have been much harder to allege and prove the various facts generally known to Fannie investors but not to the general public. In retrospect, the plaintiff's strategic legal strategy left FHFA and Treasury with the undeserved moral high ground - and it cost us two district court dismissals and now an appellate court loss.
So let's look at the crux of the decision. Boiling down 70 pages to a few sentences: The plaintiffs argued that FHFA had a duty to act as a conservator to protect and conserve Fannie's assets which duty was violated by the NWS. The court ruled that FHFA was acting with authority when Fannie was placed into conservatorship and that HERA permitted FHFA to act as both conservator and/or receiver as FHFA saw fit. This is indeed a departure from common law cited by the dissenting Judge Brown, but "Congress made clear in [HERA] the FHFA is not your grandparent's conservator. For good reason." Decision, page 34. To quote a legal axiom, "Hard cases make bad law." Here, the majority believed the background narrative of FHFA and Treasury rescuing Fannie and stretched the law to achieve what they believed a just result based on that (incorrect) narrative.
Going forward, can the plaintiffs bring the true facts to the court's attention? Unfortunately, no. With some exceptions not applicable here, facts or arguments not alleged, introduced or made in the court below cannot be raised for the first time on appeal. The Fannie longs are tied to the bed the plaintiffs made. Screaming rape is not going to help now.
The judgment question each Fannie long must ask is whether the next level court, probably a rehearing en banc, followed by a Supreme Court appeal by the loser, will place greater weight on the rule of law argued by the dissent or the need to reach an "equitable result" based on the common Fannie bailout narrative. The law is clearly on the dissent's side, as I argued in prior articles, yet, at least three courts have ruled against the plaintiffs.
There is something else to bear in mind on the legal front: invalidating the NWS, on its own, will not get you what you want. The Perry complaint essentially only request that the NWS be invalidated. If that happens, the SPSPA (with only two amendments) is then the controlling document. In other words, Fannie is back to paying a 10% dividend on $117.1B in senior preferred equity, or $11.7B annually in dividends, which is right about or slightly higher than Fannie's net average income for the last two years. This is not a good outcome.
The real result Fannie investors want is the dividends applied to the draws. Bear in mind, the Perry complaint does not ask for that relief. The Robinson complaint, now on appeal before the Sixth Circuit, does ask in the alternative that the dividends be applied to redeem (reduce) the senior preferred liquidation preference, which is what generates the dividend obligation. Bottom line, with the Perry court basing its decision on the Fannie bailout myth and the different complaints not all asking for the dividends to be applied to the draws, the legal side is a mess. There is still a chance it could work out for the investors, but in my view, there is no way to handicap this. Investing in Fannie, believing in the courts, with the current suits, is a speculation, not an investment.
We'll return to the law later, but for now, let's turn to the politics and talk about Mnuchin's interviews on CNBC and Fox Business on February 23, 2017. Why go from saying the GSEs were an early priority in prior interviews to saying they will be addressed after tax reform in August? The Perry decision for the Government.
Practically speaking, it will be difficult to emerge from conservatorship without a resolution of the shareholder suits. Justice, however, cannot settle with the plaintiffs on terms the plaintiffs will accept after a favorable decision for Justice. Hence, Mnuchin managed expectations for later in the year when more political cover could develop, either from the Perry suit, the Robinson suit or from very damaging withheld documents being made public.
The rest of Mnuchin's interview as very encouraging. He emphasized the need to end the conservatorship, protect the 30 year fixed rate mortgage and protect the taxpayer. Protecting the 30 year mortgage means keeping Fannie (and Freddy) functional. Protecting the taxpayer means that the taxpayers would not be liable for future Fannie losses. That means ending the SPSPA and adequately capitalizing Fannie.
There are three options to adequately capitalize Fannie while protecting the taxpayers: Selling shares, allowing Fannie to retain earnings and pay no dividends until a defined reserve is accumulated and returning some part of the draws to Fannie as a reserve. First, let's talk the size of the reserve. Credible speculations on an appropriate size of the capital reserve have ranged from 2% to 5%. On a $3T portfolio that means a reserve range of $60B to $150B.
Selling shares to cover the reserve isn't feasible because the market simply isn't there. Check out this chart by Renaissance Capital which depicts the annual US initial public offer market by volume. In 2014, the IPO volume was $86.6B; in 2015 it was $30.3B and in 2016 it was $18.8B. A Fannie share offering of $60B, let alone $100B or $150B would swamp the market and require every available IPO dollar for at least an entire year if not more. A public offering for more than a small symbolic part isn't realistic.
The earn out has much more potential. Fannie has an annual income of approximately $10B. Set the reserve anywhere from $60B to $150B, divide by the annual income to arrive at a six to 15 year earn out. The specifics will vary per the political demands versus the influence of the hedge fund investors but nothing says Fannie can't devote 100% of all earnings to the reserve until a defined threshold is met, then devoting a percent of earning every year thereafter until a final reserve is achieved. Release Fannie from conservatorship when the initial threshold is met, relist on the NYSE and voila!
The final option is Treasury funding some or all of a reserve as part of a litigation settlement due to the disclosure of the balance of the withheld documents. Not the most obvious option but still possible.
In a prior article I argued that challenging the imposition of the conservatorship and the SPSPA was both true to the facts and had the most upside for the plaintiffs/shareholders. The 11,000+ documents withheld by FHFA and Treasury under various claims of privilege were the best road to uncovering those facts. In the Joint Status Report filed with the Sweeney court in the Fairholme case on February 24, 2017, the plaintiffs are still pushing for disclosure of the documents with FHFA/Treasury still fighting.
In another Seeking Alpha article I examined the FHFA 290 page privilege log. Seventy percent of the withheld documents were dated in 2008. If, as Fannie longs believe, the conservatorship was un-necessary and a pretext to a backdoor bailout of the TBTF banks coupled with a surreptitious nationalization of Fannie, what are the chances it would not be reflected in the documents FHFA/Treasury is fighting so hard to withhold? My money, literally, is on those documents being so damaging that after disclosure, FHFA/Treasury will have to come to the negotiating table to avoid a new round of litigation attempting to void the SPSPA.
Just as critical, if the disclosed documents are made public and indicate a backdoor bailout Fannie didn't need to the detriment of Fannie shareholders, then the public narrative changes and the next court to review the litigation would be much more likely to agree with the dissenting Judge Brown in the Perry decision. The courts would become much more interested in upholding the rule of law than stretching the law to find an equitable result.
In that case, Justice/FHFA/Treasury would come to the table to avoid what for them would be a devastating decision and Trump would come to the table to avoid owning that result, to claim he is "draining the swamp" and cleaning up the mess from prior administrations.
If that happens, subject to the vagrancies of negotiation, the plaintiffs push to void the warrants, have Treasury return the senior preferred shares and the draws. Remember, though, this would be a settlement in lieu of litigation. In those cases, the plaintiffs settle for less than 100% of what a court might award to avoid the risk of litigation and time delay.
Three more interesting tidbits play into that scenario: First, SPSPA §6.7 which provides:
“
"Effect of Order; Injunction; Decree. 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 under Section 1367(a) of the FHE Act), Purchaser may by written notice to Conservator and Seller 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 "order, injunction or decree" finds that FHFA exceeded its authority in any way, Treasury has the right to unwind the entire transaction.
Second, in response to my requests for disconfirming evidence for the Fannie investment, some readers have suggested that only Congress can authorize the return of the $154B of draws to Fannie and that is a low probability event. In response, a quick stroll through a Constitutional clause and case law is in order.
The Constitution at Section 9, Clause 7 provides: "No Money shall be drawn from the Treasury, but in Consequence of Appropriations made by Law;" Congress, of course, has the power of the purse and makes all appropriations. Thus, once money has gone into the black maw of the Government, it becomes "public funds" and only the Congress can set it free through an appropriations bill. Usually. Here however, Treasury, which is under the direction of the President, can release funds if the original receipt of the funds was contrary to law. Yes, there is case law, not a line of Supreme Court cases but consistent lower court case law, that if the original receipt of funds by Treasury was contrary to law, then the funds can be returned without statutory appropriation.
Now replay the disclosed documents scenario. Add an adverse, though not necessarily final court decision that FHFA or Treasury exceeded their authority and Treasury should never have collected the dividends. Trump can order Treasury to unwind the entire SPSPA and has authority to order Treasury to return the dividends. But waiting for a court order may mean Trump owns that result. He need not wait for a court decision. After the documents are made public but before a court rules, DOJ could opine that the initial SPSPA was contrary to law and so Treasury had no authority to collect the dividend. Trump is entitled to rely on the advice of counsel and could then order Treasury to return the draws in the context of a settlement negotiation. The outcry would be intense, but the written proof that FHFA and Treasury (under prior administrations) conspired to un-necessarily seize the GSEs should more than provide the necessary political cover.
The third tidbit is the Consolidated Appropriations Act of 2016 at §702, which provides:
“
"LIMITATIONS ON SALE OF PREFERRED STOCK.-Notwithstanding any other provision of law or any provision of the Senior Preferred Stock Purchase Agreement, until at least January 1, 2018, the Secretary may not sell, transfer, relinquish, liquidate, divest, or otherwise dispose of any outstanding shares of senior preferred stock acquired pursuant to the Senior Preferred Stock Purchase Agreement, unless Congress has passed and the President has signed into law legislation that includes a specific instruction to the Secretary regarding the sale, transfer, relinquishment, liquidation, divestiture, or other disposition of the senior preferred stock so acquired."
The government is bound by §720, but note two things. First, nothing in §702 prohibits paying down the senior preferred stock. Trump could well agree that the dividends would pay down the draws and waive the 10% due on outstanding draws in the connection of a settlement. Second, January 1, 2018 is only nine months away. Not long in government time. Besides, if the senior preferred preference is paid down to a mere $1B, and nonvoting, it can stay part of the capital stack.
With these three tidbits in mind, return to the issue of how to fund a reserve. If the withheld documents do indicate the imposition of the conservatorship and the SPSPA were not to save Fannie, and are made public, then there is an excellent chance some or all of the reserve is funded through settlement negotiation.
The money paragraph: The most conservative estimate of FNMA as an operating entity, assuming the warrants are exercised but the reserve funded, with an annual net income of $10B and using a multiple of 10 to 14 is $15 to $20 per share. Assume the warrants are not exercised and the value increases five-fold to $75 to $100 per share. Assume further that the withheld documents are as damaging as discussed above and the senior preferred could be paid down by the dividends ($154B dividends - $117B draws) leaving a balance of $37B to be applied to a reserve. Alternatively, in the moon shot scenario, Treasury unwinds the SPSPA under §6.7, the dividends are refunded to Fannie, Treasury returns the senior preferred (after January 1, 2018), and the warrants are returned to Fannie. In that case, draws of $117B added to dividends of $154B, minus a reserve of $60B, and current interest of $1.2B to the junior preferred means $209B to be allocated to the 1.2B of common shares, or $175 per share. The $175 is in addition to the $75 to $100 per share operating value for a moon shot value range of $250 to $275.
Important note: The best outcome never happens in negotiation - something less than this will be negotiated. How much less is impossible to guess depending on the strength of the disclosed documents, the progress of the various court cases, public reaction to the documents, the personalities of the negotiators and the influence of many people the public will never know. This caution was in a prior article that first gave these figures yet many comments to the article were euphoric. Personally, I will be very content to get the warrants voided and the dividends repaying the draws. (But I will root for voiding the whole SPSPA because the FHFA/Treasury withheld documents are so damning.)
So let's try to encapsulate this. If offered an investment with a reasonable, but not guaranteed possibility of going from $3 to $15 in six years, would you take it? That represents the release and recap possibility without accounting for the senior preferred equity, but with the dividends terminated and a six year reserve earn out. Now given the same opportunity, add the chance, say 50%, that the withheld documents are released and prove the SPSPA was imposed on Fannie as a backdoor bailout of the financial system and the banks, at which point the warrants get voided, all draws returned, the senior preferred written down and the common goes from $250 to $275 a share because Treasury and Justice have capitulated and blamed it all on prior administrations. Would you make that investment? Now would you accept the deal if we add a chance, say 33%, that a court rules in the plaintiffs' favor and Treasury invokes SPSPA §6.7 to unwind the whole thing and again the common goes to $250 to $275 (minus negotiation discount)?
Returning to the title of this article, I was online when the Perry decision was released and had a copy within five minutes of release. Going immediately to the holdings paragraph, within 15 seconds, I sold all my FNMA at $4ish. Several hours later I repurchased at $2.92, increasing my shares 33% and preserving all my capital. FNMA represents 98% of my investing capital. If this tanks, I'm living on Social Security (and my wife's indulgence). If it plays out with any scenario that voids either just the warrants or the entire SPSPA it creates generational wealth.
Rockefeller is reputed to have said something to the effect of "By all means place all your eggs in one basket, but watch that basket very carefully." And so I am, as I ceaselessly solicit the disconfirming evidence with a trembling finger over the "sell" button while still believing this is a mind numbingly complex yet once-in-a-century opportunity.
Disclosure: I am/we are long FNMA.
