Fannie Mae (FNMA)

[navycmdr]

Entirely Preventable GSE Bailout Not Prevented

Feb. 15, 2018 8:29 AM ET|24 comments| About: Fannie Mae (FNMA), FMCC

Glen Bradford

..... Summary .....

--- Fannie Mae reported their earnings for the fiscal year 2017 and require a bailout because they will have to pay lower taxes due to the Trump tax plan.

--- If that sounds completely weird to you, have no fear, the purpose of this article is to explain how having to pay less can be painted as a bad thing.

--- The Senior Preferred Stock Purchase Agreement is driven by FHFA's discretionary accounting authority, so this bailout was foreseeable and preventable, but FHFA didn't do enough to stop it.

Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) are two companies in conservatorship managed by the Federal Housing Finance Agency (FHFA). The first day of conservatorship the government arranged with itself an arms length transaction formally known as the Senior Preferred Stock Purchase Agreement (SPSPA). This agreement is what allowed FHFA to issue Treasury preferred stock while simultaneously using its discretionary authority to declare various parts of Fannie and Freddie's asset base worthless. It's worth noting that in practice most funding agreements are based on actual cash need or cash shortages as opposed to discretionary accounting choices made by the party with a controlling interest. It is for this reason that when the companies reported a one-time accounting loss this past quarter they need a bailout:

To eliminate the company’s net worth deficit, the company expects the Director of the Federal Housing Finance Agency (FHFA) will submit a request to Treasury on the company’s behalf for $3.7 billion.

Further along in the press release what we really learn is that it's up to FHFA and Treasury to decide whether to keep this charade going or commence receivership:

However, any net loss the company experiences in the future could be greater than the amount of its capital reserves. If this were to occur, it would result in a net worth deficit for that quarter. If the company has another net worth deficit in a future quarter, it will be required to draw additional funds from Treasury under the senior preferred stock purchase agreement to avoid being placed into receivership.

So, if Mnuchin and Watt want to, instead of bailing out Fannie and Freddie they could administratively place them into receivership this next month. The decision will be made by the end of March.

Investment Thesis: The administration underreserved a capital buffer at the end of last year knowing full well the implications of a DTA writedown causing a draw was going to happen. If you're feeling that this whole thing is much like a shell game, you'd be right. On October 3, 2017, Melvin L. Watt went before the U.S. House of Representatives Committee on Financial Services and said:

We also know that a short-term consequence of corporate tax reform would be a reduction in the value of the Enterprises’ deferred tax assets, which would result in short-term, non-credit related losses to the Enterprises.

This bailout was preventable. It has nothing to do with Fannie's and Freddie's actual credit risk. It has everything to do with the benefit of them having to pay less tax on a forward basis making them more valuable, not less. Now we are rapidly approaching the point of no return. The administration has saved Fannie and Freddie from having to pay as much taxes in the future with a lower tax rate while simultaneously creating a bailout because this forces a write-down of Fannie and Freddie's deferred tax assets, a completely predictable event that they even predicted. They could use this opportunity to put Fannie and Freddie into receivership, muting the implementation of the capital buffer last year altogether. If you think that they take the draw or instead avoid a bailout altogether by commencing a recapitalization plan, the existing equity in the two companies currently trades like a fairly expensive call option on that outcome. The publicly traded preferred shares have roughly 3x upside to par and the common shares are likely worth more, and probably about as much more as the preferred, but it's hard to say. There are a lot of factors not limited to but including the future expected levels of g-fees, capital requirements, and cost of recapitalization capital.

Shall Receivership Commence ?

What would be interesting to know, which we don't yet know, is if Freddie Mac needs a bailout too. That is to say that their deferred tax asset writedown for the fourth quarter of 2017 would have to exceed that quarter's income thus causing a quarterly net loss in excess of their fourth quarter capital buffer requiring a draw from Treasury or receivership. The administration at this junction can choose to pursue receivership for Fannie Mae, but we don't yet know if their is a capital deficiency at Freddie Mac.

One thing remains clear throughout all the mud slinging: the government remains in complete control of Fannie Mae and Freddie Mac and since the imposition of conservatorship has issued dividends of $271B to the Treasury. This has been one of the most lucrative investments in Treasury's history. In fact, the government is currently forecasting $185B in dividends across the next 10 years despite this year's bailout assuming that the conservatorship continues throughout the next decade:

In its budget plan, the administration said it expects that issue to result in draws of about $5.1 billion, based on publicly available information. Fannie plans to report earnings on Wednesday, while Freddie reports on Thursday.

The Trump administration also said it expects Fannie and Freddie to pay the government nearly $185 billion over the next decade.

So, it would appear that the government, from a financial point of view, prefers keeping Fannie and Freddie alive and hiking their guarantee fees rather than killing them this year when they have the chance at least to push Fannie into receivership and liquidate. The point is, with hundreds of billions in profits flowing to the federal government, there is no doubt about Fannie and Freddie’s earnings power or their ability to serve the public and survive.

GSE Critics and Legislation

One development not getting enough attention these days is that GSE critics Edward J. Pinto and Peter J. Wallison are hosting a conference February 27th entitled, "Conference on the Taxpayer Protection Housing Finance Plan." Historically these two have pushed largely for legislative reform, but now they have pivoted and are pushing for administrative reform as it seems that:

Since the financial crisis, Congress has been unable to develop or agree on a workable housing finance system.

Alex J. Pollock will be there too, author of the 10% moment. The good news here is that since Bob Corker's 29th draft legislation came out, it appears that everyone has given up on it and any legislative solution like it. Going forward we wait to see which sort of administrative solution takes root.

Treasury Secretary Steve Mnuchin tells us 2018 is the year for Fannie and Freddie reform. If that's the case then it will be administrative and not legislative, which leads me to believe that the pivot by this group to address an administrative solution is on point. I'm sure there will be a growing chorus of receivership at this juncture by this group.

The Net Worth Sweep

The net worth sweep is a beautiful arrangement that allows the government to take all of Fannie and Freddie's income (100%) without technically consolidating the enterprises onto the government's balance sheet. It is for this reason the warrant coverage was only 79.9% and that the warrants have not yet been exercised. In a recapitalization, I expect them to get exercised despite the fact they were issued under false pretenses if you believe the entire conservatorship was unnecessary in the first place. I would agree with you but to me life is a game where you pick your battles and I'm not picking that one. The time to act on that in my opinion has long passed along with it the statute of limitations.

The net worth sweep was implemented in 2012 after Fannie and Freddie had finished issuing the government all the preferred stock they could by writing down their assets while simultaneously remaining remarkably cash profitable. In 2012, the companies returned to profitability and to remain in control, the government had to take all their money. The net worth sweep was the solution put in place to prevent Fannie and Freddie from emerging from conservatorship then and it remains firmly in place now. Late last year the capital buffer that was designed to wind down to $0 was raised back to the original amount set at the time of the net worth sweep ($3B) despite the fact that this did not prevent this completely avoidable bailout. The government, despite the fact that it remains in control and foresaw this happening, did not prevent it. This is an example of government failure. The capital buffer should be larger and should have been set earlier and then this bailout wouldn't exist.

Going back further, proponents of recapitalization say that Fannie and Freddie if adequately capitalized with more capital than ever before, would not have needed a bailout in 2008 and advocate for a recapitalization in line with their thoughts that raises money for the federal government by exercising the warrants.

Hensarling's Perspective

House Financial Services Committee Chairman Jeb Hensarling weighed in on the draw basically saying that they are the costliest bailout in history and should be wound down and destroyed. Jeb is furious that FHFA Director Melvin L. Watt has decided to pay the Housing Trust fund despite the fact that the GSEs require a draw from Treasury. In effect, if you study Trump's budget, the effect to cut that funding is muted. In Trump's budget, housing trust fund allocations are cut out and guaranty fee income is increased. From the 10-K of Fannie Mae:

In December 2017 and February 2018, FHFA, in its capacity as conservator, provided guidance relating to our guaranty fee pricing for new single-family acquisitions. FHFA’s guidance requires that we meet a specified minimum return on equity target based on the conservator capital framework. We must implement this target in the first quarter of 2018. We may be required to increase guaranty fees charged on some loans in order to meet this requirement.

That's hard to do when they have $0 in equity, or negative equity like they had at the end of last year until they draw from Treasury or produce that amount of income since quarters are only reported every 90 days or so. If you have $0 in equity how do you calculate a ROE when you are dividing by $0? Also, how do you justify increasing g-fees when your equity is $3B? If anything you'd think that you should lower g-fees if that's all the capital you're holding. This math seems fairly circular and doesn't make sense while the GSEs operate inside of conservatorship.

Representative Hensarling wants to put the GSEs into receivership. Hensarling doesn't want Watt to make the payment to trust funds and that's probably a sticking point because if you study this transaction, the money goes from Treasury though Fannie Mae and Freddie Mac and to the affordable housing trust funds. It's like FHFA is using Fannie Mae and Freddie Mac to launder money from Treasury to fund affordable housing programs. Considering that Watt remains in position from his installation during Obama's tenure it will be interesting to see what happens when his term is up if these enterprises are still in conservatorship. My bet is that these payments would no longer get made because the Trump budget has them not getting made to increase income for the Trump administration.

Summary and Conclusion

I own 4050 FMCCH, 8394 FMCCI, 8441 FMCCL, 400 FMCCN, 12608 FMCCP, 5042 FMCCT, 9085 FMCKP, 12934 FNMFN and 5 FNMFO. These are all preferred shares. In the last two months the ratio price of preferred to common has virtually doubled in favor of the preferred. I've thought about buying some commons as this price has shifted favorably but to date have not made the switch. I do not know if the preferreds would convert to common before or after the warrants get exercised. What I do know is that the government remains in complete control and could decide to drive this conservatorship off the cliff into receivership, especially if Freddie Mac reports that it too needs a bailout.