Hensarling Says Administration Doesn't Favor His GSE Wind Down
Sep. 17, 2018 12:33 PM ET - Glen Bradford
Summary
•Hensarling finally produced legislation, which he proceeded to call bad legislation, and then pointed out that the administration doesn't like his plan.
•This means that Hensarling's odds to become the director of FHFA are near zero.
•This article takes a look at the potential to recapitalize Fannie and Freddie as utilities.
Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) are two companies in conservatorship governed by new law passed in 2008 called HERA that only regulates their conservatorships and is different but based on the FIRREA that regulates banks. Since the two companies were put into conservatorship by board vote in 2008, they have been run like government agencies and FHFA originally forced them report to public markets massive losses 2008-2011. These losses were accounting losses that were a result of FHFA working with Treasury in order to inflate the market value for Treasury's Senior Preferred Stock. And boy did it work, Treasury's liquidation preference is around $187B. In 2012, the government implemented the net worth sweep, which they put into place to capture the accounting loss reversals for the government instead of letting the profits build as capital on the companies' balance sheets. This massive liquidation preference, claim on net worth, and lack of capital mean that the publicly traded equity shares of common and preferred that you can buy today in the stock market of these two enterprises have an intrinsic value of $0 if you discount the cash flows. Something needs to change in their structure in order for the common or preferred equity to have value, either a legal ruling or a move by the administration towards recapitalization that respects shareholder rights. The government is firmly in control of outcome and the purpose of this article is to provide some updates about what's going on.
Investment Thesis: The next major development in this investment is elections, not because it matters who wins them, but because it matters to the administration to not do anything to spook them. After elections are over, with Bob Corker and Jeb Hensarling with one foot already out the door; the landscape for potential housing reform thins markedly. Both Jeb and Bob have proposed legislation to kill Fannie Mae and Freddie Mac and hand over their business to the banks. Hensarling recently said his legislation was bad and rumors say that Corker expects administrative reform. Investors Unite recently speculated that Hensarling or Demarco may be on deck to become the next director of FHFA. Realistically, Mnuchin said that he wanted someone at FHFA who shared the administration's plan for them, and Hensarling's plan to kill them isn't making friends there. If you study what the administration has done this past year, it's put in a capital buffer, and then it put together a proposed capital rule. Trump administration insiders put together a plan that largely aligns with this proposed rule and has subsequently met with FHFA to talk about it. In the event of a recapitalization, junior preferred would likely vote to convert to common if their par value is honored and if the administration is driving the recapitalization it's likely they exercise the warrants and declare victory. The Moelis plan envisions a common stock valuation of $8-13 but that was before lower corporate tax rates. The Moelis plan envisions that the government's massive stake of Senior Preferred stock is declared paid off as part of settling the shareholder lawsuits.
The Anatomy of a Recapitalization
If you study restructurings, the people who invest the new capital make the rules. In this case, the government is not going to be putting in the capital to recapitalize the companies. The companies according to FHFA's proposed capital rule need over $100B. That money has to come from somewhere. The reason the Moelis plan is viable is because the plan is backed by new money ready to recapitalize the companies. This new money isn't oblivious to what has happened to the companies over the past 10 years.
The question you have to ask yourself a lot of the time is do the people who are backing the upcoming recapitalization own any part of the capital structure? In many restructurings, what you see is some sort of default followed by creditors taking an equity stake in the company in exchange to write down their debt. In this case, however, you have what appears to be existing equity holders putting up new equity capital. As such, since the people putting up new money are largely the same people who already own existing shares, they're going to want to make money on their existing shares and the new shares they buy. The Moelis plan makes this possible.
Administrative Timelines
Mnuchin said that he wanted to have Fannie and Freddie resolved during this administration, which ends in 2020. It takes a few years to recapitalize the companies according to the Moelis plan. If you were to speculate that the administration was going to move as fast as possible to recapitalize the companies after the elections, you'd expect them to be able to IPO after FHFA has Fannie Mae and Freddie Mac work on capital restoration plans. What I still haven't figured out is exactly how to have them produce capital restoration plans with the net worth sweep in place.
If Mnuchin is serious about working on some sort of legislation before he starts taking administrative steps to recapitalize the companies, he could push back the timeline to work on capital restoration plans until next year. Bloomberg Terminal reported that Phillips said that a Fannie-Freddie fix was at the front of Mnuchin's docket. I would expect that at some point in time, the market begins to price in these administrative timelines. Right now, with the preferred at 20% of par, it sure seems like the market is over-discounting uncertainty, which is to be expected in this type of situation where the size is so big and there just aren't that many distressed investors who want to buy and hold onto positions for now what, over four years?
Former Fannie Mae CEO
Former Fannie CEO Franklin Raines is big on recapitalization into a utility model. The argument he made was that Fannie Mae didn't have any problems while he was CEO and that the company started making the wrong types of decisions after he left. He says this can be fixed and Fannie and Freddie can be safely regulated utilities that are adequately capitalized.
