Fannie Mae (FNMA)

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Fannie/Freddie Research Report Dispells False Narratives

Nov. 18, 2019 3:04 PMFederal National Mortgage Association (FNMA)FMCC

Summary

Josh Rosner's Graham Fisher commentary speaks to the difference between publicly available market commentary and what the administration is actually planning to do.

For the past decade, there have been lots of things said about Fannie and Freddie by lots of various parties, not all of which is true or accurate.

Josh Rosner's commentary, in my opinion, is the gold standard and he has a very aggressive implementation timeline for getting Fannie and Freddie ready to exit conservatorship.

Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) are two of the most profitable companies in the United States and they have been under the government's thumb since 2008 when they were placed into conservatorship. The Federal Housing Finance Agency (FHFA) is now headed by Mark Calabria who helped write the law (HERA 2008) that governs the agency and the conservatorships. The government has taken all of their money for itself since placing them into conservatorship until Trump got elected. At the end of 2017, they were allowed to hold a $3B capital buffer. At the end of September of this year that $3B was boosted to $25B and $20B for Fannie and Freddie respectively. The companies now retain their earnings but for each dollar they retain, the government's senior preferred liquidation preference also goes up by $1. In other words, the net worth sweep is still very much in effect. The net worth sweep prohibits the companies from being able to raise capital and Calabria has talked about a fourth amendment sometime early next year. There has been a lot of debate over timelines, and Josh Rosner shows reporters have been confusing the difference between the time where the companies exit conservatorship and when the companies have reached FHFA's forthcoming regulatory capital requirements and the expected consent-decree agreements are terminated:
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Investment Thesis: This is a recapitalization story. The government still is in complete control over what's happening despite the fact that plaintiffs are now winning the lawsuits on multiple fronts. The thing about government lawsuits is that they take years to work through the system and get to the point where they can no longer be appealed and the government has been taking billions of dollars per year from Fannie and Freddie which more than offsets their legal costs of defending that taking. Nevertheless, the government is now letting the two companies Fannie Mae and Freddie Mac retain more capital with the publicly stated intention of eventually leaving conservatorship. The government has an equity position in the two companies comprised of Senior preferred stock and 79% warrants. I presently own 100% junior preferred stock and expect to convert to common sometime next year as part of settling the lawsuits and raising new capital.

Graham Fisher Commentary

Josh Rosner's Graham Fisher put out a brief this past week demonstrating that for the most part that lots of people still don't understand what's going on here because they don't accurately factor in the context of what has previously been said by whom. Josh Rosner points out that Director Calabria stated that the GSEs should retain earnings for 1-1.5 years and that they have been effectively retaining earnings since April 1:

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Josh Rosner then talks about the timeline for next steps:
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Josh Rosner also speaks to some of the concerns that I hear from time to time from larger investors, specifically if they will be able to get this done in time for the elections next year:
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What This Means To Your Portfolio

Well, if you don't own Fannie and Freddie preferred, you probably should consider it. Although it is the only thing I own and I basically have a million dollars in it (aka all my eggs in 1 basket; therefore, making it the bane of my existence), for you - you might consider this to be a speculative position. Right now, the preferred stock trades at less than 50 cents on the dollar and that's not half bad.
Fox New's Charlie Gasparino points out that there has been lots of selling of this stock lately because of other stocks held by investors who own Fannie and Freddie preferred crashing:
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This is more of a short-term thing. Eventually, the liquidations and redemptions will come to an end. On a technical level, the junior preferred and common stock still basically are worthless because of the net worth sweep and massive liquidation preference of senior preferred stock. That said, it is impossible for the companies to raise capital with the net worth sweep in place and no one is going to put money into these companies until the lawsuits are settled. The prevailing consensus among those who are in the know is that the senior preferred will be declared paid back. If so, the warrants could be worth anywhere between $50 billion and $150 billion by some estimates. From warrant valuations, you can deduce what the commons might be worth if senior preferred aren't converted. $50-150B translates to $7-20.
I figure new money would prefer to get the lowest price possible (and consequently the most upside), so I end up on the low end of that valuation. As such, assuming the senior preferred do not convert to common it looks like the common shares have similar upside with the preferred shares. Whether the junior preferred shares convert, convert at par, or convert at par plus to resolve the breach of implied covenant claims in Lamberth's court remains to be seen.
With this in mind, noting that we should expect the final capital rule and the SPSPA fourth amendment in the next four and a half months, the junior preferred will have clear value in the face of a recapitalization. As such, I anticipate that the fourth amendment leads to a junior preferred valuation of 70-80% of par if not more (aka to settle the Lamberth court cases for damages). FNMAS currently trades at 43% of par, so that's 50-100% returns in the next ~5 months. The theory is common shares have similar upside/returns. Historically, commons go up faster and preferred go down faster in any particular event.

In the coming weeks, we will learn more about the finalization of the capital rule, but if you ask me, it sounds like it is going to get re-proposed and finalized early next year.

Summary and Conclusion

As Fannie and Freddie move towards recapitalization so that Fannie and Freddie can exit conservatorship, the government remains in complete control of staging an outcome. The government needs to play nicely with investors if it wants to attract new money. The government has already said that they need to raise new money and plan to allow the companies to exit conservatorship via consent decree:

https://seekingalpha.com/amp/article/4307547-fannie-freddie-research-report-dispells-false-narratives