Craig Phillips Interview Confirms Pending GSE Restructuring And IPO Narrative
Jun. 02, 2021 6:27 AM - Glen Bradford
I have held over 100% of my net worth in Fannie and Freddie preferred stock for a few years now and doing so has largely been the bane of my existence. This trade has destroyed me personally and held me back privately because of how I structured this with maximum high interest debt, but I continue to remain hopeful.
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SitusAMC's Tim Rood has been hosting episodes of "On The Hill" with people who talk about the housing industry.
The most recent episode, episode 10, features Craig Phillips who wrote the Treasury Housing Finance Reform Plan.
Craig Phillips points out the biggest reason Mnuchin didn't restructure the equity of Fannie and Freddie was because they didn't stop the net worth sweep until September of 2019.
Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) are two government sponsored enterprises that were placed into conservatorship by their regulator the Federal Housing Finance Agency in 2008 as part of a Treasury led initiative to backstop the market for agency mortgage backed securities on the balance sheets of companies nationwide and worldwide to prevent a full fledged mortgage market meltdown. In 2012, after years of writing down assets from the balance sheets of Fannie Mae and Freddie Mac and being forced to start write them back up, the government arranged for the net worth sweep to solve budget problems and took all of the enterprises money for itself jumping the capital structure. From 2013-2018, shareholders fought in courts around the country and lost on their APA claims saying that this net worth sweep was illegal because the courts said that the government can do whatever it wants because the anti-injunction provision prevents a court from setting aside the net worth sweep. In 2019, the fifth circuit en banc ruled that based on its interpretation of the law, a court should set aside the net worth sweep if it was not taken to preserve and conserve assets. That question has been appealed to the Supreme Court and a ruling will be handed down this month.
Investment Thesis
Craig Phillips recent interview with Tim Rood gives many shareholder friendly perspectives. He explains why the Trump administration ran into trouble restructuring the equity of Fannie Mae and Freddie Mac and this all boiled down to politics and budget. The primary culprit was that the Treasury in the early years of the Trump administration needed to keep taking the money from Fannie and Freddie to fund the government budget. In September of 2019, Mnuchin and Calabria paused the cash payment aspect of this net worth sweep and in 2021 they made it so that Treasury cannot take money from Fannie and Freddie until they are out of conservatorship. This makes it so that the only way the Biden administration can get money out of its equity position is to monetize it since it is no longer paying cash dividends depleting Fannie and Freddie of their capital. As such, this is now a pending restructuring. Junior preferred have claims totaling $34B that have preference over common shares in this restructuring and trade at 20 cents on the dollar. I figure as part of the restructuring those claims will be money good. I expect similar returns for common shares albeit with more risk. I believe that because this is stacking up to be a capital raise where the majority of the post capital raise equity is owned by the new money, common shares may underperform junior preferred in this restructuring and recapitalization and so I recommend junior preferred because I am a worst case kind of guy. If you think new money wants to pay more than the historical earnings multiple to invest into Fannie and Freddie or if you're expecting different more generous restructuring mechanics than I am, then perhaps you may want to own common too or instead. I figure common are worth $3-8, noting especially that new money will want to get as much as possible for every dollar of new money they put up.
SitusAMC Interview With Craig Phillips
Tim Rood interviewed Craig Phillips in Episode 10 of On The Hill. Craig Phillips pointed out that Melvin Watt was on board with ending the net worth sweep. That was surprising to me because it implied that the only reason that the net worth sweep did not stop during the early years of the Trump administration was because Treasury had already accounted for taking that money and spending it elsewhere. Craig Phillips explained why more meaningful reform didn't happen during the Trump administration:
Secretary Mnuchin and I had a vision, the first weekend we went into the office to start to get our arms around things Secretary Mnuchin looked at me and said if you and I can't end the conservatorship no one ever will.
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Right from the get-go the president had to produce a budget.
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Secretary Mnuchin and I sat at a desk and said, well look, they've always criticized sweeping the money from Fannie and Freddie to fund Obamacare some would say or just funding the government so we should stop doing it; so our very strong recommendation is that we should stop the sweep and take that money out of the budget right away day one in January. We got this horrific reaction from two camps. One is it makes the deficit bigger we don't want to take it out. The other is we can't start letting Fannie and Freddie keep capital until we reform them.
Long story short, because of commitments from the prior administration, Mnuchin was not able to move forward with housing reform as a day 1 action item. Craig Phillips continued:
What they need is capital and right now they have almost no capital. And we were shot down. Had that gone a different way and on principle we had just stopped the sweep then it would have changed all of history and arguably was really more consistent with the republican orthodoxy to not use those unappropriated funds to fund general activities of the government.
Then what happened was really priorities. The first that happened was tax reform. Secretary Mnuchin didn't really want anything clouding our dialog on the hill with that. And we also had a really important piece of banking legislation going through and that really took up all the time and all the oxygen in the room.
Craig Phillips talked about how housing just was not high enough of a priority on the to-do list because there were other more important things to deal with during the early years of the Trump administration. Then, Craig Phillips reveals that the Trump administration just didn't want to work with Melvin Watt although it sounds like they could have if they wanted to but preferred to not move forward with housing reform because the ideology of a republican administration shouldn't have to work with a democrat when they can replace him first:
And then what happened was that there was a sentiment that we needed to wait for Watt's term to end and to have our appointee.
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Quite honestly I dealt with him (Watt) on a regular basis. I would say his position on this issue is not terribly different than Director Calabria's. He thought the conservatorship should be ended. He would have actually done almost anything we wanted to do. In fact, he felt very strongly that the sweep should be ended and they should start building capital just as we had thought. So the decision made to wait for the nominee that was ultimately Calabria.
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That was another big hiatus of time that went by. That got us all the way to 2019.
And so they didn't start on housing reform until the second half of the Trump administration and they basically ran out of time and felt like with COVID they couldn't seal the deal and restructure the balance sheets so that Fannie and Freddie could raise new money. Mnuchin did the bare minimum of stripping the incoming administration of net worth sweep dividends and putting together a time frame to resolve this after the pending Supreme Court ruling.
If Mnuchin and Phillips would have been able to end the sweep day one, recap would have been a light lift and doable during the Trump administration. Craig Phillips notes that reform is largely over and that the GSEs have scale to innovate as high integrity organizations.
Summary and Conclusion
Mnuchin was unable to end the sweep as early as he wanted to due to budgetary constraints. He did eventually get around to it. This delayed the restructuring of Fannie and Freddie. They are now pending equity restructuring. This restructuring per the Treasury plan will be done to facilitate capital raises at Fannie Mae and Freddie Mac led by JPMorgan and Morgan Stanley, their underwriters.
The current administration has decided to do nothing until the Supreme Court comes out with its ruling on Collins v. Yellen. I largely expect the court to rule that a federal court can set aside the net worth sweep if it was not taken to preserve and conserve assets. This is basically the opposite of the net worth sweep so it is possible for a lower court to rule on summary judgment based on the government's own statements that the net worth sweep is illegal based on this pending interpretation.
I expect that the Biden administration, now that it is not getting cash money from the net worth sweep and is still paying millions of dollars to defend it, will move forward with monetizing its equity position later this year. I expect that the Supreme Court ruling will allow them to politically write down the liquidation preference of the senior preferred, which is necessary to settle the lawsuits that are in the way of attracting new capital as well as to finally end the economics of the net worth sweep which also prevents attracting new capital. The pending warrant dilution and restructuring dilution in conjunction with their earnings power and capital requirements makes the common shares a tough bet to make but from where I stand the preferred shares are money good and are the only thing I own.
