Fannie Mae (FNMA)

[navycmdr]

APA Vs. Takings: SCOTUS Says FHFA Can Take

Jun. 29, 2021

.... Summary .....

--- The Supreme Court ruled that FHFA can take or do whatever it wants to do based on its interpretation of the law.

--- The APA claims are dismissed, which means that this is primarily a takings case which belongs in the Court of Federal Claims.

--- There is a lawsuit for that, there is a lawsuit for breach of contract, and shareholders won constitutional claims at SCOTUS.





Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) are two companies in conservatorship run by the Federal Housing Finance Agency. In 2012, the net worth sweep was put into place. This action has been disputed ever since in multiple courts for multiple reasons. At large, people don't seem to understand that since the beginning of this legal battle shareholder plaintiffs put up two main legal arguments, at least one of which would be valid regardless of how the law was interpreted:

APA claims - Takings claims

The premise was that the government could legally take stuff, and then it is a takings claim, or they could not, at which point the APA lawsuit would win.

The Supreme Court just ruled that FHFA legally could arrange for the net worth sweep as conservator. As such, this just means that the cases that matter are primarily the takings cases.

Investment Thesis

There are five main ways to unlock value in Fannie and Freddie securities. The first is that the Biden team implements housing reform in such a way that locks in proposed reforms by tying it to a recapitalization where the warrants are put into some sort of affordable housing trust fund of sorts for policy purposes or a democrat slush fund of sorts. The second is that the constitutional claims that were won for shareholders, upgrading their claim from what the en banc provided for them, result in a financial remedy legal victory. The third is that the breach of contract claims in Judge Lamberth's court that were remanded back to him that are unaffected by the Supreme Court ruling result in a legal victory for plaintiffs. Note that the government official Mario Ugoletti reversed his claims in this case so it will be interesting to see who in the government certifies their trial record. The fourth is that the court of Federal Claims rules that this was a takings and provides backwards relief. The fifth is that the next president of the United States moves forward with recapitalization of Fannie and Freddie. The government has not yet decreased the capital buffer of Fannie and Freddie to resume the sweep of their money to Treasury. If the companies continue to retain capital and the incoming FHFA director supports a utility model, at a certain point the stock market will wake up to option 1. For all of these options above, preferred get par. Preferred currently trade at 5-9 cents on the dollar, depending on the series. I'm not sure how exactly to start thinking about common, but it is possible that with option 1, common are worth $3-7. Biden could possibly lower capital requirements, but I don't see that happening.

Option 1: Biden Moves Towards Privatization

Aside from the fear mongering that everyone is doing now about Biden resuming the cash sweep payments from Fannie and Freddie to Treasury, which the Supreme court basically ruled FHFA could now do if it wanted to --- it is worth noting that the companies are still retaining their earnings on the path towards privatization. Biden just fired Calabria. If he wanted to grab Fannie and Freddie's net worth, he could make orders to cut back their capital buffers to $0 and take their money for Treasury. He has not done that yet which could signal that he is looking to get money out of these companies a different way, like exercising the warrants and/or establishing a commitment fee. Another way he could get money out would be to structure things so that more of their money goes to underprivileged and minority home ownership causes via all sorts of methods. Long story short, I still think this is a viable option. If Biden wants to be able to raise private capital, many of the shareholder lawsuits need to be settled. It's worth noting that the underwriters of the potential secondary offering for the GSEs, Morgan Stanley and JP Morgan, have not been fired by Fannie Mae and Freddie Mac as far as I know.

Option 2: Constitutional Claims Supreme Court Win

Somehow, people seem to forget that shareholders won the constitutional claims. These claims may lead to a large portion of the net worth sweep money being returned to the companies.

Option 3: Lamberth Breach Of Contract Claims

Mario Ugoletti wrote a signed affidavit that he later recanted that helped get the government through the first Lamberth ruling. These claims are basically that when the government arranged for the net worth sweep, they effectively trampled the capital structure violating the junior preferred shareholder contract rights as well as common shareholder rights as well. At that time in 2012, preferred shareholders would have been due their par value and 6% interest every year since then. This calculates to about 150% or more of par value for preferred which currently trades around 5-9% of par. These claims were validated by the DC District Court of Appeals and remanded back to Lamberth and plaintiffs are currently working on their damages models.

If the government wants to sit around and wait for these claims to get ruled on, it is free to do so. But if Biden is trying to make money during his term by taking it from Fannie and Freddie and he waits for this ruling, then I expect he will lose money on his choices for his first term because he will have to pay shareholders more than what he is able to take because of these contract claims specifically noting that the preferred outstanding par value is about $34B making that potential payout to preferred over $50B.

This doesn't even take into account how much money the Biden administration would lose if it bleeds Fannie and Freddie dry of their capital and then the housing market turns down and they "have to put more money into Fannie and Freddie." It's hard to know how realistic a scenario like that is because in 2008-2011 FHFA used its discretionary authority over the GSEs accounting to write down their assets under the assumption that Fannie and Freddie were going out of business. Now that guarantee fees have doubled, doing all that accounting chicanery serves no practical purpose because especially with this Supreme Court ruling, control is established. In effect, these early year accounting manipulations were not necessary based on this Supreme Court ruling. FHFA could have done the net worth sweep day 1. That said, just because FHFA can legally do whatever it wants does not mean that there are no consequences for actions like the net worth sweep and I believe the contract claims in Lamberth's court are some of the strongest claims for preferred shareholders.

Option 4: Court Of Federal Claims

These claims got upgraded by the Supreme Court ruling. The question was really whether or not the government could take Fannie and Freddie's money. I believe that if you actually read the law and know what happened here, the Supreme Court got this ruling wrong. That said, all it means is that with respect to the question, "What kind of case is this?" and the answer being either APA or Takings; the Supreme Court has solved that riddle for us. This is now a takings case. FHFA as conservator can legally according to the Supreme Court could take whatever it wants. That said, there are consequences. If the federal court takes private property, there is a court just for that. The court of federal claims is designed specifically when the government legally takes what is not theirs from private citizens. When it does this, it has to pay for it according to the takings clause of the fifth amendment to the United States Constitution, "Nor shall private property be taken for public use, without just compensation."

Option 5: Next President

Honestly, I don't think that it gets this far, but if Biden resumes the sweep and tries to drain Fannie and Freddie dry and the lawsuits somehow do not get resolved during the rest of his term (I expect major rulings by the end of his term), the next president of the United States could decide that Fannie and Freddie should not be run as private companies with zero capital. Or perhaps the other alternative would be Biden just has them retain earnings and otherwise does nothing, risking the mortgage market in the process, but at the end, these companies become the only private companies on earth that exit conservatorship and are adequately capitalized but the government still takes all their money. Who knows. At a certain point, the level of absurdity is mind boggling and senseless, but these are the sorts of things people have been telling me about on calls lately. I'm like sure, if you want to structure a Frankenstein zombie that is a complete freak of nature of capital structure that effectively voids the integral purpose of having capital structure to spite shareholders in the name of reasons that I don't understand, then there are conversations that you can have that don't make any sense and I think that this is what has been happening among lots of GSE investors this past week which drove relentless and in my opinion senseless selling.

Summary And Conclusion

The Supreme Court solved the problem of how to interpret the law. I think they chose wrong, but that's okay. It just means that the legal claims that matter are in a different court than what we would have expected if they would have interpreted the law differently. In effect, the claims that matter according to SCOTUS are the Takings claims in the Court of Federal Claims.

Honestly, this ruling kind of supports Calabria's unnecessarily high capital requirements framework from the perspective of since a conservator can do whatever it wants, shareholders who would buy into the utility model would want there to be a bigger than necessary amount of capital to prevent the companies from ever even being close to ever needing to be placed into conservatorship again by any metric because they know that if they go into conservatorship, their conservator does not have to follow standard bankruptcy law of only being able to conserve and preserve. As such, unnecessarily high capital requirements kind of makes this investable I guess by being a necessary deterrent.