Fannie Mae (FNMA)

[navycmdr]

Why Are Fannie And Freddie Still In Conservatorship ?

Nov. 01, 2021 9:42 PM ET - Glen Bradford



..... Summary .....

--- No permanent FHFA director has been chosen by the Biden administration.

--- Fannie and Freddie continue to retain earnings on their path to exit conservatorship.

--- The balance sheets of Fannie and Freddie need to be restructured in order for Fannie and Freddie to attract capital to exit conservatorship faster.

--- Restructuring the balance sheets unlocks immense value ($25-150B) for the government whereas right now it isn't getting money out of its investment in Fannie and Freddie.

Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) are two companies in conservatorship that are retaining earnings on their way out of conservatorship. If their balance sheets were restructured, the companies could work with their underwriting financial advisors Morgan Stanley (NYSE:MS) and JPMorgan (NYSE:JPM) to raise capital and exit conservatorship. The preferred are up 100% off the lows set the past three months, but still have 100% to go to get back to where they were before the Supreme Court ruled that HERA established the Federal Housing Finance Agency (FHFA) in such a way that as conservator FHFA can do whatever it wants with Fannie and Freddie. Investors expected that the law would be interpreted differently and many dumped on this legal ruling under the impression that all hope was lost. At the time, the primary question people would ask me was why wouldn't Biden turn on the net worth sweep again and just take all the money like Obama did if HERA permits FHFA to do whatever it wants. I tried to explain to them that there were more effective ways for the government to get money out of Fannie and Freddie but most of them huffed and puffed and sold their stock and at this point are perpetually disinterested. These prices still offer 7-12x return for junior preferred in a restructuring where they are made whole. Given that this administration is continuing down the path that the prior administration put Fannie and Freddie on, where they retain earnings until they exit conservatorship, the purpose of this article is to outline why I think admin action happens in the next 24 months.

Investment Thesis

The government can do whatever it wants. The Supreme Court's interpretation of HERA supports that narrative. The government currently isn't getting any money out of its investment in Fannie and Freddie. In September, rumors swirled that the administration wanted an FHFA director that would get money out of Fannie and Freddie by restructuring their balance sheets. No choice of FHFA director has been made yet. I believe we are waiting for the administration to deal with the current controversies of the infrastructure and spending bills to be complete before a permanent FHFA director can be chosen. I figure this happens sometime in November if it is going to happen. If the administration doesn't solve the capital structure problem on its own, breach of implied covenant of good faith lawsuits go to trial Summer 2022. These lawsuits were started in 2013 and buying shares today makes you the beneficiary of the past seven years of hard work on the legal front. Since Biden has been elected, Sandra Thompson has decreased enterprise capital requirements. If capital requirements continue to decrease and guarantee fees stay the same, that would be good for commons if the government's senior preferred are written down to settle the pending litigation. I figure common are worth $3-15 in a recap and release scenario.

Fannie Mae Q3 Earnings Highlights

Fannie Mae reported $4,800,000,000 of net income in Q3 2021 as its net worth continues to march higher. CEO Hugh Frater points out that Fannie Mae is committed to good business:

There is commitment up, down, and across our company to advance equitable and sustainable access to homeownership and quality affordable rental housing.

CFO David Benson pointed out that the net worth of Fannie Mae is critical to their ability to operate in a safe and sound manner:

Our net worth increased to $42.2 billion. Building our net worth continues to be critical to our ability to operate in a safe and sound manner.

Freddie Mac Q3 Earnings Highlights

Freddie Mac reported net income of $2,900,000 in Q3 2021.

CEO Michael DeVito points out that Freddie Mac is uniquely
positioned to decrease inequality for many Black borrowers:

For example, many Black borrowers may be less likely to meet the traditional credit standards, necessary to qualify for mortgage. This is often as a result of past patterns of inequality. In recent Freddie Mac research has documented ongoing house price appraisal gaps that make it more difficult to buy or sell a home in diverse communities.

Meeting these challenges and others like them is an essential part of our mission, and Freddie Mac is uniquely positioned to do this work.

CFO Chris Lown reported that the net worth is exploding higher:

On the capital front, our capital position or net worth increased
to $25.3 billion at the end of the third quarter that represented
an 82% increase compared with the prior year quarter and a
13% increase from 2Q 2021.

With these results for Fannie and Freddie, it begs the question why the government is still preventing them from raising capital and exiting conservatorship. The first problem is that the Federal Housing Finance agency needs a permanent director and that hasn't been a high enough priority with the infrastructure bill and spending bills taking up the current administration's bandwidth seeing as how they need all the party votes to get through.

FHFA Director Is A Political Appointment

With the Supreme Court ruling in Collins v. Yellen, the position of FHFA director is now a political appointment. Tim Pagliara says,

The FHFA is now a political appointment, and it will change with every administration. President Biden is going to have a belief system about the availability of financing for low- and moderate-income people that Fannie Mae and Freddie Mac serve. And if he’s going to have some lasting impact on that policy, then he has to act within 18 to 24 months and get these entities set on a path out of conservatorship. Fannie Mae and Freddie Mac need capital to fuel their mission of providing long-term fixed-interest housing for the underserved and the middle class.

What we know is that the White House was rumored to pick someone who would turn Fannie and Freddie into utilities. The government proceeds from this transition could be reinvested back into the housing industry. I expect an FHFA director to be nominated for the permanent position this next month after the infrastructure and spending bills are wrapped up.

The Delaware Bay Company - Oct 29 Report

Gary Hindes is an activist shareholder of Fannie and Freddie that occasionally puts out reports. He argues, "There is no legitimate reason for keeping Fannie Mae and Freddie Mac in conservatorship":

As proof that the taxpayer is no longer at risk, one need only look to the last two stress tests. They show that were there to be a repeat of the 2008 financial crisis, neither company would require a dime of government assistance – even at their present low level of capital! And capital raises from the private sector will further insulate the companies from ever needing a future bailout.

So, why are these companies still in conservatorship ?

Hindes offers a 4-point plan for what Biden needs to do:

--- Appoint a permanent FHFA director

--- Junk Calabria's Enterprise Capital Rule and propose a new one

--- Formulate a Consent Agreement

--- Declare the government repaid in full

Hindes argues that every dollar existing shareholders make, the government makes four.

Summary and Conclusion

My family and I own preferred stock in Fannie and Freddie and my friends own common shares. I thought that the Trump administration would restructure the balance sheets of Fannie and Freddie, but the Trump administration did stop the net worth sweep that prevented the companies from retaining earnings and eventually exiting conservatorship. Biden fired FHFA's Mark Calabria as soon as he could.

If Biden is to have a lasting impact on the future of the housing industry -- the only path to this since FHFA director is a political appointee is to recap and release with consent decree after locking in various reforms. I've heard two timelines for this. One goes before the midterms. One goes after the midterms. I think once things get moving they will move quick, but who knows. Housing reform has a history since conservatorship of taking a backseat to other administrative priorities. In every event, the upside potential here from these prices provides for a very favorable risk/reward.