Calling No Legislative GSE Reform In 30 Days A Failure Nov. 15, 2017 10:37 AM • FNMA
The government has 30 more days to deal with GSE reform before GSE Jumpstart expires. Congress/Senate leave December 14/15. GSE Jumpstart expires January 2.Key GSE protagonists Bob Corker, David H Stevens, Michael Stegman, are part of the exodus of tired and old views on GSE reformWhat goes around comes around, and the GSEs have been minting billions of dollars for decades despite short-term government discretionary accounting control making it seem otherwise.
Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) are two companies that are in a conservatorship. The conservatorship is not your ordinary conservatorship as it operates under HERA 2008, which is an entirely separate statute from the rest of the statutes governing the rest of the conservatorships. HERA 2008 was modeled after the FDIA which regulates the FDIC.
Investment Thesis: Upon the imposition of conservatorship the government injected itself into the capital structure between equity and debt. It then proceeded to write down the value of Fannie and Freddie's assets. The intended consequence was to inflate its own equity stake senior to everyone else's to the greatest extent possible. What this does is completely zeroes out junior equity shareholder interests but there are consequences to this type of behavior. During the Bush administration, Fannie and Freddie were put into conservatorship. During the Obama administration, Fannie and Freddie were forced to give all their net worth to the government via the net worth sweep. Now we are nearly a year into the Trump administration and it's mostly been more of the same with hints of change, but what can Mnuchin do while GSE Jumpstart is in place? He can say that he's looking for a bipartisan legislative solution. He can't do anything with the SPSPA or Warrants until that legislation expires on January 2 of next year. Congress leaves DC around December 15. That means Monday December 18th is the first real day that new proposed Legislation can no longer reform them in time for expiration of GSE Jumpstart.
Years Of Nothing Burgers
Despite the fact that Fannie Mae has been annually cash profitable since 2008, the government has engaged in structuring an agreement to siphon off all their cash. It's currently called the senior preferred securities agreement. Working with Treasury, two branches of government temporarily waived accounting practices 2008-2012 and wrote down assets despite the rules and manufactured a few years of massive temporary accounting losses. The senior preferred securities agreement set Treasury up to benefit from FHFA's discretionary accounting authority in this way. The more worthless FHFA claimed the GSEs to be, the more Treasury would directly make. Naturally, FHFA for years found all sorts of reasons to claim that valuable GSE assets were worth less than the cash flows actually said they were. Only honest equity agreements benefit their holders when the capital structure they are built on prospers. In this case, Treasury and FHFA selectively structured their agreements in advance to benefit Treasury to whatever extent FHFA could force the GSEs to report temporary accounting losses. Therefore, the more FHFA said the GSEs were in trouble, the more Treasury made. That is not an honest equity agreement and it gets worse. If you were paying attention to all of this, it would not have been a surprise to know that it was all done in advance of the net worth sweep, but maybe that's where you'd draw the line.
What if I told you that the government now claims that despite the fact it did all of this to hide its actions from the public that now it claims that it operated within the law and courts have so far agreed that the government could do whatever it wanted, but that's because no court has ruled on whether the government's interpretation of HERA is constitutional or not. Plaintiffs have filed that. The oral arguments are in December.
Those who had been paying close attention to the accounting transactions early in conservatorship could have known that the government saw the GSEs as a big piggy bank that they are. John Hempton as early as August of 2009 already knew what was going on. He knew the government was exaggerating losses but I'm not sure if he put 2 and 2 together to see that the government was just maximizing its investment by doing so.
The problem was that in 2012 the skies had parted and it was clear to everyone after a series of profits that those short-term temporary losses would have to be reversed. Unfortunately for junior equity holders like myself who were expecting that these gains would flow through the capital structure, this came as a surprise. For those following the intent of the conservatorships, however, this was not a surprise.
The debate rages in courts around America whether the government broke the law or not. Where we stand today is that the courts have ruled that the government can do whatever it wants but that if it violates contract law then it must resolve those per the contract. In the case of preferred that's par plus back dividends. The government effectively converted it's senior preferred to a super common with a massive liquidation preference when it signed the net worth sweep third amendment to the senior preferred securities purchase agreement. The government takes everything and for what? That's the point, if the government can simply grossly exaggerate accounting losses for 3 years to steal any company in America then maybe there is a problem. That's what the plaintiffs are saying to the SCOTUS these days. They also say that because HERA is lifted from FDIA, that what FHFA does to the GSEs has read through implications for all future banking conservatorships. Whoopsidaisies!
Summary
I own 4050 shares of FMCCH, 21688 FMCCP, 7370 FMCCT, 241 FMCKO, 12885 FMCKP, 13135 FNMFN and 5 FNMFO. These are preferred shares of Fannie and Freddie. In the event of a recapitalization, they would resume dividends and drift closer to par depending on present market conditions for their dividend. Lawsuits have been filed against the net worth sweep and a plan has been introduced by Moelis where the preferred shares convert to common on a par basis in order to help facilitate the capital raise, technically making it larger and faster. Plus, the companies can't really raise capital while the lawsuits are outstanding suing against the net worth sweep.
The Moelis plan puts the commons $8-$13. I don't know a lot about that but the valuation seems to make sense given that the market is at all-time highs and these are the two best businesses in America. In fact, they're so good they attracted the government to invest into them during the middle of a crisis where the government designed its agreement in advance to benefit from its discretionary accounting authority over them that it used to force them to take over $100B on unrepayable terms. The government has had its fill of GSE profits since then and the TBTF people who have been running GSE reform have nearly all been replaced or stepped down, or at least enough of them with Mnuchin taking the driver's seat.
Disclosure: I am/we are long fnmfo,fmcct,fmckp,fmccp,fmcko,fnmfn.
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