Updated Thinking on Fannie and Freddie
May/111
This post is an excerpt from the 1st Quarter Investor for my hedge fund. If you would like to receive a full copy of the letter, please send me an email at derek.pilecki@gatorcapital.com.
I have owned positions in Freddie Mac and Fannie Mae (the GSEs) preferred stock since the two firms were placed into conservatorship in September 2008. The shares have been extremely volatile. In the first five weeks of the year, the various classes of Fannie and Freddie preferred stock rose in price from about 2% of face value to about 6% of face value.
There are several factors that contributed to the value increase in these positions:
1. Fannie and Freddie’s financial results are improving – Both companies have improved their operations while in conservatorship. The new loans the companies have guaranteed in 2009, 2010 and going forward will be profitable. The problem vintages of 2005-2008 are being resolved and may be fully reserved for losses. In the meantime, the companies’ mortgage investment portfolios have been very profitable and are throwing off $16 billion of cash per year at each company. I believe Freddie Mac will become profitable in 2011 and Fannie Mae is potentially within 2 years of turning profitable. I believe the regulators have acted wisely in how they’ve managed Fannie and Freddie through conservatorship. Once the companies turn profitable, the nature of the policy debate will change for the better.
2. Realization that continued existence of the GSEs makes the most sense - The Republican success in the election of 2010 makes full nationalization of Fannie and Freddie unfeasible politically. On the other hand, the private market is not capable of providing enough capital to keep the mortgage market functioning smoothly especially at the low prices Fannie and Freddie charge to accept mortgage credit risk. Evidence that the private market is not capable and/or willing to supply capital to the mortgage market is Fannie, Freddie and FHA’s combined 95% percent market share of the mortgage market since 2008. The least risky option is to continue with the current system of the GSEs but impose tighter regulation on the companies to prevent bad management.
3. Recognition that Congress will not resolve the GSE issue soon - Rationality is returning to the GSE policy debate. Cooler heads are voicing their opinions that the GSE model is not broken. We are starting to see this point made from surprising sources such as Steven Roth’s annual letter to Vornado shareholders. The problem with the GSEs wasn’t their hybrid public/private model. The problem with the GSEs was incompetent management that did not recognize the danger of low documentation loans.
4. News that the GSEs asked the Treasury to reduce the coupon on its senior preferred stock – In late January, the Financial Times ran a story saying that management at both Fannie and Freddie asked the Treasury Department to reduce the 10% coupon it receives on its senior preferred stock. Freddie Mac may turn profitable this year even after paying over $6 billion in after-tax dividends to the Treasury. If the coupon rate was lowered, then Freddie could pay back the Treasury that much faster. Plus, the fact that management asked for the reduction confirms that the companies’ financial situations are in the beginning stages of recovery.
Of course, there should be several important changes to the GSE model to protect taxpayers, such as: Fannie and Freddie should not purchase mortgage loans without full documentation of income and assets, should not purchase private label mortgage securities, should step back from the market when spreads are tight and new business cannot meet their return on capital targets, and should restrict executive compensation. A final necessary reform is a requirement that any member of the board of directors be required to purchase an amount of common stock equivalent to a multiple of their annual directors’ fees with their own cash. This would incentivize board members to provide better oversight of management. As a shareholder, I wish all of these changes had been implemented years ago.
As Freddie turns profitable and recaptures some of the capital that is artificially hidden in its accounting statements (marks on private label securities, valuation allowance on deferred tax asset and generous loan loss reserve), I believe the potential exists for them to repay some or all of the Treasury’s investment. Once Freddie regains profitability and begins to repay the Treasury, a whole new set of policy options becomes available. These new policy options would be beneficial to preferred shareholders. It has been a long road owning Fannie and Freddie preferred stock, but the Fund has made a lot of money from the positions and the potential exists for future gains. Although these positions will continue to be volatile, I continue to see several scenarios with further upside.
FHFA implies Freddie Mac will be profitable in 2011
Nov/104
On October 21st, FHFA released projections showing a range of possible additional draws from the U.S. Treasury required by Fannie Mae and Freddie Mac. The report was interesting because it included projections about the companies’ future revenues, expenses and net income. Although the projections are not detailed by income statement line item, they do imply that Freddie Mac will be profitable in 2011 and Fannie Mae will be profitable in 2013 in the base case scenario.
How do you conclude Freddie Mac will be profitable in 2011?
In the FHFA’s projections, the regulator shows a chart projecting future draws from the Treasury for each company. Here’s Freddie’s chart:
By focusing on the base scenario (or Scenario 2 in the chart), we can see that the FHFA projects Freddie Mac to require a $10 billion draw from the Treasury in the 2nd half of 2010, a $3 billion draw from the Treasury in 2011 and no draws in 2012 and beyond. The draws included payments made back to the Treasury for the Zombie Dividends* on the Treasury’s senior preferred stock, which has the usury rate of 10%. The draws from the Treasury are equivalent to Net Income Available to Common Shareholders.
“Net Income” is more useful than “Net Income Available to Common Shareholders” in determining whether Freddie Mac is a viable entity because it is not obscured by the Zombie Dividends paid to the Treasury. I reviewed the reasons why the Treasury should reduce the dividend rate on its GSE senior preferred stock in previous articles.
| 2H10 | 2011 | 2012 | 2013 | |
| Previous cumulative draw from Treasury | -63 | -73 | -76 | -76 |
| Net Income | -7 | 4 | 7 | 7 |
| Treasury Zombie Dividends | -3 | -7 | -7 | -7 |
| Net Income available to Common Shareholders (i.e., current draw from Treasury) | -10 | -3 | 0 | 0 |
| Cumulative draw from Treasury | -73 | -76 | -76 | -76 |
Using the similar information for Fannie Mae, the FHFA implies that Fannie will turn profitable in 2013.
How can you say Freddie Mac will be profitable but still require draws from the Treasury?
I am most focused on whether Freddie Mac can report profits before dividend payments to the Treasury. I view the net income line item of Freddie Mac as the best indicator of the profit earning capability of the corporate entity. I view the senior preferred stock issued to the Treasury as an expensive form of capital that can be restructured if the underlying company is profitable. For example, if Freddie restructured the Treasury’s stake in a similar manner to the AIG restructuring, the Treasury’s senior preferred would be converted in common stock and the Zombie Dividends would be eliminated.
What happens if the scenarios in the FHFA’s projections are too optimistic?
If anything, Freddie’s results might be better than the base case scenario of these projections because the assumptions behind these projections are conservative. Here are the possible areas of conservatism:
1) Zero growth in credit guaranty business – Although growth in this business has been negative single digits for the past year, this will not always be the case. With the housing market weak, mortgage debt outstanding has been falling. Plus, the FHA has recently raised prices, so I would expect for more market share for the GSEs in the short-term. The private-label mortgage securities is years away from becoming a competitor again. Growth in this business will resume with the continued recovery in the housing market.
2) No additional retained portfolio business – Although this business is mandated to shrink, I believe this assumption is more aggressive than the mandated decline in the mortgage portfolio. The portfolio is the main way the GSEs are generating revenue right now. These revenues are offsetting the losses in the credit business. I think it is foolish to shrink this business since the FHFA itself has said most of the losses came from the credit business.
3) No recognition of Deferred Tax Asset value – Based on the limited information in the projections, it does not appear as though the GSEs are given credit for a revaluation of their deferred tax-asset once they demonstrate a return to sustained profitability. Recognizing this asset will create capital in the near-term to allow an accelerated payback to the Treasury.
4) 5% drop in ABX and CMBX – This assumption has already proven false since we know these markets have been strong since the June 30, 2009 start of the projections.
5) Regulator has incentive to be conservative – Government projections have been consistently conservative coming out of the financial crisis. No one at the FHFA has any desire to raise expectations and have to reverse course down the road.
Conclusion
Fannie and Freddie are not endless black holes of losses. The total loss is becoming clear with passage of time. Eventually, the Treasury may get paid back for its capital investment into the companies. Profitable companies with poor capital structures lead to restructuring opportunities.
The point of this article is there a potential restructuring opportunity in Freddie Mac’s capital structure because the corporate entity will turn profitable in 2011. The potential reform of Freddie Mac and Fannie Mae will be near impossible as liberals want a full nationalization of the companies and conservatives want complete privatization. Neither scenario is pragmatic. The clearest path is to do no damage to the housing market and modify the current form of Fannie and Freddie. This is the path of least resistance politically and the least risky option economically.
Possible options for modifying Fannie and Freddie are to improve their business practices: 1) prohibit low doc and no doc lending, 2) prohibit investment in private label mortgage securities, and 3) give the FHFA authority over both housing goals and safety and soundness with a priority on safety and soundness.
Disclaimer – Please do not buy the common stock because you read this article. I believe the common stock does not have much upside because 1) the Treasury owns an 80% warrant on both companies, 2) there is a potential for additional dilution through a preferred for common swap to restructure the Treasury’s senior preferred stock, and 3) one or both of the GSEs could be put through receivership and wipe out common shareholders entirely.
* – Zombie Dividends – I call the dividend payments on the Treasury’s senior preferred stock Zombie Dividends because Treasury Secretary Paulson wanted the GSE’s dead at the time he put them into Conservatorship. He forced them to pay a 10% dividend rate to the Treasury on its senior preferred stock investment. No other financial institution has had to actually pay to the government a 10% rate like the GSEs have. The commercial banks pay a 5% rate on the TARP preferred stock. AIG initially had to pay a 10% rate, but it was restructured into a non-cumulative preferred stock and AIG Board of Directors has chosen not to pay the dividend since early 2009.
Disclosure – long Freddie Mac preferred stock and Fannie Mae preferred stock
ICBA Calls for Restoring GSE Preferred Dividends
Mar/100
Last week, Camden Fine, President and CEO of the Independent Community Bankers Association, sent a letter to Secretary of the Treasury Timothy Geithner asking Treasury to restore the dividends on Fannie Mae and Freddie Mac preferred stock. Reading the letter, the community bankers feel like they were sold a bill of goods by Hank Paulson. It seems that Paulson’s book has enraged the ICBA, especially the fact that Paulson was proud to keep his promise to his “Chinese friends” for making them whole on GSE senior debt and MBS.
Let me know if it feels like the political rhetoric has died down regarding the GSEs.
March 12, 2010
The Honorable Timothy Geithner
Secretary of the Treasury
U.S. Department of the Treasury
1500 Pennsylvania Avenue, N.W.
Washington, DC 20220
Dear Secretary Geithner:
On behalf of the 5,000 members of the Independent Community Bankers of America I urge prompt Treasury action to remedy the status of preferred shareholders of the Government Sponsored Enterprises Fannie Mae and Freddie Mac. As the Administration and Treasury continue to control Fannie Mae and Freddie Mac in conservatorship and seek resolution to this unique GSE status, it is imperative that community bank GSE preferred shareholders are made whole to bolster capital and lending levels in this challenging financial and economic environment.
The abrupt action by then Treasury Secretary Henry Paulson to seize Fannie and Freddie through conservatorship was unjustly done in a way that needlessly crushed the value of GSE preferred shares, injuring over a thousand community banks that purchased these shares as a safe AAArated investment at the encouragement of their bank regulators. Since banks received special regulatory capital treatment for them and since banks are generally prohibited from investing in stock of other corporations, Fannie and Freddie preferred stock were important investments with full regulatory blessing.
Shockingly, Secretary Paulson fully acknowledges in his new book On the Brink that this action constituted an “ambush.” It took place shortly after he and the GSE regulators issued statements that supported the ongoing viability and capital levels of the GSEs in their current form as “shareholder-owned companies,” in order to “calm the market fears of a government takeover that would wipe out shareholders.” Now there is no doubt the government’s action was indeed an unjustified “ambush” structured in a way that continues to have detrimental consequences on many community banks that relied on the guidance of Treasury and bank regulators and were intentionally deceived on their Fannie and Freddie preferred holdings.
Americans expect and demand much better from their government and leaders. The lCBA urges the Treasury to help restore the value of the Fannie and Freddie community bank preferred share holdings to levels prior to the abrupt conservatorship of Fannie and Freddie. Preferred Fannie and Freddie shareholders should be compensated for the government’s action of eliminating all dividend payments and placing the preferred shares in a second position.
Rather than help stabilize the financial sector and boost lending, this government “ambush” further hurt banks’ capital levels, weakened the banks and reduced available credit. Such rogue changing of the rules governing preferred stock contracts also sent the entire market for financial preferred shares into a freefall, making it even more difficult for financial firms to raise needed capital. Notably, nearly $36 billion in Fannie and Freddie preferred stock was outstanding prior to their conservatorship. An estimated $15 to $20 billion was held by the banking sector and almost one-third of banks reported holdings including many Main Street community banks.
The Troubled Asset Relief Fund devoted $700 billion to help restoring financial sector credit and to increase lending with mixed use and results to date. However, if we truly want to help stabilize the financial sector, boost small business credit and economic growth, Treasury must also restore a reasonable value to GSE preferred stock so that affected banks can again increase their lending.
ICBA urges immediately restoring the dividend payments on Fannie and Freddie preferred shares and paying injured holders the amount of suspended dividends from September 7, 2008 on an estimated $20 billion in GSE preferred holdings. As the Administration works to remove the GSEs from conservatorship ICBA urges it be done in a way that will restore a reasonable value to the preferred shares. Helping restore the $15 to $20 billion in community banks capital value crushed by the unwarranted Treasury actions perpetrated on preferred shares can foster $150 billion to $200 billion in new lending as banks can leverage this capital.
Sadly, the Treasury and policymakers were forewarned of the distress and fallout that lmnecessarilv crushing GSE preferred shares would cause. For example, the attached letter dated August 271h, 2008 specifically warned of the community banks’ significant GSE preferred holdings that typically pay a fixed dividend and take priority over common stock. Unfortunately, Treasury chose to ignore the warnings when they turned the GSE preferred stock upside down when placing Fannie and Freddie into conservatorship on September 7, 2008. Mr. Paulson acknowledges in his book that he ambushed Fannie and Freddie shareholders in part to help satisfy the Chinese government, which owned billions of dollars in Fannie and Freddie bonds. Mr. Paulson notes that he called “my old friend Zhou Xiaochuan,” the head of the Central Bank of China, and China’s key financial leaders and said: “I always said we’d live up to our obligations.” ICBA believes it is now time to live up to United States obligations and help spur lending by compensating Fannie and Freddie preferred shareholders for the unjust actions of the government.
Sincerely,
/s/
Camden R. Fine
President and CEO
cc: The Honorable David Axelrod, Assistant to the President and Senior Advisor
The Honorable Lawrence Summers, Assistant to the President for Economic Policy and
Director, National Economic Council
The Honorable Eric Holder, Jr., U.s. Attorney General
The Honorable Michael Barr, Assistant Secretary for Financial Institutions
The Honorable Herb Allison, Jr, Assistant Secretary for Financial Institutions
The Honorable Barney Frank, Chairman, House Financial Services Committee
The Honorable Spencer Bachus, Ranking Member House Financial Services Committee
The Honorable Chris Dodd, Chairman, Senate Committee on Banking
The Honorable Richard Shelby, Ranking Member, Senate Committee on Banking
Interesting GSE Article at Housing Wire
Mar/100
Paul Jackson, the publisher of HosuingWire magazine, wrote an interesting article about the lack of a political solution to the GSEs.
I find this article interesting because there is a growing realization that the path of least resistence for resolving the GSEs Conservatorship is to simply allow them to exit in their current form when they return to profitability.
New LinkedIn Group for Fannie Mae Shareholders
Feb/100
I formed a new LinkedIn group for Fannie Mae and Freddie Mac shareholders. Please join the group by following this link:
http://www.linkedin.com/groups?home=&gid=2780934
The purpose of the group is for shareholders to network with each other and to discuss ways to increase shareholder value. The group is open to common and preferred shareholders of both companies.
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