Will FNMA and FMCC Bring Extraordinary Returns to Investors This Summer?

By Katina Stefanova

July 26, 2016

Due to both the unprecedented actions taken by the government following the financial crisis of 2008, and the potential windfall that many private investors and hedge fund’s stand to gain, should a favorable decision be made on the plaintiffs’ case, Fannie Mae (FNMA) and Freddie Mac (FMCC) have been two of the most divisive stocks currently trading. Now, the issue comes to a head with greater urgency and more at stake than ever before as we seem to be inching slowly towards a legal resolution.

Simultaneously, the increased likelihood of a push for legislative reform following presidential elections and the pending earning reports due from the GSEs (August 2nd and 4th for FMCC and FNMA respectively) have drawn increased attention from investors. While there are dozens of cases currently underway across the country, the spotlight has been on the upcoming decision in the Perry Capital et al. v. Jacob J. Lew (the current Treasury Secretary) appeals case before the US Court of Appeals for the District of Columbia Circuit. On September 30, 2014 Judge Lamberth issued a controversial ruling on the case, declaring that while Third

Amendment, which was introduced to the arrangement in 2012, sweeps essentially all GSE profits the Treasury and is understandably controversial, he found the plaintiffs claim for injunctive relief on the grounds that the FHFA breached its fiduciary duties were inadequately supported. Many were surprised by the binary character of Lamberth’s ruling given his reputation as a traditional Republican. The plaintiffs responded to the ruling by appealing the decision, which is now being heard before a panel composed of Justices Ginsburg, Millet, and Brown. This specific appeal is the focus of our analysis as we believe it has the greatest impact on how other related cases still outstanding will be dealt with.

The panel recently surprised many observers by issuing a series of questions directed at the plaintiffs which seems to indicate there are some potential discrepancies between the Lamberth ruling and the panel’s view. Although the legal outlook is the most promising it has been since the Lamberth ruling, investors face other challenges.

The financial health of the two companies poses an additional risk to investors. The consequences of the net worth sweep have left cash reserves at precariously low levels of less than $2.5 billion for both Fannie Mae and Freddie Mac. Fannie and Freddie are also highly exposed to Treasury yield rates as well, 10 year notes hit record low yields this month of 1.35% (albeit before proceeding to rally higher at a record pace), reflecting further cause for due concern over the financial weakness of the two. So, stripped of any capacity to build a capital buffer by the introduction of the Third Amendment to the existing agreement between the GSEs and FHFA on August 17, 2012 and with only a little more than $1 billion remaining of Treasury capital left to cover any losses for each of the GSEs, any substantial Q2 loss for FNMA or FMCC would almost certainly result in another draw from the Treasury. It is difficult to assess the impact of such an event for investors.

Even if both entities post a profit in Q2 it remains likely that the two companies will need an infusion of capital from the Treasury at a date in the near future if the current arrangement persists given their current low cash situation. On the one hand, this could ultimately be to the benefit of investors, as a Q2 draw would likely attract the spotlight of popular political media to the ongoing tug of war for the fate of the GSEs. On the other hand, a further draw on the Treasury by FNMA or FMCC prior to the resolution of the outstanding appeals before the District of Columbia Circuit Court Appeals could also make it much harder for the plaintiffs to justify their case, if not in the eyes of the federal appeals panel, then certainly in the eyes of the public. Traumatic experiences of 2008 still loom large in Main Street’s memory, so regardless of the fact that the net worth sweep authorized by the government is what would most likely lead to the need for a further ‘bailout’ in the first place, a draw would still hurt the public’s perception of the plaintiffs’ case. Given the volatility of the situation and anticipation surrounding the upcoming earnings report, it is clear that this is a race against time. Ideally a legal outcome will be handed down before the capital situation of the GSEs deteriorates further declines– if the GSEs are forced to request additional funds before a legal resolution it would likely complicate the case against GSEs conservatorship greatly. Beyond concerns regarding government takeover of private property, the lack of a capital buffer coupled with the issue posed by the complete absence of meaningful legislative reform for the GSEs also is a threat to the existence of the affordable fixed rate mortgage and therefore the US housing market itself.

Attorney Tom Ogden at Wollmuth Maher and Deutsch LLP, whose dealings with litigation relating to the bailout of the GSEs have given him a familiarity with the issues at hand, provided some insight on the possible legal outcomes for the current appeals case. Mr. Ogden believes that it would be reasonable to expect a decision in this case before years’ end, although due to the volatile political nature and legislative interest, the considerable possibility of a legislative turnover in Congress, and the unusual circumstances surrounding this particular appeals case, the likelihood of any decision being made by the panel before the end of the presidential race is quite low. Whenever a ruling is passed however, there are three clear possible outcomes

An outright affirmation of Judge Lamberth’s ruling:

Given the highly unusual introduction of new evidence in the case before the appellate case by the plaintiffs, and the favorable nature of said evidence, this seems to be a very low probability outcome. Furthermore, considering the traditionally conservative leanings of Justices Ginsberg and Janice Brown, this seems to be the least likely outcome. In this scenario, there is also a possibility that the plaintiffs could successfully bring their case before the Supreme Court, although this would be a bit of a long shot as well.

An outright reversal of Judge Lamberth’s ruling:

This is the second least likely probability. Since this is an appeals case and appeals cases are typically made on previously established facts, the introduction of important information potentially contrary to that which Lamberth’s previous judgment was based on increases the probability of this outcome. The other factors mentioned above indicate that this remains a very low probability outcome however.

A remand back to Judge Lamberth from the Federal appeals panel with stipulations:

The third scenario outcome for the appeal is a remand of the case back to Judge Lamberth with some specific guidance on the law as to how to proceed. Many observers, including Mr. Ogden, see this as the most likely outcome. A partial reversal of some kind may also accompany such a remand, with some specific rulings against what Judge Lamberth did.

If the second scenario were to play out successfully, it would undoubtedly be the most beneficial outcome for investors. In this scenario it is highly like that both stocks could potentially reach a market value of $20, a price frequently cited by Bill Ackman, or more. Many observers have called for a 12-14x return on current share price in the event of a reversal of Lamberth’s ruling that enables recapitalization. The third scenario could potentially boost the twos stock prices as well, rising on the back of speculative buying. The worst case scenario for those long FNMA and FMCC, outcome one, would likely render the stock close to worthless for the foreseeable future.

Fannie Mae and Freddie Mac were originally created with the purpose of “promoting access to mortgage credit through the nation…by increasing the liquidity of mortgage investments and improving the distribution of investment capital available for residential mortgage financing” U.S.C § 1716(3). Fannie Mae and Freddie Mac don’t accomplish this through the origination of loans themselves however; they buy and guarantee loans, then bundle loans with similar characteristics and risk profiles into mortgage backed securities (RMBS), which are then sold to investors in a tranche based system. A particularly unique aspect of the US mortgage system, the fixed-rate mortgage loan, is made possible by the stability and liquidity FNMA and FMCC add to the secondary MBS market through the securitization and guarantee of these vehicles. No other nation offers such a product, instead issuing their mortgage loans on a floating interest rate basis. This arrangement essentially shifts massive amounts of risk from private investors to the US government.

The unique relationship between the GSEs and the private markets is a double-edged sword however; while it enabled rapid growth of home ownership and mortgage origination volume in the US by encouraging private investment and participation in the residential mortgage loan market, it also played a significant role in promoting a riskier market environment which precipitated the eventual meltdown of the US financial markets, leading to the eventual government conservatorship of FNMA and FMCC.

On July 30, 2008, Congress enacted the Housing and Economic Recovery Act (“HERA”), authorizing the Treasury to invest in the GSEs on the basis of the “systematic danger that a Fannie Mae or Freddie Mac collapse posed to the already fragile national economy.” In exchange for the Treasury’s funding commitment, which as of August 8, 2012 amounted to $187.5 billion in total, Fannie and Freddie provided the Treasury with senior preferred stock, entitling the Treasure to four principal contractual rights:

First, the Treasury received “[a] senior liquidation preference of $1 billion for each GSE plus a dollar-for-dollar increase each time the GSEs drew upon Treasury’s funding commitment. Second, [the agreement] entitled Treasury to dividends equivalent to 10% of Treasury’s existing liquidation preference, paid quarterly. Third, Treasury received warrants to acquire up to 79.9% of the GSEs’ common stock at a nominal price. Fourth, beginning on March 31, 2010, Treasury would be entitled to a periodic commitment fee “to fully compensate [Treasury] for the support provided by the ongoing [funding] [c]ommitment”, (12 U.S.C § 1716(3). Under government conservatorship, FNMA and FMCC have respectively paid out dividends of more than $31.5 and $26.9 billion in excess of the principal loan they received to the Treasury over the past few years. While the dividend was initially fixed at 10% for the Treasury’s senior preferred shares, the change in initial terms in 2012 to require a variable rate dividend payout has prevented the improvement of FNMA and FMCC’s balance sheets, despite these past returns. So, for the past 8 years, FNMA and FMCC have been required to give all profits to the government in excess of $3 billion. This has not only prevented common and junior preferred shareholder from seeing any returns on their investment, but the building of capital by either GSE as well, an important step towards profitability for the two in a post-conservatorship scenario.

It is this stipulation which the plaintiffs find to be the most egregious offense of all. From a philosophical standpoint they argue that the rights granted in the arrangement between the FHFA, Treasury, and GSEs effectively amounted to the nationalization of a once private company, a fundamental violation of America capitalist history and democratic values.

Beyond this point, their legal aim is to establish that actions of the FHFA and Treasury constitute a violation of their respective fiduciary duties. The plaintiffs have further argued that the bailout was an unnecessary action, as the losses of the FMCC and FNMA were both largely exaggerated and significantly inflated due to a difference between government accounting methods and standard practices. Investors with interests in the mortgage financing twins also point out that, as newly introduced evidence has indicated, the government only stepped in and took action to provide the GSEs the capital necessary to backup their guarantees on securitized loan products they sold once it had already become clear that the two firms were on the verge of recovery and profitably. On these grounds a number of hedge funds including Perry Capital, Fairholme Funds and Arrowhead Indemnity Company are suing the government in hopes of reversing the net worth sweep and reestablishing the two firms.

While a resolution to FNMA and FMCC investors’ plight will likely come from the courts, a legislative solution is also on the table. Hilary Clinton, who would be unlikely to support calls to recapitalize Fannie and Freddie or to release them, has shared her views on the restructuring of the firms in the past; her plan would likely call for the merging of the twins as well as the implementation of some sort of catastrophic loss backstop which would mean the placement of a large buffer of private capital before government (and therefore taxpayers) would absorb any losses. A plan recently put forward and consistent with previous views offered by Clinton, indicates that this is a likely path to legislative reform under a Hillary Clinton Administration. A paper co-authored by Gene Sperling, who has already been tapped by Hilary Clinton as a top adviser, along with other high profile financial thinkers such as Jim Parrott, Mark Zandi, Barry Zigas and Lew Ranieri, calls for the merging of the GSEs and cites figures upwards of $100 billion for a potential capital buffer. On the whole however, the likelihood of a legislative solution favorable to investors appears to be quite low. Congress is also hugely undecided about what to do with the two firms, making any near term legislative solution even more unlikely, particularly before the conclusion of presidential elections.

Leaving aside probabilities and speculation, for those who bought into the GSEs at fire-sale prices, it has been clear from the beginning that an FNMA/FMCC investment was always destined for a binary outcome – the potential of a 10x return or none at all brought out investors inner daredevil. For those who took the bait, the opening of more than 120 previously sealed documents in the appeals case currently before Justices Ginsberg, Brown, and Millet seems to have significantly increased the prospects of investors realizing a return on their bets (which did not look promising after the Lamberth ruling).

Due to both the content of the supplementary evidence filed by the plaintiffs and the inherently unusual introduction of new evidence in a case such as this one, a key point made by Mr. Ogden, this turn of events is the most positive point supporting hopes for a favorable outcome for the plaintiffs and their proponents since the disappointing ruling by Judge Lamberth. Although some type of judicial resolution will likely happen before the end of the year, the risks remain high and the possibility of a complete loss is still a present danger. As the month of July winds down and we head into another midsummer earnings season, those with an interest in the GSEs as well as observers who are hoping to move in off of the sidelines would be wise to keep an eye out for upcoming earnings reports.

Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Forbes). I have no business relationship with any company whose stock is mentioned in this article.
Note: I am conducting research on trends and opportunities for disruption in asset management (www.disruptinvesting.com). If you have insight into the topic, feel free to contact me.

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Found: Mario Ugoletti

Up until now, finding a current picture of Mario Ugoletti (FHFA, US Treasury) has been a seemingly impossible task.  The only picture produced via a Google search is from Mr. Ugoletti’s high school yearbook.

mario

I recently realized that Ugoletti must have attended Congressional testimony with either Ed DeMarco or Mel Watt.

I came upon this picture of Ed DeMarco testifying with FHFA GC Alfred Pollard to the right of DeMarco and someone I thought might be Ugoletti on the left.

I also realized that Ugoletti attended the Financial Stability Oversight Council on behalf of FHFA with Watt.  So, I searched for a picture of Watt at FSOC meetings and look whose name is in front of the same gentleman from the picture above.

Ugoletti

MU card

So, we’ve finally cracked the “Where’s Mario?” mystery!

Below is the link to the testimony where Ugoletti accompanied DeMarco. This is the testimony where protesters interrupted the proceedings.

Mario looked much happier in high school. Hmm, wonder why…?  Though he did seem amused by the protesters. Pollard looked like he almost had a heart attack…!

http://www.c-span.org/video/standalone/?c4391418

Bright Ideas

Michael Bright and Edward DeMarco released a paper for the Milken Institute in June, Why Housing Reform Still Matters regarding Fannie Mae, Freddie Mac and the future of the US secondary housing market.

Apparently, this paper is the first one in a four-part series. What’s interesting is that Mr. Bright just joined Dr. DeMarco in June at the Milken Institute.

The Milken Institute was founded by Michael Milken, who in March 1989 was indicted by a grand jury on 98 counts of racketeering, fraud, insider trading and tax evasion.

From its website:

The Milken Institute is a nonprofit, nonpartisan think tank determined to increase global prosperity by advancing collaborative solutions that widen access to capital, create jobs and improve health. We do this through independent, data-driven research, action-oriented meetings and meaningful policy initiatives.

The institute is funded through different levels of sponsorship and strategic partnerships. One of Milken’s strategic partners is Citigroup, the company that agreed to a $7 billion settlement in July 2014 for packaging and selling bad mortgages to Fannie Mae and Freddie Mac. These practices, along with those at dozens of other banks, led to the 2008 financial crisis.

Though Milken Institute dubs itself as independent, strategic partners like Citigroup would likely expect a return on their investment. And Citigroup, along with the nation’s other mega-banks, has a vested interest in the outcome of housing reform.

Bright and DeMarco in their recent paper call for the elimination of Fannie and Freddie by merging them and then renaming the new entity where “…it could be folded into a government agency that provides the catastrophic guarantee for MBS (such as a Federal Mortgage Insurance Corp., a National Mortgage Reinsurance Corp., or simply Ginnie Mae).”

Our good friend Joe Light analyzed the plan writing for Bloomberg stating:

“DeMarco and Bright want to see Fannie Mae and Freddie Mac converted into mutual companies, owned by lenders, that would sell insurance against defaults instead of buying and securitizing mortgages. As they do now with Federal Housing Administration loans to less-wealthy borrowers, the lenders would issue mortgage-backed securities under the auspices of Ginnie Mae. As an exception, Fannie Mae and Freddie Mac could still buy loans directly from small lenders, the authors said.”

In other words, big banks, like Milken’s strategic partner Citigroup, will inherit a share of Fannie and Freddie’s business if they are eliminated per Milken’s recommendation.

By now, everyone is aware of the Wall Street-Washington revolving door. Banks support their executives taking on bank regulating roles in government where they can influence laws and regulations that ultimately benefit mega-banks. Those executives then return to Wall Street as heroes.

One WS/DC revolving door executive is none other than Michael Bright.

In the years leading up to the 2008 financial meltdown caused by unethical and illegal practices by mortgage lenders, Bright worked as a top executive at Countrywide and Wachovia from 2002 – 2008. Both of these companies needed to be rescued by larger banks in the wake of the crisis, which the parent banks eventually paid billions of dollars on settlements relating to faulty mortgage practices at Countrywide and Wachovia.

Was Michael Bright charged with wrongdoing while he was an executive at Countrywide or Wachovia?

Of course we know that no executive was ever charged with crimes that brought about the 2008 financial crisis.

Then surely Mr. Bright’s career must have suffered by his involvement with two collapsed mortgage companies?

Well, you likely know that’s not true either.  The following is Bright’s career path as listed on his Linkedin profile:

Countrywide: 2002 – 2006

Wachovia: 2006 – 2008

Office of the Comptroller of the Currency – U.S. Department of Treasury: 2009 – 2010

Senior Advisor to Senator Corker: 2010 – 2014

BlackRock: 2014 – 2015

PennyMac: 2015 – 2016

Milken Institute: June 2016 – Present

So, after his leadership at collapsed Countrywide and Wachovia, Bright went to work for the Treasury. Here’s what it says about the OCC on their website.

“The OCC charters, regulates, and supervises all national banks and federal savings associations as well as federal branches and agencies of foreign banks. The OCC is an independent bureau of the U.S. Department of the Treasury.

Mission: To ensure that national banks and federal savings associations operate in a safe and sound manner, provide fair access to financial services, treat customers fairly, and comply with applicable laws and regulations.”

Apparently, the qualification to become a bank regulator is to first have experience with a collapsed bank. Isn’t that like saying the qualification to become Fire Chief is to first become a master arsonist?

Where does a failed banker turned bank regulator go next with his career? Of course, the next step in the career path would be to join Senator Bob Corker’s office as the Senior Financial Policy Advisor. While working for Corker, Bright was the principal author of “Corker-Warner” and later “Johnson-Crapo” housing finance reform bills that called for the elimination of Fannie and Freddie.

Any good revolving door executive knows when best to revolve from government back to Wall Street. Next up for Bright was his move to BlackRock.

Here’s how Bright’s career path was described in the article: Fannie Mae: Former Staffer Behind FMIC Goes To BlackRock

“You may remember there was a bit of controversy last April when it came out that the Corker-Warner bill to replace (Fannie and Freddie) with a new government agency was largely written by former Countrywide Financial exec Michael Bright, now working as Senator Bob Corker’s senior financial advisor. Corker-Warner has since morphed into Crapo-Johnson, which kept the same basic framework in place, but critics still argue that Crapo-Johnson’s proposed FMIC would benefit Wall Street at the expense of smaller banks and homeowners.

Bright has never been accused of any wrongdoing, but for him to move from the heart of the subprime crisis to an important government position, influencing the future of the US mortgage market is jarring. For him to take a job with BlackRock…who lobbied Senators Corker and Mark Warner during the process, seems to confirm people’s worst fears about the revolving door between Washington D.C. and private interests.”

The Door Keeps Spinning

Bright’s seven month tenure at BlackRock was followed by a Senior Vice President position at PennyMac. For those unfamiliar with PennyMac, the mortgage finance company is basically a reincarnation of Countrywide founded and staffed primarily with former Countrywide executives.

Countrywide: It’s baaack  PennyMac is “…headed by the former executives of the most notorious subprime lender of the era that led to the financial crisis… ‘There’s free money on the table and you don’t have to work that hard to get it, especially if you are the former executives of Countrywide,’ says Michael Widner, an analyst who covers PennyMac at brokerage firm Stifel Nicolaus. ‘You’ve done this before.’”

Bright lasted twice as long at PennyMac than BlackRock clocking in a full 14 month tenure there.

Now onto Milken Institute, the independent think tank. At Milken, Bright is the Director of the Center for Financial Markets. DeMarco is a Senior Fellow for the same group. Joining Bright and DeMarco at the Center for Financial Markets is Aron Betru, Managing Director (formerly with Goldman Sachs) and Staci Warden, Executive Director (formerly with JP Morgan and US Treasury).

Bright also counts the fellow travelers at Mortgage Bankers Association (MBA) among his friends. While at PennyMac, Bright was asked to join an MBA task force charged with recommending action on housing reform.

As described by MBA: GSE Reform Legislation 

“MBA has convened a Board of Directors-level Task Force to address many of the outstanding questions surrounding GSE reform. That task force plans to unveil its recommendations in the second half of 2016.”

Though the recommendations have not been released, the following is what MBA supports:

  • An explicit federal guarantee for mortgage securities
  • Private capital in a first-loss position, backed by a federal insurance fund in the event of catastrophic losses
  • Single, highly liquid security delivered through a common securitization platform
  • Preservation of key GSE infrastructure – technology, systems, data and people – by transferring them to any new or reconstituted entities created by GSE reform

What both Milken and MBA are recommending is to merge Fannie and Freddie into one entity – back the securities with a federal guarantee and to back the entity with catastrophic loss insurance.

How is this new scheme with less competition and enhanced government support supposed to protect “the taxpayer” any better than the current structure?

Further, those that back this recommendation obviously want “something for nothing.” Common Securitization Solutions (CSS) is the company that was developed by Fannie and Freddie and paid for by Fannie and Freddie’s shareholders. CSS will manage a “single, highly liquid security” and will be administered “by key GSE infrastructure – technology, systems, data and people.”

I’m on the edge of my seat waiting for the next three Milken papers, as well as the recommendations from the MBA task force on housing finance reform.

I just can’t wait to learn more of those Bright ideas…