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.