Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) are two conservatories that retain their profits. Fannie Mae declared income last week and now reports regulatory capital terms. Freddie Mac reported two weeks ago. Fannie and Freddie point to huge capital shortfalls that could be corrected by restructuring their balance sheets. This paves the way for a restructuring where the government sells its stake and companies regain access to capital markets.
Fannie Mae reported a $173 billion government stake in the first preferred stock liquidation preference on its balance sheet, as well as 80% warrant coverage. Freddie Mac announced a $100 billion government stake of first preferred stock liquidation preference on its balance sheet, along with 80% warrant coverage. In a restructuring where the liquidation preference of the first preferred shares is honored and the warrants are exercised, the common stock has no material benefit and may be overvalued. As such, I don’t recommend owning them as an investment. There are, however, junior preferred shares in the capital structures of Fannie and Freddie. They have litigation over liquidation preference and dividend rights going to trial this summer as well as lawsuits that move into the counterfactual world of what Trump allegedly did. In the worst case, juniors prefer to hold on to their shares and dividends pick up whenever companies reach their capital requirements. There are two major catalysts here, legal action and administrative action. The world has fallen asleep at the wheel and assesses the probability of administrative action at 0%. Favorable legal action is what puts preferred stock at 10-15% of par. I think some administrative action is warranted in the short term and I recommend holding preferred stock which I expect to be worth close to face value.
Recent legal developments
In my view, there are two main legal fronts moving forward, constitutional claims and contractual claims. The constitutional claims have oral arguments beginning at the Sixth Circuit in June and the contract claims are scheduled to go to trial in July. Preferred stock stock prices seem to be anticipating less than a 15% chance of these performing favorably when I expect them both to perform favorably – and for good reason. The law has been interpreted, all that remains is to decide.
Scheduled Oral Arguments for the Sixth Circuit
The Sixth Circuit Court pleadings scheduled for Thursday, June 9 at 8:30 a.m. in the Rop case. The Rop plaintiffs will argue that the Supreme Court has already ruled that restricting the president’s ability to remove the FHFA director is unconstitutional. The only remaining question, therefore, is whether this restriction harmed the plaintiffs by preventing the President from removing the FHFA Director and implementing his policy of restoring shareholder value.
The Supreme Court held that a public statement by the president expressing his displeasure with the FHFA director and explaining that the restriction prevented him from removing the director from office would “clearly” show that the restriction hurt shareholders.
Former President Trump just posted such a statement – explaining that, without the removal restriction, he would have removed the FHFA director and restored shareholder value. Under Collins, the Rop plaintiffs argue that shareholders are entitled to a remedy. I don’t know how the government’s lawyers are going to try to argue against the Supreme Court’s clear interpretation of its requirements, subsequently met, which are somehow irrelevant. As such, I expect plaintiffs to win this case.
Lamberth DC District Court
The parties submitted a proposed modified schedule to Judge Lamberth asking him to convene a status conference on May 13 to talk about what will happen between that date and the July 11 trial date and, perhaps, hear any arguments on the motions for summary judgment in waiting. Government expects jury trial to start July 11 and expects it to last at least two weeks. On Friday, May 6, FHFA, Fairholme and Class Plaintiffs filed their responses under seal. The government’s main argument is simply to try to throw it all away — somehow ignoring Lamberth’s earlier ruling that the claims move forward trying to revive Collins v. Yelen. The plaintiffs seek to have Lamberth reject the argument that the net worth sweep could have been redeemed for the periodic engagement fee. It’s sort of the string pulling the rug that unties the rug (the government’s defense for those specific claims).
Mario Ugoletti’s affidavit managed to fool Lamberth in 2014, but the truth finally came out. Prosecutions have evolved. Rulings on how to interpret the law have been made. The shareholders now claim to stand trial this summer and the plaintiffs have produced evidence to prove their story, but a jury will have to agree with them for them to win this case. In my opinion, money does not lie and it says it all. Judges decide questions of law, juries decide questions of fact. I would expect a favorable court ruling later this year.
The path of administrative action
The Trump administration has not been able to advance its vision for housing finance reform until it seats its permanent director Mark Calabria. Similarly, Sandra Thompson must be confirmed as permanent director of the Federal Housing Finance Agency before the administration moves forward with housing finance reform.
Sandra Thompson had a head start on Mark Calabria. Because Mark Calabria and Mnuchin stopped scanning in 2019, Sandra Thompson will assume the position of permanent director with a lead of almost 3 years in terms of capital retention. Mark Calabria said that in the middle of Last year, he would have expected companies to raise capital. Instead, Biden was elected president and just like Trump, Biden refused to work with Calabria.
Fortunately for Biden, the Supreme Court ruled that he could fire Calabria and he did so immediately. Sandra Thompson took the Calabria seat and made such a good job executing Biden’s vision that he nominated her for the role on a permanent basis. Since then, she said the FHFA has been working with Fannie and Freddie to help them end their conservatorship.
The reality is that Sandra Thompson cannot do this without help from the Treasury or Congress. My take on the reality is that she wouldn’t have been named if the administration disagreed with her approach. As such, I expect the market to have assigned an implied 0% probability of near-term administrative action bordering on incompetence. Sandra Thompson outlined the steps needed to work with the Treasury to restructure Fannie and Freddie and get them out of conservatorship. It is absurd to think that this will not happen just because the administration has said nothing about housing finance reform. So far, all major reform has really been executed under Biden through Sandra Thompson at the FHFA. So far, the Treasury hasn’t been required to take the next step of opening the stock markets to Fannie and Freddie while simultaneously monetizing the Treasury’s position.
Summary and conclusion
COVID-positive Democratic senators have delayed Senate confirmations for two weeks now. Eventually, Sandra Thompson will be confirmed. In my view, this is the last remaining step before the Treasury can move forward with the FHFA and restructure Fannie and Freddie. Sandra Thompson had a three-year head start on capital retention and she didn’t have to write a capital rule from scratch. She only had to modify an existing one to make it better. Still waiting is a capital planning rule.
I don’t recommend owning commons, and before you consider buying them, I would recommend talking to someone with restructuring experience and asking them to look at the capital structure and see what he thinks about it. Even then, I would consider speaking to a lawyer to review any outstanding legal issues that you believe might suggest that the First Preferred Stock Liquidation Preference would not convert to common stock in a restructuring. with the mandates exercised.
The left standing position is preferred by juniors. I think if the government could get rid of them and destroy them, they surely would. I expect that will not be the case and I think this year is when this restructuring will be completed. Inflation is high and the government could use billions of dollars from its Fannie and Freddie stake to help support the American Dream.