Fannie Mae (FNMA): preferred shares are attractive at ~50 cents on the dollar

This wouldn’t be much of a special situations blog if I didn’t discuss Fannie Mae and Freddie Mac (the “GSEs”) at some point. I’ve followed the GSEs at a high level and recently decided it was worth developing an updated and refined view. This situation has dragged on and consumed a considerable amount of the event-driven community’s time and patience, yet most investors have little to show after a decade. Investors have been disappointed countless times over the years, however I do think this specific moment is unique and different for a variety of reasons. Fannie and Freddie securities have very similar investment propositions, but I’ll focus on Fannie to avoid duplicating certain parts of the analysis.

Thesis summary

Fannie is a classic example of a high quality franchise that strayed too far outside its core competency and paid the price. Although Fannie and Freddie’s core guaranty business is simple, dominant, and exceptionally high quality, both were tempted to leverage government-subsidized funding costs to irresponsibly insure and speculate on lower quality mortgage assets leading up to the crisis. The GSEs also operated with improper leverage levels, magnifying the pain when many of these risky mortgage assets plummeted in value. The government bailed out both enterprises, a decision that has entangled various stakeholders to this day.

It’s important to understand that Fannie’s guaranty book is significantly higher quality than 2007 and its speculative investment portfolio has mostly run-off. Regulators also better understand that Fannie’s run-rate capital levels need to be much higher than before. When properly capitalized, Fannie would be well positioned to comfortably absorb the credit losses of a comparable recession today. It would therefore be incorrect to extrapolate Fannie’s crisis performance going forward. With nearly all of the operational issues cleaned up, we’re mostly left with Fannie’s core guaranty business, a franchise that benefits from an entrenched duopoly, customer captivity, tremendous economies of scale, and low capital-intensity.

This dominant franchise is normally the type of business I’d love to own, but you rarely get an opportunity to purchase great franchises at reasonable prices. This is exactly why special situations are compelling – not every investor is comfortable or prepared to underwrite certain risks, so highly complex situations can uniquely create opportunities to purchase great companies at cheap valuations.

Although Fannie has been extensively covered by the event-driven community, I think the high level of complexity and binary nature of outcomes creates a high barrier for many investors. And given the extreme duration and fatigue of this situation, many existing investors have moved on and aren’t following developments as closely.

There have been several positive administrative and legal developments for the GSEs in recent months, and Fannie’s common and junior preferred shares (“junior prefs”) have traded well as a result. Fannie has several different classes of junior prefs outstanding, and on average the classes have rallied from ~25 cents on the dollar to ~50 cents YTD. The market is correct that recent events have greatly improved the outlook for common and preferred shareholders, however I believe that current preferred prices are still improperly discounting the prospect of receiving par in the near-term.

When you weigh the Administration’s goals and incentives for GSE reform against the constraints of recent court decisions and a split Congress, I think you conclude that there’s one particular logical path forward. I think this specific sequence of events requires a quick settlement with the junior prefs and negotiating leverage has recently shifted in favor of preferred holders. This sequence of events is also broadly bullish for the common, however there are certain complexities and unknown variables that make the investment proposition of the common stock less certain, and therefore less compelling to me.

I think the prospects for a positive near-term settlement with the prefs is high. Although a settlement could take many forms, I expect holders to successfully achieve values close to par. With most prefs trading at ~50 cents on the dollar, I think that settlement prospects remain mispriced. To the extent a settlement does not occur, there are other legal avenues to value recovery that should support the trading prices and provide a separate path to crystalizing value. I’ve purchased Fannie Series-M and Series-S junior prefs at a blended price of 49% of par.

How did we get into this mess?

Prior to the Great Depression, the U.S. mortgage market was primarily operated by private banks and thrifts. There’s a natural tension when funding long-term mortgage assets with short-term deposit funding, so lenders attempted to mitigate liquidity and interest rate risk through short-term mortgage tenors and large up-front down payments, constraining homeownership. During the Great Depression, Congress initially responded to the housing slump by creating the FHA in 1934. The FHA provides mortgage insurance to low-income borrowers, helping expand the credit box for lenders. In 1934, Congress also created the Federal National Mortgage Association (FNMA), more commonly known as Fannie Mae. Fannie was allowed to purchase government insured mortgage loans in the secondary market, providing liquidity to FHA lenders.

In 1968, Congress privatized Fannie and significantly expanded its charter, allowing it to purchase any mortgage loan. Congress created Freddie Mac in 1970 to compete with Fannie. Freddie generally purchases loans from smaller banks and thrifts, and Fannie from larger institutions. The GSE business model is to purchase loans from lenders in the secondary market, retain the credit risk, securitize the loans into Agency MBS, and sell those cash flow streams to investors. The GSEs manage their retained credit risk by setting the underwriting criteria for the “conforming loans” they are willing to purchase.

Although Fannie and Freddie have recently operated as shareholder-owned publicly traded companies, they are also federally chartered with the public mission of supporting affordable housing (a complicated dynamic). As a result, Fannie and Freddie are viewed as government-sponsored enterprises, or GSEs. These blurred private/public lines have created the perception that Fannie and Freddie have implicit government backstops.

The GSEs have successfully advanced the 30 year fixed-rate mortgage loan, providing homeowners a predictable and affordable lending product. The GSE credit guaranty also creates a highly liquid and desirable investment product, Fannie and Freddie MBS, allowing homeowners to access the global capital markets in a cost-efficient manner.

This model worked incredibly well for many years and the GSEs funded or guaranteed more than half of all U.S. mortgages by 2000. The GSEs were prudent and conservative institutions for many years, however regulatory changes in the 1990s allowed the GSEs to increasingly grow beyond their core missions. By 2000, the GSEs were effectively operating two businesses: (1) a core guaranty business and (2) a speculative investment arm. Unlike the core business, the investment activities did nothing to advance the GSE mission of affordable housing and primary market liquidity. The implicit government backstop and relaxed regulations allowed the GSEs to add significant leverage at low and distorted borrowing costs. Although the spread between investment yields and funding costs was slim, extreme leverage levels magnified portfolio returns. By the mid-2000s, the combined unproductive and speculative investment portfolios of the GSEs totaled $1.6 trillion. In direct contrast to the core guaranty business, these investment arms possessed no competitive advantage, high complexity and capital-intensity, mismatch in asset-liability durations, high liquidity risk, interest rate risk, and low unlevered returns.

To make matters worse, the GSEs increasingly purchased lower quality (higher yielding) mortgages and securities for their investment portfolios. At the peak, the GSEs owned many of the worst performing products including Alt-A and Interest-Only loans. The GSEs similarly expanded the credit box for their core guaranty business and amassed material subprime, Alt-A, and other non-traditional guaranty exposures.

Given the significant leverage of these entities heading into the recession (>20x), it’s not surprising to see that this didn’t play out well. The financial crisis generated large guaranty losses (mostly in non-traditional products) and the investment portfolios suffered massive mark-downs. Both companies were on the brink of default. Given the critical importance of the GSEs to the U.S. housing market, the U.S. government felt compelled to act.

As a result, Congress enacted the 2008 Housing and Economic Recovery Act (“HERA”), establishing the Federal Housing Finance Agency (“FHFA”) and authorizing it to undertake bold measures to support the companies. The FHFA would act as the de-facto regulator of the GSEs and would be led by a single Director. HERA charged the Director with ensuring that Fannie and Freddie would operate in a “safe and sound manner” that was “consistent with the public interest.” HERA further authorized the FHFA Director to appoint the FHFA as either conservator or receiver for Fannie and Freddie “for the purpose of reorganizing, rehabilitating, or winding up” their businesses. Once the FHFA decided whether it would restructure (conservatorship) or wind-down (receivership) the GSEs, HERA granted the regulator significantly broad authority to pursue its goals. HERA separately granted Treasury temporary authority to purchase securities issued by Fannie and Freddie, allowing the government to infuse the GSEs with capital. A sunset provision limited Treasury’s purchase authority at the end of 2009. In an effort to empower the FHFA to better tackle its monumental task, HERA also sharply limited the judicial review of FHFA actions.

The FHFA quickly placed Fannie and Freddie into conservatorship in September 2008. Treasury then entered into Senior Preferred Stock Purchase Agreements (“SPSPAs”) and committed to invest billions to avoid default. In exchange for that commitment, Treasury received senior preferred shares entitled to $1bn in senior liquidation preference (above existing junior prefs) that would increase with draws from Treasury’s funding commitment plus warrants to purchase up to 79.9% of Fannie and Freddie’s common stock. The senior preferred shares were either 10% cash-pay or 12% PIK. The SPSPAs limited Fannie and Freddie’s ability to pay dividends to junior pref or common holders without Treasury consent.

The SPSPAs initially limited Treasury’s commitment to $100bn per company, however the GSEs remained shut-out from the capital markets and this quickly appeared too low. In May 2009, FHFA and Treasury adopted the First Amendment of the SPSPAs, doubling Treasury’s funding commitment to $200bn per company. Seven months later, a Second Amendment was adopted that further increased the funding commitment to an adjustable figure based on Fannie and Freddie’s cumulative losses, with the hope that this would alleviate market concerns. By 2012, the GSEs had collectively borrowed $187.5bn from Treasury.

The actions of the FHFA and Treasury were relatively uncontroversial up until this point, however an unexpected issue emerged. The housing market remained weak and the GSEs were struggling to generate enough earnings and capital to sufficiently cover the 10% dividend on the senior preferred shares. This potentially created an unsustainable and circular sequence where the GSEs would borrow from Treasury to simply pay increasing dividend requirements to Treasury. As a result, the FHFA and Treasury adopted the Third Amendment in August 2012, replacing the 10% dividend formula with a requirement that Fannie and Freddie simply pay a quarterly dividend equal to their ending net worth in excess of a $3bn capital buffer (the “net worth sweep”). The capital buffer would then decrease annually to $0 in 2018. Although this avoided the circular scenario of Fannie and Freddie spiraling into debt to fund its growing senior preferred dividend, it separately ensured that Fannie and Freddie would never rebuild capital. Privately, government officials admitted that the Third Amendment was specifically designed to prevent the GSEs from recapitalizing.

In hindsight, the timing appeared opportune for Treasury. The GSEs had built massive loss reserves from 2008-2011, and it was becoming clear that both companies had actually over-provisioned for losses. In addition, the GSEs had taken large valuation allowances against their deferred tax assets, suggesting a pessimism that net operating loss carry-forwards would not be utilized, however profitability was beginning to inflect. As a result, both companies released their deferred tax valuation allowances in 2013 and began gradually releasing excess loss reserves, driving strong profits at both entities. The Third Amendment ensured that this profit windfall would flow solely to Treasury, and the GSEs collectively paid $130bn of dividends to Treasury in 2013 – well in excess of what would’ve been owed if the Third Amendment was never implemented.

It shouldn’t be surprising that junior pref and common shareholders were furious. Their subordinated claims are worthless under the net worth sweep, as there’s no prospects for dividends to junior security holders. The timing also smells bad, as Treasury initiated the sweep right on the eve of massive profit windfalls at the GSEs. Although it was impossible to initially prove foul play, legal discovery has subsequently shown that Treasury was well aware of this pending windfall when initiating the net worth sweep.

To the extent the net worth sweep could be invalidated, the junior prefs and common shares could again be extremely valuable. As a result, a variety of funds and groups have initiated litigation against Treasury and the FHFA. These lawsuits have involved different stakeholder groups (preferred vs. common holders), legal strategies, and jurisdictions. Although the Third Amendment clearly smells like an egregious overstep of government, the legal argument is far trickier. The main problem is that HERA provided the FHFA with substantial freedom in its actions, creating an uphill battle for plaintiffs. As a result, many legal challenges have been unsuccessful thus far.

A rare sign of hope came with the recent Fifth Circuit Court of Appeals decision in the Collins vs. FHFA case (“Collins“). Although various litigation remains outstanding, I think the recent Collins decision is particularly important in guiding how this plays out. Before we get there, it’s worth briefly going through the business in more detail. None of this matters if we don’t like the business.

Fannie’s business and economics

Although there are some complexities to Fannie’s securitization process, its core business model is actually relatively straightforward. Most of Fannie’s securitizations are “lender swap” transactions. In lender swap deals, a primary market lender will deliver a pool of conforming mortgages with similar characteristics. Fannie will place the pool in a trust for which Fannie serves as trustee. In exchange, Fannie then delivers Fannie Mae MBS that are backed by the pool of loans in the trust. Fannie guarantees that it will supplement amounts received by the MBS trust such that MBS investors receive timely principal and interest. As a result of Fannie’s credit guaranty, GAAP accounting dictates that both trust assets and liabilities are consolidated on Fannie’s balance sheet.

Fannie retains a portion of the borrower’s monthly payment as compensation for guaranteeing the credit performance of the MBS securities. This compensation is called “guaranty fees” or “g-fees” and currently averages 51bps on Fannie’s total guaranty book. Most importantly, lender swap transactions are capital-light. Fannie is simply exchanging Fannie Mae MBS for lender contributed mortgages – Fannie is not purchasing loans with cash. The lender has generally already sold forward Agency MBS in the futures market (the TBA market), so the lender will then deliver the MBS from Fannie to close out its short position. This makes Fannie’s core business comparable to a traditional insurance float businesses – it receives up-front premiums in exchange for the promise to pay potential future losses.

The above activities describe Fannie’s core guaranty business. Fannie’s balance sheet currently shows $3.2 trillion of loans held in trusts against $3.2 trillion of trust MBS. These trust assets generate no residual net interest income – all principal and interest is passed through to MBS investors – however it does generate g-fees. From those g-fees, Fannie covers credit losses for MBS investors and company operating expenses. Fannie’s $3.2 trillion of trust assets are perfectly funded with liabilities of the same duration, meaning there’s no liquidity or rate risk to Fannie.

Fannie’s guaranty book is also much higher quality than during the crisis. In 2009, the peak for mortgage losses, Fannie’s single-family guaranty book had 8.9% Alt-A loans, 6.6% interest-only loans, and 12.1% subprime loans. Alt-A loans were particularly painful for Fannie – although the Alt-A book was only 8.9% of loans in 2009, it contributed 39.6% of annual losses. Put differently, Fannie’s Alt-A portfolio suffered a 5.2% loss rate in 2009, many multiples of the 0.8% loss rate for all other loans. The Alt-A book continues to run-off and is currently <2% of the book. This means that Fannie’s credit performance in a comparable recession would be much better today.

As we know, the other part of Fannie’s business is its investment activities or “retained mortgage” portfolio. In the past, this large portfolio was >$700bn, mostly for investment purposes, and comprised of many lower quality speculative assets. In contrast, today’s portfolio is only $171bn and mostly supports core operations.

$55bn of the retained mortgage portfolio supports Fannie’s lender liquidity capabilities. We previously discussed how most of Fannie’s transactions are lender swaps. For a smaller portion of transactions, Fannie is directly buying mortgages and placing them in a trust for securitization and sale at a later date – these deals are called “portfolio securitization transactions.” Unlike lender swaps, portfolio securitization transactions require up-front capital. Portfolio securitization transactions support Fannie’s conduit activities and are much less frequent. Fannie sets minimum pool sizes for lender swap deals and many small lenders lack the excess liquidity necessary to warehouse an origination pool until it reaches the minimum threshold for a lender swap deal. To help support these small lenders, Fannie is willing to fund this working capital by purchasing and aggregating loans before securitization.

Another $77bn of the retained mortgage portfolio supports loss mitigation efforts, where Fannie purchases delinquent loans out of MBS trusts to help facilitate modification. This means that only $43bn of the retained mortgage book is for non-operating investment purposes and this balance is in run-off and continues to decline.

Fannie’s $171bn retained mortgage portfolio is funded with Fannie-issued debt. In contrast to trust assets, Fannie is exposed to both liquidity and interest rate risk on this portfolio. With that said, I find the current size of the portfolio highly manageable and it’s encouraging that the investment portion continues to decline. Fannie continues to earn a spread on this portfolio (interest income in excess of funding costs), however the contribution towards Fannie’s earnings profile is dramatically lower today. The de-risked guaranty book and declining retained mortgage portfolio combine to create an earnings profile that is much higher quality than in the past.

We can now lay out some simple numbers to analyze Fannie’s unit economics based on 2018 profitability. Fannie reported $16bn of GAAP net income before preferred dividends, however there are some required adjustments. Fannie benefited from gains on its retained mortgage portfolio and continued release of its loss provision, flattering results. When properly adjusted, I calculate $10.2bn of after-tax operating earnings for 2018.

Relative to Fannie’s $3.2 trillion guaranty book, we can lay out the following economics:

  • 43.9 bps of average net guaranty fees (after passing through certain fees to Treasury)
  • +3.0 bps of ancillary fees
  • +13.6 bps of spread income (retained mortgage portfolio net interest income)
  • -7.6 bps of cash credit losses
  • -13.3 bps of operating expenses
  • -8.2 bps of normalized taxes (21% ETR)
  • = 31.4 bps operating earnings

It’s worth noting that Fannie has recently raised its g-fees for new MBS issuances, so the portfolio’s average g-fee should continue to accrete higher in future years. The portfolio’s average g-fee on new loans is 47.9 bps, so this re-pricing should provide a $1.1bn profitability tailwind over time. As a result, we can think of Fannie’s run-rate earnings as $11.3bn.

How are g-fees set? FHFA, in its capacity as Fannie’s chief regulator, sets minimum g-fees rates for new acquisitions. FHFA’s goal is to ensure that g-fees are at a level that properly compensates Fannie with a reasonable return on equity. This exercise is somewhat distorted by the fact that Fannie currently retains immaterial equity capital as a result of the net worth sweep. Part of the Administration’s goal is to have Fannie eventually recapitalize and retain a sufficient level of capital to prudently run its business. The financial crisis made it clear that the prior capital framework was flawed. As a result, the FHFA proposed a new regulatory capital framework for Fannie and Freddie in 2018. Although Fannie is currently unable to re-build capital under the net worth sweep, the FHFA provides minimum g-fee guidance with its proposed capital levels in mind. The current method of setting g-fee floors is similar to how utility commissions set electricity rates.

Some will contend that various GSE reform proposals contemplate changes that would impact the above economics. For example, certain proposals contemplate the GSEs paying the government a fee for an explicit credit backstop. Other proposals could increase costs. Although these changes could create short-term pressures on earnings, investors should assume that g-fees would subsequently be adjusted upward in a manner to maintain reasonable returns on capital. These fees would be passed on to borrowers and impacts to primary rates would be modest.

A borrower’s primary mortgage rate is simply a sum of (i) the prevailing treasury note yield, (ii) the spread on Fannie/Freddie MBS vs. treasuries (to account for prepayment risk and the current lack of an explicit backstop), (iii) the cost of loan origination and servicing, and (iv) Fannie/Freddie g-fees. Fannie and Freddie g-fees are then set at a level that covers (i) capital costs, (ii) operating costs, and (iii) credit costs. Let’s assume that reform results in Fannie’s costs doubling from 13bps to 26bps – an extreme scenario. Fannie would then pass through the incremental 13bps in g-fees, raising primary borrowing costs by the same amount. For a $200k mortgage, this would only increase a borrower’s monthly payment by ~$15. Absent radical changes to the business model, it’s fair to assume that Fannie/Freddie could pass through any reasonable cost increases from housing reform without any material friction. We can therefore assume that our estimated $11.3bn in current earnings power is an appropriate number to continue referencing.

Recent legal developments

The Third Amendment set off a variety of legal challenges across several jurisdictions, however most rulings have been in favor of the government so far. The recent Fifth Circuit decision in the Collins case is therefore notable in that it awarded plaintiffs a key victory on the net worth sweep. Inconsistent rulings are frequently appealed and heard by higher courts to clear up any confusion, but it’s unclear whether the Supreme Court would later hear part or all of this case. I’ll later explain how I think this decision greatly increases the prospect for a settlement, but will first discuss this decision in more detail.

In the Collins case, the plaintiffs, Fannie and Freddie shareholders, are suing the FHFA and Treasury. The plaintiffs are attacking the net worth sweep under two major legal grounds: a (1) statutory basis and (2) constitutional basis. The plaintiffs utilize three different statutory arguments, but their best claim is that the Administrative Procedure Act (“APA”) affords relief because the FHFA exceeded its statutory conservator authority when entering the net worth sweep. Although HERA offered the FHFA significant latitude in how it managed the GSEs during conservatorship, the plaintiffs argued the FHFA went too far. The separate constitutional claim argues that the FHFA, headed by a single Director removable only “for cause,” violates the separation of powers protections in the Constitution. Various lawsuits have challenged the CFPB’s structure under similar arguments. If the FHFA is unconstitutional, then agreements undertaken by its Director (the net worth sweep) are potentially open for challenge.

The Collins case was first heard in district court in Houston, where the lower court ruled in favor of the government and dismissed the case. On appeal, the appellate court ruled against the plaintiffs on statutory claims, but now concluded that the FHFA was indeed unconstitutional (reversing the district court’s decision). This appellate decision was provided by a 3 judge panel, however it wasn’t unanimous. Given the magnitude of this case and split decision, the Fifth Circuit agreed to hold an en banc hearing. This vacates the panel’s ruling and re-hears the case with all judges of the appellate court. Given the resources involved, en banc hearings are rare and reserved for controversial and precedent setting cases.

The Fifth Circuit returned its en banc ruling on September 6th. In another surprising twist, the court now ruled for the plaintiffs on both statutory and constitutional claims (reversing the district court on both claims). The judges agreed the FHFA exceeded its statutory authority under HERA by adopting the Third Amendment, however it stopped short of prescribing specific relief. Instead, the court remanded the claim back to the lower court for further proceedings. The court was willing to prescribe specific relief on the constitutional violation, however it stopped short of reversing the net worth sweep under this specific argument. The court instead opted to prescribe prospective relief, such that the FHFA’s Director is now freely removable at the will of the President before his or her term is up (removing the “for cause” protection).

Barring a settlement (we’ll discuss that later), what could happen next? The statutory claim is sent back down to the lower court where it will be re-reviewed under the constraint of the majority appellate ruling. If the undisputed facts and law (when viewed through the en banc ruling) make it clear that the government would not prevail on statutory claims, then the lower court could simply issue a summary judgment. Otherwise, the case would move to trial. Both sides are prepared, so any trial would be expedited. I think a summary judgment would be the likely path. At that point, the plaintiffs would finally be awarded specific remedies for the illegal net worth sweep.

The other path is for this ruling to be appealed upward to the Supreme Court. It’s worth clarifying that there could be separate paths for the statutory and constitutional claims. It’s also worth clarifying that the defendants have changed tune on certain of these claims. Mark Calabria, the current FHFA Director, was appointed in April 2019, well into litigation. Most importantly, Calabria has previously gone on the record condemning the net worth sweep. Treasury Secretary Mnuchin has also been broadly critical of the government’s overreach during conservatorship. Taken together, it’s reasonable to expect that the defendants won’t appeal the statutory claims to the Supreme Court. On the other hand, we could very well see the government appeal the constitutional claim. If this ruling stands and a Democrat wins the White House in 2020, Calabria would then be removable before the end of his full 5 year term. This introduces political risk to Trump’s vision for GSE reform. The government would first need to petition the Supreme Court to grant a writ of certiorari, a request for the lower court to send up its records for review. I believe the seriousness of the constitutional issues (separation of powers) and inconsistency in lower court rulings would make it likely for the Supreme Court to review this case. Regardless of the constitutional claim’s path, the statutory claim likely has a relatively straightforward trajectory from here.

I’ll now talk briefly about the statutory ruling itself – was it correct? The legality of the net worth sweep has perplexed many and resulted in several inconsistent rulings across circuits. Even the Fifth Circuit has produced two different opinions (initial panel vs. en banc panel). I don’t expect this issue to get to the Supreme Court, but it’s worth having a view just in case. The en banc’s majority decision was produced by Judge Willett, the dissenting judge on the initial panel, and I thought that it was well written. I’ll walk through the major lines of reasoning.

HERA provided the FHFA discretion to appoint itself as conservator or receiver, but these roles are mutually exclusive. The FHFA may “be appointed as conservator or receiver.” We know that the FHFA elected to pursue conservatorship. As conservator, HERA grants certain specific powers to the FHFA:

Powers as conservator
The Agency may, as conservator, take such action as may be—
(i) necessary to put the regulated entity in a sound and solvent condition; and
(ii) appropriate to carry on the business of the regulated entity and preserve and conserve the assets and property of the regulated entity.

Id. § 4617(b)(2)(D)

The FHFA has power to liquidate the GSEs under receivership, but not under conservatorship. And to the extent the FHFA pursued a receivership liquidation, HERA prescribes an orderly process for processing creditor claims. The rights and ranking of junior prefs could not be ignored during this process.

Although HERA provides anti-injunction protections against any judicial review of the FHFA’s actions as conservator or receiver, the provision’s plain meaning and past judicial precedents strongly suggest that courts may nonetheless grant relief if the FHFA exceeded its statutory powers as conservator or receiver. The anti-injunction protections are not unlimited. As a result, the court has authority to overturn the Third Amendment to the extent this action exceeded the FHFA’s authority.

Let’s take a step back and think about the net worth sweep. This clause not only transferred all future earnings to Treasury, but also ensured that the GSEs would never again be in a position to retain capital. Any reasonable interpretation would therefore conclude that that net worth sweep was in direct conflict with putting the GSEs “in a sound and solvent condition” and it did not “preserve and conserve the assets and property of the regulated entity.” The net worth sweep was instead comparable to a liquidation of the enterprises, which only is possible under receivership. And to the extent the FHFA instead pursued receivership, it would then need to respect creditor protections offered under that process.

One of the major counter-arguments to this line of thinking is that HERA asserts that the FHFA, as conservator, “may” take actions to rehabilitate the GSEs. HERA is also generous in providing very general, broad, and far-reaching authority to the FHFA as conservator. In other words, the action of returning the GSEs to a sound and solvent condition is perhaps one possible action as conservator, but not an explicit requirement. Read in its extreme, one could argue that the FHFA has near-unlimited powers as conservator. Although this feels like a technicality that is not in the true spirit of the law, it also runs into legal problems.

There is an important judicial concept that statutes must be read in their entirety – it’s incorrect to focus on one section or phrase without incorporating the broader statute’s context and meaning. When reading HERA in its entirety, one concludes that the FHFA has been provided (i) various general powers, (ii) unique powers as conservator, and (iii) unique powers as receiver. Although the FHFA’s powers as conservator are broadly defined and far-reaching, this section is clearly structured to be distinct from receiver powers.

Willett would note:

In RadLAX, the Supreme Court held that when “a general authorization and a more limited, specific authorization exist side-by-side” in the same statute, “the particular enactment must be operative, and the general enactment must be taken to affect only such cases within its general language as are not within the provisions of the particular enactment.”

RadLAX Gateway Hotel, LLC v. Amalgamated Bank, 566 U.S. 639, 645–46 (2012) (quoting United States v. Chase, 135 U.S. 255, 260 (1890))

So although HERA defines conservator powers as fairly broad, the structure of HERA is suggestive that the authors purposefully identified conservator and receiver powers separately. One key receiver power is the ability to wind-down and liquidate the GSEs. This power is solely listed in the receiver section, logically suggesting that it is a unique receiver power that should not be extended to conservatorship. HERA clearly bifurcated the roles of conservator and receiver, so those specific sections should be read narrowly.

In addition, the court correctly points out that HERA’s text is largely based on FIRREA, which provided the FDIC with authority to appoint itself conservator or receiver of struggling banks and thrifts. Willett would note:

“And when ‘judicial interpretations have settled the meaning of an existing statutory provision, repetition of the same language in a new statute indicates, as a general matter, the intent to incorporate its judicial interpretations as well.’”

Merrill Lynch, Pierce, Fenner & Smith Inc. v. Dabit, 547 U.S. 71, 85 (2006) (ellipsis omitted) (quoting Bragdon v. Abbott, 524 U.S. 624, 645 (1998))

In other words, it’s correct to utilize judicial precedent for FIRREA when interpreting HERA, because Congress is expected to have understood that HERA was based on FIRREA. With this in mind, Willett would say:

In McAllister we interpreted that provision to “state[] explicitly that a conservator only has the power to take actions necessary to restore a financially troubled institution to solvency.”

201 F.3d 570, 579 (5th Cir. 2000)

This means that FIRREA precedent strongly suggests that conservator powers are generally constrained in their goals of returning an institution to safety and soundness.

There’s also a related concept known as “common-law” definitions.

The Supreme Court recognizes a “settled principle of interpretation that, absent other indication, Congress intends to incorporate the well-settled meaning of the common-law terms it uses.” And “absence of contrary direction may be taken as satisfaction with widely accepted definitions, not as a departure from them.”

United States v. Castleman, 572 U.S. 157, 162 (2014) (quoting Sekhar v. United States, 570 U.S. 729, 732 (2013)). Morissette v. United States, 342 U.S. 246, 263 (1952); see Bond v. United States, 572 U.S. 844, 861 (2014)

The Supreme Court has previously held that conservators act as “a fiduciary held to the same standard of care as a trustee.” A common dictionary definition also defines conservator as “[a] guardian, protector, or preserver.” As a result, the court concluded that HERA lacked any clear language that would reasonably lead shareholders to assume that the long-held definition of conservator should not be utilized in this instance. Without explicitly re-defining conservator, shareholders were correct in relying on prior model statutes (FIRREA), their judicial precedents, and common-law definitions. Although HERA admittedly denotes that the FHFA “may” pursue actions that return the GSEs to a “sound and solvent condition,” a phrase that is permissive, but not mandatory, this is not enough to overcome the other factors that should contribute to a reasonable expectation for a conservator preserving and conserving the assets of the GSEs. The “may” phrase more likely acknowledges that a conservator might not succeed in rehabilitating the entities, avoiding the scenario where shareholders sue the FHFA for an unsuccessful restructuring.

Once the court has established that the FHFA had a responsibility to preserve the assets of the GSEs, it’s an easy step to then conclude that the net worth sweep was in direct contrast to this goal. Shareholders invested with certain reasonable expectations and the FHFA unlawfully transferred assets to Treasury. This was a de facto liquidation, however the FHFA sidestepped HERA’s creditor protections that exist under receivership.

All things considered, I think this ruling is correct and fair. The 2008 GSE bailout was certainly generous in not wiping out junior pref or common shareholders (although common holders were materially and fairly diluted). This potential generosity does not change the fact that investors, subsequent to HERA, are entitled to a reasonable expectation around the FHFA’s actions as conservator. The FHFA did not operate with unlimited authority, but instead had statutory constraints as conservator. Dissident opinions will argue technicalities around the anti-injunction provision or the “may” phrasing, but these narrow views miss the key point. The Third Amendment was in direct contrast to the FHFA’s mission as conservator and provided an improper windfall to Treasury.

Although other courts have come to different conclusions on similar statutory arguments, Willett argues that recent discovery has resulted in new evidence that provides incriminating context around the FHFA’s actions. Willett highlights an email from National Economic Council adviser Jim Parrott, who worked directly with Treasury on the net worth sweep:

“[W]e’ve closed off [the] possibility that [Fannie and Freddie] ever[] go (pretend) private again.”

-Jim Parrott

This quote suggests that the government’s underlying intent was clearly in direct contrast to the common-law definition of conservator.

With that said, I don’t want to understate the level of uncertainty when predicting these decisions. Despite hearing the same arguments and evidence, the district court’s original 3 judge panel came to a different statutory conclusion than the en banc panel. If read narrowly, there always exists a variety of precedents and case law that could advance both pro-plaintiff and pro-defendant arguments. I don’t want to downplay the risks of this case being appealed and reversed. This unavoidable uncertainty remains a residual concern, but I get additional comfort for two reasons: (1) I expect the statutory claims to be settled and not appealed to the Supreme Court, and (2) I believe the current Supreme Court majority would lean in favor of plaintiffs.

The Administration’s plan forward

Around the same time as the Collins decision, the Treasury also released its Housing reform plan. In conjunction with recent interviews from Mnuchin and Calabria, this 53 page document can be used as a blueprint for the Administration’s goals and plan of action. It’s therefore important to review. This effort can be traced to a March 2019 Presidential Memorandum directing Mnuchin to develop a plan to achieve the following housing reform goals:

  • End the conservatorships of the GSEs (following other reforms)
  • Facilitate competition in the housing finance market
  • Establish regulation of the GSEs that safeguards their safety and soundness and minimizes risk to the U.S. taxpayer
  • Ensure that the Federal Government is properly compensated for any explicit or implicit support it provides to the GSEs

As expected, the Trump administration is pursuing a plan that will reduce the Federal government’s role in the housing market and risk of future taxpayer bailouts. The plan includes both legislative and administrative initiatives to advance these key goals. In reality, however, a split Congress will guarantee that legislative initiatives will not be undertaken. As a result, we can focus on the administrative proposals to determine what will most likely occur.

Treasury makes 49 total recommendations across a variety of issues and topics, but I’ll highlight the most important administrative proposals relevant to shareholders below:

  • Clarifying existing government support
    • Item 2: Pending legislation, to avoid market disruption, Treasury should continue to maintain its ongoing commitment to support each GSE’s single-family MBS through the SPSPAs
    • Item 4: Pending legislation, to avoid market disruption, Treasury should continue to maintain its ongoing commitment to support each GSE’s multifamily MBS through the SPSPAs
    • Item 6: GSEs should be recapitalized such that private capital assumes the first-loss position
    • Item 9: Pending legislation, each SPSPA should be amended to compensate the Federal government for the continued support of the GSEs through an appropriate commitment fee
  • Ending the conservatorships
    • Item 20: FHFA should begin the process of ending conservatorship
    • Item 21: Treasury and FHFA should develop a recapitalization plan for each GSE
    • Item 22: Treasury and FHFA should permit each GSE to retain earnings in excess of the current $3bn capital reserve, with appropriate compensation to Treasury for deferred or foregone dividends
  • Capital and liquidity requirements
    • Item 24: The FHFA’s regulatory capital requirements should ensure that each guarantor holds capital sufficient to remain viable as a going concern after a severe economic downturn, such that taxpayers are not at risk of losses

As a reminder, the above highlighted proposals do not require legislative approval. Treasury’s plan does contemplate many broader legislative reforms that would represent significant shifts in housing policy, but these are simply not likely to get past the House. For example, in a perfect world Treasury would see Congress pass legislation that modifies the GSE’s implicit guarantee. Instead of the Federal government providing an implicit guarantee and backstop for the companies, Treasury would prefer that the government, through Ginnie Mae, provide an explicit and paid-for guarantee for qualifying MBS. In light of Treasury’s broader policy goals, such a move makes sense. In a subtle admission that this would not pass the House, however, Treasury separately lays an administrative path to at least pay Treasury a commitment fee for their SPSPA backstop. If the goal is to reduce risk and properly compensate taxpayers, this is better than nothing. And because a commitment fee represents the path of least resistance, this is what we’ll likely see.

In summary, the Administration has effectively opened the kimono. There’s a lot to digest, but the relevant items for shareholders are straightforward when only considering administrative actions. The government will end the net worth sweep, allow the GSEs to build capital, pursue a recapitalization with significant first-loss private capital, begin the process of ending conservatorship, and modify the SPSPA to properly compensate taxpayers through a commitment fee. Now that we understand the Administration’s anticipated path forward, we can weigh that plan against recent legal developments and other constraints to build a thesis of how things will actually play out. We can then consider how the Fannie prefs and common will perform in such an outcome.

What happens next?

With the ball in the Administration’s court, we can walk through their incentives and constraints to try and determine the most likely path forward. I’ll lay out my reasoning below.

Point #1: The FHFA Director is now removable at will if the Democrats win the election. Following the Fifth Circuit decision, the FHFA director is now removable at the will of the President. Pending a successful stay on appeal, this means that Calabria could be removed if a Democrat wins in 2020.

Point #2: FHFA and Treasury will therefore try to accomplish their administrative objectives in the next 15 months. Housing reform has become at tremendous focus of the Administration. The new potential for Calabria to be removed should add heightened urgency in getting as much done as possible ahead of the election. The Administration has publicly laid out what they can do without Congressional action, and these steps should become a priority.

Point #3: Eliminating the net worth sweep is the easy first step to begin retaining capital. Calabria has been open that he is actively negotiating with Treasury to end the net worth sweep as quickly as possible. This is an easy first step and will set the tone ahead of any capital raising efforts. We should get this announcement relatively soon.

Point #4: Retained earnings will help, but the GSEs will need to raise significant private capital to achieve proper capitalization in a reasonable time-frame. Ending the net worth sweep is significant in its meaning and messaging, but only a small part of the math. I think Fannie will eventually need to build over $100bn in core capital to be properly capitalized. Generating ~$10bn+ of annual earnings will help, but clearly external capital raises are required to build a first-loss buffer ahead of taxpayers in any reasonable time-frame.

Point #5: Investors won’t participate in the private capital raise if the senior preferred is still outstanding. The senior preferred creates a variety of issues for common shareholders. For many common holders, it represents the egregious overstep of the Third Amendment and plundering of shareholder value. If Treasury is unwilling to admit that this has been repaid, why would investors provide new money? Investors need an indisputable message from FHFA/Treasury that there will be no future controversies around the allocation of profits. And even if the net worth sweep is ended, the existence of the senior preferred still creates an issue to the extent prior 10% dividends are turned back on. Fannie has $121bn of senior preferred outstanding, which implies $12.1bn of annual dividends under prior terms. Similar to the net worth sweep, the resumption of 10% dividends would completely erode all earnings generation. The Administration needs to raise private capital to achieve its policy goals, but this can only happen if the senior preferred is gone.

I’ll quickly walk through why the senior preferred is essentially repaid. At the end of 2012, Fannie has $117.1bn of outstanding senior preferred stock. If the net worth sweep never went into effect, 2013’s annual 10% dividend would be $11.7bn. As we know, 2013 was a significant profit year for Fannie, because it reversed the DTA valuation allowance and continued to release its excess loss provisions into profits. Fannie produced $84.0bn of earnings in 2013, but the newly enacted sweep diverted $82.5bn of those earnings to Treasury. We are now operating under the legal assumption that the net worth sweep was illegal. This means that $70.8bn was improperly sent to Treasury ($82.5bn – $11.7bn). This represents money owed back to Fannie, but we can similarly treat it as a pay-down of the senior preferred’s liquidation preference, bringing Treasury’s true senior preferred claim to $46.4bn at Q4 2013 ($117.1bn – $70.8bn). If we continue to roll this math forward, we would conclude that the senior preferred was actually fully repaid during 2018, and if anything Treasury was modestly overpaid for its senior claim.

In other words, new shareholders are not being unreasonable in demanding that Treasury admits that the senior preferred is completely repaid. To the extent the net worth sweep was in fact illegal, per the Fifth Circuit decision, this is simply the equitable conclusion.

Point #6: The government still owns warrants for 79.9% of the common shares, so it has separate incentives to maximize the share price leading into and after a capital raise. One way to think about an elimination of the Treasury’s senior preferred obligation is that it transfers value from the senior tranche of the capital structure to junior obligations. And although a court may ultimately force FHFA and Treasury to make this transfer, we’re currently contemplating scenarios of FHFA and Treasury proactively doing this. The additional nuance is that Treasury continues to hold warrants for 79.9% of Fannie’s outstanding shares. This means that the immediate value transfer of the senior preferred elimination will actually mostly flow right back to the government.

Once that initial value transfer is complete, there are additional potential benefits. To the extent the senior preferred elimination is done in a clear, concise, and swift manner, it will send strong messaging to the common and the stock should trade much higher. A higher common share price is important because it will reduce the dilution to existing holders during the requisite private capital raises. To the extent Treasury believes that the courts will inevitably void the senior preferred obligation, it’s actually acting in its best interest to proactively declare the senior preferred repaid, get the stock price higher, and raise capital at the largest possible premium to book value, maximizing the value of its common shares on the back-end.

Point #7: The Fifth Circuit decision provides administrative cover to settle with shareholders. Mnuchin’s connections to the hedge fund community creates a natural tension around optics. Regardless of his unbiased view on the net worth sweep, this is a delicate situation. With that said, the recent Fifth Circuit decision is unique in that it provides new cover for the Administration. The senior preferred obligation remains a hurdle in completing housing reform, yet a court has effectively said that this obligation is repaid. The government can publicly state that they are foregoing prolonged litigation over a losing legal argument to make immediate and meaningful housing market improvements. In addition, the total profits to taxpayers (warrant value + dividends – capital draws) will be a significant number. Treasury will be able to correctly claim that the GSE bailout was massively profitable for the government. To date, the GSEs represent the most profitable crisis bailout by far.

Point #8: There’s little to gain by appealing the Fifth Circuit decision to the Supreme Court. Treasury will be weighing the pros and cons of settling vs. appealing the Fifth Circuit decision. By settling, Treasury guarantees speed of reform, gives up some value for taxpayers (effectively swapping their senior position for a 79.9% in-the-money common position), and best positions the company for its much needed capital raise. Appealing is guaranteed to delay reform timing but is not guaranteed to return a successful verdict. And even if the Administration appeals and wins, the ability to raise new capital would be weakened following an aggressive anti-shareholder campaign. The upside is not worth it.

Point #9: Once the senior preferred is considered repaid, the junior prefs are money-good. Once the senior preferred is deemed repaid, the junior prefs are now the most senior part of the capital structure. The junior prefs would have a $19.1bn obligation that is facing $11.3bn of run-rate operating earnings, so junior pref holders should be negotiating from a position of strength.

Point #10: Although the FHFA and Treasury have discussed additional taxpayer compensation, this is probably positioning for settlement. Public comments from Calabria and Mnuchin suggest that a new SPSPA Amendment would compensate taxpayers for foregoing net worth sweep dividends while the GSEs rebuild capital through retained earnings. This would likely occur through awards of common units to Treasury during the capital raise. This is economically equivalent to the net worth sweep, just with common share dividends as opposed to cash. Such a move would go against the spirit of the Fifth Circuit ruling and likely be retroactively overturned if this ever went to district court. In advance of trying to convince new shareholders to trust the Administration and put up new capital, this is not an action that would excite new investors. It feels like more of the same shenanigans.

I think Calabria and Mnuchin both understand this. Following the Fifth Circuit decision, a lot of momentum has shifted to shareholders. Some have suggested that junior pref holders are seeking compensation well in excess of par. I think the FHFA and Treasury are simply trying to regain some leverage that they could offer up during settlement talks. Regardless, this isn’t even necessarily negative for the junior pref holders. By paying Treasury with common shares, the underlying credit support available to the junior prefs is not eroded. Shareholders should be concerned with interim dilution, but the junior prefs remain in a comparable position of value.

Point #11: To simultaneously align junior pref holders with Treasury, demonstrate confidence in the restructured companies (helping the capital raise), and avoid optics issues, the government could require junior holders to convert into common as part of the settlement. To the extent the junior prefs simply remained outstanding, holders would do very well following the senior preferred being deemed repaid. There are several different series of junior prefs, but the average dividend rate is ~5.5% of par. The expectation for a near-term resumption of dividend payments would drive most securities near par. On the flipside, Treasury would prefer to equitize the junior prefs. By admitting that the senior prefs are repaid and “swapping” its senior in-the-money claim for common, Treasury would effectively be getting primed by the junior prefs – Treasury would prefer to level the playing field. Converting the junior prefs to common would also send a strong bullish signal to new investors that are getting up to speed. Obviously the junior pref holders know a substantial amount about Fannie and Freddie – to the extent they are willing to equitize, this action would be interpreted positively and ease new investor concerns.

Point #12: A junior pref conversion into common provides an attractive opportunity for junior prefs to leverage their negotiating position, obtain a favorable exchange ratio, and do well in an optics-friendly manner. Although a junior pref conversion should reduce friction around optics and the capital raise, it doesn’t change the fact that holders will be looking to be fully compensated through the recapitalization. The easiest manner to make this work is to offer a conversion ratio that is favorable relative to the current or expected common stock price. There are only $19.1bn of junior prefs outstanding at Fannie. This is a small number relative to (i) the capital that needs to be raised and (ii) Treasury’s warrant value, so “giving up” some economics to help on the capital raise makes sense. Most importantly, junior prefs would be getting paid in stock, not cash, reducing the headline risk.

Point #13: Each successful capital raise should drive the stock price higher, providing an attractive IRR from current junior pref prices. The magnitude of the required capital means that there will be multiple primary offerings over time. Through several offerings and cumulative retained earnings, the GSEs have a credible path to grow into a proper level of capital. Each subsequent capital raise will drive higher confidence in the enterprises’ ability to reach adequate capital levels with reasonable dilution. In each new primary offering, investors will be underwriting a price that generates attractive IRRs to their “run-rate” valuation expectation. This should provide a natural accretion and IRR to common holders during the multi-year recap.

Point #14: Although the common could certainly do better under these circumstances, there’s significantly more risk and uncertainty vs. the junior prefs. Although the above sequence of events contemplates that the junior prefs will convert to common shares – somewhat aligning their fate with common holders – it also assumes that junior pref holders will obtain a favorable exchange ratio and only agree to the extent they are receiving attractive value relative to their existing claim (par). The ultimate dilution level to the common will depend on the average issuance price, which is unknowable, so the common is inevitably wearing large dilution risk. For example, my math suggests that a capital raise near the current share price would provide no material upside to the common. The junior prefs will make sure that their conversion terms drives value of at least par.

Some illustrative math

In the prior section, I laid out my base case expectation for the next sequence of events. I could be wrong about a few or all of these events. There’s a lot of uncertainty, but I still think it’s helpful to think through incentives and options. I’ll now put some math to my expected sequence of events to help frame the analysis a bit better. I’ll again focus on Fannie.

Fannie’s Q2 2019 book equity capitalization is: $120.8bn senior preferred + $19.1bn junior preferred – $133.6bn common equity deficit = $6.4bn total equity. To the extent the senior preferred is deemed repaid (with no adjustment for over-payment), then $120.8bn of equity value would accrue to the common. How much capital is needed? For this exercise, I’ll assume that a recapitalization occurs over 3 years, so we’ll have a Q4 2022 target to get the GSEs properly capitalized. Let’s assume that Fannie has $3.5 trillion assets at that time. Per the FHFA’s 2018 regulatory capital plan, the most restrictive of the capital ratios would be the risk-weighted metric. FHFA’s analysis suggests that Fannie should hold ~3.5% of its assets in core capital. This implies a run-rate capital target of $122.5bn ($3.5 trillion x 3.5%). After deducting $40bn of cumulative retained earnings over this period and $6.4bn of current capital, I estimate that Fannie will need to raise $76bn through primary offerings. This is a big check, but post-crisis precedents suggest that it would be possible if spread over a few issuances.

The next question is the magical question… at what price will Fannie raise capital? It’s a critical question but impossible to answer. The stock is currently trading just below $4.00. Obviously the stock will significantly jump to the extent the senior preferred is deemed repaid in part of a settlement. Let’s assume the average issuance price is $10.00/share (I’ll later triangulate to this price). Let’s assume that junior pref holders indeed convert to common, but at a 10% discount, or $9.00/share. This means that there will be 7.6bn new shares from primary issuances ($76.1bn / $10) and 2.1bn new shares from the junior pref conversion ($19.1bn / $9). When adding the existing common shares (1.2bn) and warrant shares owned by Treasury (4.6bn), we calculate a total pro forma share count of 15.5bn. At that point we’ll have $122.5bn of common book value, implying $7.90 BV/share. I think a reasonable expectation for run-rate trading is ~1.50x BV, suggesting $11.85 in future value post-recapitalizing. After layering in ~$1.5bn of incremental earnings on primary issuance proceeds, this implies a PE of 14x – reasonable vs. bank comps.

This is all illustrative math, but hopefully you can see that this is a reasonable scenario and there should exist simlar permutations that also work. If new primary stock buyers indeed bought at $10.00 (on average), then they should realize an attractive ~20% upside to the extent Fannie indeed settles at $11.85 (1.50x BV). If junior pref holders held on, $11.85/common would represent ~130% of their pre-conversion par obligations, so they also did well by playing along and converting. Relative to today’s price, common shareholders would realize a ~40% IRR through 2022, a solid return given that common holders bear the highest capital raise execution risk. From Treasury’s perspective, their Fannie common shares would then be worth $55bn. Treasury has already received $181bn of cumulative dividends from Fannie, bringing total gross profit to $236bn. Taxpayers provided $120.8bn as part of the bailout, so this outcome is clearly a success (2.0x MOIC). When adding in profits on Freddie, it only makes a better headline. When viewed from the perspective of all major stakeholders, this illustrative recap feels reasonable – a path exists.

Of course many or all of these assumptions could be incorrect. Things may play out dramatically different than what I expect. Maybe Treasury never settles, the Administration runs out of time before a Democrat wins, or the market tanks and the capital raise is no longer practical. Under many of those scenarios, the prospects for common shareholders is bleak. In contrast, I still believe that junior pref holders would be well positioned.

Regardless of what the Administration does, the junior pref holders still have the Fifth Circuit decision invalidating the net worth sweep. They still have the path of pursuing remedies at the district court, and the correct remedy is deeming the senior preferred to be repaid. The Administration could admittedly surprise me and appeal to the Supreme Court. To the extent the Supreme Court agrees to hear the statutory claim, however, I feel good that the conservative majority would rule with plaintiffs. Under any of these scenarios, it’s hard to ignore the fact that junior pref holders retain an important claim on Fannie’s profits and sit above common holders. Unless the net worth sweep is again found to be legal on subsequent appeal, the junior prefs have a fair claim to par. It could be a bumpy road, but it’s hard to extinguish that claim.

There are 17 different junior pref series outstanding. The most commonly referenced series is the $7bn Series-S (ticker: FNMAS). FNMAS currently trades at ~$13, or 52% of its $25 par amount. Most other issues can be purchased for ~45-50% of par. There are two major reasons for the disparity in trading prices. The first driver is liquidity – FNMAS is the largest and most liquid security, so many institutional holders prefer this security. The second driver is the fact that different issues have different dividend rates. This matters because the stated dividend yields could be considered when determining the proper exchange ratio in a conversion to common. All things equal, this makes prefs with higher dividend rates somewhat more attractive (just in case). This also helps justify the FNMAS premium, because this series has a relatively high dividend rate of 7.750%.

I’m of the personal opinion that a recapitalization will likely provide equivalent recovery values to different prefs, so I don’t expect the dividend rates to matter much. With that said, I decided to purchase two different prefs to hedge my bet. As a result, I bought some of the Series-M prefs (lower float, lower dividend yield, lower price) and Series-S prefs (larger float, higher dividend yield, higher price) to achieve a blended purchase price at 49% of par.

I think timing is very interesting today. Calabria should be trying to get everything done before the next Presidential term starts. The complexity of the situation means that the first round of capital raising will take time. And none of this can begin until the senior preferred is fully addressed. The only way this tight timeline works is if the Administration settles with shareholders quickly. I think we need resolution on the senior preferred by the end of 2019 to make the tight timeline work. I’m therefore optimistic that we will have a positive catalyst by year-end. If we don’t have resolution by January 2020, I’ll rethink the thesis and position.

Key resources