FNMA: my take on recent headlines

The resolution of Fannie/Freddie will be complicated and messy. The political nature of this situation will ensure that words are carefully chosen, news is advantageously leaked, and developments are framed in the best possible light. The key will be separating the tremendous amount of noise from what actually matters. If investors are solely focused on news headlines, the next 12 months will be a confusing mess. This is why my original post instead focused on Administration incentives. And if you solely focus on incentives and ignore the noise, my conclusion is that a swift global settlement between the FHFA/Treasury/shareholders makes the most sense. A settlement solves for many issues between key stakeholders and represents the path of least resistance. There will be a lot of posturing and management of optics, but the underlying incentives are most important.

With all of that said, there have been two key developments that I wanted to acknowledge: (1) Calabria has made public comments that are shareholder unfriendly, and (2) the Administration has requested SCOTUS review of the Collins APA decision invalidating the net worth sweep. In my original post, I argued that it was unlikely the Administration would appeal the APA claims due to timing considerations – I was wrong on that point. My preferred position is down ~10% on these headlines. This may or may not be noise, so it’s worth re-underwriting the position.

Calabria’s shareholder comments were made at an October 22nd hearing with the House Financial Services Committee. Mnuchin also attended. It should be expected that such a hearing would be somewhat adversarial in the House, and the hearing’s name didn’t hide any biases: “The End of Affordable Housing? A Review of the Trump Administration’s Plans to Change Housing Finance in America.” During one testy exchange with Democratic Representative Bill Foster, Foster pressed Calabria and Mnuchin on potential conflicts of interest given the Administration’s connections to certain hedge fund holders. Calabria first reminded Foster that he has been on the record that common shareholders should’ve lost their stakes in 2008 (as opposed to retaining 20% of the equity). Calabria would then clarify that he’s “working for taxpayers,” and “if the circumstances present themselves where we have to wipe out the shareholders, we will.” Although the hearing was over 3 hours long, many news outlets focused on those specific comments.

The entire hearing can be viewed here: https://www.youtube.com/watch?v=rzahN1GA_qI

Separately, Calabria has also downplayed the potential impact of ongoing litigation on the Administration’s reform goals:

“Obviously there are a variety of shareholder concerns,” he said, acknowledging that ending the sweep wouldn’t necessarily deal with all of them. “I don’t have any money to pay anyone damages, so that will be decided by somebody else.”

Calabria said that he doesn’t see the legal battle having any negative impact on Fannie and Freddie’s profits at this point. He said that it’s not clear yet whether litigation will affect the companies’ ability to attract new investors as they seek to build outside capital in the future.

“We will cross that bridge when we get to it,” he said.

Bloomberg: Fannie’s Watchdog Says Focus Is on Exit Strategy, Not Lawsuits, 10/31/19

On a related note, both Calabria and Freddie’s CEO have suggested that the focus on exiting conservatorship quickly has absolutely intensified.

The WSJ would also confirm that regulators are talking with banks about a capital raise, although no official mandates have been awarded: https://www.wsj.com/articles/the-white-house-wants-to-privatize-fannie-and-freddie-it-needs-wall-streets-help-11571845492

Treasury’s SCOTUS petition for a writ of certiorari on the net worth sweep claim can be found here: https://www.supremecourt.gov/DocketPDF/19/19-563/120380/20191025201313249_Mnuchin%20FINAL.pdf

That just about summarizes the major developments. It certainly feels negative at first glance, but we can now try to separate the noise.

Let’s consider the scenario in which Calabria and Mnuchin actually believe that shareholders should be wiped out. This view would explain the requested Collins APA appeal to SCOTUS. Absent that appeal, the APA claim is being remanded down to the lower court for shareholder remedies. Most believe that the correct remedy would conclude that the senior preferred is indeed repaid. The lower court is now bound by the appellate court’s conclusion that the net worth sweep was illegal, so it’s difficult to come to any other conclusion. Only SCOTUS can determine that the appellate court’s en banc ruling was incorrect, protecting the net worth sweep and senior preferred claim. If Calabria and Mnuchin truly care about retaining the government’s senior preferred position and maximizing their stake in the recapitalized GSEs, this is certainly a logical step to take. If this interpretation is true, than my prior expectations for a settlement are incorrect.

This line of thinking begins to run into issues though. First, there are various anecdotes that suggest the Administration quietly agrees that taxpayers have been fairly compensated. Craig Phillips, aid to Mnuchin and key contributor to the Treasury’s reform plan, stated earlier this year: “The taxpayer has actually been in some ways, many ways, has been repaid from the bailout of Fannie and Freddie, we’ve got to turn the page and fix it to move on.” In separate comments, Calabria would also suggest that a restructuring that provides near-par recoveries to the junior prefs is not off-the-table. Calabria was also highly critical of the net worth sweep before assuming his role at FHFA.

Perhaps Calabria and Mnuchin’s attitude towards shareholders have actually changed and they’re not willing to settle. Still, this interpretation runs into issues. As discussed in my first post, there is a real pressure for the Administration to complete significant reform before the 2020 elections. Following the Collins constitutional claim decision, the FHFA Director is currently removable at the will of the President. If Trump loses, all of this is for nothing. Although certain reforms could always be unwound or modified following a Democrat victory in 2020, a recapitalization and exit from conservatorship, a key component of the Administration’s vision, could not easily be reversed. There are several anecdotes suggesting that Calabria has a high degree of urgency today, consistent with this view. There exists an indisputable incentive for FHFA and Treasury to effectuate a release soon.

We also know that a true recapitalization requires private capital – a re-IPO. Until clarity is achieved surrounding the net worth sweep, however, I think a primary capital raise is uninvestable. You can’t raise capital for an enterprise (Fannie) that’s worth ~$150bn when the validity of a $120bn senior claim is in dispute. The Collins appellate decision strongly suggested that this claim is invalid, however it’s ultimately the district court that will assign specific remedies. And those particular remedies could again be in dispute if SCOTUS agrees to hear the case. Although it’s potentially possible for the courts to provide some degree of clarity on the net worth sweep with enough time to subsequently run a fast re-IPO process before the 2020 elections, I personally think that timeline is a stretch at best. If the Administration wants to guarantee that the re-IPO occurs before the 2020 elections, only a settlement will work.

I’ll now walk through an alternative scenario that is more bullish for shareholders.

To start, let’s acknowledge that there exists a high degree of scrutiny surrounding Mnuchin’s ties to hedge funds and GSE shareholders. If he’s seen as acting overly pro-shareholder, there will be outrage. And although I envision a reform plan that will mostly rely on Administrative actions, let’s also acknowledge that both Calabria and Mnuchin likely want to maintain amicable relationships with Congress. It’s a long shot for any legislative reforms to get passed, however alienating the House will ensure that the probability is truly 0%.

So although a settlement is in the best interests of the Administration, they need to be careful in how this is achieved. Shareholders are likely emboldened following the Collins decision, so it’s reasonable to assume that the Administration wants to regain some momentum and negotiating leverage. This perfectly explains why the repeal of the net worth sweep oddly continues to increase the Treasury’s liquidation preference. This also explains why Calabria would admit that he’s willing to wipe out shareholders “if the circumstances present themselves.” I think Calabria and Mnuchin have been highly calculated in their actions and words thus far.

This leaves a lingering question – why would Mnuchin appeal the Collins APA decision to SCOTUS? For perspective, my prior restructuring analysis concluded that existing common holders should be entitled to ~7% of the pro forma common equity if the senior preferred was deemed repaid. If the senior preferred claim is upheld at SCOTUS, this value would instead accrue to the government. If Fannie’s valuation indeed settles at ~$150bn (1.5x book value), then the Administration is fighting over $11bn ($150bn x 7%) with this appeal. If you adjust that figure for the probability of the government winning at SCOTUS – let’s say 50/50 – then the government is only fighting for ~$5.5bn of risk-adjusted value. The government is already in position to make ~$100bn of net profit on the Fannie bailout, so why risk derailing the reform timeline over a few billion?

One line of thinking is that the Administration believes that SCOTUS is unlikely to take up the case today. SCOTUS traditionally only reviews final judgments. The appellate court remanded the APA claim to district court for remedies, so this is not yet a final judgment. As a result, it’s probably more likely that the petition for appeal is denied. Could the Administration actually prefer this outcome? An appeal to SCOTUS, even if unsuccessful, could provide the necessary cover that the Administration did their best to challenge shareholders before settling to avoid dragging this mess out further. Perhaps the Administration believes that SCOTUS, to the extent they accepted the case, could indeed act quickly enough to provide a ruling with enough time to complete a subsequent re-IPO. I’m not sure, but there are credible explanations for why a SCOTUS petition is not necessarily inconsistent with my prior investment thesis.

And remember – a successful grant of writ of certiorari is not necessarily a bad thing for shareholders. It’s not the quick and clean settlement that I’m envisioning, but it does provide a separate and final conclusion to the net worth sweep debate. I think the net worth sweep legal argument has always been somewhat of a coin toss at the lower courts, but I think the core government overreach claims will resonate well with the conservative SCOTUS. And to the extent that SCOTUS indeed invalidates the historical net worth sweep and deems the senior preferred to be repaid, there’s no doubt about the junior preferred value. Regardless of the go-forward housing reform path, the junior prefs are indisputably money-good if the highest U.S. court confirms the junior prefs are the most senior part of Fannie’s capital structure.

In summary, I’m still of the belief that a global settlement is by far the path of least resistance and best solves for the goals and incentives of the major stakeholders. I think incentives matter far more than political posturing, so I’m inclined to expect that a settlement ultimately occurs. I potentially misjudged the political cover that could be gained by appealing Collins to SCOTUS, but don’t expect the junior pref value prospects to be materially impaired whether the petition is granted or denied. If the petition is denied, I’ll again be looking for a timely settlement to resolve outstanding litigation to allow for a successful re-IPO.

With that said, I need to admit that the SCOTUS appeal does add some degree of doubt in my conviction in the thesis. Although I personally believe a settlement is in the best interest of the Administration, ultimately it’s Calabria and Mnuchin’s views of the best path forward that matter. Perhaps I’m misjudging the perceived political backlash of a global settlement and therefore underestimating the Administration’s willingness to further litigate the APA claims.

Taking everything together, I’m adjusting my junior pref position such that I have ample room to add on any additional negative headlines – it’s currently half of a “fully-sized” position, which in turn is smaller than most situations (due to the binary elements here). Even if I’m correct and a settlement is still likely, it’s becoming clear that Calabria and Mnuchin want to gain negotiating leverage in advance of this. Put differently, it’s more likely that the interim headlines are negative than positive. I still think the securities are attractive below 50% of par though. I plan to continue re-underwriting this position as additional developments occur. In particular, I’ll need to seriously re-think the validity of my thesis to the extent a settlement is not announced over the next couple months.