Monday, August 18, 2014

Fannie and Freddie: Is the Debate on Net Worth Sweep Enough to Save the Commons?

In this piece I will raise questions and provide some analyses, rather than attempt to make any conclusive statements. My questions are:  “If the Third Amendment (Net Worth Sweep) is repealed, can the Senior Preferred stocks be paid down?  Or is some more fundamental challenge to the conservatorship needed?  And how would the GSE’s build capital if the senior preferred stocks cannot be redeemed?”  I will focus more on Fannie Mae here.

A couple of articles from John Carney of WSJ caught my eyes.

An interesting point in both articles is that even if the Net Worth Sweep is repealed, Fannie and Freddie would still have trouble paying the 10% preferred dividends, making the commons nearly worthless.

Not surprisingly this angered GSE supporters 

A reader commented on Carney's article: 
“You also fail to mention that if the sweep is invalidated then dividends that they "owed" were calculated incorrectly.  There are strong arguments that can be made that the Senior Preferred Stock will have to be voided in any favorable decision. 
 “With simple logic the entire premise of this article can be refuted.  Your premise is that if the 2012 third amendment sweep "agreement" is found to be unlawful and Bill Ackman wins, he will still lose because the companies will still owe 187.5 billion toward the preferred stock and would have to pay the 10 percent dividend as well the commitment fee from their earnings.

You neglect to mention that since the 2012 sweep they have paid almost 100 billion in dividends at 100 percent”

The comment is based on two related but separate premises. First, the Net Worth Sweep caused GSE’s to overpay by a large amount compared to if they just paid the 10% dividend. Second, if Ackman wins his lawsuit, that over-payment would be applied toward reducing senior preferences. 

It’s the second point that is in question here. Note that Ackman also made this assumption in his May 2014 Ira Sohn presentation.

 assuming senior preferred stocks are callable

Looking at slide 99, Pershing Square estimated ~$6-7bn and ~4bn of combined dividend to Treasury preferred in 2014 and 2015, respectively. Consider 10% on outstanding balance would amount to $19bn, it’s clear that Ackman assumes the over-payments would be used to reduce Treasury preferred principal balance and thus dividend amount. Also note that the ability to repay treasury preferred is a material part of his thesis on how GSEs will build capital.

First, what is the overpayment amount?

Quantifying the amount of overpayment is pretty straight forward. In Ackman’s latest filing, he calculated the amount GSE’s should have paid with the 10% dividend against the amount they actually paid under the Net Worth Sweep. The difference pointed to combined over payments of ~ $130bn consisting of ~$80bn from Fannie and ~$50bn for Freddie.

Were the Senior Preferred redeemable before the 3rd amendment?

If Ackman wins then ~$80bn of overpayment would be returned to Fannie - no chunk change given FNMA’s $23bn market cap. So Fannie would obviously not be worthless in that scenario. But could that amount be used toward redeeming Senior Preferred principal?  

Going back to Fannie's 10K for 2011 (before the Net Worth Sweep), I find the following: 

"We are not permitted to redeem the senior preferred stock prior to the termination of Treasury’s funding commitment under the senior preferred stock purchase agreement. Moreover, we are not permitted to pay down the liquidation preference of the outstanding shares of senior preferred stock except to the extent of (1) accrued and unpaid dividends previously added to the liquidation preference and not previously paid down; and (2) quarterly commitment fees previously added to the liquidation preference and not previously paid down.
So the Senior preferred stocks are redeemable when Treasury's funding commitment is terminated. When could that happen?  see below (emphasis mine):

The senior preferred stock purchase agreement provides that the Treasury’s funding commitment will terminate under any of the following circumstances: (1) the completion of our liquidation and fulfillment of Treasury’s obligations under its funding commitment at that time, (2) the payment in full of, or reasonable provision for, all of our liabilities (whether or not contingent, including mortgage guaranty obligations), or (3) the funding by Treasury of the maximum amount that may be funded under the agreement.

In addition, Treasury may terminate its funding commitment and declare the senior preferred stock purchase agreement null and void if a court vacates, modifies, amends, conditions, enjoins, stays or otherwise affects the appointment of the conservator or otherwise curtails the conservator’s powers..”

So technically these preferred stocks were not redeemable even before the 3rd amendment. This would support Carney's statement that even if the 3rd amendment were to be repealed and Fannie get back its $80bn of overpayment, it would STILL be on the hook for about $12bn of senior preferred dividends per year. This also means FNMA will not be accumulating capital if you use Ackman’s $10bn run rate net income. (That $80bn still sit on the balance sheet as capital, but just not adding to it)

On the other hand, the senior prefs can be redeemed if the funding commitment is terminated, either voluntarily (unlikely) or due to a broader challenge to the conservatorship (more likely)

The Need for Wider Focus

A commentator on Investor Hub widens the issues:
“(John Carney) is missing the point. The filing eluded that the conservatorship agreement was a guise for receivership, and the conservatorship agreement should be null and void. This would erase the 79.9%. This would erase any dividends owed. This would erase the conservatorship!”

I’m not a lawyer. But based on the non-redeemable nature of the senior prefs, it does seem that for shareholders to pay down the Sr Prefs and accumulate capital, they will have to challenge the conservatorship at a more fundamental level than just the Net Worth Sweep. This is a harder task. The Net Worth Sweep may be obviously unjust, but the initial decision to put GSE’s into conservatorship is harder to question given the circumstances back then. Looking at Ackman’s filing, the “Prayer for Relief” section looks pretty vague and I’m not sure what exactly he is asking for. The "Preliminary Statement" section is pretty focused on the Net Worth Sweep though.

Clearly Ackman assumes that these senior preferred can be paid down despite the legal language saying otherwise.  Given 1) I’m not a lawyer and  2) Ackman has armies of them, I’m probably missing something but I’m unsure what that is.  

From what I’m seeing though, the ability to redeem senior preferred is an important issue. GSE’s can’t redeem the senior preferred stocks unless the lawsuits goes further than 3rd amendment and perhaps invalidates even the initial conservatorship.  Otherwise GSEs will likely have trouble meeting the treasury preferred dividends, as lower reserve releases and winding down fixed income arbitrage business will both reduce earnings.

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