SCALP and I have been looking into the two Government-Sponsored Enterprises (GSE) Fannie Mae and Freddie Mac. The short answer is that we feel there is value but the trickier question is where that value lies. Obviously the equities have been making a massive run over the past couple of days. But we would view them as speculative plays as the value there is certainly in question. Even the head of the FHFA Ed DeMarco, who is the conservator of the two programs, said that there appeared to be little value in the equities. We will take a look at FNMA and FMCC in the coming weeks. Right now, the shares look like a viable play. But we want to emphasize that these are speculative and one should be looking at this as a swing trade rather than a buy and hold position.
Some Quick History- The U.S. government came to the aid of the troubled entities in 2008 (The Housing and Economic Recovery Act of 2008) as massive losses in risky mortgage products were set to topple the giants. The Treasury would provide approx $188 bln of aid to the companies (taxpayer bailout money). In return for the support, the government received senior preferred shares of the stock that pay a dividend of 10%. If you are curious the co has made approx $46 bln in dividend payments over the past couple of years so the net cost technically has been $141 bln. I use the term technically as some of those dividend payments came from borrowing from Treasury. This support has allowed the two companies to continue to support the housing industry. FNMA and FMCC continue to service approx $4.5 trl in guarantees against mortgage default and $900 bln in debt racked up before the crisis.
The Agreement- In exchange for future support and capital investments of up to $100 billion in each GSE, at the inception of the conservatorship, each GSE shall issue to the Treasury $1 billion of senior preferred stock, with a 10% coupon, without co
The Agreement- In exchange for future support and capital investments of up to $100 billion in each GSE, at the inception of the conservatorship, each GSE shall issue to the Treasury $1 billion of senior preferred stock, with a 10% coupon, without cost to the Treasury. Also each GSE contracted to issue common stock warrants representing an ownership stake of 79.9%, at an exercise price of $ 0.00001 per share, and with a warrant duration of twenty years. The agreements were designed to protect the senior and subordinated debt and the mortgage backed securities of the GSEs. The GSEs' common stock and existing preferred shareholders will bear any losses ahead of the government. Among other conditions of the agreement, each GSE's retained mortgage and mortgage backed securities portfolio shall not exceed $850 billion as of December 31, 2009, and shall decline by 10% per year until it reaches $250 billion. That has since been increased to 15% per annum in the hopes of unwinding the companies faster.
The Government Preferreds- FNMA and FMCC makes interest payments to the GSEs on these preferred dividends. Perhaps one of the concerning aspects of this is that the payment is viewed as a return to taxpayers on their investment and it does not impact the principal balance of the loan. One bright spot here is that the co's used to borrow from the Treasury to make the payment (to the treasury). This round about loop would force an embarrassing turn of events were the two companies would have to ask for money to pay the dividends. However, with a return to profitability, the two entities are now able to make these interest payments without Fed assistance.
are junior to the senior preferred stock issued to the Treasury in the restructuring of the two companies. So, in
Other Preferreds- SCALP plans on discussing this a little more in-depth. But, many commercial banks in the United States owned Freddie and Fannie preferred shares. Those shares had their dividends suspended, and are junior to the senior preferred stock issued to the Treasury in the restructuring of the two companies. So, in the case that all income goes to the Treasury, it is uncertain how these will perform.
Profitable but who gets the income?- The entities have been profitable the past three quarters as housing conditions have improved (assisted by Fed MBS buying). This is of course welcomed and been a nice tailwind for the recent run up in equity prices. But it is worth noting that all the income will be used to pay the dividend . And the companies will not be able to hold any income in order to build reserves or rebuild capital in order to emerge from under the government wings. So make no doubt about it, this is not an AIG story. These are two entities that, as of now anyway, are destined to be unwound into another entity.
Are they making money?- The answer to this is yes, at least for the past three quarters. The GSEs have raked in approx $9.6 bln in net income the past three quarters. In a recent filing FNMA noted that it would be profitable in 2012. The reason for the delay in the filing is due to how the co would value a deferred tax asset in Q4 that is worth $64 bln. The impact of this valuation could have a material impact on a GAAP accounting basis.