It’s 2008 and a financial crisis is unfolding, Bear Stearns has already gone under, Lehman Brothers Holdings Inc Plan Trust (OTCMKTS:LEHMQ) isn’t far behind, and Federal Housing Finance Agency James Lockhart announces that Fannie Mae / Federal National Mortgage Association (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) are being put into conservatorship so that Treasury can backstop the two government-sponsored enterprises (GSE) as part of broader efforts to stem disaster.
At the time, many people expected the conservatorship to be a slow-roll bankruptcy proceeding, but CapWealth Advisors LLC CEO Timothy Pagliara, the top-ranked financial advisor in Tennessee, saw an opportunity to buy in to great companies at bargain bin prices.
“I believed the conservatorship, not receivership, was an overreaction to the panic environment that existed at that time. I also knew that the entities were extremely profitable but thinly capitalized,” Pagliara says in a recent interview with ValueWalk. “I also knew that a lot of toxic assets would have to be flushed through the system. Banks couldn’t handle it. My gut told me that one of the reasons for the conservatorship was to press the two entities into service to help with the financial crisis.
“The demographics were there, everything was in place. Less than 5% of Fannie Mae / Federal National Mortgage Association (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC)’s loans were Nonperforming or in the problem category. That means 95% of them were working. The only concerns I had was that during that period it appeared as if the conservator had a lot of pressure on him to have the glass half-empty. They were writing down assets that they didn’t need to write down, they were aggressively taking positions that they didn’t have to do. They just didn’t have to make it that bad.”
After the conservatorship was announced, Pagliara started buying different series of preferred shares for his clients (including my alma mater) for about 80 cents per share, ultimately buying nearly 8 million shares in Fannie Mae and Freddie Mac. Fast-forward to 2012, and the stocks started gaining value as it became clear that Fannie Mae / Federal National Mortgage Association (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) would not only survive, but would pay back the taxpayer bailout and return to profitability sooner than almost anyone had predicted.
Treasury changes the terms of the deal
By normal standards, his position was about to pay off. Fannie Mae and Freddie Mac had rounded the corner and, it was assumed, would soon start paying dividends again; instead on August 17, 2012 Treasury announced unilateral changes to its Preferred Stock Purchase Agreements (PSPA) that “will help expedite the wind down of Fannie Mae and Freddie Mac, make sure that every dollar of earnings each firm generates is used to benefit taxpayers.”
“The agreements will replace the 10 percent dividend payments made to Treasury on its preferred stock investments in Fannie Mae / Federal National Mortgage Association (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) with a quarterly sweep of every dollar of profit that each firm earns going forward,” says the announcement, often referred to as the 3rd amendment.
“I was absolutely blind-sided, as were the markets,” says Pagliara.
Suddenly, what had been government conservatorship started to look like a soft nationalization of Fannie Mae and Freddie Mac. Investors knew they were taking a risk that the GSEs might not recover, but if they had imagined there was a chance the government would simply not pay dividends that preferred shares were entitled to, they would have stayed away.
“There was no talk about the 3rd amendment in September of 2008. The stock and preferred continued to trade. They continued to report regularly to the SEC like any other publicly traded company,” says Pagliara. “Those [government] debentures have terms and conditions like any debenture. They get a 10% payment, it’s cumulative, it’s on the amount advanced, and then they have conversion rights. Everything else has been made up. That’s what this third amendment is about, they didn’t like the terms.”
Since the income sweeps began, Pagliara has been actively campaigning against them, attending events like Nader’s Shareholder Respect roundtable earlier this month. Ultimately, he believes that the Federal government will be forced to pay the dividends that it owes, even though it looks like the courts will be required to force Treasury to turn the money over.
“These institutions are flush with cash, so why aren’t they paying their obligated dividends per share? These aren’t common, when the dividends are subject to the discretion of the board of directors. These are financial obligations of these entities subject to the availability of funds and cash flow,” says Pagliara.
“I’ve talked to Ted Olson and I’ve talked to lawyers at David Boies’ firm that have cases pending, and they are supremely confident that they are going to win. When you’ve got the two leading constitutional scholars in the United States saying that the government is wrong and they’re investing their time and capital in these cases then you’ve got to take notice of that. These are not ambulance chasing guys that advertise on the back of a phonebook.”
Treasury wanted to extinguish Fannie Mae, Freddie Mac: Pagliara
As the cases proceed to discovery, Pagliara expects to see more evidence that people within Treasury were aware that there was a ‘problem,’ that Fannie Mae / Federal National Mortgage Association (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) weren’t winding down as planned, but were in fact about to come roaring back, which ran counter to the political goal of getting out of the secondary mortgage market.
“All these people that trashed these entities are shocked that they’ve been as profitable as they have, because if you track Corker’s comments three years ago he said ‘the taxpayers are never gonna get a dime.’ But they’ve been paid back plus ten percent interest and then some, so he’s been wrong. All of the assumptions they’ve made have been wrong,” says Pagliara. “They knew that this was a problem in 2010, that’s why they had that memo. In any other company that’s fraud. They filed false statements with the Securities and Exchange Commission under Sarbanes–Oxley and every other requirement.”
The memo that Pagliara references, dated December 20, 2010, is a note from Under Secretary Jeffrey Goldstein to then Treasury Secretary Timothy Geithner discussing the option of using full income sweeps in order to “make clear the administration’s commitment to ensure existing common equity holders will not have access to any positive earnings from Fannie Mae / Federal National Mortgage Association (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC)’s in the future.” Although no action was taken then, Pagliara argues that the memo shows that the Federal government had no intentions to ever pay dividends, even though public filings never mentioned that fact.