Fairholme’s Fannie Mae, Freddie Mac: FT Gets It Wrong

Fairholme’s Fannie Mae, Freddie Mac: FT Gets It Wrong
By Hedge Funds [CC BY 3.0], via Wikimedia Commons

Doesn’t it figure, no sooner then do I compliment the FT on their coverage of this Federal National Mortgage Association (OTCBB:FNMA) / Federal Home Loan Mortgage Corp (OTCBB:FMCC) Fairholme saga they then go out and publish this tripe (they should retract it). I’ve reprinted and linked to the original so no one thinks I have cherry picked parts to make a point:

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From the FT

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“Answering The Call For Private Capital” is the title of Fairholme Capital’s plan to restructure Fannie Mae and Freddie Mac. This little gem of self-congratulation may or may not be accurate. An alternative: “Answering The Call, After The Government Cuts Us A $35bn Cheque.”

Fairholme proposes the creation and capitalisation of private, state-regulated insurance companies. These will write new insurance on mortgage-backed securities, with no government guarantees. Fannie and Freddie would write no new insurance, and be put in run-off.

The new companies would be capitalised with 52bn. From where? Two-thirds would come from the government. This sounds like an odd form of private capital. But Fairholme thinks that while that money is in federal coffers now, it belongs to holders of Fannie and Freddie’s preferred shares, who would then pony up the remaining third of the cash. But in 2012, the Treasury, after putting 187bn into the housing groups, announced that it would be taking all profits from then on. The preferreds were, as such, stripped of rights. But they still trade, spiking recently. That 35bn is the shares’ face value now. The holders are, it seems, speculating that the preferred will be restored because the Treasury acted illegally. It may have, but that is for a court to decide. And court is where Fairholme appears headed.

Fairholme and other investors are willing to risk one dollar for every two shadow-dollars’ worth of their preferreds that the government would redeem for cash. But they will not commit a penny of capital to the mortgage insurance business, unless they are first able to take a big gain on their bet on the preferreds.
As a public relations strategy for a legal fight, the proposal works. As a demonstration of the power of private capital, it is disingenuous.

Let’s go point by point…..

1- In no way shape or form will the gov’t be cutting anyone a 35B check (or cheque for the more sophisticated of us) nor does that money “sit in gov’t coffers”…. this borders on an outright lie or is an example of a journalist simply not having any idea how this works

2- Also, 2/3 of the money would NOT come from the govt’t….(see above for an explanation of this statement)

3- Where would it come from then? This neat little thing called “the market”. Here is how it would work. In order to get a SINGLE PENNY of private capital into the GSE’s, the gov’t will have to prove they have a modicum of respect for private capital and contracted property right (such as preferred shares). So, in order to do this deal (or any other deal involving a penny of private capital which is what everyone says they want), the gov’t would have to set aside the final Net Worth Sweep Agreement that takes all the profits from the GSE’s. Once they do that, the preferred shares will jump to par (or very near it) on their own as they will no longer have an extinction risk attached to them. Not a single penny of gov’t funds will be necessary for this to happen. Not …..a ……single …….penny

We should note here that Obama has expressly said he want private capital to take over the GSE’s, the ONLY way that happens under any plan if the the Net Worth Sweep Agreement to be set aside. There is no way you get private capital to touch the GSE’s with the Sweep agreement still in place.

4- Once that happens, current preferred holders then have choice, they can (A) hold their preferred and convert them to the common equity in the new entity at a valuation of par = common value or,(B) sell them to new owners prior to conversion who will then do (A).

5- Under either scenario, the value of those preferred shares is 100% private capital and that private capital will be used to fund the new company along with the 17B of additional private capital (most likely from those existing preferred holders) Berkowitz will seek

6- Further, (the FT glossed over/omitted/or did not know this) preferred holders who convert to equity are agreeing to lock those shares up for 5 years…….5 years…… this is by NO means a “quick trade” and it practically an eternity in today’s market. No one can predict what the share price of the new entity will be in 5 years…no one.

At the end of the day the gov’t gets repaid in full now AND gets 100% of future profits on >$5T of current GSE Holding Inc (NYSE:GSE) that will run off and add hundreds of billions of dollars to federal coffers over the next couple decades. This means the gov’t makes more on this bailout that any other in history. A good deal no matter how you want to try and position it and they to avoid what I think will be a humiliating legal loss in court…

The very real risk for the gov’t is they lose in court and then preferred holders see their shares rocket towards par and can cash out and the gov’t sits right where it does now……only with no offer from “private capital” to help bail them out of the GSE’s. Think about it, if legally contracted private capital has to go to court to have it rights enforced, do we really think they be anxious to then turn around and jump back in bed with those they had to sue? In all reality we’ll see action in the preferred well before any decision is handed down. Once depositions and discovery begin word will get out on the actions of various gov’t officials. The ebb and flow of the information as well as pre-trial decisions from the Judge will cause shares to react as investors places odds on the outcome. If it even looks as though the case is going against the gov’t, preferred shares will rise and the current holders of those preferred willing to do this deal can then just walk away with substantial profits and NOT have them locked up for 5 years.

Why do I think the case will go badly for the Gov’t? I’ve read the complaints and the cases referenced and I don’t think the Treasury or FHFA have a leg to stand on regarding the Net Worth Sweep Amendment. I think they could easily loose on every point raised which is why they have been desperately trying to delay even filing a response to the actions (one is due 12/5) for almost a year now. Any response is going to open a pandora’s box for them (it is going to get really interesting….trust me on this).

Additionally, when the only people defending your actions are those who sit in Congress……….well, let’s just leave it at that…

Via: valueplays

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Todd Sullivan is a Massachusetts-based value investor and a General Partner in Rand Strategic Partners. He looks for investments he believes are selling for a discount to their intrinsic value given their current situation and future prospects. He holds them until that value is realized or the fundamentals change in a way that no longer support his thesis. His blog features his various ideas and commentary and he updates readers on their progress in a timely fashion. His commentary has been seen in the online versions of the Wall St. Journal, New York Times, CNN Money, Business Week, Crain’s NY, Kiplingers and other publications. He has also appeared on Fox Business News & Fox News and is a RealMoney.com contributor. His commentary on Starbucks during 2008 was recently quoted by its Founder Howard Schultz in his recent book “Onward”. In 2011 he was asked to present an investment idea at Bill Ackman’s “Harbor Investment Conference”.
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