Peekaboo Fannie Mae, Freddie Mac Accounting May Have Helped Circumvent Fifth Amendment by Glen Bradford. The author has a long position in the companies.
Fannie Mae and Freddie Mac are run like they are government agencies. Overseen by the Federal Housing Finance Agency who have put them into conservatorship, these government sponsored enterprises historically support American home affordability. After writing about the GSEs and owning the common securities for over a year I have instead moved into preferred shares and this article is an explanation why.
According to the FHFA and US Treasury, the government all but owns the companies. With the third amendment net worth sweep in place since 2012 the net worth of Fannie Mae and Freddie Mac belongs to US Treasury and FHFA runs them. Even though the government runs them and they take all their money forever, but they are still private shareholder owned companies. Yes, you read that right.
US Constitution – Amendment V
Below is the fifth amendment of the US Constitution. I’ve bolded the portion of interest for your convenience:
Dan Loeb's Third Point returned 11% in its flagship Offshore Fund and 13.2% in its Ultra Fund for the first quarter. For April, the Offshore Fund was up 1.7%, while the Ultra Fund gained 2.3%. The S&P 500 was up 6.2% for the first quarter, while the MSCI World Index gained 5%. Q1 2021 hedge Read More
No person shall be held to answer for a capital, or otherwise infamous crime, unless on a presentment or indictment of a grand jury, except in cases arising in the land or naval forces, or in the militia, when in actual service in time of war or public danger; nor shall any person be subject for the same offense to be twice put in jeopardy of life or limb; nor shall be compelled in any criminal case to be a witness against himself, nor be deprived of life, liberty, or property, without due process of law; nor shall private property be taken for public use, without just compensation.
Fairholme has recently asked 16 questions that sure make it sound like they and other shareholders have had private property taken for public use. The crux is that the government has figured out a loophole. Look at how Fannie Mae made $85.5B of cash money during the time period that the government says they were failing:
The best price to buy something at is $0. Frankly, if privately owned companies didn’t have limited liability this would be a lot more interesting because the government could have gone beyond just taking all of the money from the company forever, the government could have taken all of the money from all of the banks and private shareholders that own the securities. With this in mind, the government isn’t in a position to eliminate the risk of Fannie Mae and Freddie Mac from its mind completely and it chooses to frame this risk in the context of broken business models. The genius behind this is that admittedly broken business models aren’t worth anything, price tag $0. That’s the formula at work.
If the government wants to have something without paying, all they have to do is declare it’s worth $0. Then, they can pay $0 to take it. Put simply, the government doesn’t have to pay anything for worthless companies:
“We need to reconstruct the record,” Jester announced about the Federal Housing Finance Agency letters.
This is a lesson in how the government can get out of paying for something that the rest of us would have to pay for. You can’t beat the price of free for two business making billions every year. The secret sauce is in the Enron style off-balance sheet accounting but don’t let yourself be fooled. The government has figured out that if they mark the assets of a business to $0 they don’t have to pay for the privilege of taking them.
Conservatorship Gives Government GSE Accounting Authority
Chapter 11 was off the table because Fannie Mae and Freddie Mac had their highest levels of capital in history. Conservatorship was chosen specifically because it provided FHFA control over the accounting. Nationalizing companies without compensation through conservatorships is made possible by employing government directed accounting that triggers the government to be given unrepayable yield bearing securities from companies at the discretion of the government. In this case FHFA directed the accounting and US Treasury was given unrepayable yield bearing securities at FHFA’s discretion, working with Treasury.
Considering that both of Fannie and Freddie’s preferred securities purchase agreements are identical in form, the preferred securities purchase agreement is the only agreement in US history that causes a private company to borrow money from the government based on accounting statements directed by the government. In good faith, the government negotiated with itself that on top of being able to determine how much money Fannie and Freddie needed to borrow from the government at 10%, it would also be fair for the government to take 79.9% warrant coverage which in this case is the right to purchase 79.9% of the companies at as close to a price of $0 as one could get while not being $0. The good faith negotiations regarding the PSPA and the warrants happened between the FHFA and US Treasury, both of which are parts of the government.
Once the conservatorship commenced, FHFA took complete control over the GSEs accounting. This led to some challenges for the CFO of Freddie Mac around the time the conservatorship started:
The challenges included a disagreement with the company’s regulator over disclosing certain information to investors.
These disagreements were serious enough for the CFO to hire a security detail to guard his house. Combined Fannie and Freddie have around $5T of assets. The government can take control of those assets without paying for them if no one disagrees that the businesses that own them are worthless. Since that has been public record so far, the government looks like it is doing Americans and the world a favor by preventing a collapse by stabilizing two failed business models that are hemorrhaging billions of dollars. This is what the FHFA website says their role is:
As you’ll note, key snippets on Treasury’s website paint a different picture where perhaps the conservator’s mission is to wind them down and prevent them from retaining profits or building capital:
Forensic Accounting Analysis: FHFA’s Accounting Authority Forced GSEs To Borrow Money They Never Needed
A forensic accounting analysis has been produced that graphically depicts what I call peekaboo accounting. Transparency Reporter for MarketWatch Francine McKenna corroborates Adam Spittler’s accounting. For three years massive net losses were reported by FHFA triggering the creation of long-term massive streams of cash flow for the government while both Fannie and Freddie kept making billions:
Make sure that you read that chart right. The companies are reporting massive net losses at the same time they are making massive amounts of cash money. I’m not saying that there is accounting fraud here. I’m saying that there might be some interesting conversations that have happened between the companies and auditors where I would have liked to have been a fly on the wall.
At present there is no one officially disputing the accounting employed by FHFA in a court of law. Perhaps the question that should be asked is whether or not the FHFA is obligated hand over the companies to US Treasury? According to government officials, Fannie Mae and Freddie Mac epitomize indigent private profits and public losses and yet over the last 10, 20, 30, and 40 year time frames the government has made billions in the process of separating the company from private investors who have lost everything so far.
Peekaboo Accounting Always Comes Out
Peekaboo is a game played primarily with babies. An early theory of why babies enjoy peekaboo is that they are surprised when things come back after being out of sight. In the same way that most infants achieve the comprehension of object permanence at eight to nine months of age, peekaboo accounting uses the fundamental structure of all good jokes – surprise, balanced with expectation. It was only a matter of time for all of the assets FHFA forgot about having removed their value from Fannie and Freddie’s balance sheet to show back up right where they found them in the first place.
The beauty of peekaboo accounting is that you can’t write down the value of valuable assets forever. As soon as FHFA began reporting certifications on the financial statements of Fannie Mae and Freddie Mac, the accounting losses were reversed but the impact was not. The third amendment also known as the net worth sweep is the Gordian knot that discriminates between classes of shareholders: public and private.
When you have two government agencies, FHFA and Treasury, making agreements and amendments that their own acting director admits trumps the law perhaps President and CEO at Mortgage Bankers Association David H Stevens puts it best:
your “rule of law” is old and tired
Fairholme points out in their semi-annual filing that even the New York Times wants to take a peek on behalf of the public and has recently filed motions:
[The defendants’] disregard for the public interest is sadly of a piece with the Government’s decision to make the depositions confidential in the first place. There is no reason that citizens should be denied the ability to effectively monitor this important lawsuit as it unfolds.
Two Classes of Securities: Commons and Preferred
I switched from being a common shareholder to being a preferred shareholder. The reason that I did this is because owning the two securities comes from the idea that the government’s third amendment net worth sweep is not going to be around for as long as the companies will be. Have you seen the renderings of Fannie Mae’s new office?
As a common shareholder my ideas were:
- The entire PSPA has the potential of being voided and G-fees more or less stay the same, meaning that $20B of annualized earnings flows across roughly $1.81B common shares and at 15x earnings or $165/common share and $25/preferred share.
- The third amendment is rescinded and the companies are allowed to retain capital per Ackman’s plan, it takes a few years for the two to recapitalize and exit conservatorship and out of the gate the commons and the preferreds are both worth $15 and gradually rise to $25 as they recapitalize.
A few other scenarios might be more appealing to the government:
- If the government were to settle and decide that they are going to help recapitalize the businesses, it’s possible that they end up taking a majority of the income on a normalized basis depending on how much capital the two are forced to retain as government sponsored enterprises.
- Another scenario is the government striking a deal and converting their stake to commons similar to the AIG restructuring. The problem as I see it is that being a shareholder of Fannie Mae and Freddie Mac in general requires me to think that there is something that they have to change because what’s been happening won’t last. With FHFA making the decisions, I wouldn’t be surprised to see them try and keep giving as much to the government as possible.
In the last two scenario’s I think the preferreds are a better bet than the commons. Overall, if I pick the best worst case scenario to be a part of, it’s owning the preferreds and that’s what I’m doing in case of a government guided settlement of sorts.
Conclusion & Summary
Government run accounting was used to force the GSEs to borrow money. The support for Spittler’s forensic accounting analysis is growing but so far there are no securities fraud lawsuits filed to support it. Experts and government officials say that the rule of law is tired and old and that there is an explicit government guarantee behind the GSEs and for that reason the best owner is the government.
If the government’s accounting is reversed in accordance with the forensic accounting analysis then that brings the nature of the PSPA into question because it would appear that the government negotiated that deal with itself. Unsurprisingly, if the PSPA is retroactively voided ab initio, the stocks are worth a multiple of their earnings, which are presently $20B/year on 1.81B shares outstanding. The government’s target is $0 because that’s how they get away with paying nothing for something.
If it is determined that nationalizations like this are possible, expect to see the conservatorship model in other situations in the future where the government benefits from controlling an industry. In this case Fannie and Freddie are, as the government says they are, worthless investments for private shareholders. In the end, we must keep an eye for other laws put into place like HERA that enables the government to create situations where it can pay nothing for something and be cautious about investments that might be affected by similar statutes. At present it is my understanding that HERA only applies to the GSEs, but if this works, there’s no reason why the government couldn’t set up similar conservatorships in the future for other industries that they think they should have a bigger role in.