It has been a whirlwind week for Fannie Mae, Freddie Mac and their shareholders. The Treasury Department released its plan last Friday, and then on Monday, a court ruled in favor of holders of the government-sponsored enterprises’ preferred shares. Now Treasury Secretary Steven Mnuchin said in an interview on CNBC’s Squawk Box that President Donald Trump has approved the plan released by the Treasury on Friday. But what happens to the common shares? And what will at the end of the day happen to the preferred shares?
It certainly looks like things are proceeding quickly after a long decade, and well-known bank analyst Dick Bove of Odeon Capital is moving up his timeline for the issue involving the junior preferred shares to be settled.
Removing the net worth sweep
One of the biggest issues in the recapitalization of Fannie Mae and Freddie Mac is the net worth sweep, which denied profits to holders of the GSEs’ preferred shares, sweeping them directly into the Treasury instead. In the interview on Squawk Box, Mnuchin said they were negotiating on an amendment to remove the net worth sweep by the end of the month.
According to Bove, Federal Housing Finance Agency chief Mark Calabria said during a presentation at the Credit Union Conference that he wants to end the net worth sweep too, although he set a longer timeline of by the end of the year. Bove now sees a year-end timeline as “a real possibility,” and if it actually happens, it would move up his timeline for resolving the issue of the junior preferred shares. He had been assuming the issue would be resolved by mid-2021, but if the net worth sweep is eliminated by the end of the year, he thinks the junior preferred shares could be resolved before next year’s presidential election.
Bove predicts that the payout on the preferred shares will likely be common stock. Thus, he believes that buying preferred shares now will be like buying common shares at a discount, so he questions why investors would buy Fannie’s and Freddie’s common shares.
Here’s what Calabria said
In addition to ending the net worth sweep by the end of the year, Calabria also said he doesn’t want to repurpose the capital rule. He also said he understands that the GSEs are too big to fail and that recapitalizing them is his most important task.
Bove noted that all the legislation aimed at eliminating Fannie Mae and Freddie Mac over the last seven years is now gone. The Republicans finally agree with the Democrats that the GSEs are essential to the housing industry and the U.S. economy. Thus, they must be recapitalized, but Bove added that Calabria seems no longer intent on forcing the companies to take on so much capital that they would be unattractive investments.
Further, Calabria understands that Fannie and Freddie can’t raise any capital unless two major problems are fixed. The first is the net worth sweep, which forced shareholders to give their profits to the Treasury. The second is that new shares of Fannie and Freddie can’t be sold if they have outstanding lawsuits for hundreds of billions of dollars. These cases can be eliminated by paying off the holders of the junior preferred shares.
“If Mr. Calabria does not deliver on his promises, the stocks will be in real trouble,” Bove wrote. “If he does there will be money to be made.”
Update on Monday’s court case - Prefs and Common shares
Bove also highlighted commentary on the court case that was announced on Monday. David Thompson, the lead council in the Fifth Circuit decision in New Orleans, spoke about the case on a conference call hosted by Investors Unite Founder Tim Pagliara. Bove explained what Thompson had to say in today’s note as well.
Thompson doesn’t believe the issue of constitutionality was fully discussed in the Fifth Circuit Court’s decision. The issue is critical because it questions the existence of the FHFA and Calabria’s position. Bove believes the Supreme Court will review this decision, which means Calabria must work fast to achieve his goals in recapitalizing the GSEs.
If the Supreme Court rules against him, then “the game is over for him and possibly the Trump Administration,” Bove explained. However, if the Supreme Court rules against him but the GSEs have already been recapitalized, then the actions taken can’t be undone. In other words, if he moves quickly enough, he can get this done.
On the other hand, if the Supreme Court rules in Calabria’s favor, he will have more time, “but no one knows how the Courts will function and the Fifth Circuit Court’s decision was based on law that stretches back to the Federalist Papers.”
The conference call Thompson spoke on also included a reference to the case in front of Judge Royce Lamberth’s court, and Bove believes it’s possible a damage judgment could be handed down there. If so, he estimates that the government could owe at least $25 billion to holders of Fannie’s and Freddie’s junior preferred shares.
Bove also believes the Trump administration may want to wind up the GSE issues so it can claim it resolved the problem the Democrats were unable to resolve. If the administration does this and also sells its warrants, it could rake in billions of dollars in the process.
Valuing Fannie Mae and Freddie Mac common shares
The bank analyst also revisited his valuations of Fannie Mae and Freddie Mac. He initially thought the government would have the two GSEs buy back the junior preferred shares on par, paying for them with common stock. This would mean a 20% discount since the common stock would decline in value due to dilution. In this event, the junior preferred shares would be worth about $20 to $22 each, he added.
However, he now sees an even greater chance that the Lamberth court will find the government “guilty of stealing the assets and earnings of the two GSEs.” If this happens, he said it could be assumed that the holders of those junior preferred shares lost about $2 per share each year in dividends for a total of $14 per share. Adding $14 to the $25 par value, the possibly payment becomes $39 per share in common stock. After assigning a 20% discount on that total, he argues that a valuation of $31 per share could be plausible.
“The reader, of course, realizes that this is pure ‘Blue Sky’ thinking and that it is still possible that junior preferred shareholders walk away with only a few dollars or nothing,” he clarified.”
This article first appeared on ValueWalk Premium