The Supreme Court takes up the case of Fannie Mae and Freddie Mac this week, and their common shares rallied after opening statements. One investor tells ValueWalk he believes Fannie Mae and Freddie Mac common shares would be worth $40 if all the stars align for shareholders.
However, Tim Pagliara of CapWealth Advisors, who also owns shares of the GSEs, says not so fast. He says there's definitely upside to the shares, but things might not happen as quickly as some investors are expecting. There are a lot of factors that will influence the value of the common shares.
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Dan Mobbs, an individual investor from New Jersey, has owned over 50,000 common shares of Fannie Mae since 2013, and he's been following the legal proceedings involving the government-sponsored enterprises. He sees $11 per share in earnings for the GSEs, based on $20 billion in combined net profits per year. Assigning a P/E of 4 would result in a share price of $44 for the common shares of Fannie Mae and Freddie Mac.
However, there are many factors that will determine what the common shares of Fannie Mae and Freddie Mac are actually worth. One of those factors is the route they will take to build capital until they can meet the capital requirements set forth by the Federal Housing Finance Agency. Mobbs argues that the Supreme Court could pave the way for the method that would be most beneficial to shareholders.
"If the Supreme Court rules that the Net Worth Sweep is void, unconstitutional, etc., it's possible that the 'overage' that Fannie Mae and Freddie Mac have paid back through 'dividends' to Treasury since 2013 will be declared refundable," Mobbs suggested in an email to ValueWalk. "This amount has been reported to be anywhere from $110 billion to $133 billion. This refund for 'illegal taking' (if the NWS is ruled to be unconstitutional since it is a loan that 'can never be paid back'), the refund will go a long way in re-capitalizing the entities."
Government has already been paid back
The Wall Street Journal also briefly discussed the possibility that the Supreme Court could order the government to return some of the money it collected from the GSEs via the net worth sweep. The Journal states that it could put Fannie and Freddie on a more stable financial footing, paving the way for them to exit their conservatorships.
The GSEs have returned more than $300 billion to the government over the years, while the government injected only about $190 billion. Essentially, the net worth sweep created a loan that can never be paid back, Pagliara told ValueWalk in a past interview.
The Supreme Court is hearing a case filed by shareholders who are challenging the sweep, arguing that it's an illegal move to keep Fannie Mae and Freddie Mac from building capital that could be available to private investors one day. Shareholders also argue that the FHFA has a structure that's unconstitutional with a single director who doesn't answer to the president. Pagliara said this week's hearing won't be good for the government.
"The information I've got says [Treasury Secretary Steven] Mnuchin will wait until after the court hearing, and the government is going to get their nose bloodied," Pagliara told ValueWalk in an interview on Tuesday. "It's not even going to be funny. They're really going to take a beating, and he will use that as a cover to get it resolved."
Problems with the thesis
Pagliara highlights some problems with Mobbs' thesis, although he agrees that there is definitely substantial upside to Fannie Mae and Freddie Mac common shares. He argues that the capital rule requires the GSEs to hold a lot of capital that Mobbs doesn't factor into his earnings analysis, which results in substantial earnings dilution. The $11 per share in earnings doesn't take that capital into account or the warrants the government holds on 79.6% of the outstanding shares.
Pagliara also said the pro forma return on equity is 9.5%, a basic utility model. Further, he agrees with Mobbs that the GSEs' recurring income stream is attractive, but the government will tie their capital to the periodic commitment fee, which is the fee they will pay the government for guaranteeing the 30-year mortgage. Fannie and Freddie will pay a higher fee for less capital, which will wipe out earnings.
"There are many investment banking solutions to meeting capital requirements," Pagliara notes. "Each solution takes the shareholders down a different path. Investors should expect two things. First, substantial appreciation of their shares once the liquidation preference is written down."
Pagliara explained the different routes Fannie and Freddie could take to meet their capital requirements. He said the key will be hitting that 9.5% return on equity. The main route the GSEs could take to build capital is through retained earnings if the net worth sweep is eliminated. This is one of the best options for common shareholders because it doesn't result in any dilution.
Fannie and Freddie could also raise capital through a secondary offering or not pay out dividends. Another option is to pay out a much smaller payout ratio of their total earnings. Pagliara also said the GSEs already have $34 billion in capital embedded in them through the preferred shareholders, which they don't have to do anything for. Whatever route the GSEs take to build capital, Pagliara said the big institutions that hold their shares aren't worried.
Pagliara notes that preferred shares will be worth their par value, which is $25 or $50 on most of them. He notes that Nomura puts the base value of Fannie Mae and Freddie Mac's common shares at $5, but that doesn't include any additional upside from what's happening now. He also said the GSEs will become new companies. They'll need two to three years of operating history and execution before that upside will materialize.
"There will be tremendous upside post IPO, but many variables will determine how successful shareholders will be," Pagliara told ValueWalk in an email. "Just like any new company. The GSEs are unique; they arguably are the most valuable financial service franchises in the world. Good management and execution will reward long-term shareholders."
As far as what Fannie Mae's and Freddie Mac's common shares are worth, Pagliara wouldn't speculate.
"They will earn their way out of conservatorship by hitting the capital thresholds that have been established for them, so how that affects common, you just don't know because you don't know what path they're going to take," Pagliara explained. "But once it goes back to the companies, they've got to make everyone happy to settle all the litigation. They're now working exclusively in the best interests of the shareholders."