Fannie And Freddie, The SCOTUS Remand, And The 5th Circuit

I. Introduction

Freddie Mac (OTCQB:FMCC) and Fannie Mae (OTCQB:FNMA) (F&F) are government-sponsored enterprises (GSEs) and litigation continues. SCOTUS has already decided on some issues with respect to Fannie and Freddie but has remanded other issues back to the 5th Circuit for their further consideration.

These cases generally have to do with the “3rd Amendment” to the Senior Preferred Stock Purchase Agreements (SPSPAs) between the Federal Housing Finance Agency (FHFA) and the U.S. Treasury (Treasury), which created a “net worth sweep” (NWS). The 3rd Amendment began to transfer increases in the GSEs’ net worth to the U.S Treasury in 2012, which was just exactly when the GSEs’ were at the cusp of becoming profitable, having recovered from the financial stress they experienced during the financial crisis period.

SCOTUS has already found that the FHFA should be organized as a political agency, not as an independent regulatory agency. SCOTUSblog reports that SCOTUS had found that “Congress had unconstitutionally insulated the FHFA’s director from termination by the president” and has found that the removal restriction that prevented Trump from replacing FHFA Director Watt was unconstitutional, which blocked the FHFA and Treasury from agreeing to a 4th Amendment that would eliminate the NWS going forward. SCOTUS has sent other issues back to the 5th Circuit Court of Appeals (5th Circuit), which are discussed here. The 5th Circuit was the court that dealt with the CFSA v. CFPB case and therefore seems likely to decide the NWS issue in a consistent manner–assuming, of course, that it decides that the situation is comparable.

As I explained here, one simple valuation metric is that a decision overturning the 3rd Amendment’s NWS could return the GSE preferreds to the stock price levels that were in place prior to Judge Lamberth’s September 30, 2014 decision. Note that FMCKJ’s stock price was $10.30 (41.2% of RV) on September 30, 2014, and that its current stock price is about $2.21 (8.8% of RV) per share. For FNMAS, the stock price was $9.20 per share (36.8% of RV) on September 30, 2014, and it is now trading at about $2.42 per share (9.7% of RV). Thus, this simple valuation metric suggests that the GSE preferreds could go up 4.5 fold with a win at the 5th District. Eventually, of course, with the end of the NWS, the GSE preferreds could move much closer to RV.

I’m not a lawyer and I therefore would leave it to others to decide whether this argument is correct. I urge investors to do their own due diligence and avoid holding an overly concentrated position in the GSE preferred or common stocks.

II. The SCOTUS Remand

The purpose of this section of this Seeking Alpha article is to provide a summary of pages 1-3 of the Plaintiffs’ Brief dated February 1, 2023. I encourage interested readers to review the Plaintiffs’ Brief here.

My understanding is that the Plaintiff’s brief argues that:

1. In Collins v. Yellen, SCOTUS agreed with the Plaintiffs that a restriction on the former President’s (FPOTUS) ability to remove the Director of the FHFA was unconstitutional.

2. SCOTUS left to the lower courts the task of determining whether Plaintiffs were entitled to a remedy for the unconstitutional removal restriction. It is my understanding that the applicable District Court quickly dismissed the Plaintiffs’ claims in their entirety. So, the Plaintiffs are now appealing that decision to the 5th Circuit.

3. Plaintiffs argue that they are following SCOTUS’ holding in Collins. SCOTUS said that a public statement that FPOTUS disapproved of the actions of the FHFA director and would have removed him from office would show that the removal restrictions harmed F&F shareholders.

4. FPOTUS provided a letter that supports the proposition that but for the removal restriction, the Trump Administration would have ordered the FHFA to release F&F from conservatorship. This letter is here. The Rule of Law guy discusses the Trump letter here.

5. By the time the FHFA Director left office, there was not enough time to effectuate the release of the GSEs from conservatorship. It is my understanding that the FHFA did make considerable progress in laying the groundwork to end the conservatorship, including ending transfers of the GSE’s net worth to the Treasury on a quarterly basis.

6. Thus, the Plaintiffs argue that the 5th Circuit should require that the district court enter an injunction putting the Plaintiffs in the position that they would have been in but for the unconstitutional removal restriction.

7. Plaintiffs state that the appropriate remedy for this constitutional violation is to vacate and set aside the 3rd Amendment.

In other words, SCOTUS told them what potential evidence would serve to prove that the applicable constitutional violation had actually occurred. The plaintiffs received a letter from FPOTUS that provides the evidence that SCOTUS suggested would be dispositive.

So, assuming the 5th Circuit agrees, the appropriate remedy would be to vacate and set aside the 3rd agreement. Given that the GSE preferreds now trade at about 7% percent and could move much closer to redemption value with a win at the 5th Circuit, this is an important case for investors in the GSE common and preferred stockholders to watch over the next year or so.

Plaintiffs also raise the question of whether the FHFA funding structure violates the Appropriations Clause. The 5th Circuit has already ruled on this issue with respect to the CFPB, as discussed here. A win on this issue at the 5th Circuit could pose an existential threat to the FHFA because it would cause funding problems that could threaten the FHFA’s ability to operate if they are not quickly resolved. At that point, if the Treasury can sell its 79.9% stake in the GSE common stock for a substantial amount of money, the recapitalization of Fannie & Freddie might seem particularly attractive.

III. GSE Preferred stock valuation

It’s hard to predict the future value of the GSE preferreds. The FMCKJ and FNMAS preferred stocks are the most widely traded and therefore I sometimes use them as a proxy for the many other GSE preferred stocks.

On average, the GSE preferred stocks are currently trading at about seven percent of redemption value, compared to about nine percent of redemption value as of 9/13/2022. On average, Freddie Mac’s preferred stocks are currently trading at about 6.95 percent of redemption value, and Fannie Mae’s are trading at about 7.26 percent.

The GSE’s $25 redemptional value preferreds tend to trade at a higher valuation than do the $50 preferreds, which may reflect their greater liquidity. Also, the GSE’s fixed-rate preferreds tend to trade at a higher valuation compared to their floating-rate preferreds. I discuss these topics in more detail here.

IV. Conclusion

A win at the 5th Circuit could dramatically affect the valuation of the GSE preferreds.

I urge investors to do their own due diligence and to avoid holding an overly concentrated position in the GSE preferred or common stocks.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.