FHFA Is Working With Fannie/Freddie To End Conservatorships (OTCMKTS:FMCC)

The Federal Housing Finance Agency (FHFA) was created by law in 2008 to oversee and regulate Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC). FHFA immediately placed them into conservatorship and they’ve been there ever since. From 2008-2010, FHFA used its discretionary accounting authority to ensure Fannie and Freddie reported losses and Treasury bought more senior preferred stock. In 2012, when Fannie and Freddie were being forced to reverse all of those discretionary accounting losses, FHFA worked with Treasury to ensure Treasury took everything via the net worth sweep. Fannie and Freddie continued to be bled dry until 2019 when Mark Calabria worked with Steven Mnuchin to change the agreement so that Fannie and Freddie could retain capital. Ever since then, Fannie and Freddie have been on a path out of conservatorship.

Investment Thesis

The main roadblock to Fannie and Freddie exiting conservatorship is that they do not meet their now finalized capital requirements. Fannie and Freddie are prevented by Treasury from being able to access the capital markets where they would be able to raise capital and exit conservatorship because of Treasury’s equity position. Treasury has Senior Preferred Stock and 79% warrants. The terms of its senior preferred stock take everything for Treasury despite the companies retaining capital, and this take everything deal would need to be restructured in order for Fannie and Freddie to be able to raise capital and exit conservatorship. FHFA’s Sandra Thompson is now saying she is committed to working with Treasury as well as positioning the Enterprises to take the steps necessary to exit conservatorship. Based on the Collins v. Yellen SCOTUS decision, the government will monetize its senior preferred stock in a way that makes common shares unattractive from a security analysis perspective. Fannie and Freddie junior preferred shares trade at less than 15 cents on the dollar, and I think they will get 100 cents on the dollar in a restructuring though. The last time we heard comments about exiting conservatorship from an FHFA director, the junior preferred shares traded at over 40 cents on the dollar and had zero net worth whereas now they have over $70B.

FHFA Committed To Working With Treasury

Sandra Thompson was asked if she thought Fannie and Freddie would remain in conservatorship through the end of the Biden administration and what she said aligns perfectly with what I’ve been saying since she was nominated to become the permanent director of FHFA (emphasis added):

First, I would say this. We closely monitor and supervise the Enterprises, and we’re focused on making sure they grow capital and improve their safety and soundness while they’re in conservatorship. Adequate capital is a necessary precondition for the Enterprises to exit from conservatorship, and that’s not a calendar-driven event. I am not in a position to unilaterally end a conservatorship; that’s a decision that involves a number of stakeholders, and there are quite a few steps that are going to have to be completed to responsibly end the conservatorships. I am committed to positioning the Enterprises and working with Treasury and Congress to do whatever is necessary to move them out of conservatorship in a responsible timeframe.

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We’re working with the Enterprises to take those steps so that they can exit from conservatorship in a responsible manner and in a timeframe that makes sense.

When Sandra Thompson was in front of the Senate Banking Committee for her confirmation hearing, she kept talking about how she would defer to Congress. Ever since then, she has been talking more and more about working with Treasury.

Here’s what we know. The Collins v. Yellen legal ruling made FHFA director a political appointee position. We can deduce then that Sandra Thompson was nominated by the same person who picked Janet Yellen for Treasury as Sandra Thompson is the first FHFA director ever nominated by the same person who can remove her at will. Thus, we can assume that Sandra Thompson is not acting contrary to Biden’s wishes as she prepares Fannie and Freddie to exit conservatorship and points to working with Treasury as she cannot facilitate the end unilaterally.

Regulating the GSEs Like Public Utilities

Richard Cooperstein, who used to work at Freddie Mac, thinks the GSEs should be regulated as public utilities. In summary, his view is that they continue doing what they are doing with a federal backstop and a governance structure (FHFA). He talks about how this can be formalized with legislation but it can also be enacted without legislation by converting the remainder of Treasury’s funding commitment in the SPSPA to an explicit limited guarantee that Fannie and Freddie pay for via a periodic commitment fee as part of their equity restructuring.

Summary and Conclusion

Sandra Thompson is beginning to sound more and more like Mark Calabria in respect to the march toward ending the conservatorships of Fannie and Freddie. One of the main differences between the Trump and Biden administration so far was that Steven Mnuchin was vocal about his goal of ending the conservatorships of Fannie and Freddie whereas Janet Yellen has not really talked about it as a priority. This may be because the heavy lifting of enabling Fannie and Freddie to retain earnings to force an outcome that is exiting conservatorship adequately capitalized has already been accomplished, and Treasury is waiting for FHFA to give the green light that FHFA has put all the pieces in place and is ready to go with the restructuring and consent decree. Still pending is the finalization of the capital planning rule.

The main event for existing shareholders is the equity restructuring. I expect common are diluted by Treasury’s equity stake and have no material upside if any. Preferred shareholders, however, should get par and have a strong breach of contract claims as well as constitutional claims moving forward.

There are a few potential catalysts. In the coming year, it would be amazing to see CRL’s Michael Calhoun get a job at Treasury as we know he favors recap and release. Shareholders getting passed the government’s motion for summary judgment in Lamberth’s court by July is also a big deal. The finalization of the capital planning rule would push Fannie and Freddie towards making capital plans sooner than later.