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Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) are two companies in conservatorship despite having net worth in excess of what they had pre-conservatorship. Both companies were put into conservatorship in 2008, but in 2007, Freddie Mac had $27B of net worth and Fannie Mae had $45B of net worth. Now Freddie Mac has $35B and Fannie Mae has $58B of net worth because they have been able to retain earnings since September 2019. The definition of conservatorship from FHFA’s own website:
Fannie Mae and Freddie Mac are in conservatorship to preserve and conserve their assets and property and restore them to a sound and solvent condition so they can continue to fulfill their statutory missions.
Treasury’s equity interests in Fannie and Freddie are currently preventing FHFA from restoring Fannie and Freddie by preventing them from being able to raise enough capital to become adequately capitalized and exit conservatorship.
Investment Thesis
Fannie and Freddie have more money now than they did before they were placed into conservatorship and are on track to continue to accumulate money on their path to having more than they ever had in history. They are now in a position where, if they could raise money via equity offerings, they could exit conservatorship. Treasury’s equity interest, which lays claim to every cent of earnings that accrues to Fannie and Freddie, actively impedes this. Despite having more money than before, the government so far has refused to let go of Fannie Mae and Freddie Mac. On an economic basis, the government is not getting paid anything for its equity investment and only the political party in charge of the White House has any say in how Fannie and Freddie are run. When the Trump admin ended, Biden took over and took complete control and put in his changes. Eventually, a different president with different political objectives for Fannie and Freddie will take office. The idea is that only the president that actually ends the conservatorships gets to lock in their vision of reform and gets to spend the money trapped in Treasury’s equity positions of Fannie and Freddie. The Trump administration did the heavy lifting of starting the retention of capital and Trump said:
My administration would have also sold the government’s common stock in these companies at a huge profit
Now, Biden is in power, but he won’t be forever. An investment in Fannie and Freddie junior preferred stock is a bet on an eventual restructuring of the equity where a president wants to fund an initiative and accomplish housing finance reform. With interest rates rising significantly this past year and republicans taking the house, the next 12 months are ripe for administrative action.
Junior preferred stock trades at less than 10 cents on the dollar but would be made whole if the government restructures its equity so that it can lock reform and spend its profits.
Capital Planning Rule
Under Biden’s Sandra Thompson, FHFA proposed a capital rule 12/27/2021 where FHFA asserted that it may require Fannie and Freddie to develop and implement capital restoration plans:
For example, pursuant to FHFA’s Prompt Corrective Action and general enforcement authority, it may require an Enterprise to develop and implement a capital restoration plan, restrict asset growth or activities, and take other appropriate actions to remediate the violation of law.
FHFA argued that despite the SPSPA preventing Fannie and Freddie from holding anywhere near the capital FHFA’s ECRF requires, this new rule would allow the Enterprises to close the gap by sorting out a capital raising framework:
The Enterprises are currently in conservatorship, are subject to the restrictions of the Senior Preferred Stock Purchase Agreements between them and the U.S. Treasury, and do not hold capital anywhere near the levels specified in the ERCF. The capital plans will allow the Enterprises to identify the amount of capital they need to raise to close the gap with the ERCF, and to consider the timing of when to raise capital, and what types of capital to raise.
FHFA went on to finalize this capital planning rule June 2022. The first plan submissions under this new rule are due May 20, 2023. Execution of the GSE capital plans gets them out of conservatorship.
Recent Shareholder Based Litigation
Shareholders have fought FHFA’s actions during conservatorship that have largely zeroed out the economic interest of non-governmental shareholders have sued the government and the companies primarily for the net worth sweep.
Collins v. Yellen
Judge Ellison ruled that Trump’s memo doesn’t matter and dismissed the constitutional claims that were remanded back down from the Supreme Court which seemed to argue that if Trump did put out such a statement that shareholder plaintiffs could use it to show harm. Judge Ellison dismissed all plaintiff claims even though they had been remanded back down from the Supreme Court. I expect that this ruling gets appealed back to en banc.
Rop v. FHFA
The sixth circuit court of appeals ruled that Ed DeMarco was not serving in violation of the Appointment’s Clause when he enacted the net worth sweep. This was a win for the government and a loss for shareholders. I expect this will get petitioned to the Supreme Court.
Lamberth Trial
Shareholders had breach of contract claims go to trial in October. The result was a hung jury. I expect this will go for a re-trial. My understanding is that plaintiffs will get to re-submit their reliance damage model. I think the jury was confused by the share loss damage model. Ed DeMarco and the government bragged that they didn’t really do any research or get any second opinions when enacting the net worth sweep, which they said was to save the mortgage market, but the jury seemed unable to determine if that was arbitrary or met any standard of due diligence.
Summary and Conclusion
The republicans just took the house of representatives. The only housing finance reform option from here on out is administrative. The government is incentivized by $100B to enact it and as a bonus gets to lock in its view on reform. If the Biden administration does not take action, they’ll lose the opportunity to lock in their view of reform and the next administration could change housing finance completely and spend the $100B on completely different objectives. As such, the government is strongly incentivized to take action since inaction hands the ball possibly to the opposing team. The junior preferreds trade at less than 10 cents on the dollar which seems to be pricing in an understanding that not only has Biden’s Treasury not yet restructured its equity in Fannie and Freddie, but that it won’t and every administration in the future will not as well. On top of this, it assigns a low probability for winning any of shareholder litigation.
I think the Biden administration aligns with all its incentives and takes action on housing finance reform.
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