Special Situation Spotlight On Freddie Mac And Fannie Mae Preferred Stocks (FMCC)(FNMA)

Introduction

Freddie Mac (OTCQB:FMCC) and Fannie Mae (OTCQB:FNMA) (F&F) are government-sponsored enterprises (GSEs). F&F common and preferred shareholders’ investments will be affected by ongoing litigation challenging the direct expropriation and de facto nationalization of the GSE’s. For those seeking political alpha, i.e., increased returns resulting from changes in public policy, there is a case to be made that favorable developments could occur in the next few months with respect to several ongoing court cases.

Litigation is underway with respect to 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).

In this Seeking Alpha article, I present my current “working hypothesis” with respect to the potential recovery of the GSE preferred stocks to levels that are closer to their indicated redemption value. I hope to begin to dig deeper into the prospects of the GSE’s over the next few weeks, focusing primarily on:

1. Studying the “acting director” issue. I’m especially interested in the argument that acting director DeMarco did not have the authority to impose an NWS via the 3rd Amendment at the time he did so because no legislature had approved his appointment to head the FHFA.

2. Examining the evidence that has been accumulating via expert reports and/or discovery in Judge Lamberth’s proceeding.

For investors in F&F preferred stocks, the ongoing litigation has, of course, been a slow process. Nevertheless, “buy and hold” investors in F&F preferred stocks that have the needed discipline and patience may eventually get a payoff. However, it is not possible to predict the timing and outcome of the ongoing litigation at this time. Investors should do their own due diligence.

The Shareholder Suits

Many shareholder suits were filed beginning in the summer of 2013 in U.S. District Courts as well as the federal Court of Claims.

Judge Lamberth’s decision (dated September 30, 2014) in the U.S. District Court (D.C.) ruled against the plaintiffs—this order was very negative for holders of the F&F common and preferred stocks.

Table 1 summarizes the changes in FMCKJ and FNMAS preferred stock prices during the period from September 30, 2014, to October 3, 2014. FMCKJ and FNMAS are the largest preferred stocks of FMCC and FNMA respectively. Thus, Table 1 focuses on the market impacts on FMCKJ and FNMAS from Judge Lamberth’s decision.

Table 1: FMCKJ and FNMAS Volume and Closing Prices, September 30 and October 1-3, 2014

DATE	Volume (No. of Shares)	Closing Price ($)
FMCKJ
September 30, 2014	902,500	10.30
October 1, 2014	34,563,800	4.34
October 2, 2014	6,612,600	3.81
October 3, 2014	13,948,100	3.96
FNMAS
September 30, 2014	1,235,590	9.20
October 1, 2014	42,719,277	4.15
October 2, 2014	6,370,276	3.76
October 3, 2014	11,672,497	3.90

Click to enlarge

I want to briefly mention three of the many court cases at this time:

1. Fairholme v. FHFA. The plaintiffs need to build a case that shows that the 3rd Amendment’s NWS breached the implied covenant owed to junior preferred stockholders. Glen Bradford states that “Judge Lamberth has been ruling that if the shareholder plaintiffs’ facts produced by discovery support their narrative which argues their contracts were breached by the net worth sweep” then, if they can build a credible and well-supported case, this “bodes well for them as they head to trial in October 2022.” At this point in time, I have not yet had the opportunity to review the documents produced by the parties in this proceeding.

2. ROP v. FHFA Appeals court decision. Glen Bradford explains that this case is “worth paying attention to and it [a decision by the appeals court] can be expected in the next 90 days and could very well reverse the net worth sweep because it was done by an acting director (Ed DeMarco) over two years after he became [acting] director.” Rule of Law Guy states that “Plaintiffs seek as relief vacating the NWS, insofar as DeMarco was invalidly acting as a ‘principal officer’ without Senate confirmation, and the same write down of the senior preferred stock preference as in Collins regarding the unconstitutional removal provision.”

3. Collins v. Yellen. While SCOTUS ruled against GSE preferred investors on some issues in this case, that does not necessarily mean that the situation is dire for GSE preferred investors. According to SCOTUS blog, “although the court agreed, by a vote of 7-2, that the structure of the federal agency that regulates Fannie and Freddie is at least in part unconstitutional, the court stopped short of ordering that the money be returned to the shareholders as a result of that constitutional defect. Instead, the case now goes back to the lower courts, which will determine whether the shareholders are entitled to any relief.” In addition, SCOTUSblog reports that “[t]he court in Collins v. Yellen agreed that Congress had unconstitutionally insulated the FHFA’s director from termination by the president.”

Inevitably, the GSE litigation raises important public policy issues. In the U.S., most “acting directors” of federal or state regulatory agencies recognize that they have not been confirmed by the applicable legislature and therefore are very careful to act within the “ground rules” established via statutes, court cases, and administrative rules that oversee and limit their conduct and discretion. To me, it appears that FHFA acting director DeMarco did not act in accordance with the ground rules that should have guided his conduct. If so, courts may eventually decide in favor of the plaintiffs.

See SCOTUSblog for additional information on four upcoming cases that could have important implications for GSE investors in the future.

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 so I will sometimes use them as a proxy for the many other GSE preferred stocks. Attachment 1 provides a list of the F&F preferred stocks, their current market prices, the redemption values specified in their prospectuses, and the market price to redemption value (MP/RV) ratio for these preferred stocks as of September 6, 2022.

One simple 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 on September 30, 2014, and that the current stock price is about $3.24 per share. For FNMAS, the stock price was $9.20 on September 30, 2014 and it is now trading at about $3.40 per share. To quote Nietzsche’s Twilight of the Idols, “[o]ut of life’s school of war—what does not kill me makes me stronger.”

Another simple metric would be to assume that the GSE’s financial structure will eventually be restructured to raise new common stock and to redeem the preferred stocks based on redemption value.

On average, the GSE preferred stocks are currently trading at roughly 9.19 percent of redemption value. On average, Freddie Mac’s preferred stocks are currently trading at about 8.95 percent of redemption value, and Fannie Mae’s are trading at about 9.55 percent.

Freddie Mac’s $25 redemption value preferreds are trading at about 10.57 percent of redemption value and their $50 redemption value preferreds are trading at 8.34 percent.

Fannie Mae’s $25 redemption value preferreds are trading at about 11.18 percent of redemption value and their $50 redemption value preferreds are trading at 8.78 percent. FNMFO has a redemption value of $105,000 and trades at 8.29 percent of redemption value.

Freddie Mac’s fixed-rate preferred stocks are currently trading at about 9.33 percent of redemption value, with the $25 redemption value fixed-rate preferred stocks trading at 10.57 percent and the $50 redemption value fixed-rate preferred stocks trading at 8.59 percent.

Fannie Mae’s fixed-rate preferred stocks are currently trading at about 9.80 percent of redemption value, with the $25 redemption value fixed-rate preferred stocks trading at 11.18 percent and the $50 redemption value fixed-rate preferred stocks trading at 9.02 percent.

Both of the GSEs have some preferred stocks with variable rates and no floor on the preferred dividend rate that would be applicable if preferred dividends are resumed. For Freddie Mac, the applicable tickers are FMCCJ, FMCCN, FMCCG, FMCCI, FMCCL, and FMCCM. For Fannie Mae, the applicable tickers are FNMAP and FNMAO. These variable-rate preferreds currently trade at about 7.93 percent of redemption value.

I have excluded FMCCS and FMCKJ from this list because they have floor dividend rates of 4 percent and 7.875 percent, respectively. Back in the day, I used to assume that the preferred dividends of the GSE preferred stocks would eventually be reinstated and that it was therefore better to invest in GSE preferred stocks that would pay a fixed dividend if dividends are resumed. I was skeptical about the potential value of these preferred stocks relative to the preferred stocks with a fixed dividend. For bargain hunters, however, the F&F preferred stocks might be worth a closer look. Attachment 2 provides information on how dividend rates would be set for these variable-rate preferred stocks if F&F’s preferred dividends were to be resumed. Quantumonline.com is my source for the information provided in Attachment 2.

Conclusion

It seems clear that a court order overturning the 3rd Amendment would have major implications for investors in the GSE common and preferred stocks.

When investing in F&F preferred stocks, my priority has been to examine the valuations of the GSE preferreds that have a fixed dividend and look for potential bargains among them. My basic approach has been to:

1. Calculate market price to redemption value (MP/RP) ratios for the F&F preferred stocks. See Attachment 1.

2. Look at the bid-ask spreads, bid*size, ask*size, and 10-day-average volumes for the F&F preferred stocks. See Attachment 3 for this information for selected Freddie Mac preferred stocks.

3. Choose a preferred stock that seems to be a good value amongst the many investment options that F&F investors can choose from.

4. Monitor the MP/RV when increasing your bids. My basic approach has been to start at a price near the bid price and work my way up to a bid that will be accepted by the counterparty but that is still attractive compared to the MP/RV of the other F&F preferred stocks.

5. Buy and hold while continuing to follow the investments diligently.

Deciding on an investment requires that the investor: (1) conduct reasonable due diligence on the investment that they are considering making; and (2) evaluate how well it would fit into the investor’s overall investment portfolio. Investing in F&F preferred stocks requires time, money, and patience, but the investment may eventually pay off for investors.

Attachment 1: Market Price to Redemption Value Ratios for the F&F Fixed-Rate Preferred Stocks as of September 6, 2022

Ticker Symbol	Market Price ($MP)	Redemption Value (RV%)	MP/RV (RV%)
FMCCG	3.99	50	7.98
FMCCH	4.27	50	8.54
FMCCI	4.00	50	8.00
FMCCJ	3.92	50	7.84
FMCCK	4.35	50	8.70
FMCCL	3.95	50	7.90
FMCCM	3.86	50	7.73
FMCCN	4.06	50	8.12
FMCCO	4.32	50	8.64
FMCCP	4.08	50	8.16
FMCCS	4.21	50	8.42
FMCCT	4.55	50	9.10
FMCKI	2.46	25	9.84
FMCKJ	3.10	25	12.40
FMCKK	4.28	50	8.56
FMCKL	2.84	25	11.36
FMCKM	2.45	25	9.80
FMCKN	2.50	25	10.00
FMCKO	2.50	25	10.00
FMCKP	4.30	50	8.60
FNMAG	4.44	50	8.88
FNMAH	2.63	25	10.52
FNMAI	2.53	25	10.12
FNMAJ	2.64	25	10.56
FNMAK	4.56	50	9.12
FNMAL	4.40	50	8.80
FNMAM	4.27	50	8.54
FNMAN	4.94	50	9.88
FNMAO	3.95	50	7.90
FNMAP	4.00	50	8.00
FNMAS	3.22	25	12.88
FNMAT	2.96	25	11.84
FNMFM	4.01	50	8.02
FNMFN	4.95	50	9.90
FNMFO	8,700.00	105,000	8.29
FREGP	4.30	50	8.60
FREJP	4.27	50	8.54

Click to enlarge

Attachment 2: How F&F’s Variable-rate Preferred Dividends Would be Determined if Dividends are Resumed

FMCCG: The dividend rate resets quarterly and is equal to the sum of the three-month LIBOR rate plus one percent divided by 1.377, and is capped at 7.50 percent.

FMCCI: The dividend rate resets quarterly and is equal to the sum of the three-month London Interbank Offered Rate (LIBOR) rate plus one percent divided by 1.377, and is capped at 9.00 percent.

FMCCJ: The Annual Fixed Dividend Rate will be 4.48% until the first redemption date, then it will be equal to the sum of the average interest rate of U.S. Treasury securities having an index maturity of two years on the applicable fixed rate calculation date plus 0.20% (with a maximum of 10.80%), resetting every 2 years thereafter on applicable fixed rate calculation date.

FMCCL: The variable dividend rate will be reset every five years starting 1/01/2005 at a rate equal to the five-year Constant Maturity Treasury rate.

FMCCM: The variable dividend rate will be reset on 4/01/2003 and every 2 years thereafter on April 1, based on 2-year CMT Rate plus 0.10%.

FMCCN: The dividend rate will be reset on 4/01/2002 and every year thereafter on April 1. The dividend rate is based on the 12-month LIBOR Rate minus 0.20%.

FNMAS: After 12/31/2010 the dividend rate will be the greater of 7.75% or the 3-month LIBOR plus 4.23% per annum.

FNMAH: The dividend rate will reset quarterly on the second business day prior to the beginning of a new dividend period and shall be the greater of 4.50% or the sum of the 3-Month LIBOR plus 0.75%.

FNMFN: The dividend rate will reset on the second business day prior to the beginning of a new dividend period and shall be the greater of 7.00% or the sum of the Ten-year CMT Rate plus 2.375%.

FNMAO: The dividend rate will reset as of September 30, 2002 and as of September 30 every two years thereafter until any redemption, based on the two-year CMT Rate minus 0.18%, subject to a cap of 11% per year.

FNMAP: The dividend rate will reset as of March 31, 2002 and as of March 31 every two years thereafter, based on the two-year CMT Rate minus 0.16%, subject to a cap of 11% per year.

Attachment 3: Bid-ask Spreads and Market Information for Selected Freddie Mac Preferred Stocks, September 2022

RV ($)	Ticker Symbol	Opening Price ($)	Bid * Size	Ask * Size	10-day avg volume
$50	FMCCG	3.89	3.21 * 100	4.00 * 100	1,310
$50	FMCCH	4.27	4.25 * 100	4.46 * 100	14,237
$50	FMCCI	4.00	3.56 * 100	4.00 * 100	2,538
$50	FMCCJ	3.10	3.05 * 100	3.10 * 100	39,647
$25	FMCKI	2.28	2.28 * 100	2.65 * 100	4,215
$25	FMCKJ	3.10	3.05 * 100	3.10 * 100	39,647
$25	FMCKL	2.84	2.70 * 100	2.89 * 100	4,179
$25	FMCKO	2.84	2.30 * 100	2.50 * 100	1,446

Click to enlarge