October 1, 2014
Special Situations: Quick Note
- OTCBB: FNMA
- Recent PPS: $1.25 (anticipating tomorrow’s opening price…)
- FD Common Shares Out: 5.8 billion
- Common Equity Market Cap: $7.2 billion
- Preferred Stock: $136 billion (as of 2Q14)
- Total Equity: $143.5 billion
FNMA shares have been extremely weak as of late, and after tonight’s news that U.S. District Judge Royce Lamberth threw out the Perry/Fairholme case that claimed the “Sweep” amendment in 2012 was illegal, we now know the reason for said weakness. Shares are going to open tomorrow significantly lower than today’s closing, which naturally will usher in a chorus of jeers from those who believe FNMA shares represent no more than a lottery ticket. While I will in no way claim that FNMA shares represent a standard investment operation, I do believe a reasoned argument can be made for a position (Full Disclosure: I own FNMAS and FNMA shares in a 2:1 ratio, as I believe worst case scenario the FNMAS shares return to par and the FNMA shares go to zero), even in the absence of a favorable court ruling on the “Sweep” amendment (Tonight’s ruling was not the final straw, as there are several cases still pending). 1) An unattainable amount of private capital would be required to replace Fannie and Freddie, and 2) the U.S. Government is simply not going to take F&F debt onto its balance sheet, which represents over 30% of GDP – as such, a private capital-friendly F&F restructuring is the only logical alternative. As Pershing Square outlined in a May 2014 presentation, a full IPO of F&F would simply be far too large for the private markets to absorb, especially if the USG steamrolls the existing F&F private shareholders – i.e. the Junior Preferreds and Common Shares. The USG has all of the tools currently in place to effect a private capital-friendly, large-scale recapitalization that maintains the current US mortgage market and nets the USG an amount well in excess of its original investment, with significant remaining upside. Due to the realities of government negotiations and a market pricing mechanism, a restructuring could be highly unfriendly to current common shareholders; thus I have chosen to hedge my common position with a junior preferred position, which I view as highly likely to work out under virtually any scenario. However, the attached spreadsheet outlines how, even with zero help from the judicial system, the common equity could work out nicely from here.
As of 2Q14, total outstanding FNMA preferred stock amounted to $136 billion, with the USG’s Senior Preferred comprising $117 billion. Were the Sweep Amendment to be ruled unconstitutional, it is likely upwards of 75% of the Senior Pref would be wiped out, as FNMA has paid a significant portion back to the USG since the Amendment. However, assuming the full amount must be paid, I estimate the common equity is worth approximately $5 per share. After a recapitalization, the USG is left with proceeds of approximately $228B – but with over $130 billion in common stock, significant upside remains over time.
Obviously there is upside and downside risk to this situation. On the downside, the market could severely punish any IPO-based restructuring due to FNMA’s current undercapitalization. While FNMA could easily recapitalize over time via retained earnings, the market may not absorb a fair value PE of 15 times at present. On the upside, if the Sweep Amendment is overruled, the common stock is worth upwards of $20 per share.
While it is certainly a high-risk situation, the stock price reaction tomorrow (or now ‘this’) morning, in my opinion, will overstate the risk of a shareholder-unfriendly restructuring. As such, depending on how the FNMAS security trades vis-a-vis the FNMA common, I will strongly consider trimming FNMAS and adding to FNMA.