October 5, 2014
Special Situations: Scenario Analysis
This write-up distilled out of a working page I had posted earlier where I was working through the various options available to the U.S. Government (USG) for restructuring Fannie & Freddie (F&F). The analysis is incomplete and indicative of mental rambling, but far along enough to put into a relatively structured write-up format. The basic conclusion is that the USG is ultimately well-incentivized – via its 80% warrant position (the “USG Warrant”) – to return F&F to the private sector, and that even in the absence of a favorable court ruling, the junior preferred and common shareholders are likely to be restored. As such, future analyses can focus on the F&F reforms proposed by Blackstone in 2011, Fairholme in 2013 and Pershing Square in 2014, as well as the various valuation scenarios for private shareholders in the event of a return of F&F to the capital markets.
Scenario #1: Status Quo
The status quo is the USG milking F&F for cash ad infinitum. Under this scenario, the USG’s primary means of financial return is via distributable earnings; thus the USG Warrant is rendered moot.
- Does F&F become an independent government agency?
- Does the USG merge the F&F balance sheet into its own?
- Is the private share structure – i.e. junior preferred and common – cancelled?
- What effect does de facto nationalization of F&F have on the U.S. residential mortgage market?
17 Mile Conclusion: Perhaps the mortgage market would function just fine under the status quo and F&F should be considered a government agency. In my opinion, however, there is far too much focus on what to do with F&F to simply maintain the status quo. Probably the most widely accepted Congressional template for restructuring F&F without fully returning them to the private sector is the Housing Finance Reform and Taxpayer Protection Act of 2013 (the “Act”) – let’s call it Scenario #1A.
The Act would 1) replace the F&F guarantee business with the Federal Mortgage Insurance Corporation (FMIC), 2) transfer the 10% first-loss position to the private market, 3) create a common securitization platform (currently being developed by F&F) and 4) wind down F&F over time.
- From the starting date of the FMIC, the FMIC/private sector would be responsible for all future mortgage originations/guarantees while F&F would run off the existing guarantee book.
- The FMIC would seek to build a reserve position equal to 2.5% of the face value of guaranteed mortgages by year 5, and 5% by year 10.
- The Act is extremely specific in that the F&F wind-down would seek to maximize the return to the senior preferred position with any remaining proceeds to go to private shareholders. Given the USG determines the distributable amounts, private shareholders would effectively be wiped out.
17 Mile Conclusion: The U.S. residential mortgage market is what it is – for better or worse, over decades the USG has allowed a duopolistic, government-guaranteed market to develop, resulting in two key facts: 1) F&F have enormous economies of scale (see the Pershing Square Proposal), and 2) virtually the entire U.S. residential mortgage market is built on the less-than-10%-down/30-year mortgage product. If the USG would like to apply to U.S. residential mortgage market reform the same disastrous bureaucratic principles it applied to the Affordable Care Act and Dodd Frank, it will destroy the residential housing market as we know it today. It would be foolish to intentionally destroy the enormous scale economics F&F possess – which flow through to mortgage consumers in the form of extreme low cost – for the sake of mortgage market reform, when a modest set of reforms to F&F – such as higher G-fees, stricter capital ratios and greater oversight – would virtually eliminate the need for any future USG involvement. As the Pershing Square proposal outlines in great detail, a private sector solution is the sensible solution. With such a significant amount of “smart money” lobbying Congress for reforming F&F/returning them to the private sector, my guess is that the final decision(s) on F&F will be far more private sector-oriented than the Housing Finance Reform Taxpayer Protection Act.
Scenario #2: F&F Returned to the Private Sector
(The following analysis utilizes FNMA figures as representative of F&F combined.)
As outlined in the recent FNMA Quick Note, at 15 times normalized earnings FNMA’s estimated total equity fair value is approximately $165 billion (a conservative figure given the upside to the current G-fee structure); the book value of the USG’s senior preferred is $117.15 billion, or approximately 71% of fair value; and the book value of the junior preferred is $19.13 billion, or approximately 11.6% of fair value. As such, the USG has two options for returning FNMA to the private sector:
- Cancel the private share structure – along with the USG Warrant – and conduct an IPO at the $165 billion valuation.
- IPO 29% of FNMA and convert its senior preferred stock into a 71% common equity stake; or,
- IPO 100% of FNMA at a $165 billion valuation and pay off the senior preferred stock balance with 71% of the proceeds.
- Restructure the entire share structure based on the $165 billion valuation. USG Warrant remains in place.
- Convert the entire share structure into common stock, with the senior preferred owning 71%, junior preferred 11.6% and common shareholders 17.4%; or,
- IPO 71% of FNMA at a $165 billion valuation in order to pay down the senior preferred, with the junior preferred owning 11.6% and common shareholders 17.4%.
17 Mile Conclusion: Outside of a court ruling that overturns the Net Worth Sweep (NWS), the USG will want to pay off 100% of the remaining $117 billion senior preferred balance. If private shareholders are wiped out as outlined in Option #1, I do not believe private capital would readily accept ownership alongside a converted senior preferred common position; as such, an IPO with the senior preferred paid off in cash seems to be the most likely route under this option.
But what is the point of wiping out the existing private shareholders – to “punish” the former owners who “drove F&F into the ground”? This makes no sense. The USG is equally to blame here for forcing F&F to lend to subprime borrowers (ahem…Barney Frank), and then not allowing F&F debt holders to actually take a loss. As Bill Ackman outlined in 2008, F&F had more than enough total capital in place to restructure itself without USG help. The USG could have easily let the banking system absorb more losses through F&F debt write-downs, and then recapitalized the system through TARP. Either way, the private shareholders have been and would have been “punished” via the decimation of investment value.
Had F&F restructured themselves in 2008, wiping out private shareholders, the new common (2008 Common) would’ve reaped the same reserve releases/DTA monetization/profit recovery the USG is currently “sweeping” to itself. The USG has already reaped the benefits 2008 Common would’ve reaped, and then some. The 2008 Common would not have received a dime in dividends – the only benefit would have come through internal recapitalization (i.e. via retained earnings) and thus higher common market capitalization over time. No dividend was needed for the senior preferred, and this is proven out by the dividend cut on the USG AIG preferred position and the conversion into AIG common stock.
Regardless of the obvious conclusion that the USG should cancel the majority, if not all of the outstanding senior preferred balance, the USG likely will not see things in this light absent a private shareholder-friendly court ruling. So for current private shareholders, Option #2 relies upon two incentives: 1) the 80% USG Warrant (which would be canceled in Option #1), and 2) the need to attract private capital in order to return F&F to the public markets.
Based on my earlier statement – “If private shareholders are wiped out as outlined in Option #1, I do not believe private capital would readily accept ownership alongside a converted senior preferred common position; as such, an IPO with the senior preferred paid off in cash seems to be the most likely route under this option.” – the USG could potentially attract the appropriate amount of private capital to restructure F&F simply by accepting cash for the senior preferred position, thus nullifying Incentive #2.
Incentive #1 requires little if any analysis. The only way the USG would walk away from free money is if they want to take a “moral” stand in order to “punish” the former owners. As outlined, the USG has zero moral leg to stand on, plain and simple. As such, I believe cooler heads will prevail and F&F will be restructured via some form of Option #2.
The following private sector-based restructuring options, in addition to various valuation scenarios, will be analyzed in future write-ups: