Special Situations: Fannie Mae Epstein Call October 2014

Two interesting takeaways from the Epstein call:

1. In order to keep F&F debt off of the USG balance sheet, the USG needed to keep its F&F ownership stake below 80%; as such, the USG needed the common stock to continue trading.

So this goes back to my point that the USG does not want F&F liabilities on its balance sheet, thus the status quo is likely not a feasible option. But if the USG wants to liquidate F&F, then the only proceeds the USG receives is through its senior preferred position. I guess the USG could continue operating F&F as is and just milk the cash for five years before selling them to the private sector in order to pay off the senior preferred. Though again, too much scrutiny for nothing to happen.

2. F&F had the PIK option for senior preferred dividend payments, yet the USG continues to argue that the Sweep was necessary to avoid a “death spiral”.

This is a hugely underreported part of this entire situation. If the Conservator was truly operating the entities to return them to health – whether back to private shareholders or not – then no rational person would eschew the PIK option in favor of the Sweep. The Sweep allows F&F to avoid the death spiral when earnings are negative, but it does not provide F&F with the option of returning to capital health in the event earnings turn positive. Yes F&F might not ever be able to get out from under the dividends on preferred issued under the PIK, but at worst the option existed for F&F to earn their way back to health…and this is more than proven out by the fact that F&F would have nearly earned their way out by now.

I am extremely tempted to add to the FNMAS position down here, as I don’t see how Sweeney does not go through with discovery on this. I realize the USG plays by different rules, but this is truly egregious. You cannot keep private securities trading and then strip them of all potential investment return – even for the USG, logic does not hold here. And as I have outlined, my base case is that F&F are restructured with the junior preferred intact – a favorable ruling would be gravy. I very well could be wrong here, but at least as of now, this is my thought process.

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