October 10, 2014
Special Situations: Millstein & Co. Proposal
Many thanks to Robert King (@robertqking) for sharing two testimonies by Jim Millstein – one from April 2013, and the other from November 2013. Turns out, the F&F restructuring proposal by Millstein & Co. embedded within Millstein April 2013 testimony is the bedrock for the Fairholme and Pershing F&F restructuring proposals, as well as the Housing Finance Reform & Taxpayer Protection Act of 2013. The Millstein proposal contains four elements: 1) recapitalize & privatize the F&F guarantee business; 2) establish a government reinsurance fund; 3) enhance PLS disclosures; and 4) fund affordable housing initiatives. Interestingly, while the HFRTP Act of 2013 employs the Millstein template virtually to a “T”, it eliminates the “recapitalize” and “F&F” parts of element #1 – in other words, the F&F guarantee business is discontinued, F&F liquidated, and the private sector left to fill the void from a standing start. As I have stated previously, it makes little sense for the U.S. Government (USG) to throw away F&F’s enormous earnings power – earnings power likely to never be achieved by the private sector, especially from a standing start – for the sake of “punishing” the private sector for running F&F into the ground. With the incentives currently in place – private sector dependence & the 79.9% USG Warrant – I believe logic will ultimately win the day. So with that said, let’s walk through the proposal.
- F&F mortgage guarantee business recapitalized and privatized with no USG support.
- USG reinsurance entity established – the Federal Mortgage Insurance Corporation (FMIC) – to provide reinsurance on qualified MBS with private insurance companies and investors in line for losses.
- Protections enacted and disclosure enhanced for investors in private-label MBS.
- Fee imposed on USG-reinsured MBS to fund federal and state affordable housing initiatives.
- Restarts private markets with an FDIC-like backstop
- GSE charters terminated, USG-backed investment portfolios wound down
- USG repaid via the AIG model of a preferred-to-common conversion and public IPO sell-down over time
- Mortgage system protected via stable transition
- Affordability ensured through the economic cycle
Recapitalization to Privatization.
- F&F earnings used to build capital for in the guarantee business
- Raise the G-fee
- Turn off senior preferred dividend
- Wind down legacy investment portfolios
- Contribute F&F infrastructure to common securitization platform
- Once adequately capitalized, charter F&F as two state corporations
- Pro forma corporations:
- NewCo #1
- Guarantee Book: $2,542B
- Net Income: $11B
- FV PE: 10X
- FV: $108B
- NewCo #2
- Guarantee Book: $1,558B
- Net Income: $7B
- FV PE: 10X
- FV: $68B
- NewCo #1
Millstein v. Pershing. The Fairholme proposal is virtually identical to the Millstein proposal, so no real need to go into it. The Pershing proposal on the other hand is an interesting twist on the Millstein proposal. Pershing believes that if the GSEs are conservatively capitalized, avoid subprime & Alt-A loans, and exit the fixed income arbitrage business, then an explicit government guarantee would not be required – as such, the FMIC would not be required. In summary, it comes down to a difference in belief about capital requirements – Pershing believes a 2.5% capital ratio for a reformed F&F would be sufficient to cover 2008-type losses, whereas Millstein proposes that the NewCos maintain bank-style capital ratios in addition to buying reinsurance from the FMIC.
Valuation. Under the Millstein proposal, if NewCo #1 represents the larger FNMA, then non-USG investors would receive 15% of the Company, or approximately $16B. I am not entirely sure what the 15% is comprised of – Millstein does not indicate how much, if any, of the 15% is from new equity issuance, nor do they indicate how much of a haircut, if any, the USG takes on the then-current face value of the senior preferred. But for ease of analysis, let’s assume the USG’s $92B represents the senior preferred position converted to equity – at a $117B face value, that represents a 21% haircut on the senior preferred. If we apply the same 21% haircut to the $19B junior preferred face value, then the junior preferred would comprise $15B of the $16B non-USG common equity valuation. At this haircut, the FNMAS security would be converted at approximately $19.75 per share. The remaining $1B of valuation is either simple rounding by Millstein or the common would receive approximately $.86 per old-FNMA share (i.e. the USG Warrant is canceled).
Based on my analysis using Pershing’s 80bps G-fee mid-pt estimate and a 2.5% required capital ratio, I estimate that non-USG investors would receive between $14.5B and $60.3B depending on the FV PE used in the restructuring. At 10X, the FNMAS junior preferred would receive $19 per share (75.6% of $25 par value) while the FNMA common shares would receive $0. At 15X, the junior preferred would receive $25 and the common $7.15.