A dive in the zombie shell of Fannie Mae

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Fannie Mae (FNMA) and Freddie Mac (FMCC) have gotten a lot of attention lately, as a court ruling sent their stocks plummeting.  With this post we aren’t going to dive into the legal mess that is the GSEs, but we’ll take a glance at their structure.

Corporate Structure

Fannie Mae is a government-sponsored entity (GSE) that was placed in conservatorship on 9/6/08 as a result of the financial crisis. Conservatorship is meant to preserve and conserve the assets of the GSE and place the company back in a position of solvency. The Federal Government, specifically the Treasury Department, owns or has rights to 79.9% of the common equity as part of the terms of government bailout.

Moreover, as part of the 2013 (which is the source of a legal battle between Hedge Funds, Investors and the Government) deal struck with Treasury, Fannie Mae cannot retain earnings, cannot pay dividends or capital distributions to anyone except the Treasury Department.

Market Capitalization

Fully diluted, there’s ~5,762,000,000 shares of common stock. That puts the market cap near $10Billion.

Shareholder Equity

Common shareholders do not have meaningful equity at present because of the accumulated deficit, overwhelming dilution and seniority of the Senior Preferred (owned by the government) and Junior Preferred shares, owned by investors.

Book Value

FNMA reports total equity of 6.1 Billion USD. The positive net equity is based on the substantial ($117 Billion USD) investment from the Treasury Department in 1,000,000 shares of Senior Preferred stock.

 

Commentary on five year developments in the balance sheet, sales, cash flow, per share earnings trends.

If not for the substantial government bailout and conservatorship following the financial crisis, Fannie Mae would have ended up in receivership. The Federal Government however chose conservatorship instead of receivership, which would have been more akin to putting it in bankruptcy. The GSEs accumulated such egregious losses that all equity and capital was wiped out. As a result, existing shareholders lost greater than 90% of the value of their equity and only retain some potential claims on a reorganized Fannie Mae that exits conservatorship and satisfies its dividend payment obligations to the Treasury Department.

Losses initially were estimated at over $200 billion, but were nearly 50% of the size. Most of the losses involved marking securities to market, and non cash charges. The GSEs are estimated to have repaid over $180 billion (Fannie and Freddie) thus far in less then 3 years which is giving fodder to Hedge Funds and investors who assert there is no way they could have paid back that cash if they didn’t need it.

Fannie Mae has resumed profitability over the last several years and expects to remain profitable for the foreseeable future. One cannot really doubt this assertion considering their dominant position in the United States mortgage market. However, the corporation is so severely encumbered by the obligations of it’s bailout terms that financial performance is less relevant to common stock shareholders than the conclusion of the conservatorship and reorganization or wind up, as it may be, of Fannie Mae.

 

Details of large or controlling shareholders.

The Treasury Department owns senior preferred shares as well as warrants purchasing 79.9% of FNMA common stock. FNMA has gone from being a government-sponsored entity to an entity that is majority owned by the government.

Common shareholders are at the mercy of the Federal Government in determining the future of Fannie Mae as a going concern, political will, and judgements of the court. One must be confident and comfortable that the government will protect common shareholders if they intend to make a long-term investment in Fannie Mae common or preferred stock. The preferred stock carries a liquidation preference and may be slightly safer then the common but both are binary events with a potential large payout and a potential large loss if things don’t work out.

 An objective hypothesis anticipating several future corporate developments.

  1. The Treasury Department converts the Senior Preferred shares into common shares as part of a liquidation plan. Fannie Mae’s operations are wound up by selling off their portfolio of loans and ending purchase and securitization of mortgage loans. Any leftover cash is distributed first to junior preferred share holders whom have a liquidation preference and then to common shareholders. This scenario is the worst outcome for common shareholders who would likely receive very little return of capital.
  2. Fannie Mae’s operations are wound up as expected but a new government sponsored entity is created to replace the essential services that Fannie Mae provided to the housing finance industry. Existing common shareholders are offered either to swap their equity in Fannie Mae for equity in the new entity, or more likely offered some kind of right to purchase discounted shares in the entity. In this scenario, common stock shareholders will be required to invest additional capital in order to continue as a shareholder or they’ll be able to sell their rights for cash. In such a scenario preferred shareholders would do better then common shareholders.
  3. Due to political inertia and/or lack of political capital in Congress, Fannie Mae continues to exist in a state of conservatorship continuing to function as a key pillar of housing finance and remaining a going concern but siphoning all earnings and cash flow except for working capital needs back to the Treasury Department. In this scenario, Fannie Mae continues to shrink the retained mortgage portfolio to $250 Billion USD by 2018. At that time, Fannie Mae will be small enough to be wound up, broken up or reorganized. However, that leaves three years before shareholders have an idea about the future value of their equity stake in Fannie Mae or whether they will ever see dividends paid to them.

Investor lawsuits will play a large role in the future of the GSEs and could drive wild pricing swings.  Investors argue that the 2013 “net profit sweep” was a violation of the conservatorship of 2009, a violation of US Law, and an unlawful taking of shareholder assets without compensation. Early legal rulings have been mixed with Judge Sweeney at the Federal Court of Appeals level taking a case into discovery and seeming sympathetic to investors while a lower District Court Judge having handed down a ruling siding with the government.

This battle is likely to take time to resolve.

Notes on the balance sheet, cash flow and income statement as well as specific lines to monitor as part of future due diligence

Bottom line is that shareholders are hostage to the Treasury Department and United States Congress as political and economic forces assemble to battle for the future direction of a reformed US housing finance industry. The key point of contention is whether or not government-sponsored entities like Fannie Mae and Freddie Mac will continue to act as buyers and guarantors of mortgages and mortgage backed securities.

As a result of the substantial bailouts needed in 2008 and systemic risks exposed by the financial crisis, it is very unlikely that Fannie Mae will retain the same position that it did before the financial crisis or continues to hold in conservatorship while it’s future position is debated. Expect reform discussions to pick up substantially in 2015. Moreover, expect the common stock to be extremely volatile as market participants seek to price eventual outcomes. Finally, there continues to be substantial litigation over the terms of the Federal bailout. Court decisions, judgments and decrees will also drive valuation adjustments dramatically and at times frantically as new information is priced.

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