Carney: Why Fannie and Freddie Shareholders May Get Wiped Out in a Recap

WASHINGTON, DC - SEPTEMBER 10: Federal Housing Finance Agency Director Mark Calabria testifies during a Senate Banking, Housing, and Urban Affairs Committee hearing on September 10, 2019 in Washington, DC. Trump administration officials were testifying before the committee in support of a report released last week calling for the privatization …
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Shares of Fannie Mae and Freddie Mac crashed on Wednesday after their regulator said the Trump administration stood willing to wipe out shareholders if needed to put the company back into private hands.

“If the circumstances present itself to where we have to wipe out the shareholders, we will,” Federal Housing Finance Agency director Mark Calabria said during a hearing before the House Financial Service Committee Tuesday.

Shares fell immediately following the comments. On Wednesday, Fannie shares fell by 9.2 percent and Freddie shares fell by 9.3 percent. Compared with its recent high in September, Fannie shares are down 27 percent.

Calabria’s comments caught many shareholders off-guard because he has long been looked at as an ally, chiefly because he has said he wants to return the companies to private control and co-authored a white paper arguing that their long stay in conservatorship is not in keeping with the 2008 law that empowered the FHFA to take them over.

The Trump administration has broken with the Obama administration’s policy, and the proposals of many lawmakers over several years, that assumed the companies would eventually be wound down, phased out, replaced by new market mechanics or private-public partnerships, or broken up. Even before President Donald Trump took office, then-Treasury Secretary-to-be Steven Mnuchin said that privatizing Fannie and Freddie was a top administration priority.

That was a welcome change to shareholders, many of whom had purchased shares of the companies in the belief that eventually they would return to private control. Many investors, including some famous fund managers, have battled the government for years seeking to pry their profits from the hands of the U.S. Treasury. These efforts have largely met with failure in federal courts, although a federal appeals court based in New Orleans recently dealt them a significant victory.

Calabria expressing a willingness to “wipe out” existing shareholders has shaken the newfound confidence that had seen shares quadruple in value this year.

That confidence looks misplaced. The FHFA said last year the two companies would need to around $180 billion of combined capital to be considered well-capitalized, although the agency has yet to finalize the capital requirements. Currently, Fannie has $6.4 billion in capital and Freddie has $4.8 billion. That leaves a $167 billion capital gap, nearly seven times their combined income last year.

The Trump administration has said it is exploring the possibility of closing that capital gap by going to public securities markets. But it is unclear how much capital could be raised. The largest initial public offering this year raised $8.1 billion for Uber. The largest IPO in history, Alibaba’s 2014 offering, raised around $25 billion.

Fannie and Freddie have incredibly complex equity structures. Fannie has common shares worth a total of $3.4 billion. The government has a contractual right to exercise warrants to 79.9 percent of the common equity, which at current the current valuation would be equal to around $13.6 billion. Each company has tens of billions of dollars of junior preferred which trade well-below face value now because the company has paid out dividends on them for over a decade and is barred from doing so without the consent of the Treasury Department.

In addition, the U.S. Treasury holds senior preferred shares that currently require the companies to pay nearly all of their positive net worth above an agreed upon amount of retained capital to the government’s coffers. In exchange for this so-called “net worth sweep,” the government gave up on an earlier right to a 10 percent annual dividend that was due even if the companies did not earn enough to pay it. A few years ago, the net worth sweep meant the government received far more than it would have under the 10 percent deal. Now it typically means the government receives billions of dollars less.

Then there is the government’s ongoing promise to supply them with new capital if they run into financial trouble–a promise that everyone agrees is absolutely vital to their ongoing ability to sell guaranteed mortgage bonds. The companies have never paid the commitment fee on this facility called for by their bailout agreement.

Finally, there is the special relationship the companies have with the Federal Reserve. The Fed has acquired hundreds of billions of dollars of their bonds since the financial crisis, making the central bank the biggest holder of their securities. This makes them unique and distinctly unprivate. Apart from Treasury bonds and the bonds of Ginnie Mae, a purely government entity, only Fannie and Freddie have the Fed as a customer for their product. In many years, the Fed has bought more Fannie and Freddie bonds than they have issued, highlighting just how significant these operations are for the companies.

Any transaction to take the companies private would require dealing with each of these pieces.

Any new equity issuance would exist the outstanding common shares, perhaps even the government’s yet unborn 80 percent stake. Raising enough capital to recapitalize the companies might be difficult if the new equity is on par with the current equity. New investors may press for the new shares to be subordinated or crammed down.

The Fed purchases would likely have to be phased out, which would test whether the market has enough appetite to absorb all of their issuances. It might also put unwelcome pressure on Treasury yields as the Fed would likely be forced to replace Fannie and Freddie paper with government bonds as the mortgage-backed securities rolled off its balance sheet.

Fannie and Freddie would have to begin paying for the ongoing backstop from Treasury, leaving less capital to meet FHFA requirements and ultimately less profit to entice new shareholders.

Most importantly, the senior preferred shares would need to be extinguished or severely modified. Obviously, so long as the government is entitled to all the profits, investors will stay away. Some have argued that the government could simply cancel the senior preferred shares, perhaps by deeming them repaid in full. Although the companies have now paid more in dividends than they received in the bailout, that could cause a political firestorm because the government would be essentially giving away an asset worth close to $315 billion for nothing.

While it is true that the government would then be able to exercise its warrants, these only give it 80 percent of the common and would subordinate the government’s interest to the junior preferred. In other words, the government would still be giving up tens of billions of dollars of value in exchange for nothing.

Making the politics even more difficult, this giveaway would result in a huge windfall for the current shareholders. The largest holders of both the common and the junior preferred are hedge funds run by billionaires. It seems unlikely that the Trump administration would want to walk through this political minefield while taking fire from populist rivals like Sens. Bernie Sanders and Elizabeth Warren.

The $315 billion figure for the value of the senior preferred shares comes from very simple equity arithmetic. It is a little more than 13 times last year’s earnings, a bit higher than the price-to-earnings ratio of J.P. Morgan Chase.

But that $315 billion political landmine could also become a bridge to taking the companies private. Instead of simply canceling the senior preferred shares, the government could slowly auction them off. This would provide the government a solid return on its assets, allow for capital to be raised over time rather than in a one-shot IPO, and allow for the price to adjust as market conditions change. It would also give the mortgage market time to adjust to the slow-motion privatization of the companies.

New investors would be asked to step into the place of the U.S. government as the holders of shares that are entitled to all of the profits of the companies, something that would likely make them very attractive to investors. The sales of senior preferred would not themselves recapitalize the companies but they would transfer control and ownership while retained earnings built up the required capital buffer.

This would wipe out the existing common shares and perhaps the existing junior preferred shares. Their current total subordination would become permanent and lasting.  No doubt some shareholders would challenge the move in court but after a long string of legal victories defending the net worth sweep, the threat of further litigation is unlikely to deter the government.

Shareholders assumed that Calabria’s drive to privatize Fannie and Freddie meant he was on their side. This may prove to be a costly error.

 

 

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