Hank P’s “Pinch” – The Fannie/Freddie Story – Bruce Krasting

This is a syndicated repost courtesy of Bruce Krasting. To view original, click here.

Former Treasury Secretary Hank Paulson has been coming out of the closet and doing some talking, He spoke on Bloomberg the other day, (Link). He was asked about the record profit of $17B at Fannie Mae in 2012. He said:

 

“Well, I read the Wall Street Journal and the Washington Post today, and I had to pinch myself. I could hardly believe what I was reading.”

 

It was Paulson who officially put Fannie and Freddie (F/F) into concervatorship. That was four and half long years ago. Paulson made a bunch of critical decisions in those chaotic months. From the very beginning I wondered why he did not take F/F into bankruptcy. It would have been cleaner that way. The Treasury Department had to assume the mortgage debts of F/F. If they had not, the lights would have gone off, and they would still be off today. So that was a no-brainer. But why did Paulson not take the opportunity to blow up the equity in F/F?

Optics, and the realities of the situation probably had some sway in the decision to take F/F into concervatorship, versus a chapter filing. A bankruptcy would have been messy. The courts would have been involved. Lots of lawyers representing 10s of thousand of people who lost money. It would have been a circus.

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Paulson is a smart guy. He must have looked at the $7t of F/F paper and said, “The hit starts at 5%”. In his mind (and many others at the time) the estimated total F/F losses were in the $400-600b range. Hank knew that a number even remotely close to that loss would put the F/F shareholders into the waste bin of the pink sheets. So Hank kept F/F alive. The actual losses were a a more modest $160b.

 

As it turns out, Hank’s decision with F/F is going to cost the government a fair bit of money. In addition, it’s going to gum up the works for an easy transition to some new government owned mortgage finance entity during the remaining Obama years. That reality is going to piss off a whole bunch of liberals in Congress. There is a ton of money to be made or lost in this story. There is the potential for some drama – a Cyprus style raid on wealth is a potential outcome.

 

If there is any value in F/F, it’s in the preferred stock, not the common shares. Some form of restructuring would seem to be the most logical outcome to this thorny problem. If that is the case, then the preferred shareholders will be first in line to get any value that might be left on the F/F carcass. The market is bidding up the old preferreds as if they were gold. I believe they might be the best performing stocks over the past six months.

There are two types of preferreds, $25 and $50 par value. An example of the price action for one of the $50 Preferreds, the Fannie G:

 

fannieg$50

 

Two “bench mark” issues are the $25 par value FNM Preferred S and FNM T. The S’s have had the highest daily turnover, (the volume is still is a trickle compared to listed shares). I follow the “T”s as it has proven to be a price leader. It trades rich to the other pref, and to my eyes, all the other pref (there are ~20 individual issues) chase the move of the preferred T.

 

Note: The “T’s were issued in 2008, just five months before the F/F SHTF. Hank Paulson forced this deal. He insisted that Fannie raise additional equity. The deal was brought to the street by a syndicate lead by Merrill. 92m shares ($2.3B) of swill was pushed out the door. A significant portion of the crap ended up on regional bank’s books. This trash paid one quarterly dividend, and then went deeply into the tank. This was an absolute stinker of a deal. Paulson knew F/F would hit the skids. In my book, Paulson sold this crap to widows and orphans, and he never looked back.

fannieT_edited-1

 

Based on Friday’s close of $4.81, all the other pref stocks are headed higher.

$25pref

 

F/F biggest asset at this point are the prior losses. These show up as deferred tax assets. For a company that has no prospect of future earnings, deferred tax assets have zero value. But for a company like GE, deferred tax assets are kept on the books at 100% of par. If this treatment were permitted for F/F, they would be technically solvent.

The market has established a value for the F/F common and preferred shares of  approximately $5b. The current values of the preferreds are equal to:

- 18% of original par value for the $25 pref and 16% of the $50 pref.

- Approximately 30% of the past due and accrued dividends.

In other words, they’re trading cheap.

 

In theory, (and based on some upside assumptions) F/F could operate for another five years, and they could pay back all of the money that the US Treasury has been forced to provide. If F/F were left alone, the taxpayers would get their money back, plus a very big return. As the government nut gets paid back, the value of the residual public securities should rise. While this would be a very desirable result for shareholders, it would also be a disaster for some politicians. The majority of congress wants to see F/F shut down, and a new government owned operation established.

I see no legal way to achieve the desires of congress. As F/F are profitable today, it will not be easy for them to be dissolved in a way that does not result in some consideration for existing stakeholders. If congress were to try to do that, there would be big court challenges. – I don’t think  it’s possible to tank F/F any longer. If that were to happen, it would be a significant expropriation of private sector wealth – think Cyprus (Cubed).

 

To me, the oddest thing about this story is that it’s the taxpayers that are going to end up paying back the F/F bailout. The deferred tax assets allows F/F to avoid paying any income taxes on their record profits. The pretax = after tax, so F/F are generating huge amounts of cash. They will use the untaxed cash to pay back the Treasury. This outcome was not considered to be even a remote possibility four years ago.

 

This story is far from over. When congress figures out that they are screwed, and F/F are coming back to life, there will be an effort to challenge that outcome. One way to blow up the common and preferreds would be to establish a new  ‘tax’ on F/F. This charge would reflect the fact that F/F benefit from an implied guarantee of their liabilities. While some charge might be justified, this would be done with the sole purpose of destroying the public shareholders. A very hostile thing to do.

 

Notes: I’ve been involved with the busted Pref for years. I’m hanging on to them – I don’t think the story is over. My original investment thinking was not based on a resurgence of F/F, I thought that the pref had to get settled one way or the other. When Hank P. put F/F into concervatorship (versus bankruptcy) the opportunity for some upside presented itself. So thanks Hank!

Investing in busted preferreds that trade in the ‘Pinks’ is very speculative business. Especially when they are “story” stocks. I believe that substantial up-and-down moves will be the norm for the pref stock. There is at least one scenario that leads to a zero value. F/F was never a suitable investment for widows and orphans – it’s much less suitable today. For the average investor, this story is better avoided than played.

 

Snafu

 

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