Thumbs Up For Brookings Institute Housing Reform Plan (OTCMKTS:FMCC)

Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) continue to retain earnings well into the Biden administration’s picking of its FHFA director Sandra Thompson who is still pending Senate confirmation. Prior GSE executives are dancing around the recap and release fire like tribal Indians during a ritual fire dance to the gods. Brookings Institute is on deck to explain to the world how best to accomplish the most effective housing reform and Janet Yellen was at Brookings. That’s relevant because she’s in the driver’s seat for monetizing Treasury’s equity stake that ceased paying cash dividends in September 2019.

Investment Thesis

Fannie and Freddie continue to retain earnings on their path towards exiting conservatorship. Their balance sheets prevent them from raising new money because Treasury currently blocks everything with its insurmountable SPSPA that’s terms make the capital structures uninvestable. People seem to want to suspend belief and think that even though the current administration is maneuvering for a restructuring that somehow it won’t pull the lever to execute it when it benefits substantially from doing so. My bet is that the restructuring results in the liquidation preference of the SPSPA being resolved either through write-down or more likely conversion. As such, I see commons as more of a gamble on the government deciding to be fair when I am not sure there is a legal avenue forcing them to be fair. The preferred, however, I think get par or more and some of the preferred currently trade at less than 10 cents on the dollar. In a restructuring that could take place later this year, X10 is not bad.

Prior GSE Executives Tribal Dance

Two GSE executives seem to think that the current administration will do everything to prepare itself to restructure its equity but not actually restructure. To me this sounds like a tribal dance around a fire where the fire is restructuring in an effort to enable the GSEs to access capital markets to raise money. Two prior directors seem to dance around this like the current administration will do everything to set it up and will go infinitesimally near it but won’t touch it. Prior CEO of Freddie Mac Don Layton wrote that GSE reform was basically dead outside of retaining earnings and FHFA making limited changes to its regulatory capital requirement:

To conclude, GSE reform is not dead, but aside from (i) the two companies retaining earnings to build capital, and (ii) the FHFA making limited changes to the regulatory capital requirement, it is very much in suspended animation.

Mr. Layton points out that this approach survived all other bolder approaches:

Today, this utility-style GSE reform is the only major idea still around with broad support. Interestingly, it did not emanate from any of the sources of earlier big and bold proposals, but out of the careful, years-long work of reforming the GSEs inside conservatorship…

What’s hilarious to me is Mr. Layton pretends that the restructuring here is so complicated that it would nearly be too tough to figure out:

Ultra-complex mechanics need to be developed and implemented for each GSE to restructure the ownership of its equity.

Don, Moelis put together a plan that accomplishes this for you to review. Also note that Houlihan Lokey, JP Morgan and Morgan Stanley are more than capable at coming up with restructuring options and that these sorts of problems can be solved in less than an hour by anyone who has restructuring experience. Complex? Yes. That said, I imagine a lot of this work was already researched out by prior Treasury’s Mnuchin and can probably be unearthed from somewhere and revisited.

Prior CFO of Fannie Mae Timothy J. Howard thinks the Biden administration needs a legal catalyst to move on restructuring (emphasis added):

As I noted in an earlier comment, my hope is that the motions to dismiss and trials in Fairholme, Collins and (eventually) the Court of Federal Claims will serve as a catalyst to shift the dialogue about Fannie and Freddie’s futures from fiction to fact, and this is in turn will convince some high-level person or group of people in the Biden administration to chart a course for the companies’ exits from conservatorship that benefits all stakeholders—the government, existing and new shareholders, and homebuyers—and not just the banks. Otherwise, I’m afraid Layton will be right: Fannie and Freddie will remain in “suspended animation” indefinitely. The banks are very happy with the status quo.

Mr. Howard thinks that the Biden team isn’t going to take restructuring action:

I don’t see any evidence of the Biden economic team deviating from the course they’re on. The banks are happy with it, and there is no pressure coming from anywhere else to change it.

Mr. Howard characterizes the current administration’s perspective as fiction based:

This is the dilemma I keep writing about. FHFA and Treasury are making policy based on fictionalized versions of Fannie and Freddie’s business and risks, and now they must deal with the consequences of those policies in the world of fact.

So you have two prior GSE executives that think FHFA and Treasury are putting up ECRFs and forcing Fannie and Freddie to submit capital plans with no real intention of moving on them. It’s hard sometimes to see the forest when you’re lost in the trees. Once you get all the prerequisites complete for the restructuring to raise capital — there’s no good reason that I’ve heard of for maintaining the status quo and doing nothing when the administration has every incentive to ring the register, not to mention that we are going to see the legal arguments get hotter in the coming months as discovery should bring forth material statements into Lamberth’s court which is heading to trial this summer. Surely people in the current administration would want to prevent some of those subsequently produced but still unseen documents from being brought forward in a court of law.

Fannie Mae Earnings Call touches On Capital Plans

During an earnings call with reporters before the opening bell, new Chief Financial Officer Chryssa Halley noted:

Though we recognized strong net income last year, we remain significantly undercapitalized.

In addition, Chryssa Halley said Fannie Mae will begin detailing capital amounts under the ERCF in Q1:

It’s important to note that the enterprise regulatory capital framework requires substantially higher levels of capital than our statutory minimum capital. Further, our efforts to build sufficient capital to meet our requirements can be significantly affected by growth in our Book of Business, which can drive increases in our required capital that offset or even outpace future increases in our available capital. We will begin reporting capital amounts as determined under the enterprise regulatory capital framework in our Q1 2022 results.

This implies that the capital rule will be finalized by then, so that’s interesting as there appears to be some coordination going on behind the scenes between FHFA and Fannie Mae at the very least.

May 20th – Capital Plans Due To FHFA

According to the Enterprise Capital Planning Proposed rule:

Under the proposal, the Enterprises would need to submit their capital plans to FHFA by May 20, the same date that the DFAST results are due to the Agency.

This rule is around helping Fannie and Freddie raise capital:

The capital plans will allow the Enterprises to identify the amount of capital they need to raise to close the gap with the ERCF, and to consider the timing of when to raise capital, and what types of capital to raise.

Raising capital is impossible with the current SPSPA the way that it is so presumably these plans will have to resolve this blocker.

Brookings Institute – The Path Forward For Housing Finance

Michael Calhoun will present the path forward for housing finance reform on February 23. In the past he has detailed his thoughts that Treasury should monetize its investment to help fund affordable housing and racial equity programs:

As part of the support of the GSEs in 2008, the government received shares of preferred stock and warrants for 79.9% of their common stock. The value of these stock interests depends on several variables, including the terms and timing of recapitalization and release from conservatorship, but they are significant assets. The value of the GSE preferred stock and warrants should be used for affordable housing and racial equity programs…

I expect that this Brookings institute presentation will illustrate how the government’s equity stake ($100b) in the GSEs can be used to accomplish its housing objectives when Congress is struggling to pass BBB:

These initiatives can be accomplished via administrative reform.

Senate Banking Committee Shenanigans

Tuesday February 15, Senator Brown and all the Democrats in the Senate Banking Committee unofficially voted Yes on Sandra Thompson’s FHFA nomination. All the Senate Banking Committee Republicans were not present as a means to block the official vote from happening to slow down the process for the Fed nominees. WSJ’s Andrew Ackerman tweeted:

Next Banking Committee hearing is Thursday. Do Republicans just not attend? Or walk out together if Sen Brown declares an executive session to vote out Fed noms?

As such, it would appear that the Sandra Thompson nomination is still stuck in committee. I wonder how long Senate Banking Committee Republicans will boycott committee votes? One alternative is for the Democrats to change the rules of the Senate to allow nominees with majority support to get a vote on the floor and another is to separate Sandra Thompson’s committee vote from the Fed nominees vote.

Summary and Conclusion

FHFA itself cannot move forward with restructuring Fannie and Freddie’s balance sheet. That work involves Treasury, which so far has been silent on the issue in its official capacity. FHFA is slated to finalize the capital rule in the next month and a half. Then Fannie and Freddie will have to submit its complete capital plan to FHFA by May 20. It’s hard to see why the administration would be moving forward with these steps if it wasn’t going to pounce on them and restructure Fannie and Freddie so that they could become adequately capitalized while also serving as a landmark win for the Biden administration. Preferred trade at a fraction of par value and have contract rights that would need to be honored in a restructuring in order to moot the pending litigation.