Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) are two companies that are in conservatorship and until last year, gave all of their money during conservatorship to the government. Last year, Mark Calabria became head of the Federal Housing Finance Agency, which regulates Fannie and Freddie. He was chosen to lead the agency because he wrote a white paper saying that prior agency actions violate HERA, which is the body of law that determines what actions can be taken during the conservatorships of Fannie Mae and Freddie Mac.

Investment Thesis

Elections are over. Now, FHFA and Treasury can move forward with the heavy lifting to get Fannie and Freddie out of conservatorship without impacting the election. Before Trump was even President of the United States, his Treasury Secretary nominee Steven T. Mnuchin said he was going to get Fannie and Freddie out of conservatorship. The comment period for the capital rule is over and so now the capital rule can be finalized and its finalization is the lynchpin that sets off the chain of mandatory FHFA actions that result in Fannie and Freddie eventually exiting conservatorship pending Mnuchin PSPA amendment. Preferreds have contract rights that have been violated and must be settled by conversion terms and no capital can be raised until the government restructures its equity position. Currently, the government has claim to everything leaving nothing for anyone else and this makes it impossible to attract capital. With the capital rule finalized, the lynchpin is pulled and the dominoes that have been stacked since Mark Calabria became director at FHFA designed to end the conservatorship will start falling and by inauguration Fannie and Freddie will be on an irreversible path out of conservatorship. Commons are worth $4-7. Preferred are worth 80-100% of par and are trading at about 30% of par currently. As such, the returns between the two classes of securities roughly seem equivalent. Liquidity has a premium and people I speak to think that with history as a guide, commons will be the first of the two to surge in a big way.

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The History Of The Capital Rule

Prior FHFA director Melvin Watt designed a proposed rule but for whatever reason, it didn’t go anywhere. Mark Calabria re-proposed the rule earlier this year. This rule was followed by Fannie and Freddie hiring financial advisors to underwrite the equity offerings that would allow the companies to achieve the levels of capital contemplated by whatever rule is finalized. FHFA recently reaffirmed its commitment to ending the conservatorships regardless of who the next president is:

“Since Director Calabria began his tenure in April 2019, FHFA has worked as quickly as possible to fulfill our statutory mandate of responsibly ending the Enterprises’ conservatorships,” a spokesperson from the FHFA told HousingWire.

Prior to Calabria leading FHFA, the push wasn’t to follow the law and release Fannie and Freddie from conservatorship. The push was to maintain government control over Fannie and Freddie and take their money into the government to prevent them from recapitalizing and exiting conservatorship.

The amount of capital that Fannie and Freddie will be forced to hold under this new rule as proposed will turn them into utilities. I don’t expect the final rule to change much from what is proposed. This, combined with an explicit limited government backstop, will ensure that during any future crisis the price of agency mortgage-backed securities will be stable and will not collapse. This fear was the reason that Fannie and Freddie were placed into conservatorship to begin with. Mark Calabria notes that the lack of capital is the reason they were placed into conservatorship and that having enough capital is going to be the reason they exit. The capital rule that will be finalized effectively is set to be the maximum amount of capital that the companies can even raise, and this is after roughly doubling their guarantee fees throughout conservatorship. In retrospect, this largely seems to be the purpose of conservatorship, to shore up the entire financial system, specifically because Fannie and Freddie play such a large part and during times of crisis we need to be able to rely on their guarantees.

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Okay, So Then What?

Once the capital rule is finalized at FHFA, the federal agency impeding GSE reform shifts from FHFA to Treasury. The companies will remain unattractive to capital markets until the government’s equity stake is restructured. As such, the only risk to this investment is that Steven Mnuchin isn’t able to get the PSPA amendment done in time. There is no risk from Congress.

After Fannie and Freddie submit capital restoration plans to FHFA with the help of their underwriters, FHFA will approve the capital restoration plans. FHFA will release Fannie and Freddie from conservatorship under consent decree and they will relist on the NYSE and prepare for equity offerings mid-2021.

Summary and Conclusion

I currently only own preferred shares of Fannie Mae and Freddie Mac but may pick up some common shares the next two weeks as a short-term trading opportunity. Contract claims in Judge Lamberth’s court will drive conversion terms as they are worth 150% of par.

After years of being involved in this, now all the pieces are in place and the finalization of the capital rule is the lynchpin that blasts Fannie and Freddie into a future where they are no longer in conservatorship. They are going to be overcapitalized utilities and are set to run the largest equity offering in history next summer. Owning a junior preferred is like owning pre-IPO equity in what is set to be a blockbuster oversubscribed IPO. I think the capital rule gets finalized this upcoming week because there are mandatory time frames with respect to the Capital Restoration Plans that need to be processed before inauguration if Biden wins the election, which FHFA seems to be contemplating.

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Disclosure: I am/we are long FNMAP,FMCCH,FMCCI,FMCCL,FMCCN,FMCCG,FMCCM,FMCCS,FMCKP,FNMFO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.



Via SeekingAlpha.com