Fannie Mae: The Road to Recapitalization
Featuring Gaby Heffesse
Published on: September 12th, 2019 • Duration: 19 minutesGaby Heffesse, CFA, chief operating officer at ACG Analytics, provides an update to her winning trades on Fannie Mae. In this interview with Alex Rosenberg, Heffesse breaks down the Treasury’s plan for recapitalization, highlights the significance of the recent court rulings, and reviews how much upside she sees for both common and preferred shares. Filmed on September 10, 2019.
ALEX ROSENBERG: Welcome to Trade Ideas. I'm Alex Rosenberg, sitting down with Gaby Heffesse, Chief Operating Officer ACG Analytics. Gaby, thank you for joining us once again.
GABY HEFFESSE: It's a pleasure to be back.
ALEX ROSENBERG: We're talking about Fannie and Freddie today. Now, you came on in December and recommended the common stock of Fannie Mae and then in February, we followed up, it had been a very good trade already and you recommended the preferred shares. Now, you're back once again, a lot has happened with the whole situation this week, but even over the past few months. If you could give us a brief rundown of what's happened since February, and why it matters for the common and for the preferred.
GABY HEFFESSE: Before we get into the split of the common and the preferred, let's just think about them as one thing, because as I watch the videos last night, as you recommended, I remember what I said. As I said, it's a story that if it happens, both should do well, and if it doesn't, it will negatively impact both of them. But since February, we had a whirlwind of events happen starting with a presidential memo that came out in late March that basically asked Treasury FHFA and HUD to put together, to answer list of questions framed in what could be done legislatively and what can be done administratively to take both entities out of conservatorship.
That was a huge day, because all of a sudden, it was out of speculation of what Calabria, the director of FHFA, wants to do, out of the Secretary of Treasury Steven Mnuchin, and what he wants to do, Mick Mulvaney, the Chief of Staff, of people who have a ton of experience in this issue, Larry Kudlow, and it put it under the docket of the President saying, "I want these to exit conservatorships. Let me know what needs to happen and what we need to do and how we can do this and what it takes."
After that, we started getting just a series for two months, three months of quotes from different people saying things like we intend to privatized them. We want to recapitalize them and release them. We want private capital to take first loss. Even Craig Phillips, who's no longer there, at one point said, we think the taxpayer has been paid back, which is a very important part of this story.
That was in March, we thought it would be a very busy summer. We thought that over the summer, starting in late June, that we would see this plan, the response to the memo and we thought that the Fifth Circuit decision that I'd spoke in February would come out around August. It was a quiet summer and in that time period, we saw the prices go down a little bit because there was this perceived timing issue coming up on the elections, which we could also cover.
Then it all happened last week. We saw the plan come out on Thursday, which some people took it disappointing. I personally think it's a very positive step. On Friday, we had a surprise Fifth Circuit decision, which we could also talk about. On Monday morning, Mnuchin went on Fox, he spoke a little bit more. Today, it's Tuesday, we had a hearing from the Senate Banking Committee. All of these things have led to almost a new trade. We're at a new place than we were at this time last week.
ALEX ROSENBERG: Let's talk about the court case briefly, because I found this a bit confusing, not following the situation as closely as you do, but basically the headline today, on Tuesday, is that Mnuchin is thinking of appealing this court decision and that seemed to be what, in fact, affect the shares to the downside today. It seemed to me that the Mnuchin has been wanting more profits to go to the holders of the common stocks so I'm confused about what Mnuchin's beef is with the court here.
GABY HEFFESSE: Well, it's really important to think about this as two separate cases. The first case, which was the decision stayed is that the director of the FHFA who could only be fired for cause before is now fireable, and that prospectively, they will serve at the pleasure of the President. That is a positive, because it put some urgency, like Mark Calabria only has around a third of his term confirmed and if a Democrat wins, you can argue that he probably will be out of a job. He has a very limited window of time to do enough progress on what he wants to do here to have it be irreversible.
That's not really what the people are talking about. What they're talking about is the second part, which is saying they remanded the decision on the APA back to the lower court with a strong suggestion that the net worth sweep, which is sweeping all the earnings to the Treasury, not letting the companies retain any capital, is now unconstitutional, or they sent it back. There's three ways that that could play out.
The first one is it could go to the lower court, have a trial that'll last a year, that'll get appealed, that's another year, and then, essentially to the Supreme Court, that's a third year, and the entire Trump administration will miss their chance to do anything, because you can't really raise capital while this litigation is outstanding.
The second option is that the Solicitor General suggests that this goes straight to the Supreme Court instead of the lower court and then you get a decision in June of this year, which is also not great, because again, you can't really start the capital raise for outside capital until you have a decision there because you just don't know what's legal in the capital structure. You don't know the preference of the senior preferred until this is ruled on and what they can do. They can't really start their plans until June, or you could settle the litigation, which is looking like the more likely outcome and the investors, the shareholders now have a much better position because they won.
ALEX ROSENBERG: They won in what respect?
GABY HEFFESSE: With the net worth sweep being unconstitutional. They're going to settle in with their negotiating position now, what they want is for the net worth sweep to end and for the senior preferred shares to be deemed paid back. That actually aligns pretty nicely with what the administration wants to do, because they've said that they intend to end the net worth sweep sooner rather than later. We've had some hints of them saying that the taxpayer has been compensated for the $190 billion. There are about $30 billion over a 10% dividends.
They've collected over $300 billion off of $190 billion so they've gotten the 10% that was required in the PSPAs, and then some, so there's plenty of room. There's some questions about what you can do with the overpayment and how much the investors will push to have that be put down for a commitment fee, or maybe the start of capital, though, I don't think that will happen. If they get the senior preferred runoff and the net worth sweep to permanently stop, then it's great.
There's also three other really important things about this court case. A, the fact that the administration can go and say we had to negotiate with investors, it's amazing political cover. B, if you stop the sweep and amend the PSPAs on a settlement in the judicial branch, it's not reversible in the same way. If you put a fourth amendment into the PSPA, who knows if you have another administration and they just add amendments, change it back.
There are some permanent things but if it's done by a court in a settlement, you can't really go back. Also, no matter what they want to do with this in your preferred, it gives them more flexibility on what they do, because in a settlement negotiation, it's just very different than having to go back and have all the contracts revisited.
ALEX ROSENBERG: Given your understanding of the situation now and the stronger place that investors find themselves in, what would you tell people in terms of the common shares and the junior preferred? We've had quite a substantial move over the past 6 months or so, do you still see a lot more upside for both of them, or is the trade more specific than that now?
GABY HEFFESSE: No, there's definitely upside. It's trading at a higher level, because the trade is different, the risk is different. We've had more concrete things come out. We should probably cover the plan. Let's say they intend to go down this path and sure, there's some timing questions, do they get an IPO done in time next year? How big is the IPO? We have to see a capital rule. We don't know how much capital they need as a minimum to really exit from conservatorship or how much they want the capital buffer to be.
There are still a lot of variables. What we do know is that they intend to go this direction and as long as you go down the path of retaining capital, amending the PSPA, and having plans to recapitalize them, it's more a question of how long it takes for it to get to this amount, but really, I would say that eventually, the common shares could go anywhere between $6 and $14, they're still below $4, and the prefs could definitely go up to par, which is $25. If they do an exchange offering, which is also mentioned in the plan, they could go above that as well.
ALEX ROSENBERG: That's the upside, how does the downside risk differ between the common and the prefs?
GABY HEFFESSE: There's the timing risk on both. Let's say we do have an IPO next year, that's actually probably worse for the common because it's another step where they might get diluted. The more capital that the entities need, the higher the number, the worse it is for the common, not so much the case for the prefs. The other risk that the common has that the prefs does not have is what they do with the senior preferred shares.
Now, I don't think that this will happen but it is an option that they have and it is something that is also in the plan as an option, that instead of saying the senior preferred shares are paid back, they convert them into common and dilute it. The government has incentive to make the common worth a lot because they own 79.9% of them in warrants and that's estimated to be worth $100 billion to $150 billion on top of the $100-change billion they already made on the first $190 billion. It's unlikely that they do that, but if they do want to have the story of, "Hey, we crushed some shareholders," it's the easiest way to do it. Again, I don't think it'll happen, but it is an added risk.
ALEX ROSENBERG: Finally, what have we learned over the past few weeks about the long term future of these, like very strange organization? The whole thing is so weird, because they're government, they're private to public, no one knows if they should be private or public or to what extent they should be which, to what extent they're doing a social good, or maybe a social bad, what do you think is the long term future of these organizations?
GABY HEFFESSE: Look, I think that they might operate under a utility model but before we go into that, I think I brought you the plan released last week, because there are a few things. This is basically the roadmap of what the administration wants to do. There's three things in here, which I marked, so that you can have them, that stood out to me as very important and very bullish. The first one is on the third page, and it says, "At the same time, reform should not and need not wait on Congress."
How does that matter? We're not waiting on legislation for an explicit backstop. They said there's other options to recapitalize them without Congress. We could do it all administratively. It hints that that's what they intend to do. On that, today, there was a hearing with the Senate Banking Committee and all the Republicans basically said-- particularly, Senator Kennedy had a funding quote on it, said, "We can try to do something in this committee but we probably won't get it done so we support you just putting the pedal to the metal and going ahead with it."
The second part that's worth reading, and I don't have to flip to that now is pages 28, and 29, which are about what they need to do to exit conservatorship and what they think on recapitalization. I think that's really the most important thing in it that you need to know. Particularly one thing to consider in the recapitalization part is they basically laid out all the options, there's no reason for them to tell us exactly what they intend to do right now. It doesn't help them in negotiations with the Fifth Circuit but if you read between the lines, you can figure out what it is that they intend to do.
Lastly, my favorite part, the appendix. The appendix is the answer to your question. The appendix basically says the roadmap of what they want to do. What you do is you cross out every line item that is legislative, because none of that will happen. Then you go into the administrative goals that Treasury recommends, and that's what they're going to do.
There's four things within the administrative goals that are very important that I was happy to see, which is they gave a mandate, it's number 6, 9, 21 and 22. Number 6, 9, 21 and 22. Number six, private capital should take first loss. In order to build a private capital, you can't really screw over previous shareholders, because new shareholders won't believe you when they say that you won't do it again. It is in their best interest to treat the investors fairly. As I mentioned in another part, the market cap is not that big compared to what they need to raise, and the money is there for them. That's it.
Number nine talks about the commitment fee there. The commitment fee is saying we're willing to do this with no explicit government backstop. It's like FDIC, so it's basically a credit line and on whatever the credit line is, you pay maybe 25 basis points every year, which is very little compared to the earnings that they make. That's a great scenario and it's just laid out there. Then 21 and 22, they should to have a recapitalization plan, both Fannie and Freddie should make one.
Then my favorite 22, which has been spoken about a lot in the last two weeks, is that they intend on ending this sweep before they amend the PSPA, so before even making a decision on what you do with the senior preferreds, they want to end this sweep. They're really-- my understanding is that they're trying to do it this month before the payment at the end of this month. Once they start retaining capital and they permanently on this sweep, you've set the wheels in motion and they're going to start building the capital.
Whether you can raise outside capital, or you do it all organically through retained earnings, you have to remember these companies both, they make between $15 billion and $20 billion a year. Today, Mnuchin said something along the lines of thinking in the ballpark of $100 billion of capital. I think it'll be a tiny bit higher than that, but if you think about how many years it takes to get that full capital buffer, even if you don't go out or convert the junior prefs or do a bunch of things that they can do to get up to that number, you'd still get there in a few years.
ALEX ROSENBERG: The first interview we've had with you about this was called, Opportunity in Fannie and Freddie? The second one was called, A New Way to Play Fannie, because it was we're talking about the prefs versus the common. If you had to title this conversation to underline the opportunity here--
GABY HEFFESSE: I got one.
ALEX ROSENBERG: All right, go.
GABY HEFFESSE: The Road to Recapitalization.
ALEX ROSENBERG: I will take that under advisement. Gaby Heffesse of ACG Analytics, thank you for joining us on Trade Ideas.
GABY HEFFESSE: It's always nice to be here.
ALEX ROSENBERG: Gaby thinks Fannie and Freddie are on the road to recapitalization. She thinks Fannie Mae's common stock is worth between $6 and $14 while the junior preferred shares will eventually be worth at least $25.
For Real Vision, I'm Alex Rosenberg.