Between Fairholme’s back-up-the-truck in GSE Preferreds (demanding his fair share of the dividend), the crazy oscillations in the common stock of FNMA, and the ongoing debacle of what to with the government’s implicit ownership of the US mortgage business, tonight’s news from Bloomberg – that a bipartisan group of U.S. senators is putting the final touches on a plan to liquidate Fannie Mae and Freddie Mac (FMCC) and replace them with a government reinsurer of mortgage securities behind private capital – is hardly surprising. Details are few and far between except to note that the proposed legislation, which could be introduced this month, would require private financiers to take a first-loss position. The new entity, to be named the Federal Mortgage Insurance Corp (or FEDMAGIC), would seek private financing to continue existing efforts to help small lenders issue securities. The ‘old entity’ – where existing equity and debtholders would seemingly reside would contain the existing MBS portfolio and be put in run-down mode. The following from BofAML provides a possible primer and pitfalls (we think the endgame is very unlikely to be positive for holders of the capital structure below subordinated debt) of this approach.
From Bloomberg we know:
- The GSEs will be liquidated within five years
- Private financiers will fund the newco, taking a first loss position adequate to cover price declines as steep as those seen during the recession
- Proceeds from the liquidation would first go to the US government as senior preferred shareholder (and lastly to holders of the common stock).
- The new entity will be called the Federal Mortgage Insurance Corp (FEDMAGIC)
That is all we know for sure. The following from BofAML provides the best primer for the possibilities that we have seen (beware the details are not particularly positive)…
What a privatization plan would look like
With a stroke of the pen, the government can choose to direct some or all of GSE profits away from taxpayers and back into Fannie and Freddie. This would be a first step toward recapitalizing Fannie/Freddie with the ultimate intention of selling them, as Millstein and Swagel have proposed. Instead of the current government backstop capital lines (117bn for Fannie and 140bn for Freddie) provided by the Preferred Stock Purchase Agreements, an explicit government guarantee would be purchased by Fannie/Freddie at fair market value. The government guarantee would back the MBS, not the equity, and probably not the debt, which would be spun off into a company with a mortgage portfolio that is federally managed and wound down. This government guarantee would be available for purchase by other private competitors – assuming they met strict standards – at a cost that would be a function of the riskiness of the loans and the company itself.
The proceeds of selling the recapitalized Fannie/Freddie would provide the return on taxpayer funds that policy makers have demanded, and would also accomplish the consensus policy goal of privatizing most of mortgage finance. The resulting privatized companies would compete with other private companies as issuers of MBS securities with access to government reinsurance that kicks in after private capital is wiped out.
Although we can envision such a possible path for Fannie and Freddie, we think it is highly unlikely, and we discuss why below. If the plan were to be agreed upon by Congress and put into motion, however, it’s still not clear that existing equity holders would benefit. That would depend on how the deal is structured. And given the history here and the political pressures involved, we think it would be less shareholder friendly than other such deals.
The biggest problem with privatization is privatization
One of the stickiest points of such a plan is that debt holders would be swept off into a new company that is winding down. Debt outstanding is currently about $1.1 trillion. As the current government capital backstop would be replaced with a purchased reinsurance agreement on the MBS, there would be no capital available to protect debt holders. Explicitly guaranteeing the outstanding debt would add substantially to the federal debt burden, and given historical precedent, we think it’s not an option. This is why the government designed the capital backstop plan rather than taking the companies onto the government balance sheet. Since the conservatorship began and the Preferred Stock Purchase Plan was put into place in 2008, the government has consistently stood by its promise to protect all obligations of the GSEs, today and in the future. As the Treasury department wrote on September 11 2008 in HP-1131:
The [Preferred Stock Purchase] agreement is designed to prohibit any amendment that would decrease the amount of Treasury’s funding commitment or add funding conditions that would adversely affect debt or mortgage-backed securities holders. Some may speculate that a future Congress could pass a law that would abrogate the agreement. But any such law would be inconsistent with the U.S. government’s longstanding history of honoring its obligations. Such action would also give rise to government liability to parties suing to enforce their rights under the agreement. The U.S. Government stands behind the preferred stock purchase agreements and will honor its commitments. Contracts are respected in this country as a fundamental part of rule of law.
In other words, privatization could be a big legal mess for the Treasury department. Even the MBS reinsurance guarantee envisioned in the privatization model would likely be more limited than what the Preferred Stock Purchase Agreement provides. Depending on exactly how the MBS backstop would work, under what conditions and with what limitations it would apply, it could render both MBS holders and debt holders in a vulnerable position.
In addition to what could be substantial disorder in agency financial markets, it’s also not clear that anyone would want to buy the GSEs from the Treasury department after they were deemed sufficiently capitalized. This is a matter of the future profitability of the GSEs: how high a fee the GSEs could charge in the future, and what volume of MBS securities they could produce. The Treasury would be forgoing profits (earnings sweeps) today in hopes of gaining something later. Our sense is that within the context of a private mortgage finance system, volumes of MBS production would be much lower overall than they are today, and fee pricing would be so competitive that it would likely require the same sort of ultra-specialization that we see in most industries today.
The idea of Fannie/Freddie maintaining a monopoly on securitizing and guaranteeing all conforming loans seems to be very wishful thinking in such a competitive environment, especially if the machinery of securitization is separated out into the Common Securitization Platform as the FHFA is currently doing. It is not clear what advantage Fannie and Freddie would have in such an environment, where loan data is available for all insurance companies to price risk competitively, and the profitable and complex portfolio management businesses are stripped away.
The other problem is FHFA doesn’t seem to like it
In addition to these issues that make us negative on buying preferred or common equity today, there is the problem that the FHFA is now leaning away from the privatization model. The most recent discussion of the future of GSE reform coming from FHFA, which is arguably the most important voice on the matter, is that there are two main paths to choose from: one is the issuer model, which encompasses any system of regulated private entities who issue and insure MBS (like Fannie and Freddie) with purchased government backstop insurance, and the other is the security model, which would be a world of structural subordination in private-label securities market in which buyers of securities are essentially the capital providers.
In the security model the buyers of lower-rated tranches would essentially be the capital providers, and no large-scale government re-insurance backstop would be necessary except for special crisis conditions where either Ginnie Mae or FHLB or some other special government entity could become activated. The FHFA has not made a final decision. Instead it is leading the discussion. But it is clear that it favors the security model, because in a nutshell, the issuer model will always be fraught with the sticky problem of how to conduct a private enterprise with an integral government component.
We are still far from knowing the future of Fannie and Freddie, and we expect the common and preferred stock to rise when Freddie announces its $20 or $30 billion of dividend payments in the next quarter or two.
But we think the endgame is very unlikely to be positive for holders of the capital structure below subordinated debt.
In our view it is all a matter of timing, and our recommendation would be keep the trade horizons very short and not hope for the best.
Putting the Bloomberg news and the BofAML ‘strawman’ together, it seems like:
- current equity and debtholders remain with BADFANNIE along with the existing MBS portfolio in wind-down liquidation mode… and
- newco FEDMAGIC will be created – via new private financing – that explicitly buys the government’s guarantee ‘rights’. This fee pays back the government, but
- there are many hurdles yet