September 13, 2019

Shares of Fannie Mae and Freddie Mac are up substantially over the past week following a significant court victory last Friday night and subsequent public statements from housing reform leadership regarding the next steps forward in resolving the longest financial conservatorship in history.  As we wrote in July, the resolution investors have been looking for got a huge jolt in March with the memorandum by President Trump seeking plans for ending the decades long conservatorship.  Last week the plans by Treasury and the Department of Housing and Urban Development (HUD) were finally released to the public, and while short on a number of specifics relating to timing, the plans made clear that the administration is focused on ending the conservatorship by bringing in third party capital and it is not going to wait for Congress.

Whether by coincidence or not (we think not), the 5th Circuit Court of Appeals issued its en banc opinion in the Collins vs. Mnuchin case after the market closed last Friday (just a day after the release of the Treasury and HUD plans).  The ruling was a big win for shareholders, and we believe will ultimately lead to a negotiated settlement with investors prior to the 2020 election.  Specifically, the Court remanded the case for further proceedings regarding the 2012 net worth sweep, instructing the district court to decide if issues of fact require a trial or if summary judgement should be granted.  This ruling reversed an earlier ruling from the 5th Circuit dismissing the claim that the Federal Housing Finance Agency (FHFA) exceeded its statutory authority in implementing the net worth sweep. 

A majority of the 5th Circuit also affirmed a previous ruling by the 5th Circuit that the director of Fannie and Freddie, the FHFA, is unconstitutionally structured.  However, rather than invalidate the net worth sweep as the plaintiffs had sought for relief, the Court granted “prospective relief” only.  That is, the remedy is to strike the “for cause” restriction from the statute.  As a result, the director is removable by the President at will and as such it is likely that a Democratic win in the 2020 election would lead to a replacement of the Director of the FHFA.  Given this risk of a limited tenure, we would expect the current Director Mark Calabria to work with a sense of urgency in enacting comprehensive housing reforms.    

In order to accomplish the Administration’s stated goal of ending the conservatorships of Fannie and Freddie, the entities will need upwards of $125 billion in capital compared to the $3 billion they each have today.  An agreement between Treasury and the FHFA is likely to be reached by the end of September which will allow for the entities to retain additional capital, however; at a run rate of $20 billion a year it will take years to retain the required level, and that assumes there isn't an economic downturn along the way.  As a result, the Treasury plan released last week instructed Treasury and FHFA to develop a recapitalization plan for each GSE “as promptly as practicable.”    

The plan contemplates a number of approaches for recapitalizing the GSEs, but ultimately no institutional investor is putting new capital into these entities until the outstanding legal issues with the existing shareholders are resolved.  In addition to the net worth sweep ruling last week by the 5th Circuit in which the plaintiffs are entitled to backward looking relief from Treasury, there are several other cases still pending before the courts, including the breach of implied covenant case (aka the Fairholme case) in which Fannie and Freddie (not Treasury) could be liable for tens of billions in damages. Thus, given legal rulings to date and the timing of future hearings/decisions, Treasury has little option but to eventually settle with current shareholders if it is going to end the conservatorships using outside third party capital as contemplated by the plan and reiterated by Treasury Secretary Mnuchin during his testimony in front of the Senate Banking Committee.      

So, what’s next?  On the legal front, Treasury has up to 90 days to petition the Supreme Court of the United States to hear the Collins case.  Given that the 5th Circuit ruling was not final, it is not certain if the Supreme Court would even take the case at this point in time.  If they did, it is unlikely there would be a ruling before June 2020.  If Treasury instead chooses to defend the remand in district court, it is likely to take up to two years for a final decision when considering the losing side would be likely to appeal.  Regardless of the path, the strongly worded majority opinion of the 5th Circuit means it is highly likely that Treasury will eventually lose, and the net worth sweep will ultimately be overturned. 

On the policy front, Treasury Secretary Mnuchin told Fox Business viewers during an interview Monday morning that “we’re not going to let this stand in the way one way or another, with housing reform….regardless of that case, we will restructure Fannie Mae and Freddie Mac so that they have private capital in front of taxpayer risks.”  Secretary Mnuchin went on to state that “our first choice is to work with Congress on a bipartisan basis.  If we can’t do that, we’re perfectly comfortable moving forward on the administrative side and making the changes we need to do.”  During an interview with CNBC on Thursday, Secretary Mnuchin declared the administration is “very focused on housing reform” and that it “is going to be a big priority of ours.”  He reiterated his interest in working with Congress on reform over the next 90 days but emphasized they will act administratively if Congress can’t pass legislation, which most would agree is highly unlikely.  In his opening testimony during Tuesday’s Senate Banking Committee hearing on housing reform, Chairman Mike Crapo (R-ID) provided his support for administrative action.  Senator John Kennedy (R-LA) told the witnesses that they should “saddle up and go” if Congress is unable to pass anything.  Given the opening comments by Ranking Member Sherrod Brown (D-OH) and the line of questioning by other Democratic members of the Committee along with the fact there hasn’t been a markup by the Senate Banking Committee in more than 500 days, a legislative solution prior to the 2020 election isn’t happening.  In other words, saddle up!  

In the coming months, we expect Treasury and the FHFA to not only allow the entities to retain  substantially more capital than the current $3 billion buffer, but also negotiate an amendment to the Treasury’s Senior Preferred Stock Purchase Agreement (SPSPA) that ends the net worth sweep and sets the stage for a capital raise in the second half of 2020.   Prior to initiating a capital raise, however; Treasury must absolutely deal with the preferred shareholders or it can’t get off go.  Last weeks court ruling gives Treasury the cover it needs to settle with shareholders.  Given the 5th circuit ruling and directives of the Treasury plan to end the conservatorships by recapitalizing, shareholders have likely never been in a better position than they are today.  Despite recent gains, preferred shares remain at roughly 50% of par value.  Consequently, we expect further gains from our investments as Treasury and the FHFA continue to execute on their plan to recapitalize Fannie Mae and Freddie Mac. 

The information contained in this missive represents Boyle Capital Management, LLCs (dba Boyle Capital) opinions, and should not be construed as personalized or individualized investment advice and are subject to change. Past performance is no guarantee of future results. It should not be assumed that investing in any securities mentioned above will or will not be profitable. Portfolio composition is subject to change at any time and references to specific securities, industries and sectors in this letter are not recommendations to purchase or sell any particular security. Current and future portfolio holdings are subject to risk. In preparing this document, Boyle Capital has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources. A list of all recommendations made by Boyle Capital within the past twelve-month period is available upon request.

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