WASHINGTON, D.C. – Last Thursday, a plan to save Fannie Mae and Freddie Mac proposed by billionaire hedge fund investor John Paulson and developed by investment bank Moelis & Co., an advisor to Paulson & Co. presents breakthrough solutions to ending the Net Worth Sweep funding Obamacare, including winding down the Treasury’s preferred stock position, recapitalizing the GSEs, and protecting current stockholders.
The purpose of this article is to highlight key features of the Moelis plan to demonstrate how precisely the plan is intended to move forward to save Fannie and Freddie, recapitalize the two GSEs, benefit current shareholders and the taxpayers, while preserving the 30-year fixed-rate mortgage to buttress middle class homeownership today and for future generations of Americans.
The Moelis “Blueprint” envisions that shares of Fannie Mae (closing Monday, June 5, 2017 at $2.57 per share) and Freddie Mac (closing at $2.46 per share) could see stock value appreciation to somewhere between an estimated $9.62 – $13.15 per share in 2020, as the Treasury exits and the GSEs recapitalize.
Key to the Blueprint is that the Net Worth Sweep (NWS) would end now, with Treasury agreeing that the government’s preferred stock position under the 2008 Preferred Stock Purchase Agreement (SPSA) is virtually paid, with only $6 billion remaining to pay off the $187.5 billion with a 10 percent coupon that the government invested in 2008, thereby retiring today virtually all the preferred stock owned by Treasury.
Finally, the plan envisions the Treasury will exercise its warrants for 79.9 percent ownership of the GSEs such that the Treasury common stock will be sold to the public in offerings scheduled starting in 2019.
Even after dilution, current common stock holders will still retain some 8 – 10 percent of the GSEs.
The retention of earnings plus the anticipated stock offerings described above are expected to bring the market capitalization of the two GSEs from some $15 billion today to somewhere between $207 – $238 billion at the end of 2020.
Current shareholders will benefit both from increased share prices, starting almost immediately, and from the resumption of dividends in 2020.
The Blueprint projects that implementing the plan will result in common share prices projected to be in the range of $7.95 to $10.87 per share in 2018; $8.75 to $11.96 in 2019; and $9.62 to $13.15 in 2020.
Ends Net Worth Sweep Now
As noted, the Blueprint plan calls for an immediate end of the Net Worth Sweep plus a Treasury agreement that the Treasury has been repaid in full – both capital invested and in the 10 percent dividends initially specified under the original Senior Preferred Stock Purchase Agreement (PSPA).
It is important to remember that under the August 2012 Amended PSPA, none of the profits swept from Fannie and Freddie under the Net Worth Sweep were allowed to be accounted to reduce the principal debt owed Treasury.
Mel Watt, director of the Federal Housing Finance Agency (FHFA), the regulator of the two Government Sponsored Entities (GSEs), told the Senate Banking Committee on May 11, 2017, the PSPA was a contractual agreement between Treasury and the GSEs that can be modified without any action required of Congress.
The Blueprint would consider Fannie and Freddie completely paid off by the NWS, reducing Treasury’s preferred stock position to the $6 billion remaining to be paid.
As of the end of the first quarter of 2017, the GSEs have returned $265.8 billion to Treasury, nearly $80 billion in excess of Treasury’s 2008 investment.
A study published by SeekingAlpha.com on March 28, 2017, concluded Treasury has benefited from the GSEs performance far more than all of the other 969 organizations/companies that received a Treasury bailout in the 2008 financial crisis totaling $622 billion.
Ending the NWS now is critical to allowing the GSEs to begin recapitalizing.
As Mel Watt pointed out to the Senate Banking Committee in his testimony on May 11, despite the GSEs massive and sustained profitability since 2012, the NWS has caused the companies to operate with diminishing buffer capital (calculated to reach zero by Jan. 1, 2018), leaving taxpayers fully exposed to the risk of having to potentially inject more money to support otherwise healthy companies.
Watt correctly instructed the Senate Banking Committee that under the Housing and Economic Recovery Act of 2008 (HERA), he has the statutory authority as GSE conservator to make the decision on his own authority to end the GSE’s in order to fulfill his responsibility to make sure the GSEs have sufficient capital to maintain sustainable operations.
Plan to recapitalize Fannie and Freddie
The Blueprint calls for the GSEs to build permanent “core” capital (analogous to Tier 1 capital requirements under bank regulations) at the corporate level through a series of capital raises.
For starters, the Blueprint projects the GSEs will build $62 billion in capitalization by the end of 2018, achieved by ending the NWS now so as to allow the GSEs to retain earnings.
The first capital raise is scheduled to be a public offering of newly-issued common stock designed to raise approximately $40 billion in 2018, followed by second issue of common stock scheduled to raise $40 in 2019, plus an offering of $25 billion in 2020 issuances increasing the junior preferred stock outstanding.
The goal is to raise $155 billion to $180 billion in core capital within four years, consisting of retained earnings, plus the three capital raises discussed in the paragraph above.
Technically, core capital raised in the range of $155-180 billion would be equivalent to over 8.5 percent of risk-weighted assets, or 3.0 – 3.5 percent of total balance sheet assets – a ratio approximately four times the pre-crisis GSE capital requirements, equivalent to 150 percent of the existing capital requirements for the Federal Housing Administration.
The Blueprint concludes that raising Fannie and Freddie’s risk-based capital requirements to 8.5 percent of risk based assets would provide a first-line defense against default, forming a core capital guarantee equivalent to ten times their pre-crisis requirements and more than double the FHA’s current requirements.
This approach reduces the need for the government guarantee needed to support the smooth operation of the secondary mortgage and to maintain the broad availability of the 30-year fixed-rate conventional mortgage to a catastrophic guarantee only.
Treasury to unwind from GSEs
The Blueprint also anticipates that Treasury will convert its preferred stock position, exercising warrants under the SPSA to obtain a 79.9 percent common stock ownership of the GSEs.
In a second step, Treasury would be expected to sell its common stock into the market to obtain additional profitability for the U.S. taxpayer.
The Blueprint noted the AIG bailout provided “an excellent template” of a large-scale transaction in which government-owned preferred stock was converted to common shares and sold profitably on the open market.
In the AIG bailout, Treasury exercised its warrants, receiving 79.9 percent of AIG’s common stock, converting the balance of preferred shares into additional common equity, before executing a series of well-timed and well-placed secondary share sales into the market.
Treasury sold $51.6 billion of AIG common stock in secondary offerings over two years, between January 2011 and December 2012, establishing a model for Treasury to follow in liquidating the GSE preferred stock.
Proceeds realized by Treasury in the secondary sale of GSE common stock are projected to add up to somewhere between $80 to $100 billion in incremental profits to the U.S. taxpayer.
At the upper limit, this could bring the total recouped by the Treasury up to some $366 billion, nearly doubling the original $187.5 billion Treasury invested in the GSEs in the 2008 bailout – a result that would equate to a 15 percent internal rate of return on the taxpayers’ investment.
Under the Blueprint, current common stock holders will see stock price increase up to six times by 2020, when dividends are expected to resume.
In conclusion, those current common stock holders wanting to liquidate their stock positon can anticipate almost immediately the opportunity to sell at appreciated share prices, while those able to hold their stock until 2020 will also be able to enjoy the resumption of dividends generated by well-capitalized GSEs, positioned for profitable operations going forward.