Welcome to Kaoboy Musings!
What started as an informal distribution list to my friends & family regarding the economy & markets has evolved into a blog about the markets, the economy, and life in general. I hope you will find the posts relevant and impactful.
After 22 years in the hedge fund business (17 of them at my own firm), I decided to close my fund to outside investors and focus primarily on managing my own money. Despite "retiring," I still have a passion for following the markets and economy and enjoy expressing my ideas and opinions. I may, from time to time, opine on an investment idea or theme that I am involved in and invite your devil's advocacy.
I’ve always found that writing my ideas down, sharing them with smart people, and encouraging dialogue and critique is often the best way to validate or invalidate a thesis and to stay mentally nimble. As a firm believer in Charlie Munger's concept of having "multiple mental models," I am a prolific reader about a broad swath of topics and will include occasional content reviews as well.
With that in mind, I encourage you to be vocal in the forums and share your views!
Fannie/Freddie explained in detail
As some of you know, I mentioned an interesting opportunity a week or two ago: Fannie and Freddie “junior” preferred stocks. Here’s the quick recap:
Thesis: I think there is a decent chance of a double or more in the next 12-18 mos.
There are about 40 different issues totaling about $34 bn face amount, and they currently trade at roughly 50% of par, although there are differences based upon issue size and liquidity. The most liquid are FNMAS and FMCKJ that trade around $13.50 (54% of $25 par amount). There are less liquid ones (which I currently own) like FNMFO, FNMAG, FMCKK, etc. that trade at lower % of par (like 45%), but they are much harder to trade.
In the name of full disclosure, I have owned these for 11 years since the conservatorship post-2008 at a basis of 2-3% of par, but it has been a long road that is finally (hopefully) coming to an end soon, given that the Trump Admin wants to have a win that does not require Congress, and recapitalizing Fannie/Freddie could be that win.
Here is a full list of tickers and current prices:
|Par/Unit||Par %||Mkt Px|
|FNMAT||$ 25||52.1%||$ 13.02|
|FNMAS||$ 25||53.8%||$ 13.45|
|FNMAJ||$ 25||50.0%||$ 12.50|
|FNMFN||$ 50||47.2%||$ 23.60|
|FNMAI||$ 25||50.6%||$ 12.65|
|FNMAM||$ 50||46.2%||$ 23.10|
|FNMAK||$ 50||46.1%||$ 23.06|
|FNMFO||$ 100,000||45.6%||$ 45,627|
|FNMAG||$ 50||46.8%||$ 23.40|
|FDDXD||$ 50||46.8%||$ 23.40|
|FNMAN||$ 50||46.0%||$ 23.00|
|FNMFM||$ 50||45.9%||$ 22.94|
|FNMAL||$ 50||46.3%||$ 23.15|
|FNMAH||$ 25||49.6%||$ 12.40|
|FNMAP||$ 50||46.5%||$ 23.25|
|FNMAO||$ 50||45.8%||$ 22.90|
|Par/Unit||Par %||Mkt Px|
|FMCKJ||$ 25||52.8%||$ 13.19|
|FMCKI||$ 25||48.8%||$ 12.20|
|FMCCT||$ 50||46.2%||$ 23.10|
|FMCKL||$ 25||49.9%||$ 12.48|
|FMCCP||$ 50||46.0%||$ 23.00|
|FMCKO||$ 25||47.4%||$ 11.85|
|FREJN||$ 50||44.8%||$ 22.40|
|FREGP||$ 50||44.8%||$ 23.14|
|FMCCO||$ 50||46.3%||$ 23.14|
|FMCCK||$ 50||46.0%||$ 23.00|
|FMCKP||$ 50||46.6%||$ 23.30|
|FMCKN||$ 25||47.8%||$ 11.95|
|FMCKM||$ 25||48.8%||$ 12.20|
|FREJP||$ 50||45.2%||$ 22.60|
|FREJO||$ 50||44.9%||$ 22.45|
|FMCCH||$ 50||45.6%||$ 22.80|
|FMCKK||$ 50||45.7%||$ 22.85|
|FMCCS||$ 50||43.9%||$ 21.94|
|FMCCG||$ 50||43.0%||$ 21.50|
|FMCCI||$ 50||43.1%||$ 21.55|
|FMCCN||$ 50||43.0%||$ 21.50|
|FMCCL||$ 50||43.5%||$ 21.75|
|FMCCJ||$ 50||43.9%||$ 21.96|
|FMCCM||$ 50||43.2%||$ 21.60|
Summary of events:
September, 2008 – Treasury Secretary Paulson put Fannie and Freddie into conservatorship in the name of forestalling a crisis of confidence (I wrote several articles back then for thestreet.com that took the opposite view – that Treasury’s actions exacerbated the crisis). In one fell swoop, Treasury stopped paying dividends on $36 bn worth of AA- rated preferred and crushed them down to 2-3c on the dollar. I bought them then, because I thought they represented “perpetuity options” – options on recovery with no imminent expiration date because: 1) Fannie and Freddie represent systemically important institutions that are nearly impossible to replicate, 2) our country is predicated on the rule of law and private property. The US government would eventually inject ~$190 bn of senior preferred ahead of the juniors with a 10% dividend to the US Treasury – never mind the fact that TARP-rescued banks only paid 5%. The FHFA was appointed the “conservator,” which traditionally means a role that conserves assets and rehabilitates its wards. Instead, FHFA/Treasury plundered the assets of the institutions they were supposed to conserve.
May, 2011 -- I pointed out the unfairness of the situation in a presentation (attached) I made at the Value Investing Congress, where I recommended these junior prefs at 6-7% of par. I predicted that despite the massive burden of the 10% dividend to government, these companies would begin to start making profits large enough to overcome these onerous dividends and then some.
August, 2012 – Right after Freddie Mac announced blowout Q2 profits over and above their 10% dividend burden, Treasury Secretary Geithner enacted the infamous Third Amendment, or Net Worth Sweep, that replaced the 10% dividend with a 100% sweep of profits to Treasury – with no termination date and with no consideration to shareholders! Needless to say, this engendered a veritable onslaught of shareholder lawsuits that are still plodding through our judicial system to this day. Throughout the years, these prefs have been on a roller-coaster ride, dictated by the ups and downs of various lawsuits. Notably, Judge Lamberth’s ruling in 2014 dealt shareholders a significant blow early on in the cases; this precedent has basically been on appeal for years in multiple jurisdictions – more on this later.
Meanwhile, the Net Worth Sweep has continued; to date, the US Treasury has swept nearly $310 billion from the capital structures of Fannie and Freddie, and not one cent of the $190 bn of senior pref ahead of the juniors has been deemed repaid, nor have junior prefs received one cent of dividend or compensation of any kind. We are used to seeing governmental plundering like this in countries like Venezuela, but certain not the United States. The result is that these mortgage giants are truly too big to fail – on a $5 trillion mortgage guarantee book, they only have a razor-thin $3 bn of capital cushion due to these relentless profit sweeps. By contrast, most banks keep $1 in reserves for every $9-$10 in liabilities. Also by contrast, the longest bank conservatorship last 18 months; here, we are going on 12 years!
Why are the prefs interesting NOW?
Earlier this year, the term of Obama-era FHFA Director Mel Watt ended, and the Trump Administration appointed its own FHFA Director Mark Calabria. This is significant, because Dr. Calabria comes from the world of mortgage finance and understands the need to recapitalize these entities. Treasury Secretary Mnuchin also comes from a mortgage finance background, and his appointment was heralded by pref shareholders initially with great fanfare; that fanfare turned to disappointment in recent years due to his inaction so far in halting the Net Worth Sweep. I believe that this inaction was due to the fact that he lacked political cover to do so, as the last several years saw many (failed) Congressional proposals to wind down Fannie & Freddie, not to mention less-than-favorable court rulings in multiple jurisdictions due to the Lamberth precedent.
All of these negative factors, however, are suddenly lifting, and I think the market is so inured and jaded by this 11-year long trade that the market is overlooking an incredible opportunity.
In my May, 2011 presentation, I outlined several potential remedies that the government could undertake to recapitalize and eventually release these companies from conservatorship. I was very excited to see that Treasury/FHFA just released a comprehensive blueprint earlier this month (9/4/19) that contemplates a range of remedies not dissimilar to the ones I espoused 8 years ago.
Perhaps even more significantly, on 9/6/19, the 5th Circuit delivered a surprise ruling in favor of shareholders on appeal from the Collins case from the Southern District of Texas; the 5th Circuit ruled the Net Worth Sweep unconstitutional and remanded to the lower court for remedies. On 9/10/19, both Mnuchin and Calabria testified before Congress regarding this blueprint. Although the 5th Circuit decision was not mentioned, I believe it has finally given Mnuchin/Calabria the political cover they need to end the Net Worth Sweep. Also significant is the fact that the hearing seemed to garner bipartisan support to recapitalize these entities – a far cry from the die-hard “GSE wind-down” voices heard just a few years ago. Indeed, Calabria gave an interview on 9/16/19 (https://twitter.com/FHFA/status/1173649117408583680) where he not only confirmed his intention to end the Net Worth Sweep, but provided hints on timing.
I believe the upside from here is 100%+. How can these go above par and yield returns greater than 100%? If you take a look at page 32 of my May, 2011 presentation, I laid the framework then for potential recapitalization scenarios that would effectively make these prefs the new equity of the recapitalized entity. I think Treasury/FHFA is contemplating some scenarios that resemble this one.
What could go wrong? At the end of the day, I believe this is a medium/medium-high risk trade with political risk as the key risk. The government has stretched this process out for 11 years, and any news of delays could knock these lower. The real risk lies in a Trump loss in 2020, because a Democratic President like Elizabeth Warren is much more likely to fire Calabria, install their own FHFA Director, and push for dissolution of the GSE’s -- even though market realities of major disruptions in the mortgage market would likely preclude this outcome in my view. Even in this scenario, I don’t think prefs will get completely wiped out, but could they trade off 50% based on the process “going back to square one”? Sure – I have lived through many years of ups and downs on this one, but have held on because I ultimately believe there is no viable solution but to recapitalize and release these entities.
. . .
I have attached 1) a 2014 interview I did where I talk extensively on this thesis (pages 4-5), and 2) my May, 2011 presentation at the Value Investing Congress.
I will end it here and invite your feedback!
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Kaoboy Musings is a private distribution list/blog that I created to encourage dialogue regarding the economy & markets, geopolitics, investment ideas, and life in general. I have a passion for the markets and investing, and even though I no longer accept investor capital, I try to keep current on global events and opportunities and remain active in the markets. I’ve always found that writing my ideas down, sharing them with smart people, and encouraging two-way discourse and devil’s advocacy is often the best way to validate or invalidate a thesis and stay mentally flexible.
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