Description

Opportunity: There is an extraordinary opportunity in the GSEs junior preferred shares (JPS i.e. FNMAS/FMCKJ) due to a perfect storm of fundamental and technical reasons, setting up an opportunistic moment in time. The JPS are currently trading at ~5% of PAR, essentially decade low prices, presenting an extremely asymmetric non-market correlated investment today. The prices represent 20x upside to PAR in any ultimate resolution (or even 5-10x upside if the market starts to potentially begin pricing in such an event occurring).

Background: The GSEs (Fannie Mae / Freddie Mac) have now been in “temporary” conservatorship for 15 years, operating as de-facto nationalized entities. The GSEs provide trillions of dollars in mortgage financing to U.S.’s housing market and generate an average of $25b+ in net income. While the Trump admin made material progress in having the GSEs exit conservatorship and re-privatized, according to public statements by then internal admin officials, they ultimately fell short on time due to COVID. One meaningful step they took was to allow the GSEs to begin retaining capital in 2019, reversing a controversial 2012 decision to sweep all the profits of the GSEs to the US government.

Fast forward to today, the GSEs i) underlying businesses have been completely reformed and de-risked for the better since the GFC (no more internal hedge fund or loose credit standards), ii) pass their stress tests with flying colors (projected to make income in a GFC-like repeat), and iii) continue to retain capital (up to $103b today) as they march to their inevitable (but timing uncertain) exit from conservatorship.

The Case for GSEs Junior Preferred Shares: Bill Ackman previously summarized why he purchased GSEs JPS his 2017 annual letter,

While the first reason re: timing remains an uncertainty, the second (restructuring hedge) and third (attractive at current levels) are more true today than they have ever been in the past.

“(3) we found the trading prices of the preferred securities attractive at current levels” - The JPS are trading at decade low prices despite the fact that not only have the GSEs unwind and replace lobbyists failed, but the GSEs have retained over $100b in capital and there is a growing consensus (from both sides of the aisle) to eventually see them released from conservatorship (it's a matter of when not if). Compared to the prices on the heels of the 2016 election when Hilary was 90% favorite to win, the democratic era policy for the GSEs was to wind them down, and the GSEs had zero capital, yet they were still trading at 3x the current share prices. Below are several paths the GSEs JPS may see material upside appreciation in the next 0-18 months.

• Changing of the Guard (2024 Elections):  Elections are less than 18 months away. Ackman nailed this on his investor call last week, “And I think it's actually probably the most interesting play on who the next administration is if President Trump is reelected, which is probably very good for Fannie-Freddie or any more conservative leaning administration." Regardless of whether it’s Trump as the GOP nominee or someone else, the JPS are MATERIALLY / inaccurately reflecting the odds of a Trump / GOP win. For example, Trump is currently polling favorite (+1.8) to win head-to-head against Biden (~70% of Democrats don’t even want Biden to run again), while the JPS are pricing a Trump / GOP win at ~5%. Where do these trade on a Trump / GOP win (or even the prospects of one), when the incoming administration gets handed the keys to the GSEs with ~$150b of retained capital day one? The JPS were trading at ~50% of par prior to the 2020 elections and the next admin could in theory instantly re-IPO them their first year in power. Make no mistake about it, this is the ultimate Trump / GOP trade. Below is a NPV table of expected value assuming a Trump / GOP win (assumes upside is capped to 90% of par, 50% odd of a Trump / GOP win, and a 15% discount rate). As an election trade alone, the JPS have an expected value of $7.65 vs $1.5 today (reflecting ~5x upside once this accurately gets priced in next year as an “election trade”, without even Trump / GOP even needing to win).

• Biden Admin Optionality: While the market suspects this is extremely unlikely, in theory, the stage is set for Biden Admin action if they choose to do so. The admin is officially locked out of spending for the remainder of their term thanks to a combination congressional gridlock and the recent debt ceiling bill passed. They can unilaterally act (without Congress) to tap the GSEs for up to $100b+ in value that they wouldn’t otherwise have access to, and spend it on their policy goals. Additionally, there is evidence someone on the Biden team previously wanted to pursue this path (when Calhoun was originally the FHFA pick). The market is not pricing in any odds of this occurring.

• Litigation: While mostly unsuccessful to date, there are still a couple of key cases worth keeping an eye on in the near-term (with rulings all expected in the next 0-6 months), and the market is not assigning any probability of success to any of the litigation.

1. Class Action Lawsuit v. GSEs: The contract claims re-trial starts on July 24^th, with a ruling expected 2nd week of August. Last trial ended with a hung jury (with only a single hold out jurist for the government). While damages are limited for now (they will be appealed after trial), it’s worth a $3 cash payment for FMCKJ (2x todays share prices) + you retain ownership of your shares. [Timing: 1-2 months]
2. Collins v. FHFA: The conservative 5^th circuit gets another bite at the apple (technically two bites). While the Supreme Court overturned their original NWS ruling in favor of shareholders, they ruled for shareholders on the unconstitutional question and remanded back to the 5^th circuit for potential remedy to shareholders. Additionally, shareholders are pursuing an appropriations claim here which the same 5^th circuit just ruled against CFPB on an almost identical subject matter (in addition to granting remedy). A decision is expected by the end of the year now that briefing is wrapped up. [Timing: 3-6 months]

“(2) it hedges our risk of a restructuring that disproportionately benefits the preferred versus the common shares” - Due to the recent litigation rulings (Supreme Court APA and the Federal Court of Appeals takings rulings), this has become a much larger risk today. In fact, previous FHFA director Mark Calabria confirmed this risk in his recent book “Shelter from the Storm.” Calabria claimed that FHFA and Treasury’s intention was to convert the governments preferred shares over to common shares, which would have the effect of wiping out / diluting the common shares down to pennies. See below for select excerpts from the book:

"I believed that, short of a receivership, the cleanest solution would be to convert all the preferred shares, even those held by Treasury, into common equity

…

A conversion of all preferred equity was one of the only ways to fix the companies' balance sheets in a manner acceptable to Treasury

…

A conversion would also allow a more accurate reflection of Treasury's claims without the political fallout of outright forgiveness. There had been some calls over the course of the conservatorship for Treasury to just forgive all or part of its claim. That was a nonstarter, politically, for Treasury. Moreover, Treasury claimed that it could not legally do so."

Why the Opportunity: Uncertainty, Fatigue, and Technical Overhang

1. Uncertainty on timing as investors are concerned that the conservatorship will continue to get dragged out indefinitely due to the perception that this specific admin does not appear up to the task of accomplishing anything re: the GSEs.
2. Investors are fatigued as it has been 15 years since the GSEs entered conservatorship.
3. Technical selling pressure: The largest shareholder of the JPS (Capital Group, specifically the Growth Fund of America) has been in the process of selling a large portion of its position since the beginning of the year.

• The Growth Fund of America began the year with ~62m FNMAS shares and ~72m FMCKJ shares
• As of 3/31/23 they own ~55m FNMAS shares and ~59m FMCKJ shares
• Based off the volumes traded QTD, it’s estimated that they now have approximately ~30m-40m FNMAS shares and ~40m-50m FMCKJ shares remaining (~80m shares total, or ~$120m at current share prices)

Catalyst

1. 2024 Elections
2. Biden Admin Optionality
3. Litigation