I haven’t written much about Fannie Mae (FNMA) and the government’s responsibilities or lack thereof when it comes to sponsoring publicly traded entities in the year since my last post. At the most basic level it is simple, should the government block a company that it is a partial owner of from distributing earnings to all of the owners or should it allow said company to pay all owners equally? It doesn’t really matter that the government took a big risk, they’ve been paid back. It doesn’t matter that their continues to be a possibility of risk, that’s the way the world works – nothing is zero risk. To date, the GSEs have paid $124 Billion… with a Capital B… more than the amount the government originally agreed to accept for return on the risk they took.
Now we’ve seen an interesting change to the story, a judge has stated that because congress wrote into their law a statement that says the courts can’t do anything to affect the actions of congress, he won’t hear the case. Yes you read that right.
Let’s review our government’s system again, there are three branches to the government – Legislative , Executive, and Judicial. Here is a little graphic in case you forgot…
You’ll note the little words in parenthesis under each of the branches. The purpose of the Judicial branch is to evaluate the laws that the Legislative branch makes. So if the Legislative branch writes into their laws a statement such as:
no court may take any action to restrain or affect the exercise of powers or functions of [FHFA] as a conservator or a receiver.
They have in a way broken the system that we run our country on – especially if the Judicial branch of the government complies with the statement. So where does that leave me as an owner of Fannie Mae? Well I own both common and preferred shares of Fannie Mae and the Fannie Mae preferred shares . As a small owner of the company, I am not going to go filing court cases like Perry, Fairholme, or Pershing. I am going to stay close to the facts, think logically about the possible and ethical outcomes, and of course stay in touch with what the market thinks of the situation.
So what is the situation exactly? We have Perry Capital and Fairholme Capital who just had their case thrown out by Judge Lamberth last week. Perry has already filed an appeal and Bruce Berkowitz of Fairholme has issued a letter that they “will continue to pursue our legal rights with the same conviction held in our other G-SIFIs (global systemically important financial institutions) – AIG and Bank of America – deemed essential to our way of life.”. This is significant because the recent drop in share price is a result of this decision by judge Lamberth. With the Lamberth appeals under way, we will probably have a few roller coasters over the next 12-18 months while those appeals play out. If you think about the things that have happened to the stock price in the last year, we’ve seen delay tactics from the government, we’ve seen discovery granted in the Sweeney case (I’ll get to that next), and during these “news” events, the stock price has moved higher and moved lower creating opportunities to buy and sell the stock while maintaining the thesis that there is underlying value there that is being negatively impacted by the litigation.
The Lamberth case wasn’t the only one going, another case was also filed with Judge Sweeney. Sweeney has taken a different approach from Lamberth and has actually granted discovery. This is a little odd. One judge in the Judicial branch is saying that “no court may take any action to restrain or affect the exercise of powers or functions of [FHFA] as a conservator or a receiver”. At the same time, another judge in the Judicial branch is saying “Thus, rather than turning a blind eye to a case and immediately dismissing it from its docket merely because the case concerns the FHFA, the proper approach is for a court to examine the factual underpinnings and legal contentions presented by the complaint, in order to determine whether the exercise of its jurisdiction is proper,” she clarified. “In essence, defendant asserts that the court should merely take its word that the documents -some of which the defendant, itself, has not reviewed-are privileged. This suggestion is contrary to law.” Yes that last bit is a direct quote from Judge Margaret Sweeney. In the case presented to Sweeney, she is allowing discovery and the case is currently progressing. This case may also go slowly, but will at least progress instead of starting over as in the appeal case that Perry Capital is restarting.
I won’t rehash all the intimate financial details of these entities researched by folks like Todd Sullivan, Bill Ackman, Bruce Berkowitz, and so on. There are a few good summaries such as this GSE presentation by Bill Ackman at the May 2014 Ira Sohn conference or this summary by Regal Point Capital. If you believe the incredible returns of investors like Pabrai are the kind of returns you would want in your portfolio, you understand that copycat investing can be incredibly profitable when you follow-up on those copycat ideas with your own research and critical thinking.
Considering Fairholme’s cost basis for the Fannie Mae preferred shares is $4.85, buying now under $4.50 seems like a reasonable time to buy. These shares have a liquidation preference at $25/share which means that if the whole Fannie Mae entity is dissolved, these should be worth $25/share. They also have a dividend of 8.25%, which means that if dividends are re-instated (they’ve been suspended since 2008), I should start to see some portion of that 8.25% every year. In other words I have a potential 5x return in 1-5yrs, I have liquidity, and there may be some payments in addition to the 5x return between now and the time the $25/share value is realized. No, I’m not talking about a startup investment here, I’m talking about an investment in the largest mortgage backer in the world.
Yes the government could wipe out existing owners in some new structure (they already proved they can with the Net Worth Sweep provision in 2012). Yes some new entrant could come along to replace the GSEs. I don’t agree with Ackman that these possibilities don’t exist. I do think the timeline and likelihood make them minimal risks and much less likely to occur than some upside.