FNMFN - Fannie Mae: A Longshot Bet On Housing Reform

2023-05-02 00:28:41 ET

Summary

• Oral arguments for the remand are scheduled for January 2024, and a decision could be expected by mid-2024.
• Upon release, each share could be worth $22.50.
• The 5th Circuit may follow its own precedent in CFSA v. CFPB resulting in a favorable outcome for FNMA.

The Story

If you're looking for a high-risk, high-reward investment opportunity, you might want to take a look at Fannie Mae ( FNMA ): a government-sponsored enterprise that provides liquidity and stability to the U.S. housing market by purchasing and guaranteeing mortgages from lenders.

The GSE operates under the supervision and regulation of the Federal Housing Finance Agency ((FHFA)), which has been its conservator since 2008. As a conservator, the FHFA has full control over Fannie Mae's business operations, capital structure, dividend policy, and legal affairs. It also holds nearly 80% of Fannie Mae's common stock through senior preferred shares issued to the U.S. Treasury in exchange for a $187 billion bailout during the financial crisis. Since then, Fannie Mae has repaid its bailout funds with interest and generated billions of dollars in profits for the government, while its shareholders have been largely wiped out. The company's common stock trades at around $.50 per share, down from over $60 before the crisis. Its preferred stock trades at a fraction of its par value. However, there is a chance that Fannie Mae could be released from conservatorship and recapitalized as a private company, which would unlock tremendous value for its common and preferred shares.

This scenario depends on several factors, including the outcome of ongoing litigation, the actions of the Biden administration and Congress, and the state of the housing market. Fannie Mae is a highly speculative and risky investment, but it also offers huge upside potential for investors who are willing to take a longshot bet on housing reform.

The SCOTUS Remand: What Now?

If you're a shareholder of Fannie Mae or Freddie Mac, you probably felt a roller coaster of emotions after reading the Supreme Court's ruling in Collins v. Yellen. On one hand, you were happy that the Court agreed with you that the FHFA was unconstitutionally structured and that you had a right to challenge the infamous Third Amendment Sweep that robbed you of your dividends. On the other hand, you were disappointed that the Court didn't just invalidate the Sweep and send you a fat check, but instead sent the case back to the lower courts for more litigation. So what does this mean for you as a shareholder? Well, it means that you're in for a long and bumpy ride.

As a brief recap, Collins v. Yellen involves a group of FNMA shareholders who challenged the net worth sweep ((NWS)), an agreement between the Federal Housing Finance Agency (FHFA) and the Treasury that requires FNMA to pay nearly all of its profits to the Treasury as dividends. The shareholders argued that the NWS violated both statutory and constitutional grounds.

The SCOTUS ruled in favor of the shareholders on the constitutional claim, finding that the FHFA's structure was unconstitutional because its director was removable by the president only for cause. However, the SCOTUS did not decide what remedy, if any, the shareholders are entitled to receive on this claim. Instead, it remanded the case to the 5th Circuit for further proceedings.

The 5th Circuit now has to determine whether the unconstitutional structure of the FHFA affected its decision to enter into the NWS, and if so, what relief should be granted to the shareholders. The 5th Circuit may follow its own precedent in CFSA v. CFPB, a similar case involving an independent agency's structure and actions. In that case, the 5th Circuit held that the Consumer Financial Protection Bureau (CFPB) violated the separation of powers because its director was removable by the president only for cause, and that the appropriate remedy was to invalidate the CFPB's action against a payday lender.

If the 5th Circuit applies the same reasoning to FNMA's case, it could invalidate the NWS and order the FHFA and the Treasury to return the excess payments to FNMA. This could have significant implications for FNMA's exit from conservatorship and its ability to rebuild capital reserves. According to some estimates, FNMA could receive as much as $124 billion in restitution from the Treasury, which would boost its net worth and reduce its reliance on taxpayer support.

However, there are also some uncertainties and differences between FNMA's case and CFSA's case that may affect the outcome. For example, the SCOTUS did not explicitly endorse the 5th Circuit's remedy in CFSA's case, but rather vacated and remanded it for further proceedings. Moreover, the FHFA and the Treasury may argue that FNMA's case is distinguishable from CFSA's case because of the different statutory schemes and factual circumstances involved. For instance, they may contend that the NWS was necessary to preserve FNMA's solvency and stability during the financial crisis, and that it was authorized by Congress under HERA.

Shareholders may want to know when the 5th Circuit will issue its decision, what are the possible outcomes and their probabilities, how will the decision affect FNMA's stock price and dividends, and whether there will be further appeals or settlements.

Oral arguments for the remand are scheduled for January 2024, and a decision could be expected by mid-2024. The possible outcomes range from a complete victory for shareholders (invalidation of NWS and restitution) to a complete loss (no remedy or dismissal). A middle ground outcome could be a prospective invalidation of NWS (no more dividends to Treasury) or a partial restitution (some payments returned).

The probabilities of these outcomes are hard to estimate, but based on my analysis of legal precedents and arguments, I assign a 40% chance to a complete victory, a 30% chance to a middle ground outcome, and a 30% chance to a complete loss. These probabilities are subject to change as new information emerges.

The impact of these outcomes on FNMA's stock price and dividends will depend on several factors, such as market expectations, valuation models, capital requirements, regulatory actions, and political risks. However, as a rough approximation, I very conservatively estimate that a complete victory could increase FNMA's stock price by 300%, a middle ground outcome by 100%, and a complete loss by more than -50%.

Finally, there is always a possibility of further appeals or settlements in this case. The losing party could seek review by an en banc panel of the 5th Circuit or by the SCOTUS again. Alternatively, the parties could reach a negotiated settlement that would resolve all outstanding claims and disputes. A settlement could be beneficial for both sides, as it would avoid further litigation costs and uncertainties.

Risks

I felt this section was especially important to include before the valuation section. FNMA is not a sure thing, far from it. This bet is the product of what is calculated to be a tremendous upside potential, alongside a disastrous downside. I strongly advise against investing any sum you would not feel comfortable losing in its entirety.

Of course, I'm not saying that you should avoid FNMA altogether. I am after all issuing a buy rating. I think that FNMA could be worth a hell of a lot more if it wins its case and gets out of government control. But I also think that there is a lot of uncertainty and volatility involved in this investment. So you have to be prepared for the worst-case scenario; in short this is not the type of investment to bet the farm on.

So what are the risks of investing in FNMA? Well, there are several risks that you need to be aware of before you buy any shares. Here are some of them:

Legal risk

The outcome of the court case is uncertain and could take a long time to resolve. Even if the shareholders get a win with this case and get out of government control, they could face other legal challenges from regulators, creditors, or other parties. There is also a risk that Congress could pass new legislation that could affect FNMA's status or operations.

Regulatory risk

The FHFA and the Treasury Department have a lot of influence over FNMA's business and financial activities. They could impose new rules or requirements that could limit FNMA's profitability or growth potential. They could also change the terms of the existing agreement or impose new fees or penalties on FNMA.

Common or Preferred?

As you know, FNMA has two types of shares: common shares and preferred shares. Common shares are the ones that trade under the ticker symbol FNMA and have voting rights and potential dividends. Preferred shares are the ones that have different series and symbols, such as FNMAS or FNMAT, and have fixed dividends and priority over common shares in case of liquidation.

So which type of shares should you invest in? Well, that depends on your risk appetite and your expectations. Both types of shares are risky and speculative, but they have different pros and cons. I will preface by saying that personally, I hold common shares. I feel it is unlikely the government would wipe out the share class in the event of a release.

Common shares are more volatile and sensitive to news and events related to FNMA's legal case and conservatorship status. They have more upside potential if FNMA wins its case and gets out of government control, but they also have more downside risk if FNMA loses its case or faces unfavorable regulatory changes. They also have no guarantee of dividends or liquidation value. If you invest in common shares, you are betting on a favorable outcome for FNMA and a significant increase in its share price.

Preferred shares are less volatile and more stable than common shares. They have fixed dividends that are paid before common shares, and they have a par value that is higher than their current market price. They also have some seniority over common shares in case of liquidation. However, they also have some drawbacks. They have limited upside potential if FNMA wins its case and gets out of government control, as they are unlikely to trade above their par value. They also have some downside risk if FNMA loses its case or faces unfavorable regulatory changes, as they could lose their dividends or be wiped out completely. If you invest in preferred shares, you are looking for a steady income stream and a partial recovery of your principal.

These are some of the major risks that you need to consider before investing in FNMA. As you can see, they are not trivial and they could have a significant impact on your returns. That's why I consider FNMA a small speculative bet in my portfolio and not a core holding. I only invest a small amount of money that I can afford to lose and I don't expect any quick or easy profits from the investment.

Unlocked Value

Alright, let's talk about how much Fannie Mae could be worth if it was released from conservatorship. As you know, Fannie Mae is one of the largest sources of mortgage financing in the country, and it has been under government control since 2008, when the FHFA took over as its conservator. This means that the FHFA has the power to run the company's operations and make decisions on its behalf, including agreeing to a deal with the Treasury Department that requires Fannie Mae to pay its entire net worth as dividends every quarter. This deal, known as the Third Amendment Sweep, has been challenged in court by a group of shareholders who claim that it violates both federal law and the Constitution.

So what would happen if Fannie Mae was released from conservatorship? Well, it would mean that the company would regain its independence and be able to retain its earnings and build capital. It would also mean that the shareholders would have a claim to the company's future profits and dividends. But how much is Fannie Mae worth right now?

According to Yahoo Finance, Fannie Mae has a market cap of $495 million. This means that the total value of all its outstanding shares is about half a billion dollars. That sounds like a lot, but it's actually very low compared to its historical levels. Before the financial crisis of 2008, Fannie Mae had a market cap of over $70 billion. The company once hovered around $60 per share.

But how can we estimate how much Fannie Mae could be worth if it was released from conservatorship?

To get a more precise valuation based on earnings potential, we can also calculate the earnings per share [EPS] and the price per share [PPS] of Fannie Mae. EPS is the company's net income divided by the number of outstanding shares, and PPS is the EPS multiplied by the price-to-earnings ratio. According to Fannie Mae's Newsroom, The company had a net income of $12.9 billion in 2022. If we divide this by its outstanding shares, we get an EPS of $2.25. Then if we multiply the EPS by the price-to-earnings ratio of 10, we get a PPS of $22.50. This means that if Fannie Mae was released from conservatorship and traded at a conservative price-to-earnings ratio of just 10, each share would be worth $22.50, which is much 5200% higher than its current share price.

So what does this mean for you as a shareholder? Well, it means that you have a lot of upside potential if Fannie Mae wins its case and gets out of government control. But it also means that you have a lot of risk and uncertainty until then. So you have to decide whether you want to hold on to your shares and hope for the best, or sell them and move on to other opportunities.

Conclusion

The 5th Circuit's decision on the SCOTUS remand of Collins v. Yellen is a critical event for FNMA shareholders, as it could determine the fate of the NWS and the future of FNMA. The decision could have a huge impact on FNMA's stock price and dividends, as well as its exit from conservatorship.

While there are many uncertainties and variables involved in this case, I believe that shareholders have a good chance of winning a favorable outcome, based on legal precedents and arguments. A complete victory for shareholders could unlock billions of dollars in value for FNMA and create a massive upside potential for its stock price.

However, investors should also be aware of the risks and challenges that FNMA faces, such as regulatory actions, political risks, capital requirements, market conditions, and litigation costs. A complete loss for shareholders could result in a significant decline in FNMA's stock price and dividends, as well as a prolonged conservatorship. There is a very real risk that this company does not escape conservatorship for a number of reasons.

Therefore, investors should do their own due diligence and research before investing in FNMA, and be prepared for volatility and uncertainty. FNMA is not a stock for the faint-hearted, but for those who are willing to take calculated risks and have a long-term horizon.

I think that FNMA has a strong business model and a vital role in the housing finance system. If released investors stand to make incredible returns. For all the above reasons I assign a buy rating to both common and preferred shares.

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