Quote From Fairholme Funds’ 2016 Annual Report
We recall Charlie Munger’s advice:
Students learn corporate finance at business schools. They are taught that the whole secret is diversification. But the rule is exactly the opposite. The ‘know-nothing’ investor should practice diversification, but it is crazy if you are an expert. The goal of investment is to find situations where it is safe not to diversify. If you only put 20% into the opportunity of a lifetime, you are not being rational. Very seldom do we get to buy as much of any good idea as we would like to.
Fannie Mae and Freddie Mac
Odds favor Fannie Mae or Freddie Mac helped your parents and you obtain a first home, and that the same will be true for your children and grandchildren. Fannie Mae and Freddie Mac guarantee the timely payment of principal and interest demanded by lenders. Investors just like you own and fund their operations. Yet, we fight an expropriation of our principal by the government. Here’s where we stand: prosperity exists in a capitalist society only when contracts are honored. The rule of law must be respected and cannot be eliminated by fiat. If you disagree, just see the despair in Venezuela. We look forward to a decision from the United States Court of Appeals for the District of Columbia Circuit that protects and preserves our investments in Fannie Mae and Freddie Mac. Signs indicate that we are nearing the end of our “Alice in Washington” journey.
Our three appellate court judges (Janice Brown, Doug Ginsburg, and Patricia Millett) published a separate decision (Heartland Plymouth Court MI, LLC v. National Labor Relations Board) that we believe is instructive to their eventual ruling in our case. Writing for the majority, Judge Brown stated:
As this case shows, what the [National Labor Relations Board (“NLRB”)] proffers as a sophisticated tool towards national uniformity can just as easily be an instrument of oppression, allowing the government to tell its citizens: “We don’t care what the law says, if you want to beat us, you will have to fight us” … We recognize the [NLRB’s] unimpeded access to the public fisc means these modest fees can be dismissed as chump change. But money does not explain the Board’s bad faith; “the pleasure of being above the rest” does. See C.S. Lewis, MERE CHRISTIANITY 122 (Harper Collins 2001). Let the word go forth: for however much the judiciary has emboldened the administrative state, we “say what the law is.” Marbury, 5 U.S. (1 Cranch) at 177. In other words, administrative hubris does not get the last word under our Constitution. And citizens can count on it.1
In another decision (DirecTV, Inc. v. National Labor Relations Board), Judge Brown was even more direct about the perils of unchecked executive action when she noted that: “Judicial review should mean more than batting cleanup for the administrative state.”2 If applied in equal measure, these sentiments bode well for our case.
Finding no clear reason in favor of extraordinary secrecy, U.S. Court of Federal Claims Judge Margaret Sweeney Fairholme Funds v. United States, No. 1:13-cv-00465-MMS) recognized that the government’s attempt to hide thousands of documents is unjustifiable, for the work of our government must withstand public scrutiny. Judge Sweeney issued a court order directing the Obama Administration to produce scores of documents that were improperly withheld based on assertions of deliberative process privilege, bank examiner privilege, and presidential communications privilege. Her decision was largely upheld upon review by the U.S. Court of Appeals for the Federal Circuit. In due course, we expect further proof that Obama Administration officials violated laws established by our founding fathers to prevent such unfettered discretion. Alexander Hamilton said it best:
The nature of the contract in its origin is, that the public will pay the sum expected in the security, to the first holder, or his assignee. The intent, in making the security assignable, is, that the proprietor may be able to make use of his property, by selling it for as much as it may be worth in the market, and that the buyer may be safe in the purchase. Every buyer therefore stands exactly in the place of the seller, has the same right with him to the identical sum expressed in the security and having acquired the right, by fair purchase, and in conformity to the original agreement and intention of the government, his claim cannot be disputed, without manifest injustice.3
We are frequently asked (i) why we own the preferred stock of Fannie Mae and Freddie Mac instead of common shares, and (ii) how this story ends. Our answers are simple: the provisions of the preferred stock contracts that we own provide us with greater security and certainty than the common stock and, as you know, we are not speculators. In this instance, we have invested in two superb insurance companies with unparalleled brand recognition, talented human capital, proprietary information technology infrastructure, and robust industry relationships. Fannie Mae and Freddie Mac are quintessential examples of what Warren Buffett would describe as “economic castles protected by unbreachable moats.” As interest rates rise, Fannie Mae’s and Freddie Mac’s portfolios become even more valuable – and we anticipate that Q4 2016 results will reflect this positive impact. Allow me to emphasize a few points that you may have heard before:
Any intellectually honest observer would proffer that the rational steps for resolution are: (i) halt the payment of any further monies to the United States Treasury; (ii) permit the companies to retain capital in order to protect taxpayers; (iii) transform the companies into low-risk, public utilities with regulated rates of return, just like your local electric company; and (iv) eventually release them from the shackles of a perpetual conservatorship so they can help more low- and moderate-income families move up the economic ladder. Only the disingenuous would assert that recapitalization of these companies would take decades and come at taxpayers’ expense, as if retaining earnings precluded the ability of each company to raise equity from private investors. Only those beholden to special interests would ignore the substantial reforms implemented at Fannie Mae and Freddie Mac over the last eight years and pretend the companies are somehow doomed to repeat the past upon release from conservatorship. And only those who oppose the dream of homeownership for America’s middle class would attempt to dismantle two publicly traded, shareholder-owned companies that have singlehandedly provided over $7 trillion in liquidity to support our mortgage market since 2009. We are optimistic that the indispensability of Fannie Mae and Freddie Mac to affordable homeownership eventually overpowers the taboo imposed upon them by the previous Washington establishment.
Important Comments from Tim Howard @ Howard on Mortgage Finance
First Quote From Tim Howard
In September 2008, Treasury granted itself 79.9 percent of the outstanding shares of the common stock of both Fannie and Freddie as a component of its purported “rescue” of them. Treasury’s action, however, was not a rescue; it was a takeover of two companies it historically had opposed, done for ideological and policy reasons. When Treasury granted itself these warrants, it had no intention of ever exercising them; its purpose was to reduce the stock prices of both Fannie and Freddie by a factor of five (since Treasury instantly gave itself the right to four-fifths of the companies’ earnings in perpetuity), in order to contribute to the sense that they were in financial free-fall (which they were not). Treasury’s intention at the time it took the companies over was ultimately to liquidate them, and to allow the warrants to expire worthless.
But Treasury, and its allies, never could come up with an alternative to Fannie and Freddie that worked as well as they did, and that Congress was willing to take a gamble on and legislate. So here we are, nine years later: the warrants still are outstanding, and Treasury Secretary-designate Mnuchin is talking about reforming Fannie and Freddie and bringing them out of conservatorship. And the warrants have become a complication.
The term sheet for the warrants says they may be exercised “in whole or in part, at any time during the exercise period [which runs through September 7, 2028]”…and that the warrants entitle Treasury to 79.9 percent of the outstanding shares of Fannie and Freddie not as of the date the warrants were granted (September 7, 2008), but “on the date of EXERCISE,” which could be any time up to September 2028.
When Treasury granted itself the warrants back in 2008, it never contemplated that the companies might issue new shares of equity to recapitalize (because it intended to kill them). But now that they might, that 2008 warrant language definitely is a problem. Unless Treasury exercises all of its warrants immediately–which would cause massive dilution and create a nearly insurmountable hurdle to reforming them and bringing them out of conservatorship–whatever percentage of its warrants for Fannie and Freddie’s “outstanding common shares” remains unexercised when they do their equity issues to recapitalize will, by the language of the 2008 Senior Preferred Stock Agreement, have to be turned into NEW shares for Treasury, for which it will pay an exercise price of one one-thousandth of one cent (meaning Fannie and Freddie will get negligible proceeds from this equity).
THAT is what I called the “deal-killer.” As long as the 2008 language governing the exercise of the warrants remains in force, the companies will not be able to recapitalize. That language never was intended to apply to companies that were going to recapitalize and come out of conservatorship. Now that this prospect is on the table, the language relating to the warrant exercises–along with other aspects of them–clearly has to be in play for alteration, amendment or cancellation.
I hope that makes this more understandable (as I said, it IS a complicated issue).
Second Quote From Tim Howard
I’ll give you my response just with respect to Fannie (makes the numbers easier to understand).
Today you have a company with about $11 billion in annual earnings, 1.15 billion shares outstanding, and essentially no capital. Let’s say Fannie needed to raise $60 billion to meet its new capital standards (not a prediction, just an example). Let’s further say that it has three years to get fully capitalized. It can get halfway there (assuming no growth in its outstanding MBS) through retained earnings, but still will need to raise about $30 billion in new equity. Factoring in dilution, let’s now assume it’s able to issue 400 million new shares at an average price of $75 per share. So now you have a fully capitalized company with $11 billion in earnings, 1.55 billion in outstanding shares, and annual EPS of $7.10 per share. At a P/E of 10:1 that’s about a $70 stock (at a P/E of 12 it’s about an $85 stock).
If Treasury exercises all of its warrants immediately, Fannie still has no capital, still has to raise $30 billion in the equity market, but now has 5.7 billion shares outstanding. Figuring the dilution that would result from Treasury selling its shares and the market anticipating the impact of mammoth capital raises is tricky, but at an average price of $15 per share Fannie would need to sell 2 billion shares of new stock to become fully capitalized. That’s a huge amount to raise in three years, and assuming you could do it, you’d end up with a company earning $11 billion per year, 7.7 million shares outstanding, an EPS of $1.43, and a stock price of about $14 at a 10 P/E ($17 at a 12 P/e).
If I’m a plaintiff, an end state that has a $14 stock versus one with a $70 dollar stock is a huge deal. I would be inclined not to settle without significant alteration of the terms of the warrants, and if I couldn’t get the terms I wanted, I would offer to fund the Washington Federal lawsuit to its conclusion, to get the warrants eliminated entirely.
That why, for me, the unaltered warrant terms are a “deal-killer.” Since Treasury did nothing to earn those warrants–it simply gave them to itself because it could–I would not accept a deal that left them unaltered (and cost me close to $55 per share on the value of the company I want to bring out of conservatorship). But we’ll see what the real plaintiffs do.
But asked by Warner if he does indeed support the recap and release of Fannie and Freddie, Mnuchin threw water on those who hope to see the Trump administration pursue recap and release.
“My comments were never that there should be recap and release,” Mnuchin said. “For long periods of time, Fannie and Freddie were well run and did not create risk to the government. I believe there are very important entities.”
That doesn’t mean that Fannie and Freddie should be left to their own devices, Mnuchin said.
But Mnuchin also said that the status quo of the housing finance system is unsustainable.
“We need housing reform,” Mnuchin said. “We shouldn’t leave Fannie and Freddie alone for the next four or eight years without reform.”
While Mnuchin did not provide specifics for how the Trump administration will seek housing finance reform, Mnuchin said he plans to do it with involvement from both parties.
“It is my objective to find a bipartisan solution to housing finance reform,” Mnuchin said.
Mnuchin was later asked to elaborate on his views on the future of Fannie and Freddie by Sen. Mike Crapo, R-Idaho, who himself is another proponent of housing finance reform.
“Do we need housing finance reform that goes further than recap and release?,” Crapo asked Mnuchin.
“I’m not a Medicare expert but on Fannie and Freddie, I think I am an expert,” Mnuchin said.
“Housing finance reform would be one of my priorities,” he continued. “We need a solution. “The status quo is not acceptable.”
Mnuchin said that he plans to seek a solution “where we don’t put the taxpayers at risk and we don’t eliminate capital for the housing market,” adding that he is “optimistic we can find a bipartisan solution.”
Gary Cohn, National Economic Council director and former Goldman Sachs COO, discusses the Trump administration’s views on the U.S economy, over regulation and more.
FABER: GARY, OUR AUDIENCE INTERESTED IN PART IN THE GSEs. AND I KNOW YOU’VE SPOKEN AND SAID A COUPLE THINGS, BUT WE’RE STILL TRYING TO UNDERSTAND DETAILS IN TERMS OF CHANGING THE CONSERVATORSHIP, CHANGING THE SWEEP, CHANGING BASICALLY WHAT’S GOING ON WITH FANNIE AND FREDDIE. WHAT DO YOU HAVE PLANNED HERE? AND ARE WE ACTUALLY GOING TO SEE THOSE PLANS SOON?
COHN: SO THE GSE REFORM IS DEFINITELY ON OUR AGENDA. TREASURY SECRETARY DESIGNEE STEVE MNUCHIN HAS BEEN SPENDING A LOT OF TIME WORKING ON THAT. ONCE HE GETS APPROVED AND CONFIRMED, STEVE WILL BE TAKING THAT ON AS ONE OF HIS EARLY PRIORITIES. SO WE DEFINITELY HAVE SOME PLANS IN PLACE TO WORK ON THAT. AND HOPEFULLY HE GETS APPROVED AS SOON AS POSSIBLE.
Smart move Chuck! The Stage is Set for Final Victory!
Follow Tim Howard at: https://howardonmortgagefinance.com
Recently filed Motion in Appeals Court
New filing in the Perry Case, click here to view. (Fairholme’s unopposed motion)
2nd filing in the Perry Case, click here to view. (Fairholme’s reply)
3rd filing in the Perry Case, click here to view.
4th filing in the Perry Case, click here to view.
Recently unsealed evidence from the Writ of Mandamus
Joshua Rosner Twitter Post