5. Conclusion
Investment
Overview
Valuation Considerations ConclusionLitigation
ParkerKim,JohnConnell,AngelaMorisette
FNMA Timeline
Government spends $188bn to bail out
FNMA in exchange for senior preferred
stock offering a 10% dividend
Federal Housing Finance Agency (FHFA)
puts FNMA under conservatorship
2008:
Financial Crisis
2012:
Government
amends
agreement
Current:
Ongoing
litigation
Future:
shareholders
win/lose
FNMA unexpectedly returns to
profitability
US Government forgoes previous
dividend policy and lays claim to all
FNMA profits effectively shutting
off equity holders from future
earnings
Shareholders file lawsuits against the US
Government alleging the Treasury acted
illegally when it amended the terms of
FNMA’s deal with the government
There are two possible outcomes for
FNMA’s shareholders as value is
derived from future legislation, not
FNMA’s core business
9. Investment
Overview
Valuation Considerations ConclusionLitigation
ParkerKim,JohnConnell,AngelaMorisette
Key Issue
Under 2008 SPS Agreement
FNMA Profits
CF to Government
(Fixed Amount- 10%)
CF to Private Investors
(Residual)
Senior
Preferred
Stock
Preferred and
Common Stock
Senior
Preferred
Stock
CF to Government
All Profits
Under 2012 Amended Agreement
Key Issue:
Does the US Treasury and FHFA’s seizure of private profits violate
by amending the terms of its stock to eliminate all private shareholders?
the Takings Clause of the 5th Amendment
10. Investment
Overview
Valuation Considerations ConclusionLitigation
ParkerKim,JohnConnell,AngelaMorisette
Litigation Overview
Perry Capital Treasury & FHFAv.
ArgumentSupport
The Treasury’s 2012
amendment to the SPS
agreement is illegal under
the Takings Clause of the 5th
Amendment and is an abuse
of power as a conservator
As FNMA is a GSE and the FHFA is its
appointed conservator, FHFA has
unrestricted control over the
company to impose any changes to
the SPS agreement
Conservative interpretation of
HERA governing FHFA
Precedent court case
Expert opinion
Very liberal interpretation of
HERA and FDIA
11. Investment
Overview
Valuation Considerations ConclusionLitigation
ParkerKim,JohnConnell,AngelaMorisette
HERA and FDIA Language
“The Conservator’s duty is to operate, rehabilitate, reorganize, and restore the health
of the troubled institution. When that is achieved, the conservatorship is terminated,
and the institution is returned to the private sector.”
– §1145, HERA (2008)
FHFA & Treasury Argument:
Like §11 of the
FDIA, §1145 of HERA
says the conservator has
a higher power than any
and all stakeholders in
the business
This sounds like
property rights of
stakeholders are wiped
out under
conservatorship;
however…
12. Investment
Overview
Valuation Considerations ConclusionLitigation
ParkerKim,JohnConnell,AngelaMorisette
HERA and FDIA Language
“The Conservator’s duty is to operate, rehabilitate, reorganize, and restore the health
of the troubled institution. When that is achieved, the conservatorship is terminated,
and the institution is returned to the private sector.”
– §1145, HERA (2008)
FHFA & Treasury Argument:
Like §11 of the
FDIA, §1145 of HERA
says the conservator has
a higher power than any
and all stakeholders in
the business
This sounds like
property rights of
stakeholders are wiped
out under
conservatorship;
however…
“…stakeholders retain
their right to payment or
settlement of their claims
on the business…”
“It shall, to the extent of proceeds realized
from performance of contracts or sale of
assets of the institution, pay all valid
obligations of the regulated entity at the time
that are due and payable at the time.”
Rebuttal:
13. Investment
Overview
Valuation Considerations ConclusionLitigation
ParkerKim,JohnConnell,AngelaMorisette
HERA and FDIA Language
“The Conservator’s duty is to operate, rehabilitate, reorganize, and restore the health
of the troubled institution. When that is achieved, the conservatorship is terminated,
and the institution is returned to the private sector.”
– §1145, HERA (2008)
FHFA & Treasury Argument:
Like §11 of the
FDIA, §1145 of HERA
says the conservator has
a higher power than any
and all stakeholders in
the business
This sounds like
property rights of
stakeholders are wiped
out under
conservatorship;
however…
“…stakeholders retain
their right to payment or
settlement of their claims
on the business…”
“It shall, to the extent of proceeds realized
from performance of contracts or sale of
assets of the institution, pay all valid
obligations of the regulated entity at the time
that are due and payable at the time.”
Rebuttal:
HERA and FDIA language supports Perry Capital’s claim that
the Senior Preferred Stock Agreement amendment was not within FHFA’s
power as an appointed conservator.
14. Investment
Overview
Valuation Considerations ConclusionLitigation
ParkerKim,JohnConnell,AngelaMorisette
Precedent Case
O’Melveney & Myers v. FDIC (1994)
American Diversified Savings Bank (ADSB) shareholders in conflict with conservator
The FDIC believes its fiduciary duty is to taxpayers, not to ADSB shareholders
Supreme Court rules 9-0 in favor of shareholders
The O’Melveney & Myers v. FDIC case serves as an effective precedent
that tells us courts will issue a ruling in favor of FNMA shareholders
15. Investment
Overview
Valuation Considerations ConclusionLitigation
ParkerKim,JohnConnell,AngelaMorisette
Expert Opinions
Takings law asserts- as it’s currently construed—if the
qualitative value of FNMA being wound down is being used as a
reason for winding it down—you still need to provide just
compensation for existing stakeholders.
““
Richard Epstein-- Professor in Constitutional Law, NYU
…[language] in the FDIA and the FDIC has shown precedent in
following procedures to maximize value for shareholders.
““
Randall Guynn-- Partner and Head of Financial Institutions Group, Davis, Polk & Wardwell
16. Investment
Overview
Valuation Considerations ConclusionLitigation
ParkerKim,JohnConnell,AngelaMorisette
Expert Opinions
If there is disclosure regarding future Fannie and Freddie
earnings and the administration has a commitment that
existing Fannie and Freddie common equity holders will never
receive any future positive earnings…this commitment would
be material to investors and should be disclosed.
“ “
Lewis Lowenfels-- Managing Partner, Tolins & Lowenfels
Takings law asserts- as it’s currently construed—if the
qualitative value of FNMA being wound down is being used as a
reason for winding it down—you still need to provide just
compensation for existing stakeholders.
““
Richard Epstein-- Professor in Constitutional Law, NYU
…[language] in the FDIA and the FDIC has shown precedent in
following procedures to maximize value for shareholders.
““
Randall Guynn-- Partner and Head of Financial Institutions Group, Davis, Polk & Wardwell
Expert sentiment is overwhelmingly in favor of FNMA shareholders:
Additionally, experts agree that FNMA has a case on both a constitutional
and contractualbasis.
18. Investment
Overview
Valuation Considerations ConclusionLitigation
Decision Tree
Favorable
Unfavorable
PT: $40
$0
9.3%
90.9%
Litigation Outcome Payoff Market-Defined Probability
Due to its investor sentiment surrounding FNMA’s past and the
risk appetite of investors leaving FNMA, current prices do not
accurately reflect the expected value for the litigation payouts.
19. Investment
Overview
Valuation Considerations ConclusionLitigation
Peer Analysis
P/E P/B
Apartment and Investment Management Trust AIV 21.7x 4.9x
Equity Residential EQR 10.0x 2.0x
UDR Inc UDR 16.3x 2.3x
American Capital Agency Corp AGNC 6.8x 0.9x
Anworth Mortgage Asset Corporation ANH 10.6x 0.9x
Annaly Capital Management NLY 3.0x 0.9x
Capstead Mortgage Corporation CMO 13.8x 1.0x
MFA Financial, Inc. MFA 10.0x 0.9x
Median 10.3x 1.0x
FNMA .65x NA
Relative Valuation
26. Investment
Overview
Valuation Considerations ConclusionLitigation
Investment Execution
Due to its rare risk-return profile, FNMA’s payoffs can result
in immaterial losses, but its upside potential contributes
significantly to overall portfolio return if sized correctly.
Portfolio Return:
+15%Portfolio Return:
-1%
Catalyst
FNMA
Rest of Portfolio
29. Conclusion
Investment
Overview
Valuation Considerations ConclusionLitigation
Investment Thesis
Shareholders are suing the US Treasury over unlawful
seizure of private assets
This seizure of shareholder assets is a violation of the
Takings Clause of the 5th Amendment
Should the court rule in favor of shareholders, we
believe substantial value to be unlocked
FNMA presents an astounding 10-15x in upside
potential
31. Investment
Overview
Valuation Considerations ConclusionLitigation
Appendix Slides
Government Plans for FNMA- 23
Intrinsic Valuation- 24
Legislation Current Progress- 25
Capital Structure- 26
Risks- 27
Price Chart- One Year- 28
Management- 29
Circumstances Surrounding Entering Conservatorship- 30
Capital Structure Breakdown over time- 31
Shareholder Base- 32
Senior Preferred Stock Agreement- 33
Historical Interest Income- 34
FDSO Calculation- 35
DCF Flaws- 36
Calculating Discount to P/E- 37
Addressing the GSE- Ultimate Power- 38
Theodore Olson – Strong Attorney- 39
O’Melveny and Myers v. FDIC 1994- 40
Existing FNMA Structure- 41
Government Suggested Structure- 42
Price Chart- Since 2007- 43
Why is it Mispriced?- 44
Recent News Decision Trees-45
Housing Industry in Regards to FNMA- 46
Credit Quality- 47
Twitter Sentiment Analysis- 48
Litigation- 6
Valuation- 12
Conclusion- 19
32. Investment
Overview
Valuation Considerations ConclusionLitigation
Government Plans for FNMA
1
Only if the government wipes out shareholders through legislation
means will it be able to shut down FNMA
2
A new system would feature several smaller versions of FNMA in which
the government would financially back mortgages—not firms.
The government’s plans for FNMA do not impact
FNMA’s value unless the government is able to wipe out
private investors.
34. Investment
Overview
Valuation Considerations ConclusionLitigation
Legislation Current Progress
Post-CourtCourt, 1.5 years
D issues
rebuttal in
November
2013
P files lawsuit
against D in July
2013
A federal judge grants
P a motion to conduct
discovery in February
2014
Lower Court Supreme Court P WINS
D WINSAppeal
State Court
Appeal
Right now, Perry Capital LLC v.
Department of Treasury is in pre-court
phase
Pre-Court, 8 months
35. Investment
Overview
Valuation Considerations ConclusionLitigation
Capital Structure
Held by US Treasury, initially issued to provide a bailout
during 2008.
Initially Issued with a 10% dividend paid quarterly on the
liquidation preference, with unpaid dividends accruing to the
LP. Amended in 2012 to pay out all of net worth.
A
117.1bn
24.1bn
19.1bn
Senior Preferred Stock-
E-Shares Preferred Equity-
2.25% dividend payment on liquidation preference.
Non-cumulative dividend, perpetual maturity.
Entitled to full dividend satisfaction before funds can be passed
on to common equity holders.
Common Equity-
US Treasury currently holds warrants to purchase up to 79.9% of
outstanding common stock that have not yet been exercised.
Under the existing senior preferred stock agreement, no new
common equity may be issued.
C
B
36. Investment
Overview
Valuation Considerations ConclusionLitigation
Risks
There is no precedent that dictates
FHFA cannot abuse its conservator
powers to eliminate equity holders
O’Melveney & Myers v. FDIC
Gave a related decision that the
FDIC’s role as a conservator was to
maximize firm value
FNMA’s stock price currently
reflects concerns over distributable
cash flows, not the fundamentals
of the core business
The core business will struggle if
the overall housing market
deteriorates- eroding FNMA’s
significant upside potential
38. Investment
Overview
Valuation Considerations ConclusionLitigation
Management
Timothy J. Mayopoulos, President and CEO
CEO since June 2012, joined FNMA in 2009 serving as General Counsel and
EVP
25 Years of legal Experience in BAML, CSFB, DB, and DLJ, DPW
$600K Base and Total Salary
David C. Benson, 54, Executive VP and CFO since April 2013
Served in FNMA/FMCC for 12 years in various executive roles
Previously an MD for Merrill Lynch
$574k Base Salary, $1.4M Deferred Salary
Terrence W. Edwards, 58, Executive VP and COO since Sept. 2013
Joined FNMA in Sept. 2009 in Credit Portfolio Management
Previously CEO of PHH Corporation, a mortgage and fleet management
services company and CEO of Cendant Mortgage Company
$500K Base Salary, $1.2M Deferred Salary
39. Investment
Overview
Valuation Considerations ConclusionLitigation
Circumstances Surrounding Entering
Boards of Fannie and Freddie consented to being put into
conservatorship because that would insulate the boards from liability
At the time, the board consented to entering conservatorship on a
number of agreements- one of which was that it would remain publicly
held so it could emerge from conservatorship as a private company with
normal corporate governance structure.
Had the board not consented to entering conservatorship, FHFA did NOT
have the statutory authority to force the company in. So turning back on
this is highly illegal
FHFA now says they have a responsibility to taxpayers to destroy it– but!
HERA and FDIA and Precedent court cases tell us as a conservator, you owe
shareholders more than taxpayers
41. Investment
Overview
Valuation Considerations ConclusionLitigation
Shareholder Base
Existing Shareholders
Shares Ownership
Pershing Square Capital Mgmt. 115.6m 9.98%
Fairholme Capital Mgmt. 25.9m 2.24%
Capital Research & Mgmt. Co. 12.5m 1.08%
Seamans Capital Mgmt. 2.2m 0.19%
13D Mgmt. .6m 0.05%
Buying Shareholders
New Shares Ownership
Pershing Square Capital Mgmt. +115.6m 9.98%
Fairholme Capital Mgmt. +25.9m 2.24%
Seamans Capital Mgmt. +2.2m 0.19%
13D Mgmt. +.6m 0.05%
Jet Capital Investors +.4m 0.03%
Selling Shareholders
New Shares Ownership
MetLife Advisers, LLC -.2m 0.01%
Lord, Abbett & Co. -.1m 0.06%
42. Investment
Overview
Valuation Considerations ConclusionLitigation
Senior Preferred Stock Agreement
Issued as an initial commitment fee in consideration of the commitment
from the treasury to provide funds.
On a quarterly basis, they can draw funds up to the amount, if any, by
which their liabilities exceed total assets.
The stock started at 1.0bn liquidation value, but has had mispayments
of dividends accrue to a total liquidation value of 117.1bn
Used to be 10% dividend but this has changed to an amount based on
net worth (total assets – total liabilities) – capital reserve (2.4bn – 600m
each year until zero on Jan 1 2018) <- effectively no CF to other
ivnestors, this is whats being lawsuited (2012 amendment to the
agreement)
They can pay common stock dividends after the senior pref is paid in full
with all liquidation pref and dividends
Funding commitment must be terminated in order to fully buyout the
treasury
45. Investment
Overview
Valuation Considerations ConclusionLitigation
DCF Flaws
We do not believe there is a material variant perspective when pricing the
fundamentals of a $300bn secondary mortgage financing giant
Consequently, we believe analyst estimates serve as our best insight into the
value of FNMA under normal capital payout structures
Additionally, applying a single WACC for FNMA is inappropriate, as the risk of
FNMA is tied to its capital structure-related cash flow considerations, not the
core fundamentals of the business.
46. Investment
Overview
Valuation Considerations ConclusionLitigation
Calculating Discount to P/E
For the Fiscal Period Ending
Restated
12 months
Dec-31-2003
12 months
Dec-31-2004
Reclassified
12 months
Dec-31-2005
Reclassified
12 months
Dec-31-2006
Currency USD USD USD USD
Interest and Div. Income, Total 47,833.0 47,456.0 44,756.0 42,936.0
Interest Expense, Total 29,587.0 29,737.0 33,339.0 36,875.0
Net Interest Income 18,246.0 17,719.0 11,417.0 6,061.0
%Margin 38.1% 37.3% 25.5% 14.1%
Average = 28.8%
Average (ex-2006) = 33.7%
Median = 31.4%
2013 Margin = 22.2%
Avg Margin = 33.7%
22.7/33.7 = 33% Discount
“Normalized
Profitability Potential”
Assuming capped
profitability
48. Investment
Overview
Valuation Considerations ConclusionLitigation
Theodore Olson – Strong Attorney
Appointed to U.S. Solicitor in 2001, served until 2004 when
he retired and went back to private practice
Olson successfully represented presidential candidate George
W. Bush in the Supreme Court case Bush v. Gore, which
effectively ended the recount of the contested 2000
Presidential election.
2006 – landmark case, defended journalists in Supreme Court
case to defend their rights to keep sources confidential, even
as request of court
2011 - awarded the ABA Medal, the highest award of the
American Bar Association
Won federal lawsuit for plaintiff in Perry v. Schwarzenegger,
which challenged Proposition 8, a California state
constitutional amendment banning same-sex marriage
Named one of Time’s Top 100 Thinkers for his work on
this case
“The government’s scheme to wipe out these investors is bad policy and a plain violation of the law that
respects private, investment-backed expectations and our constitutional protection of property rights.”
49. Investment
Overview
Valuation Considerations ConclusionLitigation
O’Melveny and Myers v. FDIC 1994
FDIC tried to show it had power beyond what the FDIA
allowed for it in conservatorship, but the supreme court said
under the statute, when you become a conservator, you step
into the shoes as a stakeholder and have a duty to maximize
value for the stakeholders.
53. Investment
Overview
Valuation Considerations ConclusionLitigation
Why is it mispriced?
Overly Negative Investor Sentiment
Few people want to be involved with a company that was at the headlines
of 2008’s housing meltdown
2008 overshadows the litigation thesis
Unique Risk Appetite Required
Few investors are willing to invest in something where a 100% loss is
possible, ignoring the significant upside.
Litigation Analysis
Our precedent case is not a direct reference to the FHFA-HERA case, as it
relates to FDIC-FDIA but given how FHFA-HERA are modeled after FDIC-
FDIA we believe it is a perfect precedent case nonetheless.
54. Investment
Overview
Valuation Considerations ConclusionLitigation
Recent News Decision Tree
Today
Litigation Outcome
FNMA is
able to pay
out profits
Post-Litigation Outcome
FNMA continues
on with the SPS
dividend = NI
FNMA is wound
down according to
Johnston-Crapo
Probability/Payout
80% / $40
10% / $0
10% / $0
55. Investment
Overview
Valuation Considerations ConclusionLitigation
Housing Industry in Regards to FNMA
As rates rise, lenders will loosen rates and more mortgages will be
available on the market
“Since 1999, mortgage purchase applications and all measures of sales
activity have actually been higher when mortgage rates were higher.” -
Forbes
In 2013, 2.5 million underwater homeowners regained positive equity
status thanks to an increase in housing value which strengthens FNMA’s
existing portfolio
Why? As default risk in FNMA’s portfolio decreases, FNMA’s investments
are more likely to reach maturity
Forecasted market trends do not negatively affect FNMA’s business
model
“Frankly, we see that our retail execution, selling individual homes to
individual buyers, as still our best execution strategy. So, we will still
continue to do the vast bulk of our executions in that way.” –FNMA CEO
Timothy Mayopoulus (Q4 2013)
57. Investment
Overview
Valuation Considerations ConclusionLitigation
Twitter Sentiment Analysis
-100% 0% 100%
Negative Neutral Positive
Average sentiment per tweet mentioning litigation
-21%
Simple random sample of top 1400 most influential tweets from March 10th – March 18th
Classified each tweet in two categories:
Litigation mentioned, yes or no?
Sentiment score: 1 positive, 0 neutral, -1 negative
Calculated the net effect of positive and negative tweets as an average sentiment per tweet
