Street Capitalist: Event Driven Value Investments

According to the Wall Street Journal the Treasury is going to release the details of the bailout plan for Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE) Sunday afternoon. It looks like they want to announce it before Asia commences trading Sunday evening, a bit like they did with the news release about Bear Stearn’s acquisition.

Here is some specific news regarding shares and dividend payments:

The Federal Housing Finance Agency, Fannie and Freddie’s regulator, is to use its legal powers to put the companies under conservatorship. Those powers allow the FHFA to run the companies indefinitely, under certain conditions, such as when the regulator finds that they are likely to be unable to meet their financial obligations. Fannie and Freddie have run up combined losses totaling about $14 billion over the past four quarters and face heavy additional losses amid the worst surge in U.S. home-mortgage foreclosures since the 1930s.

Fannie and Freddie own or guarantee more than $5 trillion of U.S. home mortgages, nearly half of the total outstanding.

Dividends on the companies’ preferred stock are likely to be suspended, people familiar with the plan say, and those on common shares to be eliminated. Any injection of capital by the Treasury would likely greatly reduce or wipe out the value of common shares currently outstanding.

Treasury to Outline Fan-Fred Plan (WSJ)

Just who owns Fannie and Freddie’s debt?

Asian investors were among the most important groups to soothe because central banks, financial institutions and funds in the region own $800 billion of Fannie Mae and Freddie Mac’s $5.2 trillion in debt, according to data compiled by the Treasury. U.S. officials were concerned that sales from the region would push lending rates higher, said the people, who declined to be named because the discussions were confidential…

Freddie and Fannie rely on foreign institutions. Investors and central banks outside the U.S. own about $1.3 trillion of Fannie and Freddie’s corporate and mortgage bonds, according to the Treasury. Chinese institutions are the biggest holders in Asia. European investors own $300 billion of the securities.

“If they stop buying the agency debt, then yields would increase,” Ajay Rajadhyaksha, the head of U.S. fixed-income strategy at Barclays Capital in New York, said in reference to Asia investors. “The costs would get passed to the consumers.”

Fannie’s Mudd Soothed Asian Investors as Yields Rose (Bloomberg)

The US Government’s backing is key here. Without it, we’d likely see the kind of selling that the Bloomberg article describes as a possibility. From the way the plan looks to me, bond holders (our foreign friends) will be completely protected which should keep rates from rising and assuage some fears about our creditworthiness. The WSJ still paints a mixed picture for the equity holders - it does mention however that if the Treasury chooses to recapitalize Fannie and Freddie with a new class of shares, the shares will fall to near $0 while limiting moral hazard and tax payer losses.

Politicians from both sides of the aisle are explicitly talking about using plans that would protect tax payers, so the probability of a scenario like this occurring should be high. All of the language used to describe the plan thus far seems worded to leave no doubt that the government will completely protect bondholders, which makes me believe Fairfax’s credit default swap positions on FNM and FRE will go to 0.

I don’t have a stake in either of these companies, but the implication of a bailout will indeed have effects on the economy. A few well known value investors took the bait on them:

No question, this panic-state among financial stocks has resulted in current portfolio pain. However, history reminds us that extreme valuation opportunities occur in world-class franchises like Freddie and Fannie only when most investors have given up on them. In our own 12-year history we have taken advantage of this phenomenon many times; several of our portfolio holdings were outstanding businesses that we were able to purchase at a fraction of their fair value due to the conventional wisdom at the time.

Looking at this list we can recall the market sentiment surrounding each at their weakest points, and the characteristics are eerily similar to that surrounding the GSEs today; current bad news, uncertainty about the likely duration and depth of the bad news, management missteps, accounting shenanigans, and stronger / better competitors. It is precisely because investors tend to focus exclusively on the struggle of the moment that real analysis becomes the province of the very few daring to question the crowd. This commitment to analyze when everyone else has given up is the fundamental force that drives the excess long-term returns for value investors, and is why we believe Fannie Mae and Freddie Mac are extraordinary values.

FREDDIE MAC AND FANNIE MAE: A SPECIAL UPDATE (Pzena Investment Management)

Pzena states that extreme valuation opportunities occur when investors give up on them, but that really wasn’t the case here. The equity holders of FannieMae (NYSE:FNM) and FreddieMac (NYSE:FRE) were buying ownership of as Barack Obama likes to call it a “weird blend” of private and public entities. When you do that, you open yourself up to the risk of the government having to step in and bailout the company if things go wrong. When that happens, you (the equity holder) are not bailed out because they are not obligated to do so. Instead, their primary focus is only keeping these companies up and running and that was the real worst-case-scenario for their valuation, not fair book value but $0.

In the context of tough credit markets and a poor housing market, I’m unsure of how an investor could have really perceived a true margin of safety with either of these companies because of their relationship with the government. Still, there are conflicting views on what shareholders will get, according to Bloomberg:

Shareholder Fate

Washington-based Fannie and Freddie dropped in after-hours trading. Fannie fell $2.25, or 32 percent, to $4.79 at 5:50 p.m. in New York Stock Exchange trading and Freddie slumped $1.40, or 27 percent, to $3.70. Fannie is down about 66 percent since the end of June as concerns about the companies’ capital grew. Freddie has fallen about 69 percent.

Fannie’s market capitalization is now $7.6 billion, down from $38.9 billion at the end of last year. Freddie’s has fallen to $3.3 billion, from $22 billion over the same period.

The Washington Post reported that the government would make quarterly injections of funds as the companies’ losses warranted, avoiding a large up-front taxpayer cost, citing sources it didn’t name. Debt and preferred shares would be protected, and common stock would be diluted while not wiped out, the Post said.

The New York Times said most or all of both the common and preferred shares would be worth little or nothing.

One of the things I’m curious about is the effect of this on credit default swaps. My largest holding, Fairfax Financial (NYSE:FFH) owns credit default swaps on both Fannie and Freddie. I’ve been wondering about how this might turn out for those positions. According to the New York Times:

As UBS analysts point out, because Fannie’s and Freddie’s subordinated debt is used when they calculate capital — the financial cushion regulators require to support the companies’ operations — interest payments on the debt may have to stop if a bailout occurs. Such a hiatus could last up to five years.

While this would hurt subordinated debt holders, a deferral of interest payments has even broader ramifications. Halting those payments would put the bonds into default and force payouts on credit insurance that has already been written. In the debt market, this is known as a “credit event.”

Because nonpayment of interest would be seen as a credit event, UBS added, entities that have bought protection on Fannie’s and Freddie’s subordinated debt would be entitled to payment by the entities that wrote the insurance. This, even though taxpayers are standing behind Fannie’s and Freddie’s debt, not allowing it to fail. Talk about the laws of unintended consequences.

However:

It is possible, of course, that a Mac ’n’ Mae bailout will be structured so as not to force credit default swap payouts. Or regulators could step in and require parties on both sides of the Fannie and Freddie credit insurance trade to unwind their stakes at heavily discounted levels. Such has been the nature of recent deals struck by financial guarantors like Ambac at the behest of the New York State Insurance Department. In one deal, the credit default swap buyer got just 13 cents on the dollar; in another deal, the buyer got 61 cents.

What Will Mac ’n’ Mae Cost You and Me? (NYTimes)

So it seems like until we get more details about the bailout plan, CDS holders will be left wondering about what happens. Hopefully that will come till monday. If anyone has a different view on how the CDS positions will be affected, feel free to comment.

Below is a cool chart I found in the bailout article:

U.S. Rescue Seen at Hand for 2 Mortgage Giants (NYTimes)

I found this chart at the Los Angeles Times that I thought is nice, it breaks down issues on the economy and provides us with both of the candidate’s views on it. As an investor, some areas of interest to me at least are Obama’s inclination to raise the tax on capital gains. While not necessarily a terrible idea, I would hope that he tries to at least tax areas like green investments less.

The other area I like to watch is the federal budget, I’m a big believer that one of the reasons for the poor performance of the dollar is our ballooning deficit. McCain appears to be a classic fiscal conservative on this end, but his plans seem much less concrete. He just says he’ll reduce earmarks but does not give us any idea on how much. Obama on the other hand at least wants to assure that we have the revenue available for new spending while also cutting earmarks.

Source: McCain and Obama have contrasting economic plans (LA Times)