In a recent post at Barron’s Jonathan Laing placed the private shareholders of Fannie Mae and Freddie Mac in his crosshairs.  When I first commented on his paper, I realized that Barron’s had removed the link to the post (see here).  I have recently been informed that significant portions of that removed post have been preserved by Tim Howard in his trenchant criticisms of  the Liang post, which I urge readers to review.

The gist of Liang’s position is easy to state: he forecasts that the government will win — and should win — its ongoing battle so “that preferred and common shareholders of the government-sponsored enterprises, which were seized by the government in September 2008 amid the U.S. housing crisis, would likely get wiped out.” He thinks that this proposition holds true today, even though smart money investors such as Richard Perry, John Paulson, William Ackman, and Bruce Berkowitz have placed large bets, especially on the preferred shares, that have risen from seven cents to 40 cents on the dollar.

I have long represented several of the institutional investors who are on the opposite side of the case, and take this occasion to explain in some detail why Laing has fumbled the issue so badly on a variety of technical issues that call for some attention. The rebuttal is in two parts. The first deals with his fundamental confusion about the legal status of two key agreements: the initial September 2008 Preferred Stock Purchase Agreement (SPSPA) and the 2012 Third Amendment to the initial agreement. The second concerns his novel and misguided argument that the government has an ace in the hole that will allow it to claim billions in “commitment fees” if its arguments fail on SPSPA.

Seizure versus Purchase

Laing starts of his analysis on the wrong foot by claiming that the government had “seized” the shares of the private shareholders in 2008. Seizure of shares means that the government takes the shares, and with them all of the voting, dividend, and liquidation rights, making them government property. The nicety of just compensation for the residual value taken would not fit into this model. If the 2008 government actions had taken that form, these shares could not have been traded in the private market after September 2008, so that there would have been nothing left to be “wiped out” down the road. The final rites to the private investors could have been read on the day of the seizure.

There was, alas, no seizure. Although the cumbersome words “Senior Preferred Stock Purchase Agreement” nowhere appears in Laing’s revisionist account of the 2008 deal, that is just what happened. It is critical therefore to read these terms with the requisite level of care, because it reflects the understandings that everyone (except for Laing) had of the initial arrangement. The two words “senior preferred” note that the government shares will stand first in line for future cash flows, ahead of the newly rechristened “junior preferred” and the residual common shares, 79.9 percent of which were subject to a government warrant, as yet unexercised, for purchase at a nominal price. The last three words are equally clear. The government purchased those shares for money (ultimately around $188 billion) which it paid to the corporations to allow them to meet their present and future liability. The shares that they purchased contained a dividend for 10 percent per year if paid quarterly, that would be raised to 12 percent per year if the dividend payments were deferred.

The talk of seizure then is a classic misdirection play. It may be the case, as Laing reminds us, that the “the two companies were dead men walking in 2008.” But what he forgets to mention is that the SPSPA did not kill the patient, but revived it, and did so consistent with the general policy under the Housing and Economic Recovery Act, which allowed the Federal Housing Financial Agency to impose a plan that would allow for “the orderly resumption of private market funding or capital market access,” a purpose that is somehow never mentioned by FHFA in its statement of the goals of its conservatorship. Instead, FHFA talks only of the need to “restore confidence in Fannie Mae and Freddie Mac,” and to “enhance their capacity to fulfill their mission” and to “mitigate systemic risk,” while turning all the private shareholder profits after loan repayment over to Treasury.

The selective reinterpretation of the government’s position was driven by its aggressive position in the so-called Third Amendment, in which FHFA and the United States Treasury made an ersatz agreement, according to FHFA’s official website that “the 10 percent fixed-rate dividend was replaced with a variable structure, essentially directing all net income to the Treasury.” At no point does the FHFA note the huge windfall to Treasury from that lopsided deal, instead claiming that “the use of a variable dividend based on net worth helps ensure stability, fully captures financial benefits for taxpayers, and eliminates the need for Fannie Mae and Freddie Mac to borrow from the Treasury Department to pay dividends.”

The first point is surely wrong, because the complete removal of all funds depletes the funds of both Fannie and Freddie. The second point — that the Third Amendment gives all benefits to the taxpayers — is an open admission that FHFA disregarded its fiduciary duties to its junior preferreds. The last point is rather odd, because neither Fannie nor Freddie needed to borrow any money from the Treasury as of the date of the Third Amendment.

Confusion on Commitment Fees

Laing does not contest any of the serious objections to the Third Amendment, even though these form the basis of most of the lawsuits the prospects for which he dismisses. Instead, he makes two arguments, both transparently wrong. First, he notes that Wall Street only took interest in Fannie and Freddie when they showed signs of life. That is exactly as it should be. The value of any financial asset should vary with its anticipated return.

His second point is both novel and bizarre. Let us suppose, he says, that the Third Amendment is struck down; there is still the nasty question of the commitment fee. But what commitment fee? As Laing spins his tale of woe for the private shareholders of Fannie and Freddie, this newly resurrected commitment fee covers the entire $4.5 trillion of loans in the Fannie and Freddie portfolio. At this point, Liang announces that an independent source said that 40 basis points (0.4%) on the $4.5 trillion guarantee portfolio would be reasonable.

It is important to unpack the confusion here.  The issue is tricky, and in an earlier version of this post, I reached the right conclusion with some wrong numbers.  But here is a fuller and more accurate version.  The first point is that Laing’s initial point of  reference is miscast, because it appears that Laing has confused a loan commitment fee, which keeps a line of credit open, with a loan guarantee to pay off all bad debts.

But never mind. Assume that he did not make this elementary apples-to-oranges mistake, such that 0.4% is an appropriate initial benchmark figure for the Fannie/Freddie commitment fee. According to Laing the total owed works out by his otherworldly estimates comes to about $18 billion a year, which was, he imagines, the sum that Treasury had waived prior to the signing of the Third Amendment in 2012. Only now he suggests that this government claim would suddenly spring back to life if the Third Amendment were invalidated. Use that figure for several years, and he concludes that government would still “remain in the driver’s seat at Fannie and Freddie.”   Laing tries to bolster this conclusion further by claiming that the government should be in a position to impose its gargantuan commitment fee “covering the past few profitable years, and into the future.” 

Laing is hopelessly confused. He is right to say that 2008 agreement called for a commitment fee that was to be paid Treasury by Fannie and Freddie. But Laing misstates what that commitment fee was for. A key look at Article 3 of the 2008 agreement shows that its commitment fee starts to accrue from January 1, 2010. Article 3 also states that the United States “may waive the Periodic Commitment Fee for up to one year at a time, in its sole discretion, based on adverse conditions in the United States mortgage market.” In fact, that fee was uniformly waived by Treasury prior to the time of the Third Amendment in August 2012.

It is, however, sheer fantasy to claim that it passed unnoticed that the United States waived $18 billion in annual fees as of 2010. It is equally incorrect to say that, once waived, these mythical fees could be recovered afterwards. But Laing’s most glaring omission is that he ignores that the commitment fee was “intended to fully compensate [the United States] for the support provided by the ongoing Commitment after December 31, 2009.”

The standard definition of a commitment fee in Investopedia reads:

A fee charged by a lender to a borrower for an unused credit line or undisbursed loan. A commitment fee is generally specified as a fixed percentage of the undisbursed loan amount. The lender charges a commitment fee as compensation for keeping a line of credit open or to guarantee a loan at a specific date in future.

At this point, the initial question is to determine the base on which the commitment fee should be calculated. As a first approximation, Fannie and Freddie each received a $200 billion line of credit, for a total of $400 billion. Additional adjustments raised that total to about $430 billion. Of that total now about $180 billion has been drawn. Left outstanding therefore is about $250 billion, to which the commitment fee could attach. For the past years no fees can be imposed, moreover, because they have already been waived.  Going forward, the 0.4 percent standard works out to about $1 billion per year for the current year, maximum.  Beyond that year, any commitment fee could only be imposed on the shrinking unused credit line.  That 0.4 percent  figure is, moreover, likely to prove excessively high because the level of any commitment fee depends not only on the amount of the unused line of credit, but also on the spread between the market rate and the commitment price.  By 2012, much of the risk in this transaction had been eliminated, so that the 10 percent interest rate was in all likelihood higher than the market rate that Fannie and Freddie could obtain.  It follows therefore that the commitment fee for that amount should be cut sharply, although by how much it is not clear. 

Going forward, the fees in question would continue to fall as Fannie Mae and Freddie Mac quickly build capital because (1) the capital base reduces the risk of a draw on the commitment and (2) the 10% yield that Treasury would receive in the unlikely case of a draw becomes even more of a premium to market.  In fact, under the agreement, the $250bn backup commitment is completely eliminated once Fannie Mae and Freddie Mac have built sufficient capital such that they have reasonably provided for their liabilities, at which point the commitment fee is zero.  Without real precise information, it is impossible to get a precise number, but my own back-of-the envelop calculations suggests that $2 billion will be a high figure for any aggregate fee over a number of years until the fee is zeroed out, and my guess is that the actual number would be well under $1 billion.

The government, moreover, cannot juice up the figure because the fee must be agreed to by both parties, and, in consultation with the Federal Reserve, which means that the issue has to go to mediation or arbitration in the case of deadlock, and those figures must reflect the underlying realities. In the grand scheme of things the commitment fee, if any, is at most a rounding error, not a knock out punch.  Ironically, the likely outcome is that the government will continue to waive the commitment fee going forward, given that it does not want to jeopardize its already weak legal position on the Third Amendment before the litigation is resolved.  In practice, it looks $0 is the best evidence of what the government will collect from this source.  It is no wonder that even the government has not made any argument about this mythical commitment fee in its papers.  

One conclusion emerges from Laing’s exercise in financial fantasy: Neutral investors sitting on the fence would do well to listen to the lions of Wall Street and to disregard Jonathan Laing’s jeremiad about the Fannie and Freddie shareholder suits against the United States.