Re: Fannie/Freddie-The Roadmap From Here. In this thread, I’m going to interpret 1) what just happened and why, 2) what it portends, 3) what confirmatory tells to look for on the way. All opinions my own, as I don my financial engineering hat once more…

1) What Just Happened and Why? MC has always said that the time to capitalize the GSEs is when the “sun is shining.” I wholeheartedly agree, and that time is NOW. Hence, I’ve always believed that the long “retain/recap” thesis is fraught with danger.

SM, MC, and JY (aka Princess Leia) all know this. But how do you incentivize a “fast recap”? A full write-down of SPS ahead of time would have inflated the EV and likely discouraged Big New Money from coming in. Doing nothing is even worse.

So they navigated between Scylla and Charybdis by making the capital retention proportionate to liquidation preference rising. I think of this as establishing an “escrow account” for the earnings power.

But they announced that the “key” to this lockbox would be reaching 3% Tier 1/settlement of the derivative claims. Why announce what the key is if the intent was to just escrow away the earnings and let the entities remain insolvent?

2) What It Portends? What I think happened behind-the-scenes here is that SM consulted with JY and the FAs and got consensus on this plan ahead of time with a tacit agreement to forgive the SPS in conjunction with Big New Money Checks/settlement.

This insures that Big New Money Participation will come in because the valuation is attractive. It’s the only way to break the chicken-an-egg problem of 1) inflate the EV too much and no new money wants to invest, 2) do nothing, and definitely no want will invest.

Some interesting tells: 1) why establish a target capital % and settlement targets? 2) why carve out the only claims that are likely not going to settle ($5 bn direct)? 3) why establish a 9/30/21 deadline if JY really was hostile to the idea?

Coming back to my options framework of JPS being call spread between SPS par and JPS par and legacy common being call struck at JPS par. We now have the low strike of our call spread rising to incentivize a settlement.

3) What Tells To Look For? Another interesting exit precondition is the exercise of gov warrants in legacy common. No, this should NOT be viewed as a profit-maximizing motive but rather potentially a loss-mitigating move for Tsy.

I’ve long believed that the disparity between pref cap and common cap was more technical than fundamental. I think this exit precondition supports my conjecture. I think Tsy will exercise these warrants and try to unload what they can as long as legacy common remains > 0.

Big New Money will NOT be coming in at the legacy common level, when the fulcrum security (JPS) now trades below 20c.

For those of you not familiar with the restructuring process, this happens all the time. If a senior security is impaired, that senior security BECOMES the newco equity and is also where the Big New Money will invest. Every FA knows this.

Legacy common is an OTM call that is becoming more and more OTM with this rising SPS “escrow account.” But the key to unlocking that account is going to come from the fulcrum where Big New Money is raised.

So back to my options analysis: the JPS essentially gets exercised into newco common. The low strike of this “call spread” will be whatever SPS floor still remains as part of the settlement. The legacy common (call option struck at JPS par) expires OTM.

The reason why the slow “retain/recap” thesis won’t work is that at any point in time the new Admin could get caught with its pants down if there’s a downturn. MBS stability is key, and I’m not talking Mohammed bin Salman anymore.

This way, Big New Money is ASSURED and breaks the chicken-and-egg logjam of how to incentive new money without first inflating the EV.

Some back-of-the-envelope math to provide clues on what comes next. SPS currently stands at $229 bn and counting. Without this amendment, they would’ve been close to their $45 bn cap. Uncapping this keeps excess divs out of Biden Admin’s hands and puts into “escrow.”

What’s normalized earnings power assuming no changes in commitment fees/g-fees? I hear $20 bn and I hear $30 bn. Let’s split the diff and call it $25 bn and slap a 10x multiple. Newco EV could be worth $250 bn, but cap reqs dictate that pretty much all of this EV will be equity.

With year-end cap levels at nearly $50 bn and a roughly $200 bn total cap req, it’s not coincidental that this amendment is carving out $140 in new raises. Equitizing $33 bn of JPS is MATERIAL to reach this bogey.

The Billion Dollar Question: what % of newco equity will JPS wind up owning? The is where the Grand Settlement comes in. This agreement clearly places JPS as the fulcrum for New Money because of not only its place in the cap stack but its leverage in the courts.

But what about derivative claims from common holders? They can very well win a Pyrrhic victory here and win on the derivative claims but have no say in where New Money gets raised. I am increasingly confident that legacy common will own a de minimus % of newco equity.