Bill Ackman's Letter to Paulson On Restructuring Plan

by: SA Editors September 06, 2008 | about stocks: FNM / FRE    
Seeking Alpha

By SA Editors

Become a Contributor Submit an Article
  • Font Size:
  • Print

Pershing Square Capital Management, L.P. sent the following letter Friday
to the U.S. Treasury Department regarding Fannie Mae (NYSE: FNM) and
Freddie Mac (NYSE: FRE):

• • •

September 5, 2008 The Honorable Henry M. Paulson, Jr. Secretary United
States Department of the Treasury 1500 Pennsylvania Avenue, N.W.
Washington, D.C. 20220

Re: Fannie Mae/Freddie Mac Restructuring

Dear Secretary Paulson:

We understand that a Treasury plan for Fannie/Freddie (“the GSEs”) may
be announced this weekend. We thought you might find useful some further
thoughts on potential GSE solutions.

As you are likely aware, we had previously distributed a proposed
restructuring plan for the GSEs. In that plan, under a prepackaged
conservatorship, equity interests would be extinguished, subordinated
debt would be exchanged for warrants, and senior debt would be exchanged
for new senior debt and common equity in the newly recapitalized
entities. The government would write a put to the new common equity
holders which would expire in three years.

It appears, however, that the GSEs may need help more quickly, and
conservatorship may not be triggered until the GSEs are formally
determined to be undercapitalized. As such, in the event the government
needs to inject capital immediately, we suggest you consider the
following transaction (“the Transaction”).

In order to minimize risk to taxpayers while being equitable to other
constituents, we suggest that the Treasury consider purchasing senior
subordinate debt in the two companies in an amount sufficient to address
their capital needs in the short to intermediate term. This senior sub
debt would be junior in right of payment to the outstanding senior
unsecured debt and senior to the outstanding sub debt, preferred stock,
and common equity. We refer to the outstanding sub debt, preferred and
common stock as “the Subordinate Securities.”

The issuance of senior sub debt is permitted under the GSE legislation
and under the existing terms of the outstanding debt and equity
securities of the two entities (please see the attached memo for further
details). As a condition of Treasury’s purchase of senior sub debt, the
GSEs would defer the interest payments on the outstanding sub debt
(which can be deferred for as much as five years), and the dividend
payments on preferred and common stock. All of the Subordinate
Securities would continue to remain outstanding according to their
existing terms.

The new senior sub debt should have a market-based coupon and Treasury
should receive low-strike price warrants (penny warrants) for a
substantial portion, i.e., 49% of the two companies. The coupon and
warrant structure should be as close to fair-market-value terms as
possible. The ultimate determination of fairness would be the
willingness of non-government investors to purchase the Transaction
securities on the same basis as Treasury. As part of the Transaction,
the GSEs would deleverage their capital structures by paying down senior
debt from the free cash flow generated by their core businesses further
improving the position of the new senior sub debt.

The benefits of the Transaction are as follows:

• The Transaction can be accomplished under the existing terms of the  outstanding GSE securities without any required consent other than from the GSEs.

• The new security would be senior in right of payment to the existing sub debt and preferred stock minimizing the risk to tax payers while providing substantial support to the outstanding senior debt that has been deemed implicitly guaranteed by the government.

• The new debt interest payments would be tax deductible, reducing the after-tax cost of capital to the GSEs, particularly when compared with preferred stock.

• In the event the outlook and performance of the GSEs and their assets were to improve dramatically, the senior sub debt could be redeemed,  distributions to the Subordinate Securities could resume, and their values would increase accordingly.

• In the event that the GSEs’ fundamentals continued to deteriorate and they became undercapitalized, the GSEs could be placed in conservatorship. In
conservatorship, their balance sheets could be restructured along the
lines of our original plan or another plan with the Treasury’s senior sub debt treated preferentially to the Subordinate Securities, again minimizing risk to the tax payer.

• The Transaction would be fundamentally fair to all constituents and would  respect the existing terms and corporate hierarchy of all outstanding GSE securities.

• The Transaction would minimize moral hazard issues for sub debt, preferred, and common stock investors.

Most importantly, we believe there are serious negative implications for
other large financial institutions in the event the Treasury were to
bail out Subordinate Security holders. The Treasury and OFHEO have done
substantial research on the benefits to capital market discipline from
large financial institutions’ issuance of subordinate debt, and the
destructiveness of the government implicitly or explicitly guaranteeing
such obligations.

See: Report to Congress “The Feasibility and Desirability of Mandatory
Subordinated Debt”, Board of Governors of the Federal Reserve System and
United States Department of the Treasury (December 2000), available at:
www.federalreserve.gov/boarddocs/rptcongress/debt/subord_debt_2000.pdf

“Subordinated Debt Issuance by Fannie Mae and Freddie Mac”, Valerie L.
Smith, Office of Federal Housing Enterprise Oversight, OFHEO WORKING
PAPERS, Working Paper 07 – 3 (June 2007), available at
http://papers.ssrn.com/sol3/papers.cfm" abstract_id=1000264;

“Signals from the Markets for Fannie Mae and Freddie Mac Subordinated
Debt”, Robert N. Collender, Samantha Roberts, Valerie L. Smith, Office
of Federal Housing Enterprise Oversight, OFHEO WORKING PAPERS, Working
Paper 07 – 4 (June 2007), available at:
http://papers.ssrn.com/sol3/papers.cfm"abstract_id=1000240 &rec=1&src
abs=1000264;

(Due to its length, this URL may need to be copied/pasted into your
Internet browser's address field. Remove the extra space if one exists.)

“Subordinated Debt and Bank Capital Reform”, Douglas D. Evanoff, Federal
Reserve Bank of Chicago, Larry D. Wall, Federal Reserve Bank of Atlanta,
FRB Atlanta Working Paper No. 2000-24 (November 2000), available at
http:// papers.ssrn.com/sol3/papers.cfm"abstract_id=252754.

To the extent the Treasury were to bail out the GSEs’ subordinate debt –
which was: (1) never implicitly guaranteed by the government, (2) always
rated below Triple A by the rating agencies, and (3) held by investors
who knowingly took on the risk of loss in exchange for a substantial
credit spread above the GSEs’ senior debt – it would endanger the
systemic benefits from subordinate debt issuance for every highly
leveraged banking institution in the world and the capital markets at
large.

Furthermore, we do not believe that the Treasury can purchase GSE sub
debt, preferred stock or common stock without incurring an immediate
loss to tax payers because of the enormous amount of existing debt
senior to these instruments. At a market coupon or dividend yield (to
the extent that one were to exist), any debt issued pari passu to the
existing sub debt, or preferred stock issued pari passu or even senior
to the existing preferred stock would require a yield that would be
uneconomic for the GSEs. No third-party investor would purchase these
securities regardless of their terms in light of their junior position
in the GSEs’ capital structure.

Please note that Pershing Square and affiliates own CDS on the
subordinate debt of the GSEs. We also note that nearly all participants
in the capital market debate on the GSEs are either long or short the
outstanding GSE securities.

We are contemporaneously releasing this letter to the public in the
interest of market transparency.

Respectfully,

William A. Ackman
 

Related Articles

This article has 22 comments:

  •  
    Sep 06 02:30 PM
    From the reports that I am hearing, it sounds like the treasury will back Fannie and Freddie at the common equity level (and then only as a backstop to their required deficit on a quarterly basis). It's creative. Ackman's letter, however, is completely self serving. He wants the treasury to inject capital conveniently senior to the reference debt of his cds position. I think it's pretty obvious that he knows his long cds position is about to get crushed on Monday as the sub debt will now be treated as virtually explicity guaranteed by government as they will be making a promise to inject capital in the position BELOW him. In fact, it's likely that that the cds will trade even narrower than when he initially put on the position. Oops. Bill is a snake oil salesman, not the great investor that people make him out to be. That's just my opinion.
    Reply | Link to Comment
  •  
    Sep 06 02:34 PM
    wow nice letter, who would have known that now a good proposal to preserve the common and preferred alive would have come from Pershing, nice plan though, hopefully it would work or considered.
    Reply | Link to Comment
  •  
    Sep 06 02:38 PM
    well looks like Freddie and Fannie are going into conservatorship, under those conditions Ackmas plan could work because nothing gets wiped out like the common or preferred, but a new sub debt gets to be stuck in the middle to give capital cushion to the conservatored GSE's.
    Reply | Link to Comment
  •  
    Sep 06 02:55 PM
    "In order to minimize risk to tax payers while being equitable to other
    constituents, we suggest that the Treasury consider purchasing senior
    subordinate debt in the two companies in an amount sufficient to address
    their capital needs in the short to intermediate term. This senior sub
    debt would be junior in right of payment to the outstanding senior
    unsecured debt and senior to the outstanding sub debt, preferred stock,
    and common equity. We refer to the outstanding sub debt, preferred and
    common stock as “the Subordinate Securities.”
    "
    This senior sub
    debt would be *senior* in right of payment to the outstanding senior
    unsecured debt and senior to the outstanding sub debt, preferred stock,
    and common equity.

    Only if the newly issued debt is *senior* to all existing debt would this cash injection make sense
    Reply | Link to Comment
  •  
    Sep 06 03:18 PM
    I don't know why it disgusts me that everyone is jockying for position and saying "Save me! Forget everybody else and just save me! And if there's some way a deal can be worked that lets me benefit on the losses of others, then that's even better! But just save me, no matter what!".


    But it does.


    Why does this have to be complicated? Couldn't FNM and FRE just issue a new series of redeemable preferred stock to be sold only to the US Treasury (and not traded on the market), at a fixed price per share with a fair (if not outright cheap) dividend? They could authorize a gazillion shares at $1,000 or $1 million per, and issue them as necessary in exchange for working capital when needed. And then redeem them as circumstances allow.
    Reply | Link to Comment
  •  
    Sep 06 03:35 PM
    Looks like they are going to do that I mean issue redeemable preferred or convertible, the situation is simple really, but the panic makes people not think well.
    Reply | Link to Comment
  •  
    Sep 06 03:53 PM
    Just,

    I am glad that Mr. Ackman's letter acknowledges the fact that CDS are in play. If Mr. Ackman owns CDS on the sub debt (and as a known short one could easily speculate that he might own such bets on the downside) then his plan would trigger a wave of CDS claims that might qualify as "mirabile visu." The NYTimes recently ran an article about this, and offered speculation that Paulson might have to structure a bailout so as to NOT trigger CDS claims.

    Overtly asking for such things is where we wind up when the government decides it is going to overtly pick winners and losers.
    Reply | Link to Comment
  •  
    Sep 06 04:09 PM
    That is exactly what Ackman is proposing - a new layer in the capital structure below "senior unsecured debt" but above the existing capital structure. This would save the edifice from collapsing while keep the GSE out of the govt. books and basically give time for the market and GSE's to heal themselves.
    Reply | Link to Comment
  •  
    Sep 06 04:30 PM
    Common stock will be worthless anyway you look at it after the injection of capital. Invest in FINANCIALS now for the pop this week...It will be short lived though so get in then get out.
    Reply | Link to Comment
  •  
    Sep 06 05:35 PM
    Ackman is, as usual, awesome (except for his Barnes and Noble position). Although not a member of the PPT, he graciously gives his advice to a Secretary of the Treasury who not only encouraged his Wall Street brethren to "push the envelope" with their structured finance voo-doo, by trumpeting that the PPT was in full swing Oct. 2006 (got your back guys), but later admonished the ibanks for doing the obvious and overworking a good thing. Ackman not only becomes a billionaire by seeing through the charade (as did Soros, Jon Paulson, and others) but has the stones to put out letters like this. Sorry, David Einhorn, I'm jumping Ackman ahead of you for now, as the guy I enjoy watching the most on Wall Street.
    Reply | Link to Comment
  •  
    Sep 06 06:45 PM
    Correction, Ackman's buying of Borders (BGP), not Barnes and Noble (like there's a difference...)

    www.secform4.com/insid...

    Got that trade was hilarious. Still is!!!
    Reply | Link to Comment
  •  
    Sep 06 07:36 PM
    Reported "rescue" plan from WSJ is the most, most stupid options for the policy makers to choose.
    1. Regional banks' assets would be wiped out or devalued. And more trouble coming at a later time from these banks.
    2. In the long run, when mortgages are all backed up by the government, the market mechanism doesn't work in the real estate market. Simply the market fails because of intervention.
    3. More importantly, if gov't can take out private ownership to suit its political needs, it is a disaster for the stock market, real estate market as a whole.
    In the short term,
    4, I don't think China or Japan or any other foreign governments would be pleased by the reported plan. IF the US GOVERNMENT can take out private assets from their own PEOPLE, these foreign governments have trouble to believe the US won't do the same to them.
    5. Wall Street won't be pleased by the plan(except maybe JPM), a huge sell-out would be on the way because the very

    FUNDAMENTAL of a FREE-ENTERPRISE system

    will be seriously damaged by the plan(if it is exactly what was reported by 09/05/08's WSJ).

    And the world won't be pleased by the reported plan. Given the market's current technical indicators plus a "rescue" plan like this, it wouldn't be difficult to see DOW down 1000+ points in a few weeks.

    And if the reported plan is executed, anyone won't be surprised that the world's financial center would be moved far away from the US in a few years time.

    Reply | Link to Comment
  •  
    Sep 06 08:32 PM
    User 250718

    Thanks for pointing out the underlying issue here. A financial system is based on the enforceability of contracts and the concepts of ownership. When a government sees fit to step in a pick winners and losers, these concepts are brushed aside. When this type of activity is endorsed, no one is safe. Add to that the current climate: increasingly, market participants (especially big ones) sense that times are desperate, that desperate times call for desperate measures, and that the normal rules have been suspended. What do we get? "Everyone grab for all they can because no one is looking". Use your influence to get anything you can. Kind of like people fighting over scooters in Saigon while the last chopper out flies overhead. In this environment investors are supposed to relax and trust the markets.
    Reply | Link to Comment
  •  
    Sep 06 09:51 PM
    God help us all. The head of a (totally unregulated) hedge fund gives advise to a former Goldman Sachs executive on how to restructure the assets of the corporations designed to help good old mom and pop home owners, but instead decided to play the Wall Street leverage games.

    Just shows that the mantra of "let free markets reign supreme" only applies when it's not your ox that's getting gored.
    Reply | Link to Comment
  •  
    Sep 07 08:01 AM
    Mr.Ackman's proposal is most ridiculous and self serving proposal that should have been titled as "Guess who is short the FRE and the FNM". In fact we have seen this good will attempt to "rescue"? the companies when Mr.Ackman(the mega short) disclosed his "rescue" plan for the bond insurers .
    Let's state the facts .As of now ,both agencies have reserves above the required levels .Their financial statements comply with the GAAP standards.
    At no time did the officials of either agency had requested any financial assistance.Given the severity of punitive measures of SOX(Sorbane -Oxley)imposed on corporate executives who resort to" creative accounting ",we should accept the fact that both agencies do not have any difficulty as of now. In fact both agencies were able to access capital markets without any difficulties .
    The problems stem from the rumors ,distortions ,unrealistic assumptions about the future requirements based upon presumed trends and risks .
    Within the context of these self serving distortions(record open short interest in the shares of both agencies),enters the Treasury.
    Not to rescue the agencies ,which are managing their risks better than most financial institutions,but to inject additional capital on behest of the Treasury to a) disspell any doubts about the committment of the "government" to long term functionality of the both agencies.
    b) to end the rumors disseminated on Friday about the "wipe out" of the common share investors.
    This is not a rescue plan ,this is an "ammunition" that will make shorts wince in pain and create a "mother of short covering " sooner or later.
    The economy/market are in the process of consolidation for the major rebound.Both the stock and the housing markets will be the primary beneficiaries of the dollar mega inflows(global flight to quality).
    the Treasury plan effectively neutralizes all of the destructive rumors .It sends the message to the "speculative elements" that the agencies are here to stay .On Friday ,the shares of both agencies have declined on the rumors that common share investors will be wiped out-not so.
    Mega rally lies ahead in the shares of both companies.The Treasury "Master Plan" sends a meassge ,if you short ,you may have to write your positions into your will .
    The economy(housing sector)will be on the way to a mega rebound by the first quarter of 2009 and both agencies will turn profitable by the second quarter of 2009.
    For the record in June of 2005 ,in an interview with Mark Gilbert (Bloomberg- London) I have predicted the issues/problems we are experiencing today.As recently as September 18 ,2007 (during the FED time) ,I have stated that the subprime risks are not over but are about to derail the markets and economy.
    Now that the problems have been identified and are being addressed by the FED ,the Congress,the Administration and of couse Treasury ,I am confident in the total resolution of the issues.I am bullish on economy and the markets.I believe that the most relevant issues in the financial sector have been and are being addressed.
    Now ,investors short financial sector are really "short" the Treasury ,Congress ,the FED and the Administration.The shorts will lose.
    Reply | Link to Comment
  •  
    Sep 07 09:00 AM
    A number of things here:

    Did Ackman really "send a letter on Friday"? If so, it will probably get there by Tuesday maybe Wednesday.


    I'm taking a guess that Paulson may be pretty busy over the weekend and this upcoming week and "may" not get too much time to peruse through his mail.


    I'll go out on a limb here and say that IF the letter makes it, and IF Paulson reads it, he will not give a rat's ass what Ackman has to say about this issue; neither do 99.9999999% of the world's population.




    Reply | Link to Comment
  •  
    Sep 07 10:36 AM
    I thought the common opinion was the Feds would hold off doing anything until Fannie and Freddie debt auctions started getting bad receptions... if you believe the press (I don't) the auctions have been going OK.

    So why now?

    More intervention to try to save a stock market that is close to breaking down through 20 year trend lines?

    Or did Lockhart's people pull back the covers and see how bad things REALLY are?

    I'm thinking the latter. And I'm thinking that after this week's probable rally ends, it bodes very poorly for stock investors and the taxpayers who will pay and pay and pay for maybe a decade to come.

    And they call this capitalism?
    Reply | Link to Comment
  •  
    Sep 07 11:26 AM
    Guess I got my answer:

    www.bloomberg.com/apps...

    Be careful what you ask for.
    Reply | Link to Comment
  •  
    Sep 07 03:57 PM
    Capitalism? What's that?
    Reply | Link to Comment
  •  
    Sep 07 07:30 PM
    something about accumulation of wealth i guess...
    Reply | Link to Comment
  •  
    Sep 07 09:00 PM
    Ackman blew up when he was at Gotham Partners, hardly a genius, just a rich kid that had connections to get going a second time through Luecadia's help. No big deal, just the way the world works but before people think he's a genius, he imploded at his previous fund. It's like saying if Tom Brown starts a new fund and makes a few solid years of returns, will people herald him as a "genius?"
    Reply | Link to Comment
  •  
    Sep 11 12:20 AM
    Ackman's plan, despite his short positions, in hindsight was much more equitable to all investors. I'm still totally dumbfounded by Treasury's theft of the GSEs.
    Reply | Link to Comment
More Comments on FNM »
Top Rated Comment Streams:

Numbers are net rating-

See all Top 100 »
More by SA Editors

Investment Resources
Money Management
Research
Seeking Alpha provides these ads as a service to its leading contributors
Articles on related themes
Consumer Credit
Insurance
Investment Banks