Saturday, February 25, 2017

Appeals Court Ruled Breach of Contract Claims are Ripe
Fairholme Capital Management Public Conference Call
November 18, 2016

David Thompson: Yes, there are three standard remedies for a breach of contract.
One is expectancy damages, which puts us in the position that we would have been in if there had been no breach of contract. Two is reliance, which is to give us our out-of-pocket costs. The third is restitution. We’re entitled to present evidence of all three and pick the highest.
But, I want to focus on restitution, because I think that is really the concept that is the most relevant here, and it’s pretty simple. You look at the benefits that the breaching party received – and here the breaching party would be Fannie Mae and Freddie Mac – and the benefit they received was par value, $25 a share. From that, you would potentially subtract any benefits as they would probably argue for an offset of any dividends that the preferred shareholders received. Now as we know, two thirds of this float was issued in 2007 and 2008. So, for those series the offset from par value would be somewhere between zero and five dollars a share. Thus, we could be looking at damages of $20 a share if we are successful on our breach of contract claim and the court agrees with us about restitution. 

Saturday, February 18, 2017

Fannie Mae core capital - 2016 10-K page F-57

The following table displays our regulatory capital classification measures.
As of December 31, 2016 (Dollars in millions)

Core capital                                                                                             $ (111,836)
Statutory minimum capital requirement                                                    $ 24,351
 Deficit of core capital over statutory minimum capital requirement    $ (136,187)

The sum of (a) the stated value of our outstanding common stock (common stock less treasury stock); (b) the stated value of our outstanding non-cumulative perpetual preferred stock; (c) our paid-in capital; and (d) our retained earnings (accumulated deficit). Core capital does not include: (a) accumulated other comprehensive income or (b)  senior preferred stock. (2)   Generally, the sum of (a)   2.50%  of on-balance sheet assets, except those underlying Fannie Mae MBS held by third parties; (b)   0.45%  of the unpaid principal balance of outstanding Fannie Mae MBS held by third parties; and (c) up to  0.45%  of other off-balance sheet obligations,  which may be adjusted by the Director of FHFA under certain circumstances.


If the senior preferred shares are recharacterized as a $116,149 loan that has just been repaid with interest, then the core capital increases to $4,313.  If some of the $23,465 allowance for loan losses can be recharacterized as core capital then even better.  With earnings at ~$10B per year, it would only take a couple of years to reach the statutory minimum capital requirement. However, it would take 7 or 8 years to reach Ackman's proposed $79B or Tim Howard's proposed $70B through retained earnings only.  Some dilution via a capital raise is probable because 7 or 8 years is too long for bureaucrats and politicians. 

Sunday, February 12, 2017

Fannie Mae valuation

Future common share price = future earnings available to common shareholders multiplied by P/E multiple divided by number of shares outstanding 

Tim Howard's FNMA estimate = $9.3B x 10 / 1.158 = $80 per share (undiluted)
Ackman's FNMA estimate = $10B x 14 / 5.79 = $24 per share (warrants exercised)
(Ackman's FMCC estimate = $5B  x 14 / 3.21 = $22 per share)

Ackman's plan is for FNMA to build up $79B (2.5% capital ratio) through retained earnings only.  Tim Howard's plan is for FNMA to build up $70B (2% single family; 3% multi-family; 2% for interest rate risk).  I do not believe that it will be politically viable to wait 8 years to build capital to these levels.  I believe that there will be an equity issuance to raise capital and that equity cannot be raised without cancelling all of the warrants.  It is hard to estimate the amount of share dilution that an equity issuance will cause, but I estimate that Tim Howard's estimate would be knocked down to $16 to $40 per share.

"There’s one final wrinkle I’ll just touch on here. As of September 30, 2016, Fannie had $22.5 billion in its loan loss allowance. That’s capital. But $21.3 billion of that is tied up in “life on loan” reserves on loans that were modified pursuant to Treasury’s mandatory Home Affordable Mortgage Program (HAMP). The vast majority of these HAMP reserves are against loans that are now performing, but the accounting rules require that the loss reserves be maintained until the loans either amortize or are paid off. If I were at Fannie—and searching for a way to reach full capitalization as quickly as we could—I would look very hard at ways to free up as much of that “regulatorily immobilized” capital as I could. Any amounts of loss reserves moved from the “individually impaired” to the “collectively reserved” category would reduce the amount of the equity capital the company would need to raise." - Tim Howard

Note: Proposed reductions in corporate tax rates would increase earnings, but DTA's would also have to be written down and capital would have to be raised (new corporate tax rate of 20% would cause a $15B write down of DTA's for FNMA & $8B for FMCC).

Sunday, December 25, 2016

114 North American Oil &Gas Bankruptcies Since start of 2015

Saturday, August 6, 2016

Thoughts on GSE's

1) Before the GSE shareholders can get anything the government is entitled to be paid back with interest.  ETA is 2017 year end.

2) Before the GSE's can be released from conservatorship they must have adequate capital.
   a) Someone has to make a decision and actually determine what is adequate capital.
      Historical ratio = 0.45% - near unanimous opinion that it needs to be more
      Ackman recommends 2.5% capital ratio or $123B
      Mulvaney bill called for 5% or $250B
      Corker-Warner and Johnson-Crapo called for 10% or $500B
      The UST has officially stated 10% too, but internal memo states 3-4% would be adequate.
   b) Where is this $125B-$500B going to come from?
      Ackman projects that just allowing the GSE's to retain earnings until the end of 2024 will build up capital to his recommended 2.5% ratio.  However, the FDIC precedent is to dilute the shareholders through a share issuance.  For example, if all of the warrants for 7.2 billion shares in both GSE's are cancelled (government is not entitled to anything after it has been paid back with interest), then the 2.5% capital ratio could be raised by selling 7.2 billion new shares in both GSE's at at price of $17 per share; a discount to the $23 per share as shown on slide 104 of Ackman's slide deck "It's Time to get off our Fannie".

However, if the government insists on a 10% capital ratio then a capital raise via a share issuance is a non-starter without higher g-fess (and therefore higher interest rates on mortgages).  Ackman's slide 104 shows that using a 14x earnings multiple and a 60 bps G-fee that the value of the GSE's is $206B.  Rational market participants should refuse to invest $500B of capital for $206B of value.  

SUMMARY - insisting on a 10% capital ratio without increasing g-fees (g-fees would need to be approximately 217 bps to attract investment) may be the government's strategy to prevent the GSE's from ever going (pretend) private again.

Saturday, January 2, 2016

$HLF v. Vemma: Pyramid Scheme Analysis; Part 6 of 6

All parts are located here.  Part 6 is also given below.

Sales to Distributors for Personal Consumption

56.  It is possible that Herbalife distributors buy products for the purposes of personal consumption.  In BurnLounge, the 9th Circuit Court noted that distributors could be “ultimate users” for purposes of the Koscot test under a narrow set of circumstances; namely, if they purchased the products for personal consumption based on consumer demand, not primarily for the purpose of participating fully in the rewards under the compensation plan for the business opportunity.  I consider it unlikely that many distributors would qualify as “ultimate users” under BurnLounge given the criteria.

57.  Herbalife’s marketing materials specifically encourage distributors to purchase product to maintain eligibility for rewards and to use as samples in connection with recruitment, and Herbalife's compensation plan strongly encourages this behavior.  People who are interested in purchasing Herbalife's product for personal consumption (including junior distributors) can obtain it cheaper from alternative outlets (see discussion in para 42, above).  Junior distributors are not entitled to any product discounts that are not available to non-distributors, so purchasers have no incentive to become distributors simply to obtain product.  Any purchases by Herbalife distributors for the purposes of internal consumption are likely incidental to the main motivation of maintaining eligibility for rewards.

Data from Actual Operations

58.  The available evidence about how the Herbalife program works in practice comes from Herbalife’s Disclosure Statements from 2013 and 2014.  The information from these sources is consistent with my findings the Herbalife likely operates a pyramid scheme.

59.  The 2014 U.S. Disclosure Statement showed that most participants achieved poor results, as would be expected based on the theoretical models previously discussed.  The Statement shows that 89% of members received a gross compensation of $0 in 2014.

60.  The company assumes that all members who did not receive discount commissions were not interested in the business opportunity and has classified them as discount purchasers.  It seems far more likely, given Herbalife’s marketing and the above discussion of the incentive structure, that many, if not most, of these individuals were interested in the business opportunity but were unable to recruit.  In other words, they are best viewed as distributors who were unsuccessful in the business opportunity, but have been redefined by Herbalife as discount purchasers.

61.  According to page 16 of Pershing Square’s presentation Side-by-Side: A Comparison of Vemma and Herbalife,

The bottom 94% of Herbalife’s U.S. Sales Leaders earned less than $2245 in 2013.
The bottom 83% of Herbalife’s U.S. Sales Leaders earned less than $303 in 2013.
The bottom 49% of Herbalife’s U.S. Sales Leaders earned less than $1 in 2013.

62.  As discussed in paragraph 18, above, pyramid schemes are often characterized by a constant churning of the base, as unsuccessful participants at the lowest level drop out and are replaced by new recruits.  According to page 25 of Herbalife’s 2005 annual report, the last time this disclosure was made, approximately 60% of the supervisors did not requalify and more than 90% of the distributors turned over.  Massive churn indicates that the vast majority of participants cannot make sufficient retail profits and only massive recruiting keeps the scheme going.

63. thru 66. - Paragraphs 63 thru 66 in the Declaration of Stacie A. Bosley Ph.D. are idiosyncratic to Vemma and do not apply to Herbalife.


67.  The Koscot test analysis is critical to the determination of a pyramid scheme, set within a marketing program with multilevel compensation.  The fundamental question, as articulated in the second prong of the Koscot test, is whether participant compensation plans grant participants the right to obtain recruitment rewards that are unrelated to ultimate users.  It is my judgment that Herbalife’s marketing program and business model meets this necessary component of a pyramid scheme and is likely to lead to widespread participant losses.  All forms of compensation are driven by recruitment or purchase volume and there is no direct connection between this compensation and retail sales or market demand.  This structure incentivizes participants to purchase product for the purposes of maintaining eligibility for recruitment rewards (inventory loading) and to encourage their “downlines” to do the same.  Company representatives continue to stress the importance of reaching and maintaining Supervisor level (or higher), and recruiting others to do the same.  Premium pricing and alternative retail outlets undermine Distributor’s ability to resell products or induce others to purchase product directly from Herbalife for personal consumption.  Company safeguards appear insufficient to ensure a minimum level of retail activity and prevent inventory loading.

68.  The anticipated result of Herbalife’s program is an endless recruitment chain, with strong emphasis on recruitment over sales to ultimate users.  At any moment that the scheme is analyzed, analysis indicates that the vast majority will be in a loss position.  U.S. disclosures corroborates these conclusions.  Internal data from Herbalife would provide additional detail on how the program operates in practice and would assist in calculating the scale of consumer injury, but I am confident it would confirm my judgement that Herbalife is a pyramid scheme.