PORTFOLIO MANAGER’S REPORT
THE FAIRHOLME FUND
Today, shareholders of The Fairholme Fund collectively own $3.4 billion liquidation value of Fannie Mae and Freddie Mac preferred stock.
That means each shareholder effectively owns approximately $25,000 (on average) of two of the most profitable franchises in America.
Yet for reasons that are not entirely understood, some in government apparently want their friends in the mortgage-industrial complex to
take for free what you, the shareholders of these companies, paid for with cash. So we continue to search for the truth:
• Why did federal regulators design a financial support program for Fannie and Freddie on the basis of academic estimates of future
performance rather than tried and true statutory accounting and claims-paying ability (which is the standard for all regulated mortgage insurers)?
• Why did federal regulators require Fannie and Freddie, while in conservatorship, to purchase $40 billion per month in underperforming
junk bonds from competitors?
• Why did federal regulators force Fannie and Freddie, while in conservatorship, to participate in Treasury’s Home Affordable
Modification Program (HAMP) and Home Affordable Refinance Program (HARP), which resulted in more than $46 billion of losses
that the companies would not have otherwise incurred?
• Why did mortgage-backed securities issued by Fannie and Freddie perform dramatically better than private label securities issued
by big banks throughout the financial crisis?
• Why did federal regulators settle litigation cases initiated by Fannie and Freddie against major financial institutions for significantly
less than what other similarly situated plaintiffs recovered?
• Why did federal regulators seize more than $18 billion in litigation proceeds recovered by Fannie and Freddie to date?
• Why did federal regulators order Fannie and Freddie to delist their securities from the New York Stock Exchange in 2010?
• Why did federal regulators prohibit Fannie Mae from selling $3 billion of Low Income Housing Tax Credits to third-party investors?
• Why were Fannie and Freddie, while in conservatorship, forced to divert billions of dollars in guaranty fees to Treasury to offset the
cost of a payroll tax cut?
• Why did FHFA, as conservator, force Fannie and Freddie to gift all of their capital and all future earnings to Treasury in perpetuity?
• Why were Fannie and Freddie, while in conservatorship, forced to pay “voluntary” cash dividends to Treasury if funds were not
available and the regulated entities were “not in capital compliance?”
• Why did FHFA force Fannie and Freddie, while in conservatorship, to issue debt in order to monetize their deferred tax assets
and pay the proceeds to Treasury in 2013, particularly when FHFA had previously stated that deferred tax assets “[could] not be
• Why did Fannie Mae CEO Tim Mayapoulos describe the Net Worth Sweep as a “positive change” with “a lot of good in it” in his
August 2012 announcement to employees? Was he coerced by federal regulators?
• Why has the Securities and Exchange Commission permitted a single controlling shareholder (i.e., Treasury) and its affiliates to
simultaneously act as director, regulator, conservator, supervisor, contingent capital provider, and preferred stock investor of two
publicly traded companies?
• Why do some Treasury officials question the sustainability of Fannie and Freddie’s earnings power in the years ahead, when
Treasury’s own 2014 Annual Report indicates that the companies will be consistently profitable for each of the next 25 years?
• Were certain federal government employees who crafted the Net Worth Sweep acting at the behest of crony capitalists seeking to
displace Fannie and Freddie?
As owners, we demand answers to these and many other questions. Administration officials and their beneficiaries respond with alternative
narratives that are wholly unsupported by the facts. They delay discovery and judicial proceedings at every opportunity. They deliberately
conceal and withhold pertinent information. They conduct the business of government with little regard for the law.
In the Court of Federal Claims, the Federal Housing Finance Agency and United States Treasury produced “final” privilege logs listing
11,292 relevant documents (perhaps 100,000 pages of information) that they will not release – not to the public, not to the Fund’s
lawyers under a protective seal, not even to the Courts. The administration’s sweeping effort to veil their conduct in secrecy has not gone
unnoticed; The New York Times recently filed motions before the Court of Federal Claims requesting that various documents, which “have
been improperly designated as Protected Information and kept confidential” by the government, be released to the public. In its motions,
the Times noted that:
The courts have repeatedly recognized that disclosure of discovery is particularly appropriate when a lawsuit sheds light on the
performance of governmental agencies and entities – which is precisely the case here . . . The public’s interest in the underlying facts
of this case is undeniable . . . The case directly addresses how the Government is going about recouping public funds used in the
bailout and whether other investors are being treated lawfully. The Government should not be able to hide from the public – voters
and taxpayers – the facts that were central to the decisions that the Government made as part of the far-reaching effort to safeguard
the U.S. economy. To the contrary, access to the evidence will enable the public to understand more fully the decisions the
Government has made in the public’s name and to assess the wisdom and effect of those decisions . . . [The defendants’] disregard
for the public interest is sadly of a piece with the Government’s decision to make the depositions confidential in the first place. There
is no reason that citizens should be denied the ability to effectively monitor this important lawsuit as it unfolds.
In the U.S. Court of Appeals (D.C. Circuit), the Fund’s recently filed opening brief explains why the unprecedented and illegal 2012 Net
Worth Sweep is antithetical to the fiduciary duties Congress imposed on FHFA as conservator of Fannie Mae and Freddie Mac – and
should be vacated. The well-established duties of a conservator prohibit FHFA from running a ward for the government’s exclusive
enrichment, at the expense of all other interested parties and completely shielded from judicial review. Common sense dictates that a
This page is not part of The Fairholme Fund 2015 Semi-Annual Report.
conservator conserves. In imposing the Net Worth Sweep, the FHFA, as conservator, unlawfully acts as an “anti-conservator.” Eight briefs
from various amicus curiae (“friends of the court”) support the Fund’s case. Here are a few highlights:
• Myron Steele, the former Chief Justice of the Delaware Supreme Court, persuasively argues that the Net Worth Sweep is “unenforceable
and void ab initio under Section 151 of the Delaware General Corporation Law (“DGCL”). Preferred stock of a Delaware corporation
cannot be given a cumulative dividend right equal to all the net worth of the corporation in perpetuity. The Net Worth Sweep is a flatly
illegal term for any preferred stock instrument, whether or not held by the federal government . . . Preferred stockholders cannot have
a perpetual claim on all the residual earnings of the Companies to the exclusion of common stockholders under Delaware law . . .
Because the Net Worth Sweep diverts, in perpetuity, all of the net worth of the Companies (assets minus liabilities) to Treasury, it neither
is paid at a ‘rate’ nor is it payable ‘in preference to’ or ‘in relation to’ the dividends payable to other classes or series of stock.”
• Thomas Vartanian, a former bank regulatory General Counsel for the federal government, emphasizes that “as a purported method
of financing the operations of the companies, the net worth sweep bears no resemblance to any prior financing arrangement ever
entered into by the FDIC as conservator. [T]he common and well-understood function of an FDIC conservator is to place the regulated
entity into a sound and solvent condition, and to preserve and conserve its assets for the eventual benefit of all shareholders and
creditors, so that the entity can be returned to the control of its board of directors and shareholders . . . not an evasion of statutory
duties and an end-run around a legal capital structure.”
• Michael Krimminger, the former Deputy to the Chairman and General Counsel of the Federal Deposit Insurance Corporation, cogently
articulates that, “Nothing in HERA authorizes the de facto nationalization of the Companies, such as occurred here, under the guise of
a conservatorship. FHFA acted outside its authority as a conservator because it affirmatively acted to strip, rather than ‘preserve and
conserve,’ the assets of the Companies and to bar any prospect that the Companies could return to a ‘sound and solvent’ condition.”
• Timothy Howard, the former Chief Financial Officer for Fannie Mae, explains that “unlike the rescues of various commercial and
investment banks at around the same time, Treasury directed FHFA to place Fannie and Freddie into conservatorship not in response
to any imminent threat of failure, but rather for policy reasons and over the objections of Fannie’s and Freddie’s boards. Once in
conservatorship, the Companies’ managements had no role in negotiating the terms on which they would be offered assistance;
Treasury and FHFA set these terms unilaterally. Treasury and FHFA [had] an extremely strong incentive to make accounting choices
for the Companies that accelerated or exaggerated their expenses and greatly increased their losses, in order to create a large and
permanent flow of revenue to Treasury . . . Treasury’s effective nationalization of Fannie and Freddie was a policy decision, and the
compensation Treasury granted itself upon taking over Fannie and Freddie was grossly disproportionate to the true economic risk it
faced, both at the time and subsequently.”
• A brief on behalf of the National Black Chamber of Commerce makes clear that the Net Worth Sweep forces Fannie and Freddie
“to operate on the edge of insolvency – even though they would otherwise post billions of dollars in profits annually – until they are
subsumed by the federal government . . . Fannie Mae and Freddie Mac play a vital role in minority communities by expanding access
to credit and ensuring affordable housing. If allowed to stand, the Government’s ‘Net Worth Sweep’ and winding down of Fannie and
Freddie will damage those communities by drying up credit and denying African-Americans and other minorities the opportunity – the
dream – of homeownership.”
While common sense and the law are clearly on the Fund’s side, critics continue to obfuscate the facts. Freddie Mac CEO Donald Layton
noted recently that the company “might actually begin to do things that would be GAAP-oriented rather than economically oriented.” This is
a stunning admission that defies all logic, except in this unprecedented scenario whereby the company’s assets are drained by its regulators.
The implications are clear: Fannie Mae and Freddie Mac are purposely being rendered less safe and less sound each quarter – in direct
contravention to the conservator’s explicit mandate. Some may think that the regulators are simply suffering from cognitive dissonance given
their feverish push for higher capital standards embodied in the Dodd-Frank Act, but there are clear indications of more disturbing elements
at work – including greed, spite, and ulterior political motives. Thankfully, our constitutional system includes an independent judiciary.
Despite the progress that the Fund’s portfolio companies have made, price performance has been weak and the gulf between our estimates of
intrinsic values and market prices has widened in recent months. History teaches us time and time again that investment prices can experience
periods of underperformance before becoming “overnight successes.” Unfortunately, we are not proven market timers. Fortunately, we have
high confidence in our company-specific analyses and ample liquidity (cash and cash equivalents comprise 14.3% of the Fund portfolio), and
we recognize Mr. Market’s propensity for sudden mood swings.
Onward and upward,
Bruce R. Berkowitz
Chief Investment Officer
Fairholme Capital Management
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