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 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."
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
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 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 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.
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
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),
"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
"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:
1&srcabs=1000264 (due to length of the url, please copy and paste
"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.
William A. Ackman
Pershing Square Capital Management Releases Letter to U.S. Treasury Department Regarding Fannie Mae and Freddie Mac
Saturday September 6, 4:28 pm ET