Monday, September 8, 2008

Activist Hedge Fund Pershing Square Sends Letter to US Treasury Secretary Paulson

Pershing Square Capital Management Releases Letter to US Treasury Department Regarding Fannie Mae and 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 Treasurys 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 Treasurys 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:

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: 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

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, L.P.
William A. Ackman, 212-813-3700