Pershing Square Capital Management Releases Letter to U.S. Treasury Department Regarding...

Pershing Square Capital Management Releases Letter to U.S. Treasury Department Regarding Fannie Mae and Freddie Mac

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

-0-
*T
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
*T

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 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

Pershing Square Capital Management, L.P.
William A. Ackman, 212-813-3700

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