Reining in Fannie Mae
(February 24, 2005)
Dear Subscribers and Readers,
Here is a thought about the broad market: The latest Investors Intelligence data just published tonight suggests a Bulls-Bears% Differential of 32.7% - a slight decline from 35.4% last week but still too high to indicate a bottom here. I believe investors should pay heed to the breakdown of the Bank Index, especially if you're investing in financial, mortgage financing, or homebuilding stocks. Remember the last time that the Bank Index started breaking down in early 1998? Well, we all know what happened next.
Which brings us to today's commentary - a discussion of Fannie Mae (FNM). First of all, this is not a recommendation to buy FNM shares and is not intended to be. Rather, I want my readers to ponder about the prospects of FNM going forward. For readers who are familiar with the company and the valuations, I also would like you to participate in our current poll of FNM. Using a traditional valuation method, FNM appears to be undervalued given its current and forward-looking P/E ratios, especially as it made another four-year low today. Sure, there are accounting problems. There are also calls from the government to put a limit on FNM's portfolio size, but then there has always been calls during the last few years and they haven't historically had much of an effect. It has also been no secret that FNM is a selection of the Motley Fool's "Inside Value" publication - with the author claiming an "intrinsic value" of over $100 using a discount of earnings model. But let's be more "conservative" in our model. Following the Fool's footsteps - if we assume earnings of $6.00 a share in 2005 (which is 20% below the estimates today, allowing for accounting restatements) and assuming 3% growth perpetually and a discount rate of 10% (given its cheap access to capital), then one gets a present value of approximately $88 a share - which gives us a 35% margin of safety (the stock closed at $57.16 at the time of this writing). Sounds like a good buy? Maybe.
On the other hand, it is also no secret that Jim Rogers has been a very vocal critic of FNM and has been publicly stating over the last few years that he is short FNM and expects an ultimate share price of $5 a share. Mr. Rogers is definitely looking pretty smart right now - but the prospects of seeing $5 a share may be pretty dim, unless, of course, a perfect storm occurs (such as Congress succeeding in cutting FNM's portfolio size to $150 to $200 billion, the occurrence of a housing depression, and a derivative accident - all happening at the same time). It is also interesting to note that at the trough during the Russian and LTCM crises in late 1998, FNM traded at a low of "only" $45 a share (on an adjusted basis) on an intraday basis - even as the integrity of the modern financial system was called into question. Surely, this would be a buy at some point as it continues to spiral down?
Before we go on further, let's discuss the basics of FNM's business model. Readers can access the 10-K for the fiscal year ended December 31, 2003 at the OFHEO website but following is a direct quote from the 10-K that describes FNM's business segments:
We provide liquidity in the secondary mortgage market through our two primary business segments: the Portfolio Investment business and the Credit Guaranty business. In the Portfolio Investment business, we purchase mortgage loans and mortgage-related securities from mortgage lenders, which replenishes those lenders' funds for making additional mortgage loans or other investments. We also purchase mortgage loans, mortgage-related securities and other investments from securities dealers, investors and other market participants. In addition, our liquid investment portfolio primarily invests in high quality, short-term, nonmortgage assets that can provide us with liquidity as the need arises. We acquire the funds to purchase these loans, mortgage-related securities and other investments from our equity capital and by selling debt securities to domestic and international capital markets investors. By doing so, we expand the total amount of funds available to finance housing in the United States. Income from our Portfolio Investment business comes primarily from the difference, or spread, between the yield on mortgage assets and other investments in our portfolio and our borrowing costs.
In the Credit Guaranty business, we receive fees for our guaranty of timely payment of principal and interest payments due to certificateholders on MBS. The guaranty fees we charge are based on the credit risk we assume, the costs of administering the MBS and market and competitive factors. We typically issue MBS by exchanging mortgage loans from a lender for MBS. The lender may then hold the MBS as an investment or sell the MBS in the market to replenish its funds for additional lending. This activity provides liquidity to the lender because MBS, which carry Fannie Mae's guaranty, are more readily marketable than mortgage loans without this guaranty.
The following two charts explain how FNM's business operates. Again, these charts are taken straight from the 10-K. The first chart details the process of a mortgage portfolio loan purchase by FNM:
The second chart details the typical MBS Guaranty Process from FNM:
Finally, it is interesting to note that "In some instances, a seller requests that we resecuritize their mortgage-related securities into a new MBS. In this case, the seller transfers the mortgage-related securities to Fannie Mae. We set aside and place these mortgage-related securities in a trust that assumes the legal ownership of the mortgage-related securities. We serve as trustee of the trust. In exchange for the mortgage-related securities, we issue and deliver to the seller (or its designee), our MBS certificates that are backed by the mortgage-related securities. These MBS carry Fannie Mae's corporate guaranty of timely payment of principal and interest. MBS monthly distributions are made from principal and interest payments from the underlying mortgage-related securities, with a portion of the interest cashflow used to pay the costs of providing Fannie Mae's corporate guaranty."
Basically, the company makes money from the spread between its borrowing costs and the interest from their mortgage and MBS portfolios and from the guaranty fees paid by the original lenders. Investors are obviously seeing a lot of risks on the horizon, as any one of the following could significantly reduce earnings:
- A reduction in its portfolio size.
- The further flattening of the yield curve. No matter how low FNM's borrowing costs are, it surely can't be below the Fed Funds rate.
- A restatement of earnings and a further tightening of accounting reporting going forward.
And just when we thought that we have nearly uncovered everything that could be uncovered at Fannie Mae, the OFHEO reported more accounting issues at FNM earlier today. This may not be a significant piece of news, but for now, we don't really know. Right now, anything that contains the phrase "off balance sheet financing" sends shivers up my spine.
Technically, the stock isn't acting so well, as it just made a new four-year low earlier today - and as shown on the following P&F chart, a piercing of a quadruple bottom support level that dates back to early 2003:
So is Fannie Mae a buy? You be the judge. For now, I expect to see more downside, based on technicals and also my belief that the risks haven't been fully factored into the stock yet. Things will start getting more compelling; however, if/once FNM approaches its October 1998 price level of $45 to $50 a share.
Henry K. To, CFA