Shares of the Federal National Mortgage Association (OTCQB:FNMA) have nearly doubled in the last year as activist investors and hedge fund managers rally behind the mortgage giant. Efforts in Congress to wind down the government-sponsored entities (GSE) have gone nowhere and there are several catalysts for upside. For further proof of the potential, the investment has actually brought Bill Ackman and Carl Icahn to agreement after years of bitterness.
Great Minds think Alike, Sometimes
Activist investor Carl Icahn and hedge fund manager Bill Ackman are probably not sending each other Christmas cards this year. The two investing gurus are have been known to be at odds on investments with their feud over Herbalife (HLF) becoming a regular drama in the financial press.
Icahn has said he's, "had it with this guy Ackman" and calls him the cry-baby of the schoolyard. For his part, Ackman has said that Icahn, "is not an honest guy," and a, "guy that takes advantage of the little guy."
Both are savvy businessmen with more resources to analyze an investment than I could ever hope to match. When these two can actually set aside their heated rivalry and agree on a stock, I sit up and notice.
It has happened recently on Federal National Mortgage Association and Federal Home Loan Mortgage Corporation (OTCQB:FMCC), the government-sponsored entities better known as Fannie Mae and Freddie Mac.
Ackman released a 111-slide presentation (pdf) to investors in May showing that shares of Fannie Mae could be worth as much as ten times its current share price and disclosed a 10% stake in the GSEs by his fund Pershing Square Capital Management.
The Financial Times reported recently that Icahn bought $50 million in the two GSEs from Fairholme Capital Management in March. Icahn paid $4.03 per share for $27.5 million in Fannie Mae and $4.04 per share for $23.2 million in Freddie Mac. The transaction was made on the day that leaders in the Senate Banking Committee announced they had reached an agreement on an outline plan to replace the GSEs with a new type of federal mortgage reinsurance.
Too Big to Scale Down
The announcement by the Senate Banking Committee sent shares of Fannie Mae down by 31% on the day with a 27% drop in shares of Freddie Mac. Shares of Fannie Mae have rebounded 25% while shares of Freddie Mac are up 32% since the selloff. Since the announcement, it has become increasingly clear that the two mortgage insurers will likely not be replaced and that efforts of reform in Washington will go nowhere.
In its most explicit acknowledgement yet that the government cannot scale back the GSEs, Mel Watt, the new director of the Federal Housing Finance Agency and lead regulator for the mortgage insurers announced that the size of loans approved for purchase would not be reduced. The FHFA also announced that standards for put-backs, the rules regarding when a bank must buy-back its loan, would be eased. Not only is the government not going to scale back the GSEs, it is expanding their role in the housing market.
The GSEs bought 61% of the residential mortgage-backed securities (MBS) originated in 2013 with banks holding the remaining 38% of originations. Private MBS issuers, the companies that the government wants to fill the GSE's role, accounted for less than 1% of the market last year.
Undervalued with strong short-term and long-term catalysts
Ackman contends that Fannie Mae could post earnings just over $11 billion this year, well above the $84 million in adjusted net income booked last year. Even at a price multiple of 14 times earnings, the lowest in Ackman's valuation models, shares of Fannie Mae could be worth $14 a share on a diluted share count of nine billion.
While that would be an increase of three-fold from current trading, shares could go even higher. The average fees Fannie Mae charges to lenders to back new loans, the G-fee, have been increasing to help private issuers compete in the market. G-fees increased to 0.37% last year but Ackman argues that they would need to increase to at least 0.60% for the private issuers to be profitable and take a significant share of the market.
Increasing the G-fee to 0.60% increases Fannie Mae projected net income to $17 billion and a potential share value of $23 on the same 14 times multiple. Ackman also analyzes the share value for a G-fee of 0.80% ($35 per share) and for 1.0% ($47 per share).
Part of the reason shares of Fannie Mae trade for just $4.50 now is what is known as the Net Worth Sweep. As part of its conservatorship with the government, the GSEs are required to pay out all of their net income to the Treasury. To March of this year, the GSEs paid dividends of $203 billion to the government, well above the $187 billion received after the financial crisis.
Besides the longer-term potential on higher income, I think there are some strong short-term catalysts on the shares. The GSEs are currently traded on the OTC markets but could potentially move to one of the larger exchanges. Share prices have traded for more than a dollar over the last year and there is certainly enough liquidity and information on the companies. A re-list on one of the exchanges would bring in a wave of investors not allowed to buy from the OTC market and would be a big boost of confidence in the shares.
Besides a re-listing, there is currently litigation against the Net Worth Sweep as unconstitutional. The GSEs have more than repaid their debt to the government and it isn't really fair that investors have no residual right to profits. A right to future cash flows won by a court ruling would send the shares closer to the 14 times price multiple used above.
Most of the valuation above was given for Fannie Mae but the same case is made for Freddie Mac. I took a position in Fannie Mae earlier this year and plan to hold it at least until the shares hit $10 each. There is still significant risk that the government finds some way to limit the GSEs or that the companies never come out of conservatorship. I believe that these risks are fairly low given the companies' role in the housing market.
Disclosure: I am long FNMA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
