Fannie Mae Rocked By Housing Crisis, Again

Fannie Mae (FNM) reported a larger-than-expected loss for the first three months of 2008 (see conference call transcript). The loss of $2.2 billion was better than the previous quarter’s $3.6 billion shortfall, which may partially explain why the stock is up more than 5% today. Extreme weakness in the housing market is clearly to blame for the company’s poor performance, and CEO Daniel Mudd warned that home values and mortgage defaults would likely worsen in the coming quarters. The company is predicting that home values could reasonably drop another 7-9% this year, which would be nearly 20% off of peak levels. Even though the company is taking steps to strengthen its financial position, we do not recommend holding FNM at such a risk-laden time as this.

Fannie is slashing its dividend in order to provide the company with almost $400 million of additional liquidity. Also, for the second straight quarter, Fannie is increasing loan loss reserves--this time by $2 billion. This is necessary because the number of mortgages that are “seriously delinquent” rose from .98% to 1.15% over the past three months.

Furthermore, Fannie will attempt to raise some $6 billion through the sale of additional stock. While the company is preparing for the worst, CEO Mudd thinks that FNM will emerge from this crisis much stronger than before. Many in the financial industry are reducing exposure to the troubled mortgage sector, yet Fannie and Freddie (FRE) are growing at full tilt. The two government backed corporations were responsible for 76% of new mortgage business ($450 billion) in the first three months of the year. The two mortgage giants have always owned a substantial portion of the domestic mortgage business but never to such a degree as they now control. Thus, revenues at Fannie grew by 23% over the same quarter a year ago, up to $3.8 billion.

As for our current ranking of Fannie, we are concerned by the losses, but profit—it can be argued—is an accounting fiction. At Ockham Research, we prefer to focus primarily on cash flow and sales which are much more difficult to finagle. Fannie’s cash flow right now is negative, only slightly, but still a red flag in our model. Also, the current price-to-sales is high at 2.686 compared to the historically normal range of .978-1.53. Based on these valuation metrics as well as the tough times ahead, as admitted by the CEO, we have a final Ockham Rating of strong sell. When home values begin to stabilize and a housing market recovery is on track, Fannie and Freddie could again be suitable investments. We are not market timers, so we rely on valuation which tells us to avoid FNM at the present time.

Disclosure: none