Will Fannie Mae Survive?

There was a great piece Tuesday morning put out by Charles Duhigg of the New York Times. Duhigg's article was an examination on the precarious nature that Fannie Mae (FNM) and Freddie Mac (FRE) are now finding themselves in after substantial losses in their mortgage portfolios and the mortgages that they insure. The article was perfectly timed to coincide with Fannie Mae’s earnings release Tuesday morning.

Fannie Mae’s earnings were a little worse than some analysts were expecting, but on the whole they showed a company that was still functioning quite well and doing a fairly good job of adjusting to the new environment it has found itself in. The headline numbers of course were not encouraging as the company lost $2.18 billion for the quarter and stated its plan to raise $6 billion in new capital.

Another challenge the company has been struggling to deal with as a government mandated corporate entity has been the capital requirements that come along with being such an entity. This has been a difficult for the company as shareholder equity dropped from $44 billion at the end of 2007 to $38.8 billion at the end of last quarter. The level of core capital, which is measured slightly differently then shareholder’s equity, stood at about $42.7 billion at the end of the quarter giving the company a capital surplus of about $5.1 billion.

While it is clear that Fannie Mae is facing a challenging environment there were some bright spots in its quarterly report that have gone relatively unnoticed and believe likely point to the company surviving its current ailments. One bright spot can be seen in the dramatic drop in interest rates caused by the Federal Reserve's cuts. Fannie Mae is now dramatically benefiting from low short-term interest rates and a widening of its interest rate spread.

For the quarter net interest income climbed to $1.69 billion up $554 million from the previous quarter’s total of $1.14 billion. Management stated in the investor summary section of their quarterly report that they expect this trend to continue well into 2008, resulting in a substantial increase in net interest income over the prior year. The graph below can be found in management’s supplemental material to the quarterly report and shows the impact of the Federal Reserve's recent interest rate cuts.

The expansion of net interest income, coupled with the other bright spot in the company's report, higher fees and premiums related to Fannie Mae’s guaranteeing of 2.4 trillion in mortgages, should help the company expand its revenue base in the coming year. The insurance side of Fannie Mae saw its premiums jump $130 million for the quarter to $1.75 billion. While the revenue growth in the two areas mentioned above will not be enough to prevent further capital raises, they will give management something to sell to investors and regulators.

Fannie Mae’s inability to take gigantic write downs or loan loss provisions will undoubtedly force it to raise capital on probably a semi annual basis to ensure that it meets its regulatory capital requirements, these share offerings will likely be in a similar to what was announced this week. I would under no circumstances want to own shares in the company as dilution will likely severely impair the value held by current shareholders. However, I strongly believe that it is important to understand how the company works as it plays an incredibly important role in the American economy.

Is a full-scale bailout going to be necessary as some individuals have speculated? Its hard to say but I don't think so, while the company either holds or guarantees $51 billion in sub-prime mortgages and $344 billion in Alt-A mortgages the company has been facing delinquency rates of only about 1.15% as of last quarter, which is still fairly low. Furthermore, 42% of the sub-prime securities it has ties with are rated AAA by the rating agencies (for what its worth), as are all of the Alt-A mortgages the company is on the book for.

Time shall tell whether or not Fannie Mae will be able to offset some of its loan losses and mark-to-market losses with new revenue streams and the rest of the losses through capital raises, it will likely be close, but I believe the company will remain an independent entity a year from now with a shareholder base that will likely have expanded considerably.

For Further Review:

New York Times Article

Fannie Mae Q1 Investor Summary

Fannie Mae Press Release

Disclosure: None.

Comments

[jcrash]

This seems to be a no brainer. $2.4 Trillion in mortgages? 2% of that is
$48 Billion. I can't see how they don't lose that much which is more than their equity base.

[Bkraswting]

FNM/FRE have a market cap less than $40b. That is the real stockholder equity.

Good article.

No comment on the fact that this $5Trillion is not actually guaranteed?

[jkort]

If FNM can spread the pain over a long enough time frame they should be alright. The only question is well the market let them?