Fannie Mae - Or May Not

Only an idealist or someone sadly mistaken believes the worst is behind us in the housing sector. In fact, it appears likely that we’ll witness the implosion of a major mortgage holder before it’s over. And, needless to say, Fannie Mae (FNM) has got to be on the short list of possible implosion suspects.

As always, take a look at the balance sheet if you want a snapshot of the health of a company. At 3/31/08, Liabilities were $804 billion while Shareholder Equity was $39 billion, which equates to a Debt/Worth ratio of 20:1. The notion that “we could never have another 1929-style wipeout because they don’t allow 10:1 leverage in the stock market anymore” is utterly absurd. We are surrounded by 10:1 leverage at a minimum, with the only difference this time is that the only thing that isn’t leveraged at 10:1 is the stock market.

But wait, that gigantic Debt/Worth ratio gets much worse when you consider contingent liabilities. Not only does FNM have to worry about the $741 billion in mortgages and Mortgage-Backed Securities [MBS] on its own books, but it has to worry about the $2,242 billion (or $2.2 trillion, if you like) of MBS held by third parties that FNM has guaranteed! If we throw this onto the balance sheet, where it arguably belongs, this inflates the debt/worth leverage ratio to an absolutely ridiculous 78:1. This equates to a capital ratio of its inverse at 1.3%. No normal bank can get away with this kind of leverage.

Perhaps you’re saying, “but those are guarantees. They’re not really on the balance sheet.” True enough. As long as they’re performing that is. Give that some thought if you’re holding these shares. Hmmm. Would you like a side of cyanide with your contingent liabilities?

The fees, by the way, on these guarantees are miniscule at an average of 22 basis points per year since 2003. That’s 22/100 of 1%. With residential mortgage delinquency/foreclosure rates at something like 4%, it’s hard to imagine earning your way out of this predicament.

FNM also has a ridiculously high proportion of Alt-A and subprime mortgages both on its books and in the MBS portfolios it guarantees. Of the total of $2,242 billion of loans and guarantees, $396 billion, or a whopping 18%, are Alt-A or subprime. To be fair, only 2.3% are subprime, but that’s still $50 billion and still more than the company’s net worth of $39 billion. These figures do not bode well for a mortgage market that has yet to stop deteriorating.

You can comb through the 10Q and 10K reports and find an almost unlimited number of more such frightening facts. Such as that 21% of all loans have a Loan/Value (or LTV, which is the loan balance as a percentage of a home’s value) in excess of 80%. My guess is that this is based on the original appraisal and purchase price. So, with home prices down 20% in some places, you can chalk many of these up in the 100% and over category today, not to mention that the previous 60-80% LTV category now moves up to the 80-100% category. With the kind of leverage that’s been used in the mortgage market in recent years, you don’t need much of a decline in values to squeeze all of the equity out of a mortgage loan.

Another potential risk on the balance sheet is a heavy reliance on very Short-term Liabilities for a fairly substantial portion of funding. Specifically, the largest portion of Short-term Liabilities at 3/31/08 consisted of Discount Notes (which are effectively commercial paper) of $216 billion with a maturity of one year or less. While this does not immediately appear to be mismatched with Short-term Assets (consisting primarily of Trading Securities and Securities Available for Sale) of $339 billion, the risk here is that the yield on the short term assets (being long-term mortgages) is fixed, while the interest rate on the short term liabilities will be whatever the market thinks it should be at any given time. If the lenders under these Discount Notes lose confidence (ahem…), these rates may go through the roof. This sounds dangerously close to those idiotic Auction Rate Securities that funded long-term assets such as municipal building and infrastructure projects with debt that re-priced every 7-31 days. For Fannie, this has the makings of a potential liquidity squeeze that could pop her eyeballs right out.

Recent income statements, I believe, paint the picture of things to come. The 1Q2008 loss of $2.5 billion is somewhat deceptive since this actually represents a pre-tax loss of $5 billion less a benefit for income taxes of $3 billion. (This, by the way, is almost the exact same math for the entire year 2007 - $5 billion pre-tax loss, partially offset by a $3 billion “negative” income tax, for a net loss for 2007 of $2 billion. These figures compare with 2005 and 2006 net income of $7.6 billion and $4.2 billion, respectively.) This is quite a deterioration, with the loss in 1Q2008 equivalent to the entire loss for 2007. The 1Q2008 loss comes exactly from where you would expect it: Fair Value Losses (i.e. valuation losses) of $4.4 billion, and Provision for Credit Losses (including those guaranteed loans) of $3.1 billion.

So… with 1Q2008 Losses and Provisions for Losses of $7.5 billion, perhaps the worst is finally over? Well not so fast. The question is, how long will the 3/31/08 Allowance for Loan Losses of $1.0 billion and the Reserve for Guaranty Losses of $4.2 billion last? If the results from 1Q2008 are any indication, the answer is until about May 20. That is, the 6/30/08 statements will show nothing in these accounts other than what was provisioned back into them during the quarter.

The next question, of course, is how long can FNM operate if the mortgage mess continues? After-tax losses of $2.5 billion per quarter would give them almost sixteen quarters before Shareholder Equity of $39 billion is gone… as long as these Losses and Charge-offs don’t get worse. (The top line is likely to shrink, too, as the pace of new mortgages continues to slow.) No wonder they’re passing the hat for $6 billion in new capital. Ok, make it eighteen quarters - if the deterioration doesn’t accelerate.

Most arguments for holding this stock center around the quasi-government nature of FNM and the expectation that Uncle Sam will bail her out. This notion was recently reinforced by Washington in identifying Fannie (and her not-so-little brother Freddie (FRE)) as lynchpins in the resuscitation of the home mortgage market. (Excellent strategy, by the way. Solve the problems caused by the greatest debt orgy in human history with new and possibly even more exotic debt…). But how good of an argument is this for holding these shares? Even if Uncle Sam bails out Fannie (and Freddie), it will likely do so only after the patients are in the Intensive Care Unit. And even with successive transfusions, these patients will probably be unconscious for a very long time.

In the end, Fannie may survive as the troubleshooting arm for those problem-solving wizards in Washington, but it will likely not survive as a well-performing portion of anyone’s investment portfolio. The fact that FNM shares have already lost 85% of their value may make it seem like a bargain, but always remember that, mathematically, a stock can lose 85% of its value many times before it gets to $0. And that’s not just in theory, as Fannie may prove before it’s over.

Disclosure: none

Comments

[User 9759]

terrific analysis

[BS Detector]

"The fees, by the way, on these guarantees are miniscule at an average of 22 basis points per year..."

Let's see, $2.2T x .0022 = $4.84B per year. When you're talking about a company with $40B of capital, how can you call this miniscule? In addition, billions of dollars of principal payments are made every month; this reduction in the insured and held portfolios is normally turned over into new loans. If FNM were to suspend lending operations and dividends for one year, it could reduce its leverage on owned loans from about 20 to less than 17.5. How does this compare? I don't know. Goldman's about 24 times leveraged, but they've got a lot of diversity. NLY looks to be about 12x if I'm reading my balance sheets right.

Note, this says nothing about the huge portfolio which they insure.

"With residential mortgage delinquency/foreclosur... rates at something like 4%..."

I challenge you to cite a credible source for a number higher than 2% of all mortgages that are even delinquent.

The key to the continuation of FNM and FRE as they are currently organized is an explicit guarantee by the government of the mortgages insured by them.

[My FriendsCall MeLASER]

Can we translate this banter into a quantifiable market advice. If everyone agrees that Fannie and Freddie will survive no matter how ugly their balance sheet is or highly leveraged they are, why not buy at an 85% haircut. There is absolutely no risk-reward in shorting the stock at this point to know that ultimately the government throw them any life line, necessary or not. However to buy now would be insane. Fannie already experienced the BSC

[My FriendsCall MeLASER]

bouce, that's what I'm calling it. BSC $50 to $3 to $10, Fannie $13 to $6 to $16 in approximately the same time frame and for similar reasons. I'm still upset for missing the best trade of the year (long BSC at $3). I would like to hear some short-term trading advice on FNM. Standing on the sidelines isn't an option.