Over the last week, Freddie Mac (FRE) and Fannie Mae (FNM) have seen their share prices decimated. The primary concerns are higher funding costs and misinformation about the companies' business and balance sheets.
In listening to all of the rumors and discussions on television in regards to the GSEs' prospects, it is clear that most commentators and observers discussing these institutions have very little understanding of the actual businesses.
Let’s get a few facts out right away just to show how overblown this whole situation is.
First of all, the issue at hand is whether or not credit losses will significantly deplete the GSEs' capital base. This is something that can only be properly evaluated over time, but if you understand the business model and risk profiles of these companies, you would quickly ascertain that the chances of this happening are immensely remote. The reason that Freddie has negative equity, as eloquently illustrated by Mr. Poole, is a result of mark to market losses that have been incurred on its portfolio. These mark to market losses are the result of widening spreads on mortgage backed securities and are not the result of credit losses. There are a number of reasons for widening spreads, including market sentiment, technical factors, and hedging techniques. None of these reasons provide us with any indication of the actual credit losses that Fannie or Freddie will incur. Also the GSEs do not have any CDOs which are driving the majority of write downs for the banks, but instead they purchase and insure straight pass through mortgages.
In comparison to most banks, the GSEs' credit standards were significantly higher, and the structure of their insured portfolio provides them with a great deal of protection to credit losses that makes their securities unique and impossible to value by utilizing the ABX indices. In Freddie Mac’s quarterly report, the company was extremely detailed in their projections of what losses would be in a variety of different situations.
The main concerns in Freddie’s massive portfolio are their exposure to subprime and Alt-A securities. Let’s assume the worst scenario possible that we could discuss with a straight face in terms of the housing market. Assuming a 60% default rate and 50% severity, Freddie would be looking at losses of $99 million. This number might seem shockingly low, especially after seeing the GSEs write down billions in mark to market losses, but Fannie and Freddie enjoy a huge cushion on securities that they insure before they take on any losses. They insure and invest in “pass through” mortgages, and not CDOs. Freddie and Fannie get paid first, and when the mortgages aren’t performing up to expectations then cash is deferred from subordinated levels to the GSEs' senior positions.
Fannie and Freddie have multiple layers of protection on the securities that they insure to shield themselves from taking substantial losses on mortgage portfolios that aren’t living up to expectations. The ABX indices do not accurately reflect the losses that Fannie and Freddie are taking, because the ABX AAA tranches are drastically different then the securities that Fannie and Freddie issue.
Once again, the actual “losses” that Freddie Mac has incurred up until now have been the result of widening spreads on mortgage-backed securities, as seen on the ABX indices. These spreads are market driven and have no serious relation to expected losses that Freddie Mac or Fannie Mae will actually take on their portfolios. As time goes by, these mark to market losses will pass back through the income statement and on to the balance sheet as the reality of their actual credit losses overtake the emotional sentiment that is impacting the fair value of these securities at this point in time.
These widening spreads are actually allowing Freddie and Fannie to conduct businesses at extremely profitable levels. They have significantly raised prices and credit standards, and are now responsible for approximately 80% of the mortgage market. Both Freddie and Fannie could conceivably earn 15% on their capital, and I think both companies could easily earn $5-$7 a share as their explosive revenue growth and higher profit margins develop over the coming years.
In regards to the GSEs' ability to attract funds, the situation is a little more ambiguous, but is still vastly overblown in the old rumor mill that seems to move markets more then fundamentals these days. The government and the regulators have repeatedly maintained that the GSEs have the implicit guarantee of the government and would not be allowed to fail. Bond investors will realize this and continue to fund these companies, and even if spreads remain wider then they historically have been, the GSEs will certainly survive.
In terms of Freddie raising the 5.5 billion that they have committed to, there are a number of options. Currently, Freddie is over their capital requirements so there is no rush on the issue. It is absurd to think that the GSEs will not be able to raise capital when the likes of Washington Mutual (NYSE:WM) can raise 7 billion.
Also, it is in the government’s best interests to keep the GSEs private. If worse came to worst, the government could invest in the GSEs in a preferred offering, being that the GSEs are already a part of the government and issue more debt then any other enterprise. There is no incentive for the government to nationalize these institutions when they are adequately capitalized, writing profitable new business, and liquid. What would the Bear Stearns (NYSE:BSC) event be for these institutions? They are extremely liquid and credit worthy, and the world changed after the Fed rescued Bear Stearns, so the idea of these entities not having access to capital is completely absurd.
Even if they do raise dilutive capital, the return on equity will be substantial on the capital raised. Their future book of business will be of the highest quality and profit margins will be significantly higher than what we have seen in the last several years. Dilution is by no means ideal, but if you have any concept of history in the financial markets, it should be clear that recapitalizations occur all the time and often at difficult levels. Companies can come back to be extremely profitable enterprises as long as the underlying business prospects are sound. As the mark to market losses come back on the balance sheet, over time these companies will be able to reduce their leverage as the credit markets ease and housing stabilizes.
Richard Pzena of Pzena Investment Management, who in my opinion is right on in regards to his bullishness towards FRE and FNM, made the following points towards the capital issues.
Fannie Mae has a great deal of flexibility in dealing with the capital issue. First, it has a liquid investment portfolio that can be liquidated to generate $1.6 billion in capital. Second, there is an annual dividend payment of $1.3 billion, which in our opinion should be immediately eliminated. Third, there is the ability, if necessary, to shrink its portfolio through natural attrition and generate over $3 billion per year in capital. And, finally, OFHEO could reduce Fannie Mae’s excess capital requirement since it has fixed the issues that gave rise to in the first place. This would free up over $9.5 billion in additional capital.
In conclusion, I could not name a more attractive investment opportunity than Freddie Mac and Fannie Mae at the current share prices for the long term investor who is willing to bet against the crowd and ignore the noise.
Disclosure: I am long both FRE and FNM, and am short puts on both as well.