After the stunning developments that occurred today I thought it would be a good idea to update my previous views on Fannie Mae (FNM) and Freddie Mac (FRE). I'm not going to get into any moral hazard discussions because A) I don't believe in judging others, and B) it is irrelevant to evaluating this investment. A few key points:
1) The businesses didn't change last week. The stock prices did which is irrelevant to the actual business fundamentals. These companies do have some embedded losses in their portfolios due to the housing slump, but I have no doubt that the actual losses will be substantially less than the mark to market losses that have already been taken by the respective companies. Horrendous and irresponsible journalism had far more to do with what we saw last week then the actual fundamentals of the business.
2) My original investment thesis in FNM and FRE was that they should be the number one beneficiary of the current mortgage crisis. Their importance to this nation has never been so evident in providing affordable home ownership to the public. They are increasing market share at impressive rates and profit margins on new business has risen due to increased pricing. This is an extremely lucrative business in which they have an incredibly low cost of capital, and can write business on favorable terms due to the government backing. The run off value of the existing portfolio is already far in excess of the current share price.
3) Dilution is not as scary as you think as long as you participate in the discount the market is offering to the businesses' intrinsic value. I've taken large paper losses on my investments in these firms as I started buying in the mid 20's, but I have continued to increase my position as the shares have sold off, and with today's developments I will continue to do the same thing. The return on equity on new business will be substantial and these government measures ensure the GSEs' growth.
Eventually the value of the business and the share price will converge and by increasing my ownership when Mr. Market is acting irrationally I will be able to benefit when his mood is brighter. It is important to understand that the new equity will help assist future growth at higher margins, and will help provide support to the mortgage market which increases the value of the existing book of business.
4) The risk to the Government Issue is vastly overstated and the media coverage has been truly terrible. If you analyze the existing book of business and view it even at stress case scenarios you will see that the risk to the government is not too severe. These companies have real assets. They own and insure mortgages with houses behind them. GAAP accounting for these companies is an absurdity in that they are long term holders of these securities so mark to market losses on credit spreads widening should have no impact on the actual financial condition of these companies.
I have no doubt that if the government does indeed invest equity into these companies it will make multiples on its money. I found it interesting to watch CNBC and hear the shows' hosts recommend selling the shares, and I constantly reflected on how likely it was that shareholders would get wiped out. I myself would not feel comfortable questioning the viability of a financial company without taking the time to research the firms by reading the 10K's and 10Q's etc. Often their "sources" are hedge fund managers that are short shares and I truly hope that the SEC is vigilant in their investigations of these damaging rumors.
5) The major concerns in the GSEs' portfolios are their Subprime and Alt-A exposures. Freddie provides a tremendous amount of detail about what the stress case losses would be. Assuming a 60% default rate and 50% severity, Freddie would be looking at losses of $99 million. Compare this to the billions in worthless mark to market losses they have already taken and the irrelevance of GAAP in evaluating these companies financial strength should be more apparent.
In conclusion last week was quite rough and the risk of government intervention was disconcerting. I make no prediction at how the stocks will trade on Monday or the next 6 months for that matter, but as a value investor I analyze the facts and have to believe that at some point the fundamentals of the business will be properly accounted for by the share price. We will see how it plays out.
Full Disclosure: I am long FNM, FRE, and am short puts on both companies as well.
