Fannie & Freddie: Myth vs. Reality, Part 2

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.

Comments

[JudeJin:]

all i can say that you are freaking brave. why don't use call options to limit your downside risks? double down on these two names are insanely risky!

2008 Jul 14 10:49 AM

[BrunoT:]

Long FNM and FRE? What a shocker he'd reach these "conclusions". Sounds like someone's trying to spin a silk purse out of a sow's ear.

Too bad Jim Rogers and Peter Schiff and other heavyweights saw this coming a mile away. Schiff was saying they'd go bankrupt 2 years ago.

Too bad this writer doesn't seem to have a problem with socializing risk via inflation and govn't involvement in private companies so that rich people can keep their private jets. So what if the little people can't afford food or fuel, right?

2008 Jul 14 10:52 AM

[markg:]

Losses of $99million? Where did you get this number?

What facts are you basing your conclusions on?

2008 Jul 14 11:01 AM

[bbzz24:]

Tim-0-thy,
all this market scare for 99m? Why did not you call han&ben? They are talking billions more to keep them afloat, you see only 99m of already written off losses.
You must be a genius to see something no one else can in the financials of those deadbeats. Or maybe a lunatic. Either one supports your thesis well.

2008 Jul 14 11:15 AM

[Timothy Travis:]

"Losses of $99million? Where did you get this number?

What facts are you basing your conclusions on? "

Go on the FRE website and look at the investor presentation-freddie mac update.

2008 Jul 14 11:33 AM

[TommyG:]

Bought a modest amount of both, the GAAP mark to market has created large opportunities in financials.

2008 Jul 14 12:44 PM

[morgan77:]

Time will tell what's going on here. Right now, I wouldn't touch it except for shorts.

2008 Jul 14 01:07 PM

[carey_jim:]

I think you are probably right but I hear whistling in the dark too:

Mr. Market is all too often irrationally "exuberant" or "depressed" and many people have lost fortunes being right at the wrong time.

Far too many fortunes have been made by people who have been "wrong" at the right time too: e.g. short selling FRE and FNM!

Some Americans who were already wealthy multiplied their fortunes many times buying stocks during The Great Depression when they hit their lows from 1930 to 1933. But they had to wait until after World War II to realize most of their huge gains. They could afford being right at the wrong time!

The mood of Government is unpredictable too: If both Freddie and Fannie are nationalized (can we believe Government pronouncements?) then the price shareholders will get might be the share price on the date of announcement.

The only certainty about such an announcement date is that it will be shocking and unexpected if it comes. Note that I am not predicting nationalization just pointing out the whimsical nature of most governments.

2008 Jul 14 01:37 PM

[QUESTIONABLE:]

Why should any of this surprise anyone? What I can't figure out is why the Government is blind or I should ask "Who has the Duct Tape over it's mouth?" The other amazing thing is no one sees the connection between the Mortage debacle and the Speculation Market????? There are so many people who claim to moniter stocks and company information and I a person who just sit back and watch can put it together????????? The same Banks and Financial Institutions in the Property/Home Mortgage Industry are the same ones that are making purchases on the Speculation Market???? Give me a break.... Wake up America....... First of All who goes into Wlamart and offers to pay $1,000 for a loaf of bread???? That is how the Commodities and Futures Market works... Set your own price..... These Financial Institutions A puts down $10 on each barrel of oil it wants to buy with Federally Insured Loan from B using the overnight Loan Law that lets them do this without Federal Oversight or Approval, B then does the same thing for the same amount of oil on a loan from A, within 24 hours they default on each other, each gaining possession of the same amount of oil from the other.... they have been doing this since 2000.... so much they have default forms and letter prewritten with just the date as fill in the blank..... this created a method of "Coining Money" and made the World Markets as a whole view this as having more American Dollars in circulation than is actual.... this created Artificial Inflation driving down the value of the American Dollar helping them to further drive up the price they offered to pay per barrel...this Artificial Inflation pushed the Federal Government to lower the Interest Rate.... Opening another door for the Financial Institutions.... Home Mortgages to the Poor and those that did not Qualify under any terms to begin with....... Fanny Mae, Freddie Mac, and FHA..... Federally Insured Again...... Federally Insured Loan Programs are not fully administered by the programs but at the offices of these Financial Institutions.... The banks do the loan approval and the paperwork,,,, got people who they knew would default within a two year period on Federally Insured Loans and BOOM!!!! How can Delta, Jet Blue, JB Hunt, buy oil by the barrel???? Do they own their own refinaries??? Only 3% of a barrel of oil comes out as Jet Fuel.......25% as diesel.... It's like paying extra money for a new Monopoly game just to get the board pieces to play on an old one. The increase in oil demand since 2000 is 70%... the increase in oil purchases on the commodities and futures market since 2000 is 70%, the increase in the number of mortgages given out since 2000 is 70%..... buying oil that doesn't exist yet is a false demand..... Heavy Equipment and Farm Machinery Sales in foriegn Counties is up 45 to 150% verses North America where it is down 25 to 45%...... this should tell you those countries aren't paying $150 per barrel of oil.... there are two types of Math 1) you ad figures and get numbers, 2) you add facts and get conclusions.

2008 Jul 14 04:30 PM

[borisb:]

so whats the fair value of Freddy Mac factoring in the current concerns?

2008 Jul 14 08:29 PM

[Duff:]

$99 Million....huh your way off...

2008 Jul 14 11:22 PM

[jjason:]

I would like to see Congress make short selling, hedge funds, and buying and selling options in stocks, bonds and commodities illegal.

None of these "investment vehicles" ( or whatever you want to call them) contribute anything to productivity.

Also, people should learn about fundamentals. For example, the difference between a debt to equity ratio of one and a debt to equity ratio of over 20.

And how about book value and TANGIBLE book value. Look at some of the coal companies or POT or WB. Does anyone know when something is overpriced?

When a company is worth $20.00 per share and people will pay $200.00 per share, the stock is overpriced.

When a company has $20.00 of debt for $1.00 of equity, the leverage is too high.

The author should have looked at the Fundamentals for Freddie and Fanny and bought ACAS instead.

Long ACAS.

2008 Jul 15 07:42 AM

[QUESTIONABLE:]

The Current State Of Affairs is Reflect in the Market Value of Fannie May and Freddie Mac because they are not a Private Loan Company... in 1933 Rosevelt created Fannie Mae as a work around the FDIC and the standard loan requirements so that Indigent and Poorer Veterans could obtain a home loan. The Current Market Value is based on the Future and True Intent of these Programs.... They are Federal Insurance for local/branch offices of the same big finance institutions doing the damage to our economy as I stated above...... why are the two detitute and having monetary troubles????? because they spent all their capital backing up the defautled improperly and illegally approved by these big financial institutions, who pushed down the interest rates with their artificially inflated demand and "coining of Money" on the Futures and COmmodities Markets with defaulting of Federally Insured Loans to one another........ this is FALLOUT........... and now you the tax payer will pay..... You next question why are these same banks doing so poorly then...... look at the Executive pay increases, payouts, and shifting of funds in investments outside of the US..... that's were this ignormous profit is....... and what are the banks doing now yet again...... shift and hide the profits, cook the books and ask for Federal Bail-out, sell off..... or get the bail-out stay ofloat and keep shifting the foriegn investments around using hedge funds...

2008 Jul 15 08:57 AM

[runlikeanat...:]

why are poeple ignoring future cash flows right now? and why aren't these cash flows being reflected in the price of the stock? these wide mbs spreads are great for a part of the gse's business as they can issue debt at a lower rate (debentures) than they recieve payments from mbs's -- essentially garunteeing that these companies will record good profits in the future. these new accounting requirements are translating into a capital change due to the vincibility of this bear market, and it is unnecessary. a lot of people are missing some key points here...

2008 Jul 15 10:16 AM

[Velshan:]

What is important to any normal person about Freddie or Fannie is what it implies and what will happen to us, due to the fiasco.

First lets understand that Whoever is at fault and Whoever is the mastermind of all this debacle, is not really important. Because they probably are too smart to be caught. Or if they are indeed stupid will be caught and yet cannot prevent any of the consequences.

This debacle has happened due to actions by a very large group of people including the Politicians, Congressmen, Senators, Bankers, Ex-Bankers (or I should say, people who are still indebted with Banks but work in Government positions now), and a whole of financial consultants. (and of course the silent or biased media)

The importance of the above factors is that all this people are running our Government and I don't see they giving up their luxurious lifestyles because they made a mistake.

The mistake is
"Take available opportunity to create more money for yourselves". Is this a mistake? Not an easy answer right? Not important either.

What is the key development from this "mistake"?

The Building of so many Houses? For people who cannot afford it?
Not really. Because, if someone has already build a house for say, $100,000 dollars. He can keep the house for years until someone is ready to buy the house for a price above the cost.

But what if you have borrowed the money (say from China) with an interest that you can afford. No problem right. Just pay the interest and hope soon someone will buy your house for a price that now will include the interests that you have paid.

But what if you have not enough money to pay the interest and you still have not found the buyer? Then you go crying to the Government for help. And Government may keep you alive by giving you additional loans. Or buy all your houses at a fixed price.

This is the discussion that is going on. Instead of clarifying the actual value of the houses and interests that Freddie and Fannie are obligated to pay. The Government keep giving the "ALL is OK" speech.

While now, the owners of the Freddie & Fannie shares are beginning to wonder about actual situation and are selling of their shares at whatever prices that is possible.

This means, we all have to wait and see if American people can continue to earn enough money to keep paying the interest on money borrowed (yes that is from - China, Japan, Russia, among others).

And if American people will want to continue paying that money. If not then there will be serious problems between America and all those countries who provided that money.

The only solution is to simply let the company Freddie and Fannie fail. Then sell all the assets at very cheap prices to Americans at any affordable price and tell our lenders - "oops sorry. This is how Capitalism works".

But America as a super power and trusted Business and Trade partner will be gone. Dollar will be also gone. But Americans will not really lose anything. in fact get cheap houses.

It will wake up a lot of countries. But the World will be a better place.

Fantastic!...

[Note : I like the article posted by Questionable. His is right ]

2008 Jul 16 10:58 AM

[QUESTIONABLE:]

LookTOFuture, brought up the best point, there are many invloved including our Representatives. Bernanke told the Senate and House that there is no single shot in the arm repair.... He was wrong. As I watched him he stumbled through carefully watching what he said.... he knows which Government Officials have been involved in this with many on the committees he was addressing, the Fed has been investigating.... but he is only human and is choosing his battles wisely... First of all the birth of NAFTA coincided with this emerging Futures Market under Wendy Graham when she was the head of the CFTC.... China loved this, they starting buying up properies in Central America, agreed to take over operations of the Panama Canal, and boom, now 95% of all products made in China come across our border tax/tariff/duty free..... If a true accounting were taken, it would be determined that the amount they owe the US would be equal to our debt with them.... The one shot answer to this is FREEZE the Futures/Commodities Markets.... under emineint domain take possession of all market shares there of oil, auctin it off, and then tell the holders, welcome to capitalism... this would put all of this future yet to be pumped, artificailly inflated demand, oil back into circulation..... boom, the US Dollar would rebound past the Euro which would be stuck at the mercy of the London Futures/Commondities Market...... Then send Port Authority to our Borders and inspect every Load.... "Made In China" gets refused, Chinese Products get backed up at the border, and we tell CHina, oops, "WE OWE YOU, YOU OWE ME, LET BECOME A HAPPY FAMILY," (Barney sing song) and say lets call it even and from now on, if you wan to use the borders instead of the ports start paying!

2008 Jul 17 09:37 AM