Fannie Mae: Why the Government Must Step In

The debate is escalating.  Wall Street wants to know if the government is going to bail out Fannie Mae (FNM) and Freddie Mac (FRE).  The following article should be considered an opinion.  Given the current financial  condition of these companies and the integral part that they play in our currently struggling economy, the government's hand is being forced. 

The government must step in to protect the solvency of these companies.

Most economists and market analysts would agree with the above statement.  Some pundits would argue that these firms should be allowed to fail, but the repercussions would devastate our economy and therefore failure is virtually out of the question.

The main concern for Fannie Mae and Freddie Mac is spread risk.  Fannie Mae, in my opinion, is the better of these two companies.  The observations below will focus on Fannie Mae.

The recent share price declines have raised the perceived risk levels for Fannie Mae.  As perceived risk increases the cost of capital increases along with it.  The main concern is the increasing cost of capital given current market conditions.  Moreover, the risk of default coverage seems less of a concern because Fannie Mae seems to be well-capitalized and able to handle more than 100% of the potential defaults from the subprime mortgages on its balance sheet.

The concerns then revert back to profitability and debt coverage.  Spread risk is the difference between the amount Fannie Mae earns from the mortgages that it provides versus the amount Fannie Mae has to pay to issue debt in the open market.  The profitability of Fannie Mae is dependent on an adequate spread.

With declining spreads, profit margins decline and the risk of default begins to escalate. the government can alleviate this problem.

In my opinion, the government should step in and secure all of the current and future debt obligations of Fannie Mae.  This should allow Fannie Mae to secure lower costs of capital going forward and it should solidify the spread which directly influences profitability.  This move would not only resonate well with bondholders, but shareholders will also be pleased.

Fannie Mae earned over $2 billion last quarter if market related losses are factored out.  Although the mortgage crisis is far from over, if light can be seen at the end of the tunnel, and if shareholders realize that profit risk is limited to defaults and current market conditions which FNM is capitalized to handle, valuation begins to become much more attractive at current levels because shareholders can focus on future profitability.

If perceived risk isn't limited to defaults and if Fannie Mae has adequate capital to cover more than all of the potential defaults on their books, then investors reasonably could expect profitability again once this mortgage mess is put behind us.  This, of course, would require the government to back Fannie Mae's debt obligations as noted above.  In addition, shareholders would carry a different tone.

Fair value, based on current market conditions, is approximately $14 per share in my opinion if the government indeed steps in to secure this debt.

Disclosure: Author does not own FNM but has recommended it to his clients. 

 

Comments

[Jimmy Lathrop:]

There is only one word missing from your article.

Homeowner.

The GSEs were created to provide liquidity in the mortgage market to allow homeowners to obtain loans at a lower cost.

The GSEs turned into a vehicle by which a financial institution could get rid of loans taking up space on its balance sheet in order to create more loans.

Because of the credit crisis caused by mortgaged backed securities, inflated appraisals, cheap credit and a lack of due diligence by underwriters who were unwilling or unable to hold the loans like a traditional portfolio lender, we have a situation where the Fed Fund rate is at 2 percent and national mortgage rates are a quarter point under 7 percent. That doesn't sound like a great benefit to a homeowner. It sounds like a great benefit to financial companies, investors, and the GSEs themselves.

The thesis of your article is that although the GSEs were designed so that the government could avoid taking on these obligations onto their balance sheet, the government (despite inroads in electronic markets, pools of investor cash, sophisticated technical analysis and risk management professionals) should do the exact opposite, and say, hey, we need the bailout after all.

Furthermore, while the private market made up the bulk of Mortgage Backed Securities pre-2007, those markets have seized up and non agency debt is no longer issued. The unspoken word is that Fannie and Freddie are going to step in and pick up where the investment banks have retreated. No one can articulate a benefit from that except that it is necessary to keep banks churning out loans beyond a normal portfolio model. This is unsustainable and should not be subsidized by the taxpayers on a moral and social level, stockholders and bondholders be damned.

A thorough reading of a paper titled "How Resilient are Mortgage Backed Securities to Collateralized Debt Obligations?" presented at the Hudson Institute on February 15, 2007 by Joseph R. Mason and Joshua Rosner provides the statistics and analysis bolstering my position.

www.hudson.org/files/p...

Remember, you can't have a mortgage without a homeowner.

2008 Aug 27 07:56 AM

[User 61942:]

You are a MORON, time will heal all of FRE /FNM 's problems. I have been in Real Estate since 1976. This has all happened before to one degree or another and will come to pass. I assume you are short. Well guess what? You better go cover.

2008 Aug 27 08:33 AM

[David Martin:]

Another attempt to privatise profits and socialise losses.
The first means to restore the profitability of these institutions would be to bring negligence and dereliction of duty charges against the executives of Fannie Mae and Freddie Mae and the rest of the bandits who were in cahoots with them in the lending industry for the recovery of their vast option profits, bonuses and severance payments.
Secondly, if they need a bailout, fair value of the shares is zero, not $14.
Weird that the author made no statement on conflicts of interest!

2008 Aug 27 08:49 AM

[Jimmy Lathrop:]

User 61942 - when you say that you have been "in Real Estate since 1976" - do you mean that you have been locked in a basement or an attic?

2008 Aug 27 09:08 AM

[Econ 101:]

Yes the government will bail out the GSEs. Sometime between November and January.

But it isnt for the homeowners or the public, it is for the big banks and wall street. Let them die! Let GM and Ford go bankrupt and shed their huge health care "obligations". Let the depression begin so that our economy can rebound before the BRICs ( esp the Chinese) and Islamists have all the capital. A depression now would break the system and allow Americans a chance to rebirth.

That assumes the government doesnt "Help" too much.

Remember the scariest words are, "Hi, I'm from the government, I'm here to help"

2008 Aug 27 10:52 AM

[Be Advised:]

@ Those who say let them die; I say you will not be loving life after Fannie Mae and Freddie Mac are gone. In order for housing to have any value it must be able to be bought and sold. In order for housing to be bought and sold it must be able to be financed. The GSEs along with HUD are about it in terms of available mortgage money right now. HUD can't do it alone.

If you have a passing interest in a stable housing market, and therefore a stable economy, pray for Fannie Mae. I don't just mean if you own a home, even if you simply want to live in a home, pray for Fannie Mae.

If your job is in any way involved in the housing industry you should be buying FNM and FRE stock as a show of support. Don’t consider it a stock investment so much as livelihood insurance.

2008 Aug 27 12:13 PM

[carey_jim:]

In a well functioning economy, people work hard to obtain the knowledge and skills essential to work for companies or to start their own companies that produce goods and services that make life better for everyone. They continue to work hard at their jobs, raise families and try to "do the right thing."

These people save money for down payments for houses, cars and other things and banks loan them money because it is, more or less, clear to banks that they will pay back their loans with interest.

In the present American economy, too many people think they can make money by doing nothing other than speculating and gambling.

It might seem that it is a good thing and even necessary for the government (all the American people) to save the few from their greed and folly but it is truly an unwise "liberal" folly.

As far as possible, the people who got something for nothing should pay back what they got by losing it.

Fannie Mae and Freddie Mac should die natural deaths and another, better regulated institution should be created in their place.

2008 Aug 27 02:22 PM

[Snuffy:]

But I bought my home and paid for it by hard work.I did not overbuy.I worked hard and made extra payments. I plan on living in my home for the rest of my life. Now I'm being punished for doing the right thing. I don't care if the value drops to nothing! It's paid for. I am living in it, I'm not going to sell it.

2008 Sep 07 06:01 PM