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.