Fannie Mae Earnings Primer: Value Investors Stay Away (OTCMKTS:FNMA)

What to do with Fannie Mae (OTCQB:FNMA) stock? At present, FNMA is selling at $1.07, or a $6 billion market cap. Yet the company is on track to earn something like $17 billion this year. The problem of course is that a federal government bailout of Fannie Mae in 2008 transferred the great bulk of the benefits of ownership from the equity owners and to the government. And despite a huge earnings recovery by Fannie and lots of legal and political wrangling, not much has changed to today.

Discussing how Fannie’s legal status might change is pretty much pure speculation. I’ll briefly add my two cents below. Rather, overlooked are discussions of how Fannie Mae performs as a business. That’s the purpose of this piece. I have some expertise here, having covered Fannie Mae as a stock analyst for 20 years, up until its seizure.

The Fannie Mae basics

Fannie Mae is a government-sponsored enterprise (GSE). The Federal National Mortgage Association Charter Act requires Fannie Mae to:

“Provide ongoing assistance to the secondary market for residential mortgages by increasing the liquidity of mortgage investments… “The GSE Act requires that we serve very low-, low-, and moderate-income families.” (Fannie Mae 2022 annual report)

The main benefit of the GSE charter for investors is that Fannie Mae securities – both its mortgage-backed securities (MBS) and its debt – have the implied guarantee of the U.S. government. As a result, Fannie Mae’s securities yields are well below private sector competitors. For example, Fannie Mae mortgages were nearly 20 bp cheaper on average than jumbo mortgages over the past five years. And its debt typically trades at 35 bp over similar-maturity Treasuries, while even AAA corporates averaged 120 bp over Treasuries for the past five years. These lower yields are huge operating advantages.

Fannie Mae meets its charter requirements by operating three businesses:

1. Home mortgage credit guarantees.

2. Multifamily housing credit guarantees.

3. Mortgage and securities investing.

The home mortgage credit guarantee business

An easy way to understand this business is to track a home mortgage’s chronology.

• A mortgage lender originates a fixed rate mortgage loan, underwriting it to Fannie Mae’s detailed lending standards.
• If the borrower doesn’t put down at least a 20% downpayment, he/she is required to buy private mortgage insurance (PMI). The insurance protects Fannie Mae – if the borrower defaults, the PMI company pays Fannie a claim equal to about 25% of the mortgage size.
• Because banks and mortgage bankers can’t safely hold fixed rate mortgages due to their significant interest rate risk (see First Republic Bank’s recent failure), they look to sell them to investors.
• After pooling says $100 million of fixed rate mortgages, the lender requests a credit guaranty on the pool from Fannie Mae. The guaranteed loan pool is now a Fannie Mae mortgage-backed security (MBS). Fannie takes all of the default risk of these loans unless the lender did not correctly follow Fannie Mae’s underwriting guidelines, in which case the lender must repurchase the loan.
• Fannie Mae then reinsures some (currently 35%) of the mortgages with investors and others to reduce its credit risk.

As of November 30, 2023, Fannie Mae insured $4.1 trillion of mortgages. It has two primary competitors in the guarantee business. One is peer GSE Freddie Mac ($3.4 trillion insured). The other is Ginnie Mae, a federal government agency, with a little over $2 trillion insured. Together they insure about 75% of all U.S. mortgage debt.

Home mortgage credit insurance financials:

• Guarantee fees average 47 bp at present.
• Fannie passes 10 bp of the fee along to the federal government as part of the conservatorship deal.
• Reinsurance costs Fannie 3½ bp.
• Operating expenses cost another 7 bp or so.
• Loan charge-offs due to home foreclosures are currently about 2 bp.

That leaves about 25 bp of the 47 bp of revenues as profit at present or about $8 billion in after-tax profits.

The multifamily housing credit insurance business.

This business is identical to Fannie Mae’s home mortgage business, with the obvious difference that Fannie is guaranteeing business, not consumer loans; an apartment building owner is the borrower. The economics are also similar. At year-end 2023 Fannie Mae insured about $470 billion of multifamily loans and earned about $2.5 billion after-tax.

The mortgage and securities investment business.

At one time, earning interest income from owning mortgages and securities was a major business for Fannie Mae. For example, in 2005, Fannie owned over $800 billion in mortgages and earned half of its income from this business. Fannie Mae did well in this business because of its super-cheap debt.

But Fannie’s regulator decided that mortgage investing was too risky for taxpayers, and Fannie has shrunk its mortgage assets over many years, to only $50 billion today. It also holds $100-150 billion of short-term high-quality investment securities. These assets give Fannie the ability, if the country’s debt markets seize up, to sell them and buy mortgage assets when other investors won’t. Fannie therefore can fulfill its mission of supporting the housing market by “increasing the liquidity of mortgage investments”.

This table shows a recent history of Fannie’s portfolio interest income, plus a history of the main two drivers of that income:

Sources: Fannie Mae financial reports, FRED (fed funds)

Fannie’s short-term securities are financed primarily by long-term fixed rate debt and by equity. The result of this funding structure is that Fannie’s interest income rises when short-term interest rates rise and falls when interest rates decline. And mortgage loans have higher yields than securities, so their dramatic decline has caused a downward trend in interest income.

Fannie Mae’s earnings drivers

Now that we know what Fannie Mae does for a living, we can identify the factors that drive its earnings. There are four:

1. The Fannie Mae MBS growth rate
2. Home mortgage default costs
3. The rate of decline of home mortgages owned
4. The fed funds rate

Let’s forecast them.

Forecast: The Fannie Mae MBS growth rate

Here is a recent history of Fannie’s MBS portfolio growth, compared to U.S. home mortgage debt growth:

Sources: Fannie Mae, the Federal Reserve

The chart shows that Fannie Mae’s MBS growth is a function of (A) U.S. mortgage debt growth, and (B) Fannie’s market share.

National mortgage debt growth averaged 2½% a year over this time period but was obviously pretty volatile. The key long-term driver of home mortgage debt growth should be household incomes, which grew by 4½%. Going forward, I expect mortgage debt growth to average about 4%.

Fannie Mae’s market share grew for many years after the ’08 Great Financial Crisis but dipped in recent years. The early ‘00s decade housing bubble was fueled by private (not GSE or Ginnie Mae) credit, in particular risky subprime and other non-prime loans. As private lenders stopped making those loans, and those paid down or defaulted, Fannie and its peers steadily took share. Fannie’s share rose from 25% in ’08 to a peak of 33% in early ’21. Since then, the squeeze on housing affordability (high home prices, high mortgage rates) caused non-GSE products like adjustable-rate loans to grow more popular, lowering Fannie’s market share a bit.

Net/net, I expect Fannie Mae’s MBS credit guarantee business to trend up from 1% growth at present to 4% long-term.

Forecast: Home mortgage default costs

This is the big one. As primarily a home mortgage credit guarantor, credit losses incurred are the big swing item for Fannie’s earnings.

I focus on cash default costs, not accounting adjustments. Before discussing the credit outlook, a very quick accounting note. Fannie Mae recognizes credit losses in its income statement in two different ways:

1. Cash losses from mortgage defaults as they occur.
2. Accounting losses or gains as Fannie Mae (and any other bearer of lending credit risk) adjusts a loan loss reserve to recognize today what management estimates might be future cash losses. These are non-cash adjustments that in practice create huge swings in reported earnings. For example, in 2008, Fannie Mae took a $21 billion hit to reported earnings to recognize future expected losses. And in 2014 Fannie reversed $7 billion of those reserves, adding to reported earnings.

I ignore the non-cash loss reserve additions and subtractions. Here is a history of Fannie’s cash loan charge-offs:

Source: Fannie Mae financial reports

Why the surge in charge-offs 15 years ago, and why the minimal losses today? Two factors – (A) Loan underwriting standards, and (B) Housing market supply and demand.

Loan underwriting standards. Here is a history of the availability of mortgage credit:

Source: Mortgage Bankers Association

You can clearly see the loosening of home mortgage loan lending standards in the early ‘00s, and the tightening of those standards by 2009 that has persisted to this day.

Fannie Mae in large part followed the same path, as this comparison of some key lending standards between ’06 and today highlights:

Source: Fannie Mae financial reports

Housing supply/demand. The “law” of supply and demand says that an excess of supply causes lower prices, while a shortage of supply causes higher prices. This law works for housing. Housing supply and demand are well measured by the number of vacant housing units (single-family homes and apartments). The historic average vacancy rate is 3.5%. Here is a difference in the excess or shortage of housing units versus that average:

Source: The Census Bureau

The chart clearly shows the excess housing that helped drive down home prices during ’07-’11, and the housing shortage that helped cause soaring home prices over the past few years.

Net/net, the loan standard and housing vacancy data show that Fannie Mae’s surge in loan charge-offs after ’07 was the result of a “Perfect Storm” – very risky lending standards meeting over-built housing. Today is “The Perfect Calm” – very conservative lending standards meeting under-built housing. Meaning the great likelihood of very low charge-offs for the foreseeable future.

Forecasts: The rate of decline of home mortgages owned and the fed funds rate.

As I discussed above, these are the two drivers of Fannie Mae’s interest income. I will make this quick. First, my guess is that Fannie Mae is near the end of its two-decade shrinkage of its home mortgage portfolio. The company should want to retain the ability to hold mortgages that aren’t easily securitized, but whose terms help it meet its mission of helping lower income households achieve homeownership.

Second, we all know the fed funds story. The Federal Reserve has stated that the next move for the fed funds rate is down.

Net/net, Fannie Mae’s interest income should drift lower for the next few years.

My thoughts on Fannie Mae’s ownership issues.

I hold four views:

1. Fannie Mae will retain its GSE status. I say that because doing so benefits three very large political lobbies. One is homeowners, who get cheaper mortgages. A second is the housing industry, from lenders to realtors to homebuilders, all of whom value lower mortgage rates and the liquidity that keeps mortgage money flowing even in high-stress economic scenarios. A third is investors, who value the GSE guarantee against loan defaults.

2. Fannie Mae’s will retain its business model. Could the private sector take over Fannie Mae’s credit guarantee function? Yes. But the private sector has shown no interest in doing so in the 15 years since conservatorship.

3. It is unlikely that conservatorship will end until Fannie Mae is reasonably well capitalized. Fannie said in its Q-3 10-Q that its total risk-based regulatory capital requirement is $187 billion. Its current capital is $74 billion, and more than all of that is preferred stock; common equity is ($47) billion. Fannie needs another roughly $125 billion of capital, which will take 6+ years of earnings retention.

4. The government wins nearly all legal battles. The federal government has been sued by lots of GSE investors trying to re-assert private sector ownership rights. Little progress has been made. Congress is unlikely to step in to support the wise-guy hedge funds and other investors pursuing the lawsuits.

Valuing the stock.

As I said above, Fannie Mae should earn about $17 billion this year. My discussion of Fannie’s fundamentals suggests slow growth, say 3-5%. A related GSE I write a lot about is Farmer Mac (AGM). Farmer Mac has a much smaller share of its market, and therefore much better growth prospects than Fannie. Further, Farmer Mac pays dividends, while Fannie Mae cannot because of the conservatorship status. Farmer Mac’s stock is trading at a 12 multiple. A lower multiple is therefore appropriate for Fannie; 9 feels about right. That suggests a $150 billion market cap.

That wasn’t so hard. But making a per share valuation estimate is. There are about 1 billion common shares outstanding. But the federal government has a $180 billion claim on Fannie Mae through preferred share ownership. How that converts to common is unknown.

So what is a fair value per share? Got me. And be quite suspicious of anyone who thinks they know that answer.

The bottom line.

Fannie Mae is a very profitable operating business, but the ownership unknowns make it impossible to value the stock with any degree of confidence.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.