Every once in a while the markets hand you an investment that practically screams buy or sell.
While some of these "no-brainer" investments jump spectacularly, leaving little opportunity for later investors to profit, others are more gradual in their rise.
Too Big To Scale In its most explicit acknowledgement yet that talk of winding down the Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage Corp. (FMCC) -- or Fannie Mae and Freddie Mac, as they're more commonly known -- is futile, the key regulator for the government-supported enterprises (GSEs) recently said it would not reduce the size of the mortgages the firms can buy.
The Federal Housing Finance Agency also said it would ease standards for when banks must buy back faulty loans, called put-back provisions. Rules on put-backs have been a sticking point for banks in easing credit standards for borrowers because they feared they would eventually have to buy the loan back from Fannie or Freddie.
The regulator's announcement only makes it clearer that Washington is in no hurry to limit the role the GSEs play in the housing market (in fact, its announcements expand their role). Whether reform is needed or not, Fannie and Freddie are not going anywhere.
The fact is that housing needs the GSEs to support the $5 trillion market for mortgage-backed securities (MBS). Last year, the GSEs bought 61% of the residential mortgage-backed securities originated; banks held about 38%. Private-label MBS issuers accounted for less than 1% of the market, well below their 30% share before the collapse of the housing bubble.
Does anyone really believe the private sector is able or willing to step in to fill the gap left by Fannie or Freddie if they were limited?
For better or worse, the immense size of the GSEs and their relationship with the government lowers mortgage interest rates and opens up homeownership to millions of Americans. This role would be incredibly difficult for the private sector to fill.
A Guru Makes His Pitch Hedge fund guru Bill Ackman released a 111-slide investor presentation this month detailing the issue and arguing that Fannie Mae could be worth as much as 10 times its current share price. Ackman's Hedge Fund Pershing Square Capital Management holds a 10% stake in the GSEs.
The average fee Fannie Mae charges to lenders to back new loans increased last year to 0.37% from a long-term average around 0.22% since 1990. The FHFA has required that the GSEs increase these fees to help private issuers be more competitive in the MBS market -- and Ackman argues that the guarantee fees will need to be increased to at least 0.60% for private issuers to be profitable and attract new suppliers into the MBS market.
Even at the current level of guarantee fees, Fannie Mae could post earnings in excess of $11 billion and may be worth as much as $14 per share on a price-to-earnings (P/E) multiple of 14. Ackman estimates that if the guarantee fees were raised further, to between 0.60% and 1%, the stock would be worth somewhere between $23 and $47 a share.
Dividends For Shareholders, Not Uncle Sam Currently, Fannie and Freddie are required to pay out all earnings to the U.S. Treasury in what's called the net worth sweep, which means that shareholders really own only the hope that the GSEs will come out of conservatorship.
Through March of this year, the GSEs have paid dividends of $203 billion to the government, well in excess of the $187 billion received during the crisis. I expect the courts will ultimately require the government to end the net worth sweep -- and start sharing the right to earnings with investors.
Shares of Fannie Mae trade on a significant discount due to the net worth sweep and fears that the GSE may yet have its mandate limited. I think it's highly unlikely that the government will be able to scale back the entities in any significant way -- and I further expect the shares could start trading closer to their fair value as early as next year.
Risks to Consider: Both GSEs are still in conservatorship and are required to distribute 100% of earnings to the Treasury. Shareholders have filed lawsuits the matter may not see resolution for some time. Short-term movement in the push to wind down the two entities could weigh on share prices but the upside potential should remain intact over the long term.
Action to Take --> It seems that the government has no plan for winding down Fannie Mae or Freddie Mac and regulators have the mortgage giants expanding their role in the market. Shares could go much higher as the housing market continues to recover and uncertainty is reduced around the GSEs. I am setting a buy-under price for Fannie Mae of $6 a share and a target price of $20.
