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FNM AT A GLANCE

P/E ► -0.0126   EV/EBITDA ► -7.05   ROA ► -13.5% VERY LOW ROE ► -994.5% VERY LOW Debt to Equity ► -86.1   Current Ratio ► 0.00291 AVG Interest Coverage Ratio ► -2.96 LOW

 

 

 

 

 

 

The Federal National Mortgage Association (Fannie Mae) (NYSE:FNM), the second largest corporation in the United States in terms of assets, buys mortgages from banks and financial institutions and sells mortgage backed securities (MBS), a type of bond, to investors of all sizes. Fannie was structured to play a dominant role in the secondary mortgage market and ensure a steady and reliable supply of funds for U.S. homebuyers. In August 2008, the U.S. federal government's implicit backing of Fannie Mae became explicit when former Treasury Secretary Henry Paulson announced that Congress had approved a plan giving the Treasury the authority to bail out Fannie if its capital levels dipped too low. Investors, who feared that a significant infusion of capital from the U.S. government would dilute the value of their holdings, punished Fannie's stock, which fell by as much as 90% in 2008.^[1]

On September 8, 2008, investors' fears were realized when Paulson announced a comprehensive plan to take Fannie and Freddie under "conservatorship", essentially placing the companies under temporary government control and giving the Treasury the right to pump as much as $100 billion into each company, as well as buy a 79.9% share of both Fannie and Freddie.^[2] At the same time, Herbert Allison Jr. was appointed the new Chief Executive Officer (CEO) of Fannie Mae. On April 18, 2009, CEO Herbert Allison Jr. was nominated to run the Troubled Assets Relief Program (TARP)^[3], and on June 19 2009 he was approved by the Senate, becoming assistant Treasury secretary for financial stability.^[4] Michael Williams, Fannie Mae's former Chief Operating Officer and Executive Vice President was appointed CEO as Allison's replacement.^[5]

On August 7, 2009 Fannie Mae announced it would need another $11 billion in aid from the U.S. Government, as it posted a net loss of $15.2 billion for the second quarter of 2009.^[6]The losses were attributed to $18.8 billion in credit losses, as nearly 4% of the loans Fannie Mae owns or guarantees were delinquent.^[6]

Company Overview

Fannie Mae is a Government Sponsored Enterprise (GSE) a hybridized enterprise endowed with an advantageous set of special privileges. It is a non-bank financial institution created by the U.S. federal government in 1938 and given a range of special privileges, including exemption from state and local taxes, a $2.25 billion line of credit with the U.S. Treasury, and the implicit backing of the federal government.^[7] Fannie Mae's business model is that it earns income from the mortgages it owns, using some of it to pay interest on its mortgage backed securities (MBS); rising default and foreclosure rates, however, meant that more and more of its mortgages weren't generating any income at all, forcing the company to write these mortgages off as losses on its income statement.

The purpose of Fannie Mae is to make it easier for Americans to own a home. Fannie Mae accomplishes this goal by expanding the supply of funds available for mortgages. For example, when a bank lends out a mortgage, it normally has to wait until the loan is repaid before lending the funds out again. Fannie Mae, however, steps in and buys out the mortgage from the bank, allowing the bank to make a second loan sooner; Fannie Mae meanwhile earns the interest from the mortgage. Fannie Mae also sells bonds tied to the mortgages, called mortgage-backed securities. While the mortgage might not be repaid, Fannie Mae guarantees full repayment of its bonds, allowing Fannie Mae to charge a security premium.

Fannie Mae is also highly leveraged, as it loans out much of its surplus cash by buying mortgages, and then generating revenue by issuing additional securities. High leverage often leads to a high return on equity (ROE), or a high profit per dollar invested. However, this high return also bears substantial risk because a default on a single mortgage can affect Fannie Mae's ability to repay multiple bonds.

Business and Financial Metrics

Together, Fannie Mae and Freddie Mac (FRE) hold approximately $5.3 trillion of the $12 trillion total in U.S. residential mortgage debt as of August 4, 2009.^[8] As such, a failure at Fannie Mae could wreak havoc in the residential housing market and the economy as a whole because many other large financial institutions hold Fannie bonds. Although the government was not obligated to assist Fannie Mae, the potential mayhem caused by Fannie's demise is what many believe led the to government ensure Fannie Mae's continued viability.

At the end of 2008, Fannie Mae had approximately $3.1 trillion in mortgages and other guarantees.^[9] In 2008 Fannie Mae had $8.8 billion in net interest income and $7.6 billion guaranty fee income.^[10] However, it had losses of $7.2 billion in investment income, $20.1 billion loss related to derivatives, and a $29.8 billion loss related to its provision for credit losses as well as foreclosed property expense.^[10] Combined, this led to a net loss in 2008 of $59.8 billion, compared to its 2007 net loss of $2.6 billion.^[10]

Business Segments

Fannie Mae breaks its operations into three business segments: i) Single Family, ii) Housing and Community Development (HCD), and iii) Capital Markets Group.

Single Family

The main source of revenue for the Single Family business is guaranty fees, which increased from $5.8 billion in 2007 to $8.4 billion in 2008.^[13] However, Fannie Mae's Single Family business had a net loss of $27.1 billion in 2008 compared to its net loss of $858 million in 2007.^[13] The large loss despite increases in revenue is due to significant increases in credit-related expenses, as it had to increase its provision for credit losses due to increased charge offs, delinquencies, and defaults.

Housing and Community Development (HCD)

In 2008 Fannie Mae's HCD segment recorded a net loss of $2.2 billion, compared to its 2007 net income of $157 million.^[14] Its primary source of revenue is guaranty fees, which totaled $633 million in 2008, an increase from its 2007 fees of $470 million.^[15] The reason for this loss is because Fannie Mae established a partial deferred tax asset valuation allowance against Fannie Mae's net deferred tax assets prevented it from recognizing tax benefits on losses occurring after the third quarter of 2008. The net effect of this between 2007 and 2008 was approximately $2.2 billion.^[15]

Capital Markets Group

Fannie Mae's Capital Markets Group business segment recorded a net loss of $29.4 billion in 2008, a huge increase from its 2007 net loss of $1.3 billion.^[16] This segment mainly earns revenue through interest; its net interest income in 2008 was $8.7 billion, a significant increase from its 2007 income of $4.6 billion.^[16] The huge loss is due to a variety of contributing reasons. First, net investment losses increased from $803 million in 2007 to $7.1 billion in 2008, largely a result of falling fair values for many of its securities.^[17] Second, losses related to derivatives such as interest rate swaps increased from $4.7 billion to $20.1 billion between 2007 and 2008 due to a decline in interest rate swaps.^[16] Finally, a partial deferred tax asset valuation allowance against Fannie Mae's net deferred tax assets prevented it from recognizing tax benefits on losses occurring after the third quarter of 2008. The net impact of this was a $9.6 billion loss between 2007 and 2008.^[16]

Trends and Forces

Interest and mortgage rates over time

Reporting Problems

In 2004 Congress released a special report detailing Fannie Mae's violation of the Generally Accepted Accounting Principles (GAAP) and alleged that Fannie Mae misreported losses and expenses from hedging activity. It charged the operating team at the time with poor management and accused them of deliberately misrepresenting net earnings so as to maximize their bonuses. Aside from punitive repayment, Fannie Mae was forced to revise its financial statements. While revising financial statements is technically a violation of New York Stock Exchange protocol, Fannie Mae's stock remains listed because of its pledge to update its books and its GSE status. Finally, the accounting errors and lack of oversight have prompted Congress to consider additional legislation governing Fannie's operations. Congress has already imposed a 30% capital reserve requirement, which will force Fannie Mae to lower its previous 78:1 debt-to-equity ratio.

Fannie Mae's Non-performing Loans increased 439% in 2008

A loan is generally considered non-performing after it has become delinquent for more than 90 days, meaning the borrower has fallen behind on payments by 90 days. Since Fannie Mae generates a significant portion of its revenues from mortgages, an increase in non-performing loans reduces its revenues and hurts earnings. In 2007, non-performing loans nearly doubled from $13.8 billion to $27.2 billion.^[9] However, between 2007 and 2008, its non-performing loans increased to $119.2 billion, a 439% increase from its 2007 levels.^[9] If Fannie Mae's non-performing loans continue to increase rapidly, it will have further trouble recovering from its losses.

Effect of Subprime Meltdown

The mortgage industry expanded in the late 1990s and early 2000s as the market for subprime loans grew rapidly. Fewer than 100,000 subprime loans were made in 1995, but in 2004, over 1.5 million loans written were considered subprime. Subprime loans are loans made to borrowers with poor credit scores or low incomes. These borrowers are obviously riskier, but this same reason enables banks to charge premium interest rates to compensate for the higher risk. In the early 2000s, banks began pooling mortgages to spread the risk, making subprime loans seem even more lucrative, further expanding the market for them. Since 2007, however, the subprime sector has collapsed as repayment rates have dropped in response to rising mortgage payments and falling home values. About half of all current subprime mortgages have adjustable rates, meaning that the rate of the loan (and, subsequently, the monthly payments) are tied to interest rates. In March of 2007, 13.5% of all subprime mortgages were delinquent, up from 11.5% the year before. Fannie Mae was originally thought to have been safe from the subprime crisis; however, in November 2007, it reported a $1.39 billion loss as a result of an increasingly large number of defaulting mortgages. Fannie posted another loss of $3.6 billion for the fourth quarter, leading to a $2.05 billion loss for 2007. Any questions about Fannie Mae's insulation from the market turmoil have since been answered, as its losses continue to mount.

U.S. Housing Market disappoints

In 2007, new and used home sales declined to their lowest level since 2001. For the year, a projected 6.28 million homes were sold, down 7.1% from last year and only just higher than the 6.2 million sold in 2001. This decrease in the number of home sales correspondingly leads to a drop in the number of mortgages written, which hurts Fannie Mae and other mortgage companies. Although Fannie does not write mortgages itself, the fall in mortgage demand leads to falling interest rates. As a lender, Fannie won't make as much profit on the mortgages it acquires if interest rates drop, compounding the impact of the housing market on Fannie Mae's profit. Additionally, Fannie's monthly summary for April 2008 showed that the serious delinquency rate for single-family mortgages had risen from 0.62% in March of 2007 to 1.15% in March of 2008, a significant increase.^[18]

Fixed interest rates decrease flexibility

The majority of the mortgages that Fannie Mae acquires have fixed rates, meaning that the amount a borrower pays back is based on the interest rate at the time the mortgage was signed. This can impact Fannie Mae in several ways. Much of Fannie's business involves selling bonds, and Fannie cannot sell a bond at a rate much lower than the current prevailing rate. If interest rates rise, Fannie's income from the fixed-rate mortgages it currently owns will remain unchanged, but its ability to capitalize on those mortgages, or use them to back securities, will fall. For example, if Fannie holds a mortgage with an annual rate of 2.5% but current interest rates are at 5%, it will be unable to earn a profit because it only earns 2.5%, but must pay out 5% for any investor to purchase the bonds.

Competition

Because of Fannie Mae's relatively specific purpose and its GSE status, comparisons to other corporations are difficult to make. The best comparison would be to its sister company, Freddie Mac (FRE). Both have similar charters, are similar in size, and both hold status as GSEs.

References

1. ↑ U.S. seizes Fannie, Freddie, aims to calm markets | U.S. | Reuters.com
2. ↑ U.S. seizes Fannie, Freddie, aims to calm markets | U.S. | Reuters.com
3. ↑ Fannie Mae CEO Allison Nominated to Run TARP. Henry J. Pulizzi. The Wall Street Journal.
4. ↑ Senate confirms Allison as TARP chief. Reuters.
5. ↑ Fannie Mae Website. About Us. Executives.
6. ↑ ^{6.0 6.1} Alan Zibel. Fannie Seeks $10.7B More Aid, Posts Loss. TheStreet.com.
7. ↑ Fannie Mae Charter Act.
8. ↑ Fannie Mae, Freddie Mac Likely to Be Wound Down, Moody’s Says. Jody Shenn. Bloomberg.
9. ↑ ^{9.0 9.1 9.2} FNM 10-K 2008 Item 6 Pg. 81
10. ↑ ^{10.0 10.1 10.2} FNM 10-K 2008 Item 6 Pg. 80
11. ↑ ^{11.0 11.1 11.2} FNM 10-K 2008 Item 8 Pg. F-4
12. ↑ FNM 10-Q 2009 Item 1 Pg. 112
13. ↑ ^{13.0 13.1} FNM 10-K 2008 Item 7 Pg. 117
14. ↑ FNM 10-K 2008 Item 7 Pg. 118
15. ↑ ^{15.0 15.1} FNM 10-K 2008 Item 7 Pg. 119
16. ↑ ^{16.0 16.1 16.2 16.3} FNM 10-K 2008 Item 7 Pg. 120
17. ↑ FNM 10-K 2008 Item 7 Pg. 121
18. ↑ Fannie Mae's Monthly Summary for April 2008
19. ↑ FRE 10-K 2008 Item 6 Pg. 58