barron's recently slammed fnm; here's another viewpoint.
barron's presented an alarmist view of the company’s current situation and prospects. while it is possible that credit losses will push fnm over the brink, i consider it to be highly unlikely. as barron's correctly pointed out, the spreads on mortgage-backed securities (MBS) guaranteed by fnm have widened dramatically. but the spread widening says nothing about future credit losses at fnm. rather, it simply indicates a supply and demand imbalance for MBS in the marketplace. in fact, gnma paper, which is explicitly guaranteed by the federal government, has experienced
similar spread widening.
the real issue is whether fnm has enough capital to weather the storm and what the ultimate credit losses turn out to be. on the capital issue, we believe the “soft assets and understated liabilities” that barron's refers to are much sounder than barron's suggests. the deferred tax assets of $13 billion arise primarily from the accelerated non-cash mark-to-market write-downs that are required under gaap. on a cash basis, fnm is highly profitable. during 2007, fnm paid $1.9 billion in taxes and over the past six years paid $12.8 billion – hardly the result of a moneylosing
operation. the losses stem from esoteric accounting write-downs, none of which are “hard” enough to allow a deduction with the irs. consequently, fnm will be able to carry-back a substantial portion of any future taxable losses and realize the deferred tax assets. any extra taxable loss will offset the taxes due on future guarantee fees and spreads, both of which are being put on the books today at record levels. thus, it is unlikely that accountants will require the write-off of the
deferred tax assets in the foreseeable future.
similarly, the $8.1 billion of Lower Income Housing Tax Credit partnership investments that the barron's article references are of sound value because the underlying tax credits are transferable. in fact, in 2007, fnm sold $930 million of such credits for a gain. further, if tax rates rise in the future, these credits would likely increase in value. the liability for future credit costs, which the author in the magazine identifies as understated for fnm versus the more aggressive mark that fre chose to take, mainly impacts a non-GAAP measure of the company, “Fair Value.” but capital requirements are determined by GAAP. furthermore, the article criticizes fnm's mark of its private label securities portfolio as being less aggressive than the marks taken by many of the banks. there are many reasons for this:
first of all, there are no CDOs in fnm's. yet CDOs are what is driving the majority of the large write-offs at other financial institutions. when one compares the prices at which fnm has marked these securities, they are comparable to the marks that other institutions have taken on securities of a similar nature. more important, i believe that the company is unlikely to realize any real economic losses in these holdings given the level of credit enhancement. fre, in its quarterly report, provided very detailed disclosure on its subprime and Alt-A securities. even under an extreme scenario of 60% default and 50% severity, fre is projected to suffer
losses of $99 million, a loss rate of 0.1%. while similar levels of details on fnm's subprime and alt-a security holdings are not available to me, i don't think there is any reason to believe that they differ materially in nature from fre's or that fnm will incur sizable losses under similar assumptions.
i also believe that the $50 billion of potential credit loss that the author projects could arise from the existing portfolio is unlikely to be that severe. it appears to us that what the author called “conservative” loss rates are significantly worse than what most observers view as “worst case” loss rates. clearly, defaults of 40% on subprime, 12.5% on Alt-A, and 4% on prime for all loans including those originated prior to 2005 are not conservative. the credit enhancement that fnm has on its portfolio will mitigate the severity of the losses as well. while there is not sufficient history to guide us in a national home price decline, we do know that prior regional stresses where both housing prices and employment have been very weak have led to loss rates of perhaps half the stress level implied in the article. i believe fnm can absorb $25 billion of losses over the next three to four years out of its annual fee and net interest income revenue of roughly $12 billion and
its capital of $45 billion.
in addition, fnm has a great deal of flexibility in dealing with the capital issue:
first, it has a liquid investment portfolio that can be liquidated to generate $1.6 billion in capital. second, there is an annual dividend payment of $1.3 billion, which should probably be immediately eliminated. third, there is the ability, if necessary, to shrink its portfolio through natural attrition and generate
over $3 billion per year in capital. and, finally, OFHEO could reduce fnm's excess capital requirement since it has fixed the issues that gave rise to it in the first place. this would free up over $9.5 billion in additional capital.
in summary, i continue to believe that fnm and fre have done an admirable job in this very difficult housing environment. expecting these two agencies to bail out a system that went off track due to the behavior of other players is extremely unreasonable. to date, fnm and fre are the only reason that the mortgage market is still functioning. most important, as an investor, i believe fnm and fre can withstand the travails in the mortgage market – and that these companies are extremely undervalued because of the dominance of fear over rational analysis
in the market today.
disclosure - long a little fnm - do your own DD!