Fannie Mae Under the Gun

By: Ram Seshadri | Mon, Oct 11, 2004
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I have not updated my site for nearly a month as I was busy professionally. But there is a couple of pieces of news that caught my attention recently that has broader implications for the whole market. One is that Fannie Mae's regulator has tightened the noose around the company's implausible growth over the last decade. The second is that Pulte Homes (PHM) cut it's forecast for the 4th qtr because of price reductions in the homes it was selling.

In my last few updates, I kept saying that "I am bearish here" only to see another rip-roaring rally hit my face. So in order not to risk another egg landing on my visage, let me just state the facts and not make any predictions as to what next week may bring.

For those of us who have been waiting for someone, somewhere to rein in Fannie Mae which we saw as an out of control monster that was distorting the US financial system (the other monster is the Federal Reserve), our long wait was finally rewarded. Fannie Mae's regulator OFHEO, finally found its voice and its religion when they investigated Fannie Mae thoroughly and issued a scathing 200 page report on Fannie Mae and its management. We were overjoyed when the same regulator called for the heads of Fannie Mae to resign or be forced out.

The stock took a mighty tumble and even some of the Wall Street cheerleaders finally pulled in their pompoms a little bit.

I have been expecting since the beginning of the year that Fannie Mae blows up sometime this year. I think this is the beginning of the end for the old Fannie Mae as we know it. I am almost certain that the "20% predictable earnings growth Fannie" that Peter Lynch was fond of is dead and therefore immortal. It will not come back. The new Fannie Mae will be a $30 stock and grow with the economy and fall with the housing market. How am I so sure?

Take a look at the chart below: it's the 3-month chart of the long bond prices (10 year and out).

Notice how the prices of long bonds have been going up from July through September? This means that yields have been going straight down. But this is totally contrary to what everyone expected in July: remember, we were all worried about rates going up? Including Fannie Mae! If I recall rightly, Fannie Mae in it's last regulatory filing, noted that it was properly hedged for a rising rate environment! In addition, the company provided details of its hedging strategy. It said, that if rates rise, it's impact would be minimal (zero it noted proudly). But if rates fell (a concern that nobody shared at that time), the company would lose about 2 billion dollars in its hedge book. Wow!

Now, all of you remember the nonsense about a "soft patch" that Greenspan was blathering about this summer(see my article on Greenspan to understand his Greenspeak a little better)? Well, the media speculated that the soft patch was what was contributing to the massive decline in yields. Well, I have a different view: notice in the chart how yields fell slowly and tentatively in july and august (i.e. prices were inching up) when the economy was actually slowing. But they took a dive (and prices shot upward) during September especially the last week. Wanna know why?

I think our big brother in the mortgage and treasury market, Fannie Mae, which must have been massively short the treasuries (due to its hedging strategy outlined above) saw the steep rise in treasury prices during early September and decided that it couldn't be short this market anymore. It couldn't afford to miss earnings - so there must have been a mad scramble by Fannie Mae to buy treasuries and the sound of a giant bull marauding into the China shop should have caused quite a dislocation in that market during the last week of September. That's why yields overshot 4% and went as low as 3.9% during that week. And the happy folks in the media speculated that may be the bond market knows something about a recession that the stock market didn't. Sorry folks, but we should know in a week or two from Fannie Mae whether it was the bull in that China shop last quarter - I am 99% certain that they were the ones - the paws on the mud seem too much like theirs.

With that said, let me also bring your attention to the housing market. If Pulte has to cut it's prices on homes by as much 20-25% can you imagine how horrible this housing bubble is? When this bubble bursts, as it almost certainly will next year, you can bet that Fannie will take another big hit to it's derivatives book and its earnings. Now that stock doesn't look like a value play anymore, does it?

Talking about valuation, let me tell where I think you should buy back Fannie Mae stock if you are short it. When I last checked, Fannie Mae had shareholders' equity of about $22.5b on a close to 1b share count (967m to be exact). But if you are talking round numbers, you can say that Fannie's shares are worth about 22.5 bucks in book value. With the coming writeoffs in earnings (due to massive losses in their hedge book), let's assume about $8b in past earnings is written off - that means almost $8 in book value disappears (leaving BV at $14.5). If you value Fannie as just another financial institution on Wall Street, you value it at 2 times book which means Fannie's stock is worth between $28 and $30. So that gives you an idea of how far this stock has to fall between now and next year which is when I think this scandal will finally close. But there will be many rallies and declines between now and then, but I think Fannie's denouement has begun and the clock is ticking on its eventual unraveling.

I don't have much in terms of holdings since I have been shaken out of of most of my shorts during this month long rally, but here is how they look:


Gold: Gold stocks had a good month but I have mostly silver in my portfolio. I still have only IMXPF (a silver play) in that sector though it's a big position. It has nearly doubled in the last 6 weeks which has been good for me.

Oil: Oil services stocks still look decent here though I have been a seller and have no longer any positions in them.


Tech: I am short some semis here based on what I am hearing about their fundamental health. Mostly semicaps.

Financials: I think the small counter trend rally in Fannie Mae is over - I am short FNM and short FNM calls.

Happy investing and researching! We'll see what next week will bring.

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Ram Seshadri

Author: Ram Seshadri

Ramadurai Seshadri
Alyx Funds LLC

Ram Seshadri is investment manager at Alyx Funds LLC

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