Our Fannie Mae (FNM) Investment – A Case Of Escaping With Minor Wounds!

We allocated about 8% of our portfolio on Fannie Mae (FNM) at $30.70 on 02/11/2008 only to sell out on 03/10/2008 for a 35% loss in a period spanning one month. FNM at $40 was one of our stock picks at the beginning of the year for the SINLetter stock contest and we purchased it in good faith around then. Admittedly the joke was on us, but ensuing events serves to establish that trimming losses in the face of continued uncertainty in the company’s business makes financial sense –The government took over the reins of Fannie Mae (FNM) as bankruptcy loomed essentially wiping out the value of equity. Holding on to our shares would have been a disaster – in less than six months the entire investment would have wiped out. Suddenly, a ~2% hit in the portfolio value is more palatable!!

The government takeover is officially termed conservatorship - The Federal Housing Financing Agency (FHFA) placed Fannie Mae (FNM) under the conservatorship of FHFA on September 7, 2008. Under that action, they dismissed the Chief Executive Officer (CEO) and the board of directors. The common stock was diluted by 79.9% by issuing preferred stocks and warrants. The value of the common stock to investors was greatly diminished due to two factors:

• Dividends were suspended indefinitely, and
• Under conservatorship, Fannie Mae’s major concerns shifted to homebuyers (with respect to keeping mortgage rates as low as possible) and bondholders from shareholders unlike the previous management.

Fannie Mae’s (FNM) business can be summarized as: own and guarantee consumer-housing mortgages. The reasons for the government takeover at a time when FNM had a portfolio of over $700B in mortgages can be traced back to concerns regarding the size of Fannie Mae’s portfolio and guarantees. As a Government Sponsored Enterprise (GSE), FNM had certain competitive advantages that resulted in ever-increasing portfolio size. GSE’s borrow money at low rates to fund their portfolio and unlike their public counterparts, no regulatory requirements limited FNM’s size – in particular, while other financial institutions are required to maintain a capital to asset ratio of 3%, FNM was unbound. Further, FNM’s Mortgage Backed Securities (MBS) has the advantage of an implicit guarantee of the federal government – there is no explicit guarantee, but given the GSE’s existence hinged on providing liquidity for mortgages, government backing can be assumed for any event responsible for an outright collapse in the liquidity. If Fannie Mae fails to pay-up on their MBS guarantees, demand for such securities plummet impacting liquidity resulting in risks for the government proportional to the size of the portfolio. In hindsight, it is clear that steps to limit these risks were forthcoming.

Control at the reins enables the government to contain the size and limit further risks. The dual structure (a public enterprise trying to make money for shareholders and a GSE) also contributed in Fannie Mae straying past its sole government intended purpose by purchasing mortgage loans and bonds outright using borrowed money, thus increasing leverage. The plan calls for the Fed to purchase Fannie Mae’s MBS’s from the open market – this will provide Fannie Mae with access to funding mortgages. After the expiration of the purchase program by the end of 2009, the plan calls for a reduction in FNM’s mortgage backed securities portfolio at an annual rate of 10% moving forward. But why not reduce the portfolio size immediately? – The rationale is to minimize the impact in the global mortgage backed securities market and a gradual reduction in the portfolio size over time makes better sense.

Below is an analysis of a couple of alternative shareholder friendly scenarios:

1. The federal government could have made the guarantees explicit through legislation of the debt owed by Fannie Mae (FNM). This would immediately have an impact on Fed’s balance sheet. Further, the need for better regulation and reducing the size of Fannie Mae’s portfolio had finally become a necessity and this alternative would not stand the test of time.
2. The federal government could have loaned Fannie Mae (FNM) money perpetually on an as-needed basis. This was even less desirable because it would easily be seen as invitation for Fannie Mae executives to take even more risk

A look back at what went wrong with our judgment should be educational as we manage this portfolio moving forward:

1. We were very much aware of the global housing situation, seeping across much of the western world including Europe and Australia. However, on a comparative basis, Europe seemed more expensive and more susceptible for a bigger correction. Also prices around the rest of the world kept pace - in some developing countries, house prices doubled in mere 3-5 years especially in the tier 1 and tier 2 cities. Piecing these factors together, we concluded that the middle ground would be with house prices in the US taking a correction in the order of 10-15%. Such an orderly correction would have had very little impact on Fannie Mae (FNM) and so investing in the face of falling valuation did not seem bordering lunacy. It is nobody’s guess that we completely underestimated the size of this correction.
2. We naively believed one of the alternative scenarios suggested above would receive preference over a government takeover of Fannie Mae (FNM).
3. We expected the requirement of writing conforming loans gave Fannie Mae a fair amount of protection against losses. What really happened is the exact opposite - It is unreal that the high-end of the market was not as affected as the lower ends. This may indicate the growing disparity between the top 5% households who have mortgages exceeding half-a-million dollars and the rest of America whose mortgages Fannie Mae ends up writing.
4. We expected guarantee claims to be limited given that the vast majority of mortgages that Fannie Mae holds/guarantees are older than four years and so are not exposed to the effects of the bubble. While this is true in general, we failed to consider the fact Fannie Mae was taking on risks at an accelerated pace as the mortgage bubble developed.