Mortgage magic

12 March 2014 By Richard Beales, Daniel Indiviglio

Fannie Mae investors may be using magic calculators. With the latest reform blueprint taking shape in the U.S. Senate, hedge funds like Fairholme Capital Management have urged Washington to revitalize Fannie, the mortgage finance giant, which along with Freddie Mac was kept alive with nearly $190 billion of taxpayer cash in the aftermath of the financial crisis. The prospect has pushed up the price of Fannie’s preferred stock more than 10-fold in 18 months. But according to a Breakingviews analysis, even cheerful assumptions suggest Fannie’s business isn’t worth enough for shareholders to get much if anything back.

Although the two companies’ volatile common stock plunged on Tuesday, news that the top Democrat and Republican members of the Senate’s banking committee have agreed on the outline of a bill to wind down Fannie and Freddie shouldn’t have changed the calculus much. While some kind of government backstop is part of the latest plan, exactly what the new regime will look like and how to get there remain unknowns. Even so, the government will surely try to extract as much value from Fannie and Freddie as possible.

Take Fannie Mae. Its mostly mortgage-related assets were worth about $490 billion at the end of 2013 at fair value. The other big part of its business is guaranteeing mortgages it doesn’t own. Fannie’s $2.8 trillion guarantee book provides a stream of fees averaging 0.32 percent after losses. Apply the 5 times multiple recently paid for an Ocwen mortgage servicing pool, and that historical business could be worth $44 billion.

Then there’s new guarantee business, which could be sold to private investors. Refinancing activity, 62 percent of the U.S. mortgage market total in 2013, is likely to slump as interest rates rise. Suppose Fannie’s new business shrinks from nearly $800 billion in 2013 to, say, just above $430 billion initially. Breakingviews also assumes guarantee fees go up, netting 0.42 percent after losses and the cost of relatively cheap government reinsurance. Discount that perpetual stream at 6 percent after allowing for 2.5 percent annual growth, and the present value of the business comes in at $52 billion.

Add it all together, and that’s $587 billion of value. That only just covers Fannie’s $555 billion in reported liabilities on its non-guarantee business at the end of 2013. The $32 billion difference doesn’t get close to covering the $117 billion of preferred stock owned by the Treasury, never mind leaving any cash left over for junior preferred or common shareholders like Fairholme.

An investor lawsuit, if successful, could force the Treasury to give back an estimated $68 billion of the funds Fannie has handed over. But even that would not give Fannie enough to pay down all the Treasury’s preferred stock. Fairholme may be using rosier assumptions. But the hedge fund and its brethren seem to be clutching at straws – unless, of course, they can persuade Uncle Sam to give away too much.


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