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Fannie’s Profits May Be Fleeting
[Financial Analysis and Commentary]
The profits keep piling up at Fannie Mae. But when dealing with such a political animal, bullish investors shouldn’t count on the gains ending up in their pockets.
Nearly two weeks ago, Fannie reported record earnings of $84 billion for 2013 and has racked up eight consecutive profitable quarters. Its fellow mortgage giant, Freddie Mac, last week also reported a banner year, with earnings coming in at $48.7 billion. Such profits have spurred a cadre of fund managers to argue the U.S. should, and eventually will, allow the two to exit their conservatorships and operate independently.
Such hopes already have led to big gains for both preferred and common stock in Fannie in the past year. They are up 505% and nearly 16-fold, respectively.
Some well-known funds, such as Perry Capital and Fairholme Capital Management, have even sued the U.S. government to overturn a 2012 change to terms struck when Fannie and Freddie became wards of the state in September 2008. The revision mandated all the firms’ profits be paid out to the government as opposed to a previous dividend of 10% on its holdings of senior preferred stock.
William Ackman’s Pershing Square Capital Management said last November that it had purchased $400 million of common stock of Fannie and Freddie. He recently said he thinks the Supreme Court will strike down the profit sweep and, as a result, shares could trade at 10 times current prices.
But even if fund managers are right legally, the upside may be more limited than ebullient share prices imply.
For starters, consider Fannie’s 2013 profit: A huge part, $45.4 billion, arose from the reversal of a write-down of deferred-tax assets. An additional $14.6 billion was due to gains that aren’t easily replicated.
Put those aside and Fannie earned about $24 billion. About half that, though, resulted from the firm’s ability to borrow at low rates because of its government backing. Fannie paid $10.27 billion on the $499.7 billion of long-term debt it held on average last year, a rate of just 2.06%. Meanwhile, its $529.9 billion portfolio of mortgages and mortgage-backed securities generated interest income of $22.12 billion.
Absent government backing, Fannie’s borrowing costs would be far higher. Without it, Moody’s Investors Service would give Fannie a below-investment-grade, or junk, rating. The average interest rate of a comparably rated corporate bond is about 4.8%. At that higher funding cost, Fannie would be looking at a loss of about $2 billion.
Fannie’s other big source of income is its mortgage-guarantee business. This generated about $12.3 billion of income last year, excluding loan-loss releases, on about $3 trillion of single-family and multifamily mortgage guarantees.
Again, though, this business is so profitable only because of government support, something the firm doesn’t pay for. Yet the bailout agreement envisioned the government levying a fee for what is effectively reinsurance. While its size was never determined, the fee was waived in the 2012 change to the bailout terms.
So, should the government’s profit sweep be struck down, Fannie may have to compensate taxpayers for their backing. That would take a bite.
Then there is the question of Fannie’s capital, or lack of it. Although it isn’t a bank, Fannie would be considered a systemically important financial institution. That could lead regulators to require it to hold far higher levels of capital than in the past. Gauging just how much under new, more stringent rules isn’t clear-cut. There is the question of how to gauge the riskiness of its assets given a government backstop.
If its guarantees and mortgage holdings were treated in the same way as those of private banks, Fannie likely would need about $155 billion in capital. If it received a more preferential risk weighting reflecting government support, it would need a bit more than $60 billion.
The answer likely would lie somewhere between those bounds. And the firm, like too-big-to-fail banks, also may have to meet leverage requirements that don’t risk-weight assets. In that case, the capital goal posts might move to between $96 billion or $160 billion, depending on the leverage-ratio-threshold applied.
Say, then, that it needs to raise about $100 billion of capital in total. That wouldn’t be impossible, but it would be a long haul.
If Fannie were to keep generating $12 billion or so of core annual earnings — a generous assumption because recent results benefit from its government backing and from being in the sweet spot of the housing-market cycle — it could take about eight years to reach that level. And that is supposing there are no housing downturns during that time.
Even then, Fannie would still need to repay the $116.8 billion in government bailout money it received. That could take another 10 years.
Ultimately, Fannie’s fate is a political question. That could lead to an outcome that favors private-sector shareholders. But they can’t assume the firm’s return to profitability guarantees they are on the road to riches.