mrfence
1 day ago
$FMCC~ $FNMA~ Steve McNamara Awaken the Sleeping Giants: Fannie Mae and Freddie Mac (Part 2) - How much are they worth?
Two of the largest financial institutions in the world could soon return to public markets. For investors with an appetite for risk, the returns could be enormous.
JAN 12, 2025
Part 1 of this report covered the history of Fannie Mae and Freddie Mac and set the stage for Part2 - an overview of their business models. Part 3 will complete the report with a valuation of both companies.
A Simple, Lucrative Business Model
The business models of Fannie Mae and Freddie Mac are simple. They each operate two business categories: (1) Securitization and Guarantee Business and (2) Retained Portfolio business. The Securitization and Guarantee Business is by far the most important, as the Retained Portfolios have been effectively wound down and will be a negligible part of their earnings going forward.
Securitization and Guarantee Business
The companies acquire “qualified” mortgages from lenders, bundle them into pools of Mortgage-Backed Securities (MBS), and sell these securities to investors. They guarantee the timely payment of principal and interest on these securities by charging a “guarantee fee” (g-fee) to lenders for this service. Lenders pass on the fee to the homeowner. This fee has ranged from 50 to 60 basis points in recent years. It is embedded in the mortgage rate itself – making it largely unnoticed by homeowners.
The companies take on two main risks associate with this business line: Credit Risk and Pre-Payment Risk. Credit risk is the risk of a borrower defaulting on their mortgage. Pre-Payment Risk is the risk that borrowers refinance their mortgage (or otherwise pay off) their mortgage earlier than expected, thereby affecting the g-fee income stream.
To mitigate against Credit Risk, there are strict underwriting standards for mortgage eligibility. The g-fees are priced based on risk (i.e. they charge more for riskier mortgages, or to borrowers with lower credit scores). They also use g-fee income to build capital reserves to cover potential losses. In recent years, they have introduced a Credit Risk Transfer system by selling portions of risk to investors. To mitigate against Pre-Payment Risk, the companies structure MBS pools with callable or non-callable options that can manage pre-payment speeds. There are also complex hedging strategies to offset the financial impacts of pre-payments.
The g-fees charged are meant to provide capital to cover any potential losses arising from Credit or Pre-Payment Risk. Importantly, housing is one of the areas where extensive long-term data sets are available. Forecasting risk becomes relatively straightforward. Capital reserves are built to withstand shocks to the housing finance system that occur very infrequently [Note: Dodd-Frank Stress Tests are conducted annually to mimic another Financial Crisis and determine capital sufficiency. In recent years, both companies have passed easily]. The g-fee business has proved extremely resilient over time.
Retained Portfolio Business (“pre-2008”)
Both companies also maintain a “retained portfolio” where they acquire mortgages from lenders, but retain them instead of selling MBS to investors. Naturally, this comes with Interest Rate Risk as well as Credit Risk and Liquidity Risk. However, this business consists of mortgage pools on their books from before the 2008 Great Financial Crisis. Regulations introduced after 2008 prevent the companies from re-entering this space. The legacy pools of mortgages have largely run off their books by the time of this publication. Going forward, their contribution to either Fannie Mae or Freddie Mac’s income streams will be effectively negligible.
The business model has scaled with the size of the US housing and MBS markets, and has proven to be highly lucrative over time. The Retained Portfolio was the source of trouble for both companies during the Great Financial Crisis, not the Securitization and Guarantee Business. Going forward, they will only be in the Securitization and Guarantee Business.
Net income has averaged $17.4 billion and $9.3 billion for the last 5-years for Fannie Mae and Freddie Mac respectively. These enormous returns are very stable and could command a high valuation if/when their conservatorships end.
An investment thesis emerges
At time of writing, a new Trump administration is preparing to take office. There is considerable speculation about this new administration moving to end the conservatorships. There is also considerable uncertainty that needs to be recognized. The biggest question is what Treasury will do with their existing SPS obligation. The only reason that the SPS has not been wound down by this point is the “non-repayment” provision in the PSPA. This stipulated that when all profits were being paid to Treasury (the “Net Worth Sweep”), these payments did not count as “repayments” of the original SPS balance. The easiest option (and potentially the most lucrative for Treasury (and by extension, US taxpayers) [again, please refer to Tim Howard on Mortgage Finance blog for details] is to amend the PSPA to deem prior payments as being towards the SPS balance. This would effectively deem the SPS “repaid”.
If Treasury does not deem the SPS repaid, they face two options: forcing the companies to pay down the SPS balance again via retained earnings over time or converting the SPS to common shares. If they take the first option, then both Fannie Mae and Freddie Mac will remain in conservatorship for another 15 years at least. This is inconsistent with President Trump’s stated policy of ending the conservatorships and re-privatizing the enterprises. If they convert their SPS position to common shares, it will render existing common shares worthless - including the 79.9% warrants that Treasury owns. This could also face significant legal challenges - especially after a recent ruling stipulated that the Net Worth Sweep (including the non-repayment provision) was entered “in bad faith”. Nevertheless, investors should note that there is a risk that the common shares could be rendered worthless. For more risk averse investors, the Junior Preferred Shares (JPS) are likely the more attractive option. In all scenarios, regardless of what happens to the SPS, the JPS are likely to return to par value as their dividends get reactivated once the companies exit conservatorship. I do not do a deep dive on the JPS investment case in this report. However, as a very brief summary: JPS shares (as of Jan 9 2025) currently trade at roughly 40% to 45% of par value. Assuming a return to par value in 2028-2029 [part of the investment case below], this would be a 100% return in roughly 3-4 years. While this represents a good return, I think the common shares are much more interesting.
The common shares of Fannie Mae and Freddie Mac get interesting
In estimating the target share price for Fannie Mae and Freddie Mac common shares, I take the assumption that the SPS will be deemed repaid in full based on payments already made to Treasury from 2012-2019. With this in mind, the thesis below hinges on two key questions:
When will Fannie Mae and Freddie Mac have enough capital to exit conservatorship? Can this be done within the term of the incoming Trump administration.
Once they exit conservatorship, how much will the shares in these companies be worth? Both Junior Preferred and Common Shares should be considered
Both are critical, but the question of timeline needs to be addressed first. As stated above, I won’t do a detailed breakdown of the current capital rule and arguments for change [for this, I highly recommend two sources that cover this topic in detail: (1) Rule of Law Guy’s Newsletter substack; (2) Tim Howard on Mortgage Finance blog]. Suffice to say, the current capital rule needs to be changed. So long as the current rule is in place, the companies will not be able to exit conservatorship during the incoming Trump administration’s term. This has to come from FHFA, as they are the owner of the rule and ultimate arbiter of whether Fannie Mae and Freddie Mac have enough capital. For the purposes of this investment thesis, I am assuming FHFA adopts a new capital requirement of 2.0% to 2.5% of total assets in capital before conservatorship can end (applies to both companies). [Note: to arrive at this target range, I refer again to Rule of Law Guy’s Newsletter and Tim Howard on Mortgage Finance blog. They have conducted extensive analysis of current capital requirements, annual stress test results etc.]
To estimate a potential timeline by which Fannie Mae and Freddie Mac can exit conservatorship, I take the following steps:
Forecast of total assets: based on historical growth rates in total assets, from 2018-2023, and projecting this forward. By 2028, Fannie Mae and Freddie Mac will have $5.1 and $4.3 Trillion in total assets respectively. These total asset figures will be the basis for determining how much capital they will need to exit conservatorship.
Forecast of capital reserves: based on an average net income from 2018-2023, and taking this forward I estimate the build in capital reserves for each company. By 2028, Fannie Mae and Freddie Mac will have raised $165 Billion and $94 Billion in capital via retained earnings
Capital scenarios: comparing the forecast capital reserves versus a range of capital requirements (from 1.0% to 3.0%) to estimate a timeline for release from conservatorship.
Using this approach, and an assumption that a new capital requirement of 2.0% to 2.5% of total assets is established, both Fannie Mae and Freddie Mac will have enough capital to exit conservatorship in 2026-2027. If capital requirements are set closer to 2.5% or above, Freddie Mac will take longer to achieve sufficient capital via retained earnings. However, targeted asset sales or a consent decree from FHFA could mitigate this to harmonize the release timeline for both companies.
Establishing this is critical, as it makes clear that new capital will not need to be raised by either company by issuing new shares. From this, we can assume that the only dilution for common shareholders will be when Treasury exercises their warrants for 79.9% of the total outstanding equity. After the warrants are exercised, Fannie Mae and Freddie Mac will have 5,761,629,687 and 3,234,127,129 common shares outstanding. [based on their existing share counts representing 20.1% of fully diluted total share count after Treasury’s warrants (worth 79.9%) are exercised]
Both companies operate a highly stable, low risk business. In addition, the profits are highly predictable. They are, in effect, a type of royalty / low-risk insurance float on a large scale in mortgage finance. An above average P/E multiple of 25-35 would not be unreasonable.
For this P/E range, the common shares of Fannie Mae are worth $76 - $106 per share. For Freddie Mac, the common shares are worth $40 - $56 per share. Based on the closing share price (as of Jan 9 2025) for Fannie Mae and Freddie Mac of $4.98 and $4.94 respectively, this represents a target potential return of 15x - 21x and 8x - 11x for Fannie Mae and Freddie Mac respectively in 2028.
Fannie Mae and Freddie Mac: high-risk, high reward
Despite their critical role in the U.S. housing finance system and their enormous scale, Fannie Mae and Freddie Mac have operated in relative obscurity since the 2008 financial crisis. The re-election of Donald Trump has renewed optimism that the end of their conservatorship is near, creating a compelling case for reassessing their value. The potential for significant returns, particularly for common shareholders, hinges on key developments: the resolution of the Senior Preferred Stock obligations, the establishment of a revised capital requirement by FHFA, and the companies’ eventual release from conservatorship.
Under reasonable assumptions, including a capital requirement of 2.0%-2.5% of total assets and Treasury’s willingness to deem prior payments as repayment of the SPS balance, both companies could exit conservatorship by the end of 2026 (within the timeframe of the second Trump term). This, combined with their predictable and resilient business models, positions their common shares for substantial value appreciation, with potential returns of 15x-21x for Fannie Mae and 8x-11x for Freddie Mac by the end of 2028. While significant risks remain—particularly around the resolution of SPS obligations—investors with a long-term perspective and appetite for navigating these uncertainties may find this is a “high risk, high reward” bet worth taking.
https://mcnamarabrief.substack.com/p/awaken-the-sleeping-giants-fannie
$FMCC~ $FNMA~
mrfence
1 day ago
$FMCC~ $FNMA~ Steve McNamara Awaken the Sleeping Giants: Fannie Mae and Freddie Mac (Part 1)
Two of the largest financial institutions in the world could soon return to public markets. For investors with an appetite for risk, the returns could be enormous.
STEPHEN MCNAMARA
JAN 10, 2025
Fannie Mae and Freddie Mac are two of the largest financial institutions in the world. They underpin roughly 55% of all residential mortgages in the United States. Their Mortgage Backed Securities (MBS) liabilities would represent the 4th largest bond market in the world (if it was ranked in that way). Ranking the largest US companies by assets, Fannie Mae would be #1 and Freddie Mac #3.
Yet despite their staggering scale and influence, these publicly traded giants have languished in obscurity since the Great Financial Crisis in 2008. For over 15 years, they have been relegated to the “pink sheets”, trading over-the-counter (OTC) often for under $1/share. They still filed quarterly and annual reports with the SEC. But their earnings calls were almost perfunctory, often lasting roughly 20 minutes with no analyst participation allowed (no Q&A with the management team). For all but some avid investing nerds, these companies were forgotten – out of sight, out of mind.
The re-election of Donald Trump has significantly changed the dynamic. Optimism abounds once more. Bill Ackman, the famous hedge fund investor, proclaimed Fannie Mae and Freddie Mac his top stock picks of 2025. Values have recently surged, albeit from a low base. In the last 1-month, both Fannie Mae and Freddie Mac are up 70%. Over the last year, they are up 380% and 430% respectively (as of market close Jan 8 2025)
I’ve followed Fannie Mae and Freddie Mac closely for over a decade (falling into the “avid investing nerd” category). The recent surge in interest has inspired me to share my thoughts and lay the groundwork for an ongoing exploration of these companies and their investment potential. My goal is for this to be the first of several articles in the coming months or years about these two companies. While this article reflects my personal views and is not financial advice, I hope it prompts discussion and deeper analysis.
A Brief History
The story begins with the Great Depression – often seen as the worst economic trauma in US history (certainly of the 20th century). Unemployment surged, housing prices plummeted, and a wave of mortgage defaults threatened the financial system. The Federal National Mortgage Association (“Fannie Mae”) was established in 1938 to buy mortgages from banks, thereby freeing up capital for more lending. This stabilized the mortgage finance system, and provided liquidity and improved housing affordability. But as Fannie Mae was a government entity, the mortgages (and liabilities) it acquired from the banks went onto the government balance sheet (i.e. the federal debt). In 1968, with the Vietnam War straining the US Budget, Fannie Mae was transformed into a “Government Sponsored Enterprise” – a private, shareholder owned, publicly traded company with a government charter. This moved the company’s liabilities and operations off the government balance sheet. It also had the extra benefit of using private capital to further expand the secondary mortgage market. To avoid Fannie Mae having an outright monopoly in this market, congress created the Federal Home Loan Mortgage Corporation (“Freddie Mac”) in 1970. Freddie Mac had a similar government charter and corporate structure – shareholder owned, publicly traded. Over the years and decades, both companies grew with the US housing market and became synonymous with steady, predictable shareholder returns.
However, The Great Financial Crisis in 2008 changed everything. In the years prior, banks and other lenders had gotten into the business of issuing MBS. This intense competition for issuing mortgages undermined underwriting standards across the United States. To remain competitive, and protect shareholder returns, Fannie Mae and Freddie Mac grew the size of their Retained Portfolio with higher risk mortgages [see business model descriptions below]. The ensuing downturn in housing prices led to significant losses. As importantly – the market panic led to public concerns that neither company had enough capital to absorb the losses (i.e. they were insolvent). This threatened the guaranteed payments on their guaranteed MBS, and by extension the stability of the US housing finance system.
In September 2008, the Federal Housing Finance Agency (FHFA) placed Fannie Mae and Freddie Mac under conservatorship with the US Treasury Department providing a bailout to cover potential losses. The initial agreement (the Preferred Stock Purchase Agreement, or PSPA), saw loans from Treasury in the form of Senior Preferred Shares and warrants issued for 79.9% of the outstanding common shares with a 20-year term (expiring September 2028). By 2012, the companies had drawn down $187 billion to cover loss provisions.
However, in the height of the panic in 2008 it was hard to know exactly what the losses on the mortgage portfolio would be. The historical models for credit risk, default rates etc. were not trusted. To restore market confidence, Treasury essentially demanded loss provisions – and a public bailout of those provisions - in excess of the actual losses being incurred at the time. But there is a big difference between a loss provision (which is an accounting mechanism) and an actual loss. In 2012, with the dust settled and market stabilized, it became clear that Fannie Mae’s and Freddie Mac’s actual losses were far less than feared. The loss provisions had to be reversed – an enormous accounting profit was coming. Moreover, with the businesses stabilized the companies would return to their profitable ways. This was going to be enough to repay Treasury in full - and in short order.
This should have been a huge victory for the US government with another successful bailout - taxpayers repaid in full, with interest. In 2012, for varied and controversial reasons [I won’t elaborate further, as I prefer to avoid politics when possible] Treasury introduced the “Net Worth Sweep”. The massive profits from Fannie Mae and Freddie Mac would be swept, in their entirety, to Treasury in perpetuity. Moreover, these payments would not count as repayment of the outstanding SPS balance (i.e the bailout loan). The companies had essentially been nationalized. Shareholders sued, and the government won in court every time (to much investor astonishment and dismay).
The election of Donald Trump in 2016 was the first sign of potential change in the air. He had publicly indicated a desire to re-privatize the companies. Getting the process started was delayed until 2019, when his appointee for FHFA Director could finally be confirmed. He arrived to find two companies completely starved of any capital reserves (their profits having been sent to Treasury). In 2019, the PSPA was amended to allow Fannie Mae and Freddie Mac to finally retain their earnings in order to build capital. Critically, this amendment did not address all the prior payments to Treasury as being repayments for the bailout. As a result, the $187 billion obligation (in the form of SPS) remained on the balance sheets.
In 2020, FHFA finalized a new capital rule for Fannie Mae and Freddie Mac (the “ERCF”). The rule was highly controversial [for detailed breakdowns of the ERCF, I refer the readers to two outstanding sources: (1) Tim Howard on Mortgage Finance blog, (2) Rule of Law Guy’s Newsletter on Substack. For simplicity, I will skip these details]. At the time of this publication, this rule remains in place and both companies continue to retain earnings. In theory, the conservatorships can not end until they have sufficient capital. At current run-rates for retained earnings, this will be sometime around 2040.
The re-election of Donald Trump in 2024 has again injected optimism that his administration can finally end the conservatorships. In Part 2 of this series, I will break down the business model, capital levels, provide an anticipated timeline for ending the conservatorship and a valuation of the common shares.
https://mcnamarabrief.substack.com/p/awaken-the-sleeping-giants-an-investment
$FMCC~ $FNMA~
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