Monday, August 31, 2009

Fannie Mae (FNM) and Freddie Mac (FRE): No Underlying Value Remains

FBR Capital is reminding investors that they believe there is no fundamental value remaining in FNM & FRE:

Fundamental value does not support shares. The government has already invested almost $100 billion in the GSEs, with a $51.7 billion capital infusion for Fannie and $45.9 billion for Freddie. Ultimately, we believe there are no "free lunches," and this capital must be repaid if the GSEs are ever going to be stand-alone entities in the future. However, credit costs are digging Fannie and Freddie further in the whole, and we believe both companies are under-reserved to face future losses. As of 2Q09, Fannie's nonperforming loans totaled $170 billion against reserves of only $55 billion, implying a 32% coverage ratio. Likewise, Freddie's nonperforming assets totaled $77.5 billion with reserves of only $25.2 billion, or a 32.5% coverage ratio. With serious delinquencies continuing to rise at alarming rates, we would expect continued NPA pressures to drive reserves higher.

Future of the GSEs still undecided. The future of the GSEs remains a large question mark, and to our understanding, we will not get an answer anytime soon. The Administration is keeping discussion about the GSEs behind closed doors, and inklings of potential decisions have not really been leaked. They tested the waters in July with the "good bank/bad bank" scenario, and we heard that the response was very negative. As such, it sounds like the Administration is back to the drawing board. Congress iswaiting for the Administration to take the lead, but President Obama's team will not table the issue until after the FY 2011 budget is delivered on February 1, at the earliest.

Most likely scenarios. In the Treasury's white paper on financial reform, six scenarios are discussed as future outcomes for the GSEs. The key decision is whether Fannie and Freddie will be private companies, essentially arms of the government, or whether they will be "quasi-private" and retain their hybrid business model. In our view, the most likely scenario is that the GSE's operations will be split up, and Fannie and Freddie will be spun out of the government as mortgage insurers with small portfolios; the majority of the portfolio would likely remain in the government's hands.

Action: It is usually not a very good idea shorting into such a huge rally. Some might even call it suicidal. However, with AIG tanking on Friday and getting some beating again in the pre-mkt, the other crap financials should follow the lead. I'd expect see the shares of FNM & FRE at least 10% lower today.

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