rd80 (99.11)

A Numbers Play with Fannie Mae

September 08, 2008 – Comments (4) | RELATED TICKERS: FNMA , FMCC

Enough complaining about the gov't bailout, nothing we can do about that.  It's time to see if there's any money to be made. 

The turmoil from the bailout (‘scuse me government assisted program) of FNM and FRE was worth a look to see if things might be overdone.  Given the huge number of unknowns, there’s no way to come up with a solid valuation, but the problem can be bounded to add some color to the risk/reward potential of scooping up some cheap shares.

To summarize what we know:

   - Treasury is buying a new class of super senior preferred shares for $1 billion.

   - The common stock and preferred stock dividends have been eliminated.

   - The deal comes with warrants good for shares representing 80% of the common stock, the exercise price of the warrants is one-thousandth of a cent each, so there’s no more money coming when the warrants get exercised.

   - Treasury has the authority to purchase mortgage backed securities (MBS) from FNM and FRE.  They will be purchasing $5 billion now and have authority to buy up to $100 billion.

   - The plan establishes a direct secured credit facility for FNM and FRE at the Treasury.

   - FNM closed at about $7 on Friday before the deal was announced.

   - As of 30 June, FNM reported net tangible assets of $41.2 billion on the balance sheet and long-term assets of $774 billion.  

   - The trading range on Mon 8 Sep was $0.65 - $2.05 with a close of $0.73.

What we don’t know:

   - How much of the long term assets will be written off.

   - What the book value would be if everything was valued at market prices.

   - Whether this is the last capital injection and share dilution by Treasury.

   - Unknown unknowns.

Defining the lower bound is simple.  The stock is still trading, but if business deteriorates to the point where there’s another capital injection, share value will quickly approach zero.

There are a couple of approaches to an upper price range.

The only thing that’s changed since Friday’s closing price is the bailout plan.  At $7 per share, the market cap was about $7 billion.  Treasury’s plan brings the diluted share count to four billion shares.  $7 billion/4 billion shares = $1.75 per share for one plausible stock valuation.  Friday’s closing price would have included some risk discount for a possible gov’t wipeout of the common stock.

Another company with heavy mortgage exposure and questions about its future is Washington Mutual.  As of 30 June, WM reported net tangible assets of $18.5 billion which works out to a P/B value of 0.38 based on Monday’s closing price of $4.12.  Applying that P/B value to FNM using the fully diluted share count would value FNM at $3.65 per share.

Anyone with other valuations on FNM, please feel free to comment.

In addition to massive dilution, the gov’t intervention takes several measures that should help FNM business prospects going forward.  Treasury’s authority to buy MBS provides a market for those securities that didn’t exist before, the credit facility offers financing at low spreads and the gov’t action to back FNM and FRE debt should improve demand and lower spreads for their regular debt auctions.

The gov’t intervention’s impact on the housing market is unknown, but lower rates and an improved credit market should help stabilize the market, even if it just slows the rate of price declines.  Any stabilization of housing prices helps limit foreclosures and should reduce the amount of write downs FNM will need to take.

IF (there aren’t big enough letters for this if) FNM can survive without further dilution of the common or massive loss of tangible book value, buy back the gov’t super preferred and move to a private sector company; it’s reasonable to assume it could eventually trade at P/B of something like 2.  That would be a way in the future, everything’s wonderful, share price of $19 based on the 30 June net tangible book.

On the downside, it would only take a little more than a 5% write down of the assets to totally wipe out the net tangible book.  That’s a big charge-off number, but well within the realm of possibility.

This doesn’t look bad as a very, very high risk investment or a trade.  At 73 cents a share, there’s a plausible near term upside of between 140 and 400% if the market decides Friday afternoon’s value for the company was reasonable or gives it a multiple similar to WM.  Longer term, the upside is huge IF all that stuff listed above happens.  Of course, there’s a strong possibility of a total or near total loss of the investment.

I tried this today with a small piece of my virtual portfolio at Marketocracy and am well under water with it (entry point ~1.22).  After running the numbers, I’m considering it with a tiny slice of my real portfolio, but will most likely leave this to the pros.