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Fannie Mae: An Indirect Bet On Trump Polling Numbers
Jun. 30, 2024 3:29 AM ET - Harrison Schwartz - 15.59K Followers
.......... Summary ..........
--- Fannie Mae's value has rocketed higher following the Trump-Biden debate, implying it is an indirect bet on a Trump win.
--- Historically, Trump is far more likely to end FNMA's conservatorship than the Biden administration.
--- There are no guarantees that Trump will successfully end the conservatorship, having not done so in his last term. Further, FNMA's fundamental risks would not necessarily decline in this scenario.
--- Fannie Mae's book value should be below its market value by 2027-2028 at its current income level, given it continues to retain its profits.
--- Although home prices seem likely to decline, Fannie Mae's exposure is limited because very few people are obtaining mortgages at today's extremely low affordability levels.
The Federal National Mortgage Association, or "Fannie Mae" (OTCQB:FNMA), has avoided significant headlines in recent years. The government-sponsored enterprise remains in conservatorship under the Federal government roughly sixteen years after its failure. Fannie Mae and its peer, Freddie Mac (OTCQB:FMCC), are the primary mortgage insurance providers to qualified or "agency-backed" mortgages, backing around 70% of US mortgages. Most mortgages are pooled into mortgage-backed securities or "MBS," such as those seen in the ETF (MBB).
Fannie Mae is on the hook if mortgage borrowers fail to pay their loans. Thus, theoretically, mortgage-backed securities have limited credit risk, given that Fannie Mae should protect against losses. Historically, that would not be true if not for the government bailout in 2008, as Fannie Mae (and its peer) lacked the funds to meet the immense obligations created during the 2008 foreclosure crisis.
The company has not been tested to the same degree since then. Although delinquencies rose in 2020, these were classified as "forbearance," stemming from the temporary issues created during the large but short-lasting unemployment spike during lockdowns. In my view, if not for the immense QE-driven decline in mortgage rates in 2020 and the stimulus efforts, we would not have seen the recovery in real estate.
Of course, we could argue that the housing market's "recovery" since 2020 has created a renewed housing bubble. Home valuations are at record highs. Now that mortgage rates are far higher, affordability is extremely low. Home sales are also at, and often below, the levels seen during 2008. The market has had added support from rising rents and low inventories, though these two beneficial factors are fading, increasing the potential for a decline in home prices over the coming year or two. As such, we must reconsider the risk profile facing Fannie Mae to determine if its long era of conservatorship has improved its stability.
Further, we must consider the election, as it is generally viewed that a Trump administration would end its conservatorship. Hence, the stock is positively correlated to Trump's poll numbers. The company was close to restructuring and privatization toward the end of his term, but that was upended by the economic shock caused by lockdowns. As such, I'd argue that macroeconomic factors play a more significant role in FNMA's value regardless of who wins in November.
Fannie Mae's Capitalization is Improving
Investors in mortgage-backed securities indirectly pay a small fee to Fannie Mae to provide insurance risk coverage, ranging from 25 to 50 bps. Typically, the number of mortgages in default that require Fannie Mae coverage is relatively low and predictable. Thus, the company usually earns a solid profit margin on its revenue. In a normal (non-recessionary) period, its profitability is primarily driven by its operating overhead costs, which have been sustained at ~10% in recent
years. See below:
Fannie Mae is earning significant profits today because very few mortgage owners are in default. The 2010s decade saw very low mortgage rates and fair housing prices. Those who borrowed in this period often had lower payments than their incomes, giving them low default risks. Fannie Mae cannot pay its income out to investors, per its conservatorship rules, but it has used this income to improve its balance sheet. Still, its net book value for common stock investors is quite negative. See below:
The company's shareholder equity was near zero from 2010 to 2020, as it was still not seeing great solvency improvement as it recouped its immense losses from the decade prior. Thus, there is a large time lag between the company's solvency and the solvency of homeowners. Today, it is benefiting from the strong solvency conditions of those who borrowed during the 2010s. Depending on what occurs in the property market, it may be years before current borrowing conditions impact its solvency.
Fannie Mae's equity is much healthier today, but its equity for common stockholders remains very negative, amounting to a book value per share of -$50. In other words, should the company liquidate all its assets, liabilities, and preferred equity, it would have no money for common shareholders in FNMA. Thus, FNMA is similar to a stock option or warrant on the company's overall equity. Its fundamental value may rise dramatically above its current value only if its common equity rises by another ~$58B.
FNMA's market value is $8.2B, so a $66B increase to its common equity (through retained earnings) must be discounted to its book value. The company's annual income has been around $15B to $20B in recent years, and all else being equal, it should rise with today's larger mortgage sizes (given home prices), so its book value should be very attractive within three to four years.
If we could assume that there was zero risk to the housing market, FNMA would likely be undervalued today since its net income is generally 2X its market value. However, if a slight shock exists in the property market, this value trade is upended. Fannie Mae's solvency has markedly improved, but its total liabilities to assets remain at 98%. See below:
So, if Fannie Mae takes a 2% loss on its assets, its shareholder equity (including preferreds) would be back at zero. From 2008 to 2012, Fannie Mae's book value fell by ~$150B. It had around $880B in assets in 2008, meaning it took a ~17% loss due to that mortgage crisis. So, even if we see a similar issue around a sixth as large, there is decent potential that FNMA's equity would be back at zero.
Home Prices Will Fall, But Fannie's Risk Is Low
The housing market today is similar to that of 2008 in many respects. However, the key difference is that most outstanding mortgages were made at far more affordable rates and prices. From 2020 to 2022, the company saw its assets rise by a staggering ~$750B, but that figure has stagnated since then since very few people are willing to buy homes at today's affordability level.
Theoretically, this limits Fannie Mae's exposure significantly because current borrowers are at much greater default risk than those of the 2012-2022 period, given affordability. We can see this statistic from today's low mortgage debt service payments to disposable income ratio:
This figure is more important for Fannie Mae than others. In 2006-2008, there was a housing valuation bubble, and many people were buying into that bubble. Today, there is, in my view, a potentially larger housing bubble, but far fewer people are exposed to it. Indeed, if we look at mortgage debtors at large, their ability to pay their debt has never been better.
It is the new borrowers that Fannie Mae needs to worry about. Home sales prices to income are relatively high today as affordability is low. Home sales are back at extreme lows after the housing shock and 2020. See below:
Notably, the US median home price to income ratio is around 7.7X today, well above the 6.7X peak in 2006. The metric above compares the price of homes sold to disposable incomes (which are lower), so it is a higher ratio. Further, the metric above has declined because smaller-priced homes are moving much better today than larger, more expensive ones; the actual overall home price-to-income ratio has not declined since 2022, as home values continue to march to all-time highs.
Realistically, large homes are probably significantly overvalued today. Technically, their values have not declined significantly, but they're also not moving. This is seen as older Americans are typically not selling their usually larger homes, defying the historical pattern. Suppose this changed and more looked to downsize. In that case, I believe there would be significant negative price discovery in larger homes because they're currently highly unaffordable to those who require a large mortgage.
This is a significant risk to the housing market but is likely not a risk to Fannie Mae. Most owners of large homes are older and, therefore, have lower mortgage debt insured by Fannie. Further, that demographic likely purchased their homes at a much lower price, so a decline in valuation would only limit appreciation gains, not resulting in negative equity.
Arguably, home prices have not declined because inventories have been low. Rental vacancy levels have also been low, stemming from decreased building activity in the 2010s. This is starting to change, as building activity rose significantly from 2019 to 2022 and is now reversing. Inventories and rental vacancies are also increasing, signaling a shift back toward a "buyers' market." See below:
Overall, I think there are many tell-tale signs that US home prices are in the process of peaking and should decline. Theoretically, a substantial decline of around 50% is needed for affordability to return to historically normal levels. Realistically, home prices should not fall by 50% outside of a severe economic crisis. Instead, I expect prices will stagnate or decline while inflation will increase, creating a ~50% decline compared to a decade or more in the future. Thus, it will likely be that people will begin to see housing as a poor investment, but I only expect those who purchased from 2022 onward to be at risk of negative equity (the chief risk for Fannie Mae).
Fannie Mae's Political Exposure is Large
FNMA's value has spiked by 25% over the past week, with most gains occurring after the recent Trump-Biden debate. It is not my aim to present a political bias here, but it is a fact that Trump is far more interested in releasing Fannie Mae than Biden. In 2021, the Biden administration utilized a Supreme Court ruling to fire the Trump-appointed FHFA chief interested in ending its conservatorship.
Since the debate, betting odds of Trump returning to office rose from ~52% to ~59%, while Biden's fell from 45% to 36%. FNMA's value has spiked accordingly, adding to its 230% YoY gain, which largely stems from the positive longer-term trend in Trump's odds compared to Biden's. Still, there remains considerable potential that Democrats do win, which would likely delay Fannie Mae's restructuring. Further, Trump did not end this issue during his term, so there is no guarantee that he will in a potential future term.
The political issue seems to have had a significant impact on FNMA's volatility lately. That said, I don't think it's essential in the long run. Fundamentally, FNMA's equity value will rise if mortgages don't go belly-up. Yes, FNMA could have dividend potential under Trump, but I think it would be fine if it retained its income and improved its solvency further before paying dividends. Of course, an end to conservatorship would give FNMA other benefits, such as more capital access that may benefit it, so a Republican win is bullish for FNMA.
The Bottom Line
Fannie Mae's risk-reward profile today is tricky. I'd argue the US housing market is weak. Further, based on an argument I've presented regarding bonds, unemployment will likely rise over the coming year in a recession. For this reason, I think investors should be cautious about buying housing-related stocks, particularly homebuilders.
However, Fannie Mae's risk is significantly mitigated because most homeowners today are not in the high-risk cohort created in 2022. It would take a massive decline in home prices for the median homeowner today to have negative equity.
Still, even if a small portion of Fannie Mae's exposure is to those new buyers since 2022, that could be enough to create significant issues for the company, particularly if it coincides with an unemployment driven recession. Its solvency is much better than it was, but it is still not necessarily adequate.
On the other hand, FNMA's valuation is extremely low compared to its potential EPS if released from conservatorship. My view on FNMA is very speculative, but I am bullish on it since I think its financial risk exposure to mortgages is low. The odds of Trump winning are decent, albeit far from guaranteed, at ~60%. That is not a political opinion but a view based on the betting market odds (which may be more accurate than polling data).
That said, FNMA faces significant risk. It is very volatile and has a negative common book value. I expect it may decline during a housing market shock and recession over the next year or two, so my bullish outlook is long-term. Unless the recession is severe, I'd see declines in FNMA's value as a buying opportunity. Lastly, the long-term risk to FNMA is likely new homebuyers from 2022 onward. If the housing bubble continues, FNMA may end up in a 2008 repeat as it's exposed to a more significant portion of high-risk loans.
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.
This article was written by - Harrison Schwartz - 15.59K Followers
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