This blog’s evolving view on Fannie Mae

I was once short Fannie Mae understanding (well before their regulator) of the extent of the scam in their derivative accounting. I even managed to quantify it. [Funnily enough executives who I thought up to their neck in that scam are still in senior positions at Fannie. Will the conservator please sack them for cause. If they leave with big packages I will be disappointed.]

The stock however didn’t fall out of bed – and whilst we made money – it was hardly worth the stress.

When I first looked at Fannie for this blog my predisposition was to go long. However I would not do that without analysis – so I had a go at doing the analysis.

The first post – Fannie Mae Part I – detailed the revenue and pre-provision profit potential of the company. That was really the “upside case” and it was considerable. I got quite a lot of emails from short sellers who thought I was insane. They were right I might add.

Fannie Mae Part IA detailed my views about the way Fannie was feeding business to insolvent mortgage insurers to keep them solvent. It was bearish because the mortgage insurers provide protection for Fannie on a large number of high loan-to-valuation mortgages and if the mortgage insurers were rubbery then Fannie also was.

The next post was a plea to help model Fannie Mae’s losses. The range of numbers in the marketplace was huge – and the analysis behind those numbers was thin. It was however thin for a reason as the modelling post makes clear. My plea for help fell on deaf ears. This blog has 1000 daily visits but nobody could provide me a decent model of Fannie’s losses.

Fannie Mae Part II discussed whether Fannie Mae was insolvent or profoundly insolvent. I thought that mattered then and it matters now. If Fannie Mae is correctly reserved now I figure the stock is worth more than $8 even after the bail out. It is however not correctly reserved – and the extent of shortfall is the critical factor for the value of Fannie Mae and for the risk to Federal Government from this bailout. I figured if the shortfall were 80 billion then Fannie Mae was “borderline profoundly insolvent”.

Fannie Mae Part III gave up altogether and produced what I think remains a rubbery estimate of Fannie Mae losses above trend. The number was $64 billion – but there is some Alt-A and I should include trend losses. If you do that you get something close to $80 billion. I concluded – much to my surprise as follows:

My a-priori expectation was that Fannie was going to be better than that. If you had put a gun at my head and asked me would I prefer be long or short I would have said long.

Now I would say short.

I have no position and it is likely to stay that way. But for once I do not think the shorts are grotesquely overstating their case.

That call was good – but not strong enough. I should have shorted the stock.

After the fix was in and the legislation was in place to guarantee Fannie Mae I was perplexed that Fannie Mae spreads did not drop. In this post I made one of the best observations I have made on this blog – but I did not hammer it home because I thought the spreads were so irrational they would drop shortly. I said:

Monday, August 18, 2008
Foreigners selling Fannie and Freddie debt
I wrote here about what seemed to be the irrationally wide spread on Fannie and Freddie debt. We are after the Paulson plan. The US Government has promised it stands behind these entities. But the spreads still widen.
Widening spreads will cause the end - because Fannie and Freddie need to borrow humungous piles of money.
Now Naked Capitalism has a nice post on foreigners selling Fannie and Freddie debt. That seems irrational to me - but it is still happening - and that is not good news for the GSEs.

I expressed my opinion about the irrationality here.

Even then I did not think that the Bush administration would step in and socialise the problem.
The Bush administration is hardly characterised by decisive well considered action. There is an election coming – why not just palm it off on the next guy?

I "missunderestimated" them. Paulson is his own man and whilst George Bush didn’t think it was a bailout Paulson knew better.

I think the bailout was the right thing to do – expressed here. And I am surprised it is so generous (expressed here).

The question will now come down entirely to the “known unknown” – which is how big are the credit losses. I think my estimate here is the best so far anywhere in the market – and I barely think it worth the place in the Blogger computer server. Nobody knows. If they are bigger than about 80 billion the Government will probably wear some losses. If they are less than 80 billion the preferred will probably retain some value. If they are less than 40 billion the common will be a good buy. Unfotunately I come out about 80 billion. That will make the government whole but leave everyone else very distressed. Freddie Mac being worse than Fannie Mae will wind up costing the government money.

I hope this series has helped people. It helped me to write it.

Finally - this bail-out is only worth doing if the spreads on agency debt falls. Funnily enough it still is not - see this post from Naked Capitalism. That looks strange to me. But I have given up disbelieving things because they look strange.



John Hempton