Company Overview
Federal National Mortgage Association (OTCQB: FNMA), also known as Fannie Mae, is a government-sponsored enterprise (GSE) chartered by Congress. The company serves as a source of liquidity for purchases of homes and financing of multifamily rental housing. Fannie Mae’s primary purpose is to ensure qualified borrowers have access to affordable mortgage credit.
The rapid deterioration of the housing market in 2008 significantly affected the company’s financial condition and left it unable to fulfill its mission without government intervention. Therefore, on September 6, 2008, the Federal Housing Finance Authority (FHFA) placed Fannie Mae into conservatorship. As conservator, the FHFA holds all rights, titles, powers, and privileges of the company, and of any shareholder, officer, or director with respect to the company and its assets.
Although the company remains under conservatorship, the FHFA has delegated management to Fannie Mae’s executives and board of directors. Critical matters remain subject to the FHFA’s review and approval.
Products and Services
Fannie Mae does not originate loans or lend money directly to consumers. Instead, the company provides liquidity and stability to the U.S. mortgage market by securitizing individual mortgage loans into Fannie Mae mortgage-backed securities (MBS) that are guaranteed by the company. While the company is a GSE, its obligations are only implicitly, and not contractually, guaranteed by the U.S. government.
The company’s business consists primarily of mortgage acquisitions, credit risk management, and credit loss management. The two primary operating segments are:
Single-Family, which refers to the securitization of single-family fixed rate or adjustable rate, first-lien mortgage loans or mortgage securities backed by these types of loans.
Multifamily, which refers to the securitization of multifamily mortgage loans into Fannie Mae MBS. The company also provides credit enhancement for bonds issued by state and local housing finance authorities to finance multifamily housing.
Market Overview
Fannie Mae was the largest insurer of single-family mortgage securities in the secondary market in the first quarter of 2017 with an estimated market share of 39 percent.
Source: Company Reports
The company also owned or guaranteed approximately 19 percent of the outstanding debt on multifamily properties as of December 31, 2016.
With respect to market conditions, the company expects the single-family serious delinquency rate to gradually decline, but will remain high compared to pre-crisis levels until delinquent loans originated prior to 2009 can be resolved via the foreclosure process. Fannie Mae projects that the single-family mortgage market will shrink an estimated 20 percent to $1.58 trillion in 2017, and that originations from refinancing will decrease from $949 billion in 2016 to $510 billion.
Treasury Agreements
As conservator, the FHFA entered Fannie Mae into a senior preferred stock purchase agreement (SPSPA) with the U.S. Treasury. In exchange for proceeds of $116.1 billion, the Treasury received one million shares of Variable Liquidation Preference Senior Preferred Stock, Series 2008-2 and a warrant to purchase (for a nominal price) shares of common stock equal to 79.9 percent of the total number of Fannie Mae’s common shares on a fully diluted basis. Including the initial liquidation preference of $1 billion (for which no consideration was paid), the Treasury’s total liquidation preference is $117.1 billion.
The SPSPA initially provided for a cumulative, quarterly cash dividend at an annual rate of 10 percent of the then-current liquidation preference of the Treasury’s senior preferred stock. However, the dividend calculation was amended in 2012 to an amount based on Fannie Mae’s net worth (assets minus liabilities). Specifically, the quarterly dividend is equal to the amount by which the company’s net worth exceeds a reserve amount ($600 million in 2017, $0 as of January 1, 2018). This dividend payment is also known as the net worth sweep. Fannie Mae’s draws and dividend payments under the SPSPA are detailed below:
Source: Company Reports
It should be noted that the dividend payments do not reduce the liquidation preference of the preferred stock, and the company is generally not permitted to make payments toward the outstanding principal.
The SPSPA contains certain covenants that restrict the activities of the company. These include paying dividends to junior preferred or common shareholders, issuing additional equity securities, and issuing subordinated debt.
Shareholder Litigation
The SPSPA, especially the net worth sweep provision, transfers essentially all profits and significant shareholder value to the U.S. Treasury. While the government has argued that this is necessary to ensure that taxpayers receive a fair return on their investment, subordinated shareholders have challenged the net worth sweep in court.
The most recent decision on the case came in February 2017 in Perry Capital LLC v. Mnuchin. Perry claimed that the government was illegally seizing profits from a private business and harming its shareholders. In a 2-1 decision, the D.C. Court of Appeals disagreed and ruled that shareholders of Fannie Mae (and its sister entity Freddie Mac) may not pursue many of their claims against the government.
However, the court indicated the plaintiffs may still pursue certain contract-based claims. , claims related to breach of covenants regarding liquidation and dividend preference were remanded to the district court for further proceedings.
Outlook
The timing of any future court decisions remains unclear. However, reform of GSEs (Fannie Mae and Freddie Mac) may come sooner via direct action by Treasury Secretary Steven Mnuchin. The Treasury Secretary has previously indicated that he would like to release Fannie Mae and Freddie Mac from government control, but has provided few details. A more detailed proposal may come in the second half of 2017. Whether this will ultimately benefit existing shareholders is not yet known.
First Quarter Financial Review
In the first quarter of 2017, the company reported net income of $2.8 billion and a positive net worth of $3.4 billion. Given the reserve requirement of $600 million, Fannie Mae expects pay the Treasury a $2.8 billion dividend in June 2017. As of now, the company has paid the Treasury nearly $160 billion in dividend payments.
Fannie Mae expects to remain profitable on an annual basis for the foreseeable future. However, the volatility of the company’s results may be impacted by certain factors including interest rates and home prices.
Stock Influences
- Court decision regarding ongoing shareholder lawsuits;
- A government policy shift towards GSEs
- Significant changes in the profitability of the company; and
- The state of the housing market and the economy overall.
Risk Factors
- The company is under conservatorship and there remains significant uncertainty regarding the future of the company and shareholders’ claims on its net worth;
- Due to the net worth sweep, effectively all profits are transferred to the Treasury and the company is unable to build excess capital reserves;
- The company could incur significant credit losses in the future; and
- The FHFA does not have a fiduciary duty to the shareholders.
Stock Performance
As of June 7, 2017, shares of Fannie Mae closed at $2.46, down 3.5 percent on the day. As shown above, the shares traded as low as $1.57 in September 2016, but hit a high of $5.00 shortly after the U.S. election. Year-to-date, Fannie Mae is down more than 35 percent, primarily due the court ruling in February. Shares of Fannie Mae currently trade over-the-counter.
Summary
Along with the U.S. housing market, Fannie Mae has made a strong recovery from the depths of the 2008 financial crisis. The company has continually reported strong results, and appears well-positioned to maintain the trend of positive earnings.
However, it seems that that the U.S. Treasury, and not common shareholders, will reap the benefits of Fannie Mae’s success. Ongoing shareholder litigation and/or GSE reform initiated by the Trump administration could be beneficial, but the timeline and actual effects remain uncertain.
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