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(B)(N) Fannie Mae & Freddie Mac

August 22, 2014
Securitization with Fannie Mae and Freddie Mac

Securitization with Fannie Mae and Freddie Mac

Deal Book. Fannie Mae and Freddie Mac provide liquidity to the mortgage market, but do not themselves originate mortgages or lend money. Banks, credit unions, S&Ls, and so forth, negotiate and originate mortgages, which they can then sell to Fannie Mae or Freddie Mac, both of whom will own or “securitize” the mortgages into “packages” of mortgages, with various credit, default, and pre-payment risk and return characteristics, for sale to investors who want income and capital gains – and the originators can then do much more of what they do – originate mortgages, and other credit vehicles, and lend money for profit.

Both companies are  “government sponsored enterprises” (GSEs), with Fannie Mae chartered in 1938 and Freddie Mac in 1970, and since September 6, 2008, they are both in “conservatorship” under the Federal Housing Finance Agency (FHFA), which agency effectively “owns” them (as in post-bankruptcy) and has no obligations to the previous shareholders, and although there is still a market for their stocks, which continue to be actively traded and are up 10-fold since early 2013, and +40% this year, from the previous 25¢ to the current $3 to $4, not all “investors” are happy with that (Bloomberg, August 15, 2014, Ackman’s Pershing Square Sues U.S. Over Fannie, Freddie) ; please see Exhibit 4 and 5 below for more details about these companies

Since 2008, these two companies have returned more than $190 billion in “investment” profits to the government, that is, to the taxpayers, who bailed them out in 2008, and they are still on the hook for the original $190 billion of bail-out funding and the government has the option to acquire up to 80% of the stock, possibly by issuing more of it with no par value. Nice.

Investors who own the stock, however, don’t actually “have” anything, even though they’re willing to pay (roughly) $4 per share for it; what they have is a “certificate”, but they don’t have access, or rights, to either the earnings or the cash flow, which the “owners” might have, and they don’t have any votes. But, please see below (The X-Factor) for the solution, and how that will affect the likely stock price.

X?

What is X?

In order to turn the “zero” into something that is not a zero, the stock needs to be “re-floated” – that is, x-number of old shares shall be converted into one new share with an issue price to be determined, but which makes its “worth” similar to the “worth” of its “trading connections”, which are, for practical purposes, the banks, and to eliminate excessive arbitrage opportunities on the stock, and “windfall” or “unearned” profits on the “price” of it.

The Picture of Dorian Gray by Oscar Wilde 1890

“The Picture of Dorian Gray” by Oscar Wilde 1890

But what is “x”? We can be certain that x≠1, because there’s no way that the current market value of the two companies, $7 billion, should “buy” or “own” $5.1 trillion of assets and $10.4 billion of “shareholders equity”, if investors are also willing to pay, for example, $219 billion (30×) for $2.5 trillion of assets (half) and $227 billion (22×) of net worth for the bank, JP Morgan & Chase; please see Exhibit 3, below, for the fundamentals.

The table in Exhibit 3 also reminds us that investors routinely demonstrate that even though they might know the “price” of everything, it’s doubtful that they know the “value” of anything (Oscar Wilde, 1890); please see our Post “(P&I) Dividend Risk and Dividend Yield“ for more on that.

We are not being unkind – only realistic – that we might find a “fair price” for these companies and, therefore, a “fair market price” for the stocks that these “owners” have, but for which they are not “responsible” as owners because what they “own” is zero circa 2008, very much as we might have an ownership and equity interest in our house with a  20% down payment, and an 80% mortgage, but we won’t “own” it until we try to sell it; for a more colorful explanation of that situation, please see our Post “(P&I) The Process – The Balanced Budget“.

The “value” of Fannie Mae and Freddie Mac as a “going concern” is their Coase Dividend (GW*) which is the “balance sheet worth of the trading connections” for which the investors are willing to pay only $0.09 (9¢) for $1 of it, whereas they are willing to pay $5.88 for $1 of it in the case of JP Morgan & Chase, and even $11 for $1 of it in Wells Fargo, for example, and an average of $6.81 everywhere else, and even more, elsewhere, such as in the Dow Industrials ($26) or the S&P 500 ($24);  please see Exhibit 3 below.

The reason that the Coase Dividend is priced differently for different companies, even in the same industry, is that the “price” depends on the market value of the firm which, objectively, is indeterminate for anything other than what it is, because it depends on what investors are willing to pay for what they see, or might see, or anticipate, and so forth – and there are as many “reasons” for a stock price as there are investors and their money.

However, in the Theory of the Firm, there is no “price”, but only what the Coase Dividend (GW*) creates, and that is (N*) which projects objectively to the “factors of production”, N*=Accumulated Depreciation + GW* + Fixed Assets (Net) + Inventory, where we need to understand that the accounting values of the Accumulated Depreciation, Net Fixed Assets, and the Inventory, are not necessarily the ones that are relevant to the production; please see, for example, the meaning of that for the banks in our Posts “(P&I) The Banker’s Modality” and “(B)(N) The Canadian Bank Act“.

We further note that the “Enterprise Risk” (1+log(N/N*)) is around 2.50 for all the other banks, but only minus (-1.28) and minus (-0.89) for Fannie Mae and Freddie Mac, respectively, which “says” that to own these companies – Fannie Mae and Freddie Mac – at par, as per their current stock prices – is a steal. And thank you, America, but you don’t really owe us that much.

The X-Factor

Management Discussion Fannie Mae 2014

Management Discussion Fannie Mae 2014

Should the shareholders have any doubt that they don’t “own” anything, please see the Management Discussion on the right, and for more details, the amazing  Quarterly Report June 2014.

The idea of “x” (above)  is that when these stocks are re-floated, the investors who own them now, will not reap windfall profits (or losses) when other investors have a notion to buy them, as opposed to other stocks that they might own in the same industry or business, which, in our case, is the banks.

In other words, we need to find the price of risk – that is, the price that clears this market (the banks) of either excess demand (too low a price), or excess supply (too high a price) for FNMA and FMCC.

Exhibit 1: The Enterprise Risk & Solution

Figure 1.1: Enterprise Risk

Figure 1.1: Enterprise Risk

We can do that by finding the stock price for which the “Enterprise Risk” = 1+log(N/N*), is “effectively zero” by locating it, or “positioning” it, in the “convex hull” of its trading connections with respect to the price of the Coase Dividend, by market value; please see Figure 1.1 on the left for the current situation.

Figure 1.2: Enterprise Risk Solution

Figure 1.2: Enterprise Risk Solution

The solution (or a solution) is shown in Figure 1.2, and if the number of shares outstanding remains the same, then the stock prices “jump” to $231.60 (FNMA) and $229.20 (FMCC).

Obviously, the current management (FHFA) has a lot of flexibility in how they price the stock, and all that they have to do is leave $385.1 billion ($260.7  billion for FNMA and $124.4 billion for FMCC) behind, in the shareholders equity, of which they own 80%, in any case.

If they leave less (or N=zero, as is their current plan) in the shareholders equity (N), the solution will obtain in any case, because these companies are a “money machine”; moreover, if the FHFA exercises its option of owning 80% of the equity, by floating more shares, the stock prices will still “explode” from the current $4 to $46.32 ($231.60/5) and $45.84 ($229.20/5), and there’s nothing that they can do about that, except profit from it, like everybody else who owns these stocks, for 25¢, or the current $4.

Another consideration is that these calculations are done pro forma, according to the current balance sheets, which are rendered somewhat casually, with not much purpose in mind, but we really need to know the “private balance sheets” in which liquidity risk and credit risk result from the “inventory”, which contains securities which these companies manage for their own accounts, and to “make the markets”, which is their job; please see Exhibit 2 below for the significance.

Exhibit 2: The Private Balance Sheet

Liquidity & Credit Risk - FNMA FMCC & The Banks

Figure 2.1: Liquidity & Credit Risk – FNMA FMCC & The Banks

The modality counts, and affects the Enterprise Risk, the Coase Dividend, and the Profit Box; for more information, please see our Posts on “(P&I) The Profit Box” and “(P&I) The Banker’s Modality” and “(B)(N) The Canadian Bank Act“.

From the chart on the left, FMCC demonstrated a modality of α=0.280 in 2008 and 2009, based on the information that we have, but which could be confirmed by the companies.

Banana Republic

α=0.280

But that modality is a “bankrupt” modality, which would have required several previous years to acquire, and is most often seen in “Banana Republics”.

We can’t say that we weren’t told; we (or they) just didn’t know what it meant.

Exhibit 3: Fannie Mae and Freddie Mac – Fundamentals

Fundamentals - Fannie Mae and Freddie Mac

Fundamentals – Fannie Mae and Freddie Mac

Exhibit 4: (B)(N) Federal Natioanl Mortgage Association (Fannie Mae) – Risk Price Chart

(B)(N) FNMA Fannie Mae

(B)(N) FNMA Fannie Mae

Fannie Mae buys and holds mortgages, and issues and sells guaranteed mortgage-backed securities to facilitate housing ownership for low to middle-income Americans.

From the Company: Federal National Mortgage Association (Fannie Mae) provides liquidity and stability support services for the mortgage market in the United States. The company securitizes mortgage loans originated by lenders into Fannie Mae mortgage-backed securities (Fannie Mae MBS). The company’s Single-Family Credit Guaranty segment securitizes and purchases single-family fixed-rate or adjustable-rate, first-lien mortgage loans, or mortgage-related securities backed by these loans; and loans that are insured by Federal Housing Administration, loans guaranteed by the Department of Veterans Affairs and Rural Development Housing and Community Facilities Program of the Department of Agriculture, manufactured housing loans, and other mortgage-related securities, as well as provides single-family mortgage servicing, REO management, and lender repurchase evaluation services. Its Multifamily segment securitizes multifamily mortgage loans into Fannie Mae MBS; purchases multifamily mortgage loans; and provides credit enhancement for bonds issued by state and local housing finance authorities. This segment also offers debt financing structures to facilitate construction loans; delegated underwriting and servicing; and multifamily mortgage servicing services. The company’s Capital Markets segment manages its mortgage-related assets and other interest-earning non-mortgage investments. This segment provides funds to the mortgage market through short-term financing and investing activities that include whole loan conduit transactions, early funding transactions, real estate mortgage investment conduit and other structured securitization activities, and mortgage-backed securities trading services. Fannie Mae serves mortgage banking companies, savings and loan associations, savings banks, commercial banks, credit unions, community banks, insurance companies, and state and local housing finance agencies. The company was founded in 1938, has 7,000 employees, and is based in Washington, the District of Columbia.

Exhibit 5: (B)(N) Federal Home Loan Mortgage Corporation (Freddie Mac) – Risk Price Chart

(B)(N) FMCC Freddie Mac

(B)(N) FMCC Freddie Mac

Federal Home Loan Mortgage Corp provides credit guarantees for residential mortgages originated by mortgage lenders and invests in mortgage loans and mortgage-related securities. Its segments are Single-family Guarantee, Investments and Multifamily.

From the Company: Federal Home Loan Mortgage Corporation provides credit guarantee for residential mortgages originated by mortgage lenders and invests in mortgage loans and mortgage-related securities in the United States. It operates in three segments: Single-Family Guarantee, Investments, and Multifamily. The Single-Family Guarantee segment purchases single-family mortgage loans originated by its seller/servicers in the primary mortgage market; securitizes the purchased mortgage loans into guaranteed mortgage-related securities; and guarantees the payment of principal and interest on the mortgage-related securities. This segment serves lenders, including mortgage banking companies, commercial banks, community banks, credit unions, housing finance agencies (HFAs), and thrift institutions. The Investments segment invests principally in mortgage-related securities and single-family performing mortgage loans that are funded by other debt issuances and hedged using derivatives. It serves insurance companies, money managers, central banks, depository institutions, and pension funds. The Multifamily segment is engaged in the investment, purchase, sale, securitization, and guarantee of multifamily mortgage loans and securities; issues other structured securities; guarantees multifamily HFA bonds and housing revenue bonds held by third parties; and offers post-construction financing to larger apartment project operators. Federal Home Loan Mortgage Corporation was founded in 1970, has 5,000 employees, and is based in McLean, Virginia.

For more information on real “risk management” and additional references to the theory and how to read the charts and tables, please see our Post, The RiskWerk Company Glossary and “(P&I) Dividend Risk and Dividend Yield“, and our recent Posts “(P&I) The Profit Box” and “(P&I) The Process – In The Beginning“; and we’ve also profiled hundreds of companies in these Posts and the Search Box (upper right) might help you to find what you’re looking for, such as “(B)(N) TLM Talisman Energy Incorporated” or “(B)(N) ATHN AthenaHealth Incorporated” or “(B)(N) PETM PetSmart Incorporated“, to name just a few.

And for more applications of these concepts please see our Posts which rely on the Theory of the Firm developed by the author (Goetze 2006) which calibrates The Process to the units of the balance sheet and demonstrates the price of risk as the solution to a Nash Equilibrium between “risk-seeking” and “risk-averse” investors within the demonstrated societal norms of risk aversion and bargaining practice. And for more on The Process, please see our Posts The Food Chain and The Process End-Of-Process.

And for more on what risk averse investing has done for us this year, please see our recent Posts on “(P&I) The Easy (EC) Theory of the Capital Markets” or “(B)(N) The Easy (EC) Theory of the S&P 500“, and the past, The S&P TSX “Hangdog” Market or The Wall Street Put or specialty markets such as The Dow Transports & Utilities or (B)(N) The Woods Are Burning, or for the real class actionLa Dolce Vita – Let’s Do Prada! and It’s For You, Dear on the smartphone business.

And for more stocks at high prices, The World’s Most Talked About Stocks or Earnings Don’t Matter – NASDAQ 100. And for more on what’s Working in AmericaBig OilShopping in America or Banking in America, to name just a few.

Postscript

We are The RiskWerk Company and care not a jot for mutual funds, hedge funds, “alternative investments”, the “risk/reward equation” and every other unprovable artifact of investment lore. We have just one product

The Perpetual Bond
Alpha-smart with 100% Capital Safety and 100% Liquidity
Guaranteed
With No Fees and No Loads on Capital

For more information on RiskWerk, please follow the Tags or Categories attached to this Letter or simply enter Search for additional references to any term that we have used. Related data may be obtained from us for free in a machine readable format by request to RiskWerk@gmail.com.

Disclaimer

Investing in the bond and stock markets has become a highly regulated and litigious industry but despite that, there remains only one effective rule and that is caveat emptor or “buyer beware”. Nothing that we say should be construed by any person as advice or a recommendation to buy, sell, hold or avoid the common stock or bonds of any public company at any time for any purpose. That is the law and we fully support and respect that law and regulation in every jurisdiction without exception and without qualification to the best of our knowledge and ability. We can only tell you what we do and why we do it or have done it and we know nothing at all about the future or the future of stock prices of any company nor why they are what they are, now. The author retains all copyrights to his works in this blog and on this website. The Perpetual Bond®™ is a registered trademark and patented technology of The RiskWerk Company and RiskWerk Limited (“Company”) . The Canada Pension Bond®™ and The Medina Bond®™ are registered trademarks or trademarks of the Company as are the words and phrases “Alpha-smart”, “100% Capital Safety”, “100% Liquidity”, ”price of risk”, “risk price”, and the symbols “(B)”, “(N)” and N*.

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