Fannie Mae’s Profit Trap Comes Into View
Mortgage-Finance Company’s Shares Appear to Be Overvalued
By John Carney
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Fannie’s quarterly results last week were mostly free from the huge nonrecurring tax and legal items that have obscured its earnings power in earlier periods. So, it is now possible to better assess the value of its shares.
The results showed Fannie earned net income of $3.9 billion in the third quarter, up from $3.7 billion in the prior one. Extrapolating from those quarters, annual earnings from operations likely would run about $14.8 billion.
But investors can’t just think in terms of Fannie’s profits, given its need to pay dividends to the Treasury Department, its ward-of-the-state status and its depleted balance sheet. As well, since the government has warrants for 79.9% of Fannie’s common stock, private shareholders at most are entitled to 20.1% of Fannie’s profits.
Currently, the government sweeps away all of Fannie’s profits. Given that, the common shares are essentially worthless. Some investors are fighting this in court and Fannie’s shares have risen on hopes the sweep will be struck down.
The question: What would the shares be worth if the sweep were set aside?
In that case, it is likely original bailout terms would be restored. These required Fannie to pay a 10% dividend on the government’s $117 billion preferred stake and a commitment fee on its undrawn backstop.
Going forward, Fannie would have to pay the Treasury an annual dividend of roughly $11.7 billion. The commitment fee was never set. Assume a 0.75-percentage-point fee, and Fannie would have to pay about $900 million a year.
That brings Fannie’s annual Treasury obligation to $12.6 billion. Assuming $14.8 billion in earnings, Fannie would generate $2.2 billion in excess of those payments. Further assume those earnings increase at a 2% rate for the next five years, lifting unencumbered profit to about $3.7 billion.
In all likelihood, the government would have to return to the company about $79 billion in payments received in excess of that due had Fannie only been paying the 10% dividend. That money could help start to rebuild Fannie’s capital base.
At that level, it would take Fannie nearly 11 years until it had generated total excess earnings that, combined with the returned $79 billion and current $2.4 billion capital reserve, would equal the money the government had given it.
Not that it could simply use that to buy back the government’s preferred stock. Instead, Fannie would need to keep building its capital base.
Next, make the generous assumption that Fannie would be required to have 5% capital in a stressed scenario; some would argue for much higher levels. If so, the company would need a further $143 billion on top of what already would have been generated and the government’s preferred stockholding. That would take another 39 years of earnings at the above rate.
So common stockholders couldn’t really expect to have any value flow to them for about 50 years.
Discounting those future available earnings by Charles Schwab’s expected long-term annual return for midcap stocks of 8.2% produces a present value for the stock of about $877 million.
In light of the government’s warrants, about $175 million would be applicable to private common stockholders. That translates into a value of about 15 cents per diluted share.
Because the common shares sit behind junior preferred with a face value of about $35 billion, though, it is safe to say the common stock has a fundamental value closer to zero.
This means the significance of the net-worth sweep has been overestimated. Even setting it aside, the shares appear to have little to no value.
The thick mists of legal controversy may conceal this for a while. If and when they lift, those still holding the common stock could see their hopes of windfall wealth dashed.
— John Carney
