Description

As a GSE, FNM occupies a unique niche in the US mortgage Market. The Company’s competitive advantages (Funding, Implied Gov. Support, Credit Quality of Guarantee, and Pricing/Liquidity of MBS) allow for sustainable and growing economic earnings of between $6-10 per share in 2-3 years which should be supportive of a $60-$150 share price. FNM’s stock is under priced due to a combination of confusing/misleading GAAP results, credit crisis and market fear.

Fannie Mae is a stockholder owned company (since 1968) chartered by the US government (in 1938) to provide liquidity, affordability and stability for the US residential mortgage market. FNM offers banks and other mortgage lenders financing, credit guarantees, technology and services so that lenders can make more home loans at lower rates. FNM improves secondary mortgage market liquidity through two primary activities: 1. Credit enhancement: in exchange for a fee (premium), FNM provides a guarantee (insurance) on pools of mortgages that meet its underwriting criteria (conforming mortgages); 2. Portfolio Holdings: FNM holds a portfolio of mortgages and mortgage backed securities.

The company’s credit enhancement activities add to liquidity by turning an irregular illiquid asset, a single mortgage, into a liquid asset, namely a regular pool of mortgages guaranteed by FNM.  FNM’s guarantee improves liquidity by replacing credit quality/risk of individual mortgages with credit quality/risk of its own guarantee, eliminating the need for mortgage holders to perform credit analysis on underlying mortgages, thus improving the marketability of conforming mortgages.  FNM’s credit guarantee is deemed to be as near a US government guaranty as exists in financial markets.  

The company’s Portfolio Holding activities provides cash to lending institutions in exchange for pools of mortgages and actively participates in the secondary MBS market; these activities improve liquidity by providing lending institutions cash they can use to make new loans and insuring a functioning, orderly and liquid (both demand and supply) secondary market. Increased liquidity drives down the spread required by the market to hold mortgages and thus reduces borrowing costs for home owners.

 FNM’s business is dependent on the market’s continued lofty perception of the company’s credit quality.  To FNM’s great advantage, the market perceives the company to be government supported, so its credit quality is treated without peer in the corporate credit market. In fact, the US government does not guarantee any FNM business (see more on government relationship later in doc).  The perception of government support comes from the company’s founding charter, federal oversight, affordable housing obligations, presidential board designees, and $2.25bn line of credit with the treasury.

What’s in it for FNM shareholders? FNM’s Business Economics

FNM operates three reporting business units: 1. Single Family (or Guarantee business), 2. Portfolio Investing, 3. Multi-Family/Housing and Community Development (HCD). FNM’s businesses are compensated for taking 2 primary types of risk: Credit and Interest rate. The Single Family business takes credit risk and the Portfolio business takes, but attempts to minimize, interest rate risk. HCD engages in credit and portfolio operations in the multi-family market, assuming credit and interest rate risk.

Single Family Business-

Economics

The single family business is an insurance business.  In exchange for an insurance premium (guarantee fee or G-fee paid over the life of the mortgage) FNM agrees to pay all principle and interest on any insured mortgage that fails to perform.  FNM guaranteed mortgages are packaged into MBS and returned to the originating institution or sold in the secondary market.

The Single Family business generates revenue from G-fees (insurance premium), investment income, float income, trust management fees and other technology fees. Revenue in this division is driven by the dollar value of mortgages guaranteed, rate of fees and rate of earnings on investments (over 80% of the revenues come from G-fees).  Expenses in the Single Family business are composed of credit costs and general administrative costs (processing loans, payments, corporate, IT, accounting, consulting, communications expense, and excess mortgage insurance).  General expenses are relatively fixed and can be leveraged over time as the business grows.  Credit expenses are driven by rate of defaults, cure rate on defaults, recovery/severity on defaults and foreclosure/property disposal expenses.

Historically, the Single Family business economics have been spectacular, generating ROE’s between 27%-44% while growing nearly 10 fold in the past 20 years and more than 2 fold in the past 9 years. G-fee (or premium) has averaged 20bps of average exposure over time and other fees/float/investment gains have averaged 5-7bps of average exposure. The g-fee business administrative costs have averaged 6bps over this time.  Credit costs have ranged from 0 to 12bps in any individual year and averaged 5bps. So, the Single Family business has had pre-tax profits of between 8 and 20bps of average insured exposure over the past two decades.

The Single Family business is required by OFHEO to maintain 45bps of capital to insured exposure. Currently, OFHEO requires FNM to hold 30% excess capital – assuming that this requirement existed over the previous 20 years and was funded with 6% preferred – the ROE would have been between 24 and 42% historically.

            Outlook

            The single family business faces material increases in credit costs over the next few years. FNM currently (December 2007) estimates that credit costs will increase form 4-6bps in 2007 to 8-10 bps in 2008 and could be higher in 2009. Credit costs will weigh on the division’s economic earnings over the next few years and likely result in a year or two of profitability at or below the lowest results of the past 20 years. In addition to direct credit costs, the company will need to increase credit reserves over the next 2 years, further depressing segment results. A deep recession would likely result in economic loss in the current book of business during at least one of the next two years.

In light of increased credit losses across the mortgage market, demand for FNM’s guarantee has increased materially in the past six months. Strong demand and market conditions have allowed FNM to increase price while simultaneously gaining share. In addition to G-fee price increases, FNM has instituted a surcharge on all mortgages it guarantees beginning March 2008. The surcharge should partially off-set increasing credit costs. Once credit costs revert to historic levels, the Single Family business will materially benefit from the quality (rate/terms) on business written during the period of credit difficulty. The combination of increased rate and market share gains should result in the Single Family business being materially bigger and more profitable in 3-4 years.

Earning Power

The earning power of the Single Family business are determined by aggregate exposure multiplied by total fees (G-fees, investment income, float income, trust management fees and other technology fees)  less total costs (credit and administrative). Pre tax profit has averaged about 15bps of exposure during the past 20 years.  Using 9/30/07 exposure and 15bps of pre tax profit, the single family business has $2.3 per share of earnings power. Currently the single family business is growing 15% per year – assuming growth is maintained for 2 years, the division will have over $3.1 per share of earnings power. Assuming that the business is able to maintain recent price increases, the single family business could earn over $4 per share in 2010.

Portfolio Business-

Economics

The portfolio business is a highly leveraged (40x) portfolio of mortgages and mortgage backed securities. FNM’s holdings consist of its own guaranteed pools, individual mortgages and highly rated senior most tranche of privately issued mortgage backed securities. (see spreadsheet for break down of mortgage portfolio, FNM takes de minimums credit risk in its Portfolio Business) FNM funds portfolio holdings by issuing unsecured debt. FNM endeavors to minimize interest rate risk by issuing callable debt and utilizing derivatives intended to match liabilities to the company’s assets. The company aims to keep its duration gap between +/-6 months, and during the past 4 years has been between +/- 1 month.

FNM’s portfolio business benefits from a cost/term of funds advantage (funding at a discount to LIBOR and issuing long dated callable debt). This advantage stems from the market’s perception that FNM would be supported by the US gov if the company were to ever experience material difficulty. The economics of the portfolio business are driven by the OAS  (Option Adjusted Spread) of FNM’s mortgage assets vs. the company’s funding costs – OAS spread has ranged from 15-120 bps and averaged 50bps over the past 15 years resulting in an average after tax ROE of 17% over the past 15 years.

The portfolio business is required to hold capital equal to 2.5% of assets, and currently, OFHEO requires the company to hold a 30% capital surplus. Given the surplus requirement and assuming it is satisfied with 6% cost preferred, the historic ROE in the Portfolio business would have been 15%. In addition, FNM is currently restricted by OFHEO from growing its owned portfolio (HCD and single family) beyond its current $727bn size.

            Outlook

            Current restrictions on portfolio growth limit the potential for this business. Despite the portfolio cap, returns in the portfolio business should improve as current holding (acquired during periods of tight OAS) roll off and are replaced with new positions at wide OAS are added. If the portfolio cap is lifted, FNM will be able to grow the portfolio business and take advantage of wide OAS spread opportunities. The company has suggested that if/once the cap is lifted it will pursue a strategy of opportunistic portfolio activities; growing during times of wide spreads and shrinking or slowing growth during periods of tight OAS. During the 1990’s the company pursued portfolio growth with less regard for the level of OAS.

Earning Power

Base on the 9/30 balance sheet and 2.5% statutory capital requirement (30% surcharge funded with 6% preferred), the portfolio business has between $1.8 (12.5% ROE) and $2.5 (17% ROE) per share earnings power. If the portfolio caps were lifted, this business could earn over $3.5 per share, assuming new positions were acquired in today’s market environment.

HCD

Economics

HCD operates a credit business and a portfolio business focused on multi-family properties (economics are similar to the Single Family and Portfolio Holdings segment). In order to meet affordable housing mandates set by HUD, HCD also invests in low income tax credits. The economics of low-income tax credit deals are as follows: FNM buys $1mm worth of tax credits – then every year for 10 years the company gets $100k as a tax credit (direct reduction in tax) and also recognizes $100k of loss on the investment it had made, the $100k loss is treated like NOL’s and offsets income, so the $100k loss is worth $35k per year (assuming 35% corporate federal tax rate – FNM is exempt from local tax). The Investments in low income tax credits provide economic return and help to meet low income housing goals.

            Outlook

            Credit losses in the HCD business are at record lows, driven by low unemployment and demand for rental units. Credit quality should remain strong as many former homeowners become renters and 89% of the company’s exposure is credit enhanced. The portfolio portion of the business operates under the same aggregate cap as the portfolio business and benefits from adding new investments at currently wide spreads.

Earning Power

Base on historic results, the HCD business has between $.5 -.6 of per share earnings power.

Competition-

Due to the Government charter, public purpose, perceived government support and capital rules, the GSE’s have a unique competitive position. In the single family business, FNM/FRE effectively operate a two party monopoly. The only real competition is the private securitization market and lending intuitions retaining conforming mortgages. Generally, the private market and portfolio retention can not compete with the pricing and liquidity offered by GSE guarantees. Retention suffers from a relatively high capital charge compared to GSE guaranteed mortgages. Private label securitizations suffer from materially worse liquidity and volume.  During periods of tight private market spreads and ample liquidity, the GSE’s can be compelled to reduce rate in order to maintain share. In periods of credit crisis the GSE’s tend to have pricing power and operate without meaningful competition.

The portfolio business competes with other mortgage holders (banks, REITS, specialty finance companies, foreign governments, pensions and loan funds), but tends to have a material term/cost of funds advantage. The cost of funds advantage is drive by low regulatory capital required to support portfolio holdings, tight credit spreads on the company’s unsecured debt and the ability to issue long-dated callable debt. The company’s portfolio advantages are driven by the company’s government relationship (OFHEO capital requirements and the markets perception of credit support).

Relative to FRE, FNM is bigger, its debt and MBS trade at tighter spreads.

US Mortgage Market

            Mortgage debt outstanding (MDO) has grown 9% annually over the past 26 years. Fundamental market growth is driven by population, home ownership, home size and home values. Given FNM’s unique market position, the company should be able to grow its credit book in line with MDO growth. MDO growth will most likely be between 5-10% over the foreseeable future. During difficult credit environments (as expected over the next 2-3 years), the GSE’s should grow faster than the market, as they take share. The long term growth of the mortgage market should allow FNM to achieve above average growth over the long-term.

Outlook/Credit Crisis

The US housing market is in the midst of a depression and 2008 will likely experience the first 2 consecutive years of national house price decline since the 1930’s. House price declines affect FNM’s single family business by increasing the number of defaults and the severity on defaults. FNM has always restricted it activities to the safest portions of the mortgage market and did not noticeably lower it standards during the housing boom. In additon FNM has mortgage insurance on a majority of its most risky mortgage exposures. In extreme scenarios, the Portfolio business could experience a year or 2 of economic credit losses. (see discussion of Portfolio business and attached spread sheets)

 Despite the nature (conventional, conforming, fixed rate, high fico, low LTV) of FNM’s underwriting and relatively pristine asset credit quality, the company will face mounting credit losses over the next 2-3 years.  It is impossible to know the extent of credit losses that FNM will face, but the company expects credit costs to be 8-10 bps in 2008. The existing book of credit exposure produces roughly 18-20bps of pre credit cost profit per year. In the past 30 years, FNM’s worst single year of credit loss was 12bps in 1987. Based on OFHEO’s worst case credit scenario (ALMO region, early 1980’s vintage) applied to FNM’s entire portfolio as of 9/30/07, FNM would experience annual credit losses of 24-45 bps per year. (see attached spread sheets for exposure characteristics and potential credit scenarios)

Plainly, nobody knows the extent of credit losses in FNM’s current book of business. FNM has responded to the down turn by increasing price for its credit insurance. Because the GSE market is currently the only place to do business, the GSE’s have pricing power – FNM has initiated a surcharge (as of 3/2008) of .25% on all loans guaranteed and a surcharge of .75-1% on all loans with greater than 70% LTV. In addition, FNM has raised price on all bulk purchases in the 3^rd Q and has increased rate for all renewing flow relationships (bulk represents 25% of the business and flow can be re-priced as contracts renew).

            Given FNM’s demonstrated ability to increase price, continued (real) demand for mortgages and the company’s increasing market share, we are left with the following likely out come of the credit crisis. FNM currently has a suboptimal book of business, this suboptimal book will either produce profit or loss (we can’t be sure, but history would suggest profit), either way, FNM will raise price on new business sufficient to cover any profit shortfall or loss on the exiting credit book. Given the dynamic that profit (pricing) on future business can make up for potential losses (or profit shortfall) on existing business, the credit crisis for FNM is more like the insurance industry experiencing a cat loss than like a bank/lender experiencing a deteriorating loan portfolio. After huge losses (think 9/11 or Katrina/Rita) insurance pricing becomes so good that the new business written at the new rate makes up for the losses of the past (true for the market as a whole - some insurers get carried out, the more well capitalized make excess profits and gain share during the hard market). The same phenomenon is likely to occur with FNM’s Single Family business. If, during a horrible credit environment, conditions get so bad that FNM has big embedded losses in its existing credit book, pricing will get so good as to make up for the losses. Because the GSE’s are the market during a crisis, FNM is fairly assured to generate excess profit during the “hard” market. FNM’s underlying credit business should remain profitable though the cycle.

Valuation –

FNM trades at 1.1x tangible book and 1.34x fair value book (both as of 9/30/07).  In a conservative case (assuming no growth in any business or excess capital relief, but a normalized credit environment – ie profits of between 8-20bps on single family business) FNM has around $4.7 per share in earnings power. Assuming that FNM is able to grow its businesses in line with the US mortgage market, maintains recent price increases and gets relief from excess capital, FNM would have between $9-10 per share of earnings power. For perspective, FNM has traded between 2 – 4x book during the past 17 years and averaged a 14 P/E (ex. the bubble and recent accounting difficulties).

Upside – Manageable credit costs, Increased pricing, MDO growth and share growth, OFHEO relief on excess capital and portfolio growth, return of capital.

Base –  Credit costs result in at least one year of economic losses in Single Family business, Increased pricing, MDO growth and share growth, No OFHEO relief on excess capital and portfolio growth, No return of capital.

Downside – Higher than expected credit costs, no price increases, No OFHEO relief, No MDO or share gain, raise capital.

Worst case – Blowup driven by portfolio mismatch/derivative problem, Credit losses, or loss of confidence/Gov. Support.

ACCOUNINTG

Despite straight forward fundamentals and economically profitable operations, FNM reported losses in the 3rdQ and is likely to report losses in the 4thQ and potentially in 2008. FNM’s relatively simple business economics described above are confused by GAAP accounting rules that require income statement and balance sheet entries that do not necessarily reflect economic reality. At some point in 2008, I expect the company to begin to produce and talk investors through economically relevant results. Below is a discussion of how each businesses’ economics are obfuscated by GAAP accounting convention.

Single Family business

The single family business receives insurance premiums for the life of a mortgage in exchange for agreeing to pay interest and principle in the event the borrower defaults. Each month that the mortgage is outstanding, FNM receives a portion of the interest paid by the borrower as an insurance premium.  Cash flow is fairly strait forward, every month premium comes in, expenses for general admin, foreclosure, and reinsurance go out and credit losses are realized. The accounting is complicated. As per GAAP, at the time of entering into the guarantee, the company must record an asset for the NPV of the G-fee on to its balance sheet and simultaneously record an equal guarantee obligation as a liability. When FNM determines that it has entered into a contract at a G-fee rate less than the rate the company estimates that the market would charge for a similar contract (inclusive of an adequate profit margin), FNM must take a charge to income of the present value of the difference between what a 3^rd party would charge and what the company has actually charged for the guarantee. This charge (loss on certain guarantee contacts) shows up as an expense and an increase in deferred guarantee obligation.  Assuming that the guarantee ends up being profitable over time (vast majority of the cases) the deferred liability (that was booked at the time of the contract) is amortized into revenue as the guarantee is received and loss fails to take place.  GAAP inflates revenue (amortization of deferred liability) in future periods, inflates costs (loss on certain guarantee contacts) in the current period and understates shareholder equity (guarantee obligation).

FNM generally issues MBS in 50bp yield increments (5.5%, 6 %, 6.5%). In order to create consistent secondary market coupons the company adjusts the price it pays for mortgages through an up front fee paid by itself to the originator (buy-up) or by requiring the originator to make a payment to the company (buy-down). When mortgages pre pay differently than the estimated schedule implied by the buy –up/buy-down, the company takes income statement charges to reflect the reduction in buy-up/buy-down balance sheet items.

            The company’s economic credit costs are the difference between the par value (plus accrued interest) on guaranteed mortgages that fail to perform and the ultimate realized value of collateral seized and sold as part of a default. Generally, when a mortgage defaults, FNM purchases the mortgage from the trust for par plus accrued and then works to cure the default or maximize recovery on foreclosure. When applying GAAP (SOP3-3), the company must recognize the “fair” value of mortgages purchased form trusts at the time of purchase, so the company must take a charge of the difference between the secondary market price for defaulted mortgages and the par plus accrued that the company has paid for the mortgages at the time of purchase. The market price may or may not reflect the actual or likely realizable value of defaulted mortgages purchased. It is important to realize that FNM does not sell purchased mortgages and that the secondary market is not an active or real market (it is generally based on the scratch and dent market or some indicated level from Wall Street dealers). In fact, FNM is one of the world’s experts in managing defaulted mortgages and historically has cured or reworked the majority of defaulted mortgages that it has purchased. In times of market distress, the accounting treatment for purchasing mortgages out of pools (SOP3-3) has the effect of front loading and likely overstating credit related losses. 

            These two accounting conventions (recognizing losses at the time of entering into a guarantee contract and applying SOP3-3 to loans purchased from pools) have the effect of distorting the true economics of the single family business and currently understating FNM’s economic earnings and shareholder equity.

Portfolio Business

The portfolio business buys an asset (pool of loans or MBS) and funds the asset with unsecured debt. Simultaneously, FNM enters into derivative contracts to hedge asset/liability mismatch and attempt to minimize duration exposure. Through these actions the company locks in an OAS and fairly simple portfolio economics emerge: leverage ratio multiplied by OAS yields plus the yield on equity funded positions equal the economic return of the portfolio and ROE of the business. Despite relatively simple economics, GAAP requires multiple accounting treatments for the various portions of the portfolio: assets, liabilities and derivatives. The incongruence of accounting treatment serves to obfuscate the economics of the business

Derivatives are classified as either fair value or cash flow. Derivatives classified as fair value hedges flow though the income statement along with offsetting changes in the instrument being hedged. Cash flow hedges are deferred and then recognized into income matching the asset/liability the instrument is intended to hedge. Cash Flow hedges affect Equity in the period in which the value of the hedge changes, but the asset/liability being hedged may or may not be marked to market during the same period (only AFS securities are marked to market, held to maturity securities are not marked to market). For derivatives accounted for as cash flow hedges, gains/losses are reported in AOCI component of shareholders equity. Over time the gain/loss will either reverse its self or be recognized into earnings in the periods in which the hedged items affect income. Most of the assets/liabilities intended to be hedged are not marked to market under GAAP while the derivative hedge instruments are – thus distorting economic reality and shareholders equity.

Due to FNM/FRE’s historic accounting and business process short comings, the companies were deemed to have not adequately documented the effectiveness of hedges; consequently the companies lost that designation for their cash flow hedges, (ie they were no longer hedges they were just derivative contracts) so all changes in derivative values must flow through the income statement. Timing on market to market and income statement recognition of AFS, MTM, liability and derivatives make the accounting for the portfolio business deviate from economic reality.

GAAP accounting conventions effecting single family and portfolio operations also impact the HCD business.

Accounting Restatement

In 2003, OFHEO began a special examination of FNM and ultimately concluded that the company’s reported results were not consistent with GAAP. In February 2006, the Rudman report was issued outlining the boards investigation into accounting problems. At a high level, the Rudman report found that the company (primarily thought the CFO – Tim Howard and Controller – Leanne Spencer) knowingly miss applied GAAP in an attempt to create smooth earnings and avoid upgrading systems necessary for implementation of FAS 133& 91. Due to the findings of the Rudman and OFHEO investigations, the company changed senior management, accounting practices and restated earnings for the period 2001-2004. The result of the restatement was a $6.2bn decrease in earnings and $10.4bn increase in equity (through AOCI).

The restatement process and new procedures have cost the company as much as $2bn a year in accounting, legal and consulting fees. The company plans to eliminate these costs during 2008. I have assumed these costs are eliminated when estimating earnings power.

As part of the investigation, OFHEO required the company to hold 30% excess capital as a surcharge above regulatory capital requirements, fined the company ($400mm) and caped the portfolio at $727bn. As of the 3^rd Q 2007, FNM has caught up on financial filings and the company anticipates becoming a timely filer with the filing of its 2007 10-K.  Timely filing is a requirement for OFHEO to lift the portfolio cap. Final resolution of the accounting issue though a reduction in the capital surcharge and/or a lifting the portfolio cap would be a material positive for FNM.

Importantly the company never lost its special credit treatment in the market, despite not having timely financial statements. Seeing the company’s competitive advantage survive though such stress is evidence of durability.

Government Relationship

OFHEO – Congress - President Appoint Board – Capital requirements and tests.

The Government does not directly guarantee or support FNM obligations or actions, but FNM’s actions directly serve the nations interest in stable home ownership. Through regulatory oversight, the government has ultimate control over the company’s operations, providing a reasonable belief that the government will come to the company’s aid in one fashion or another. In addition OFHEO runs a robust stress test on the company, stressing both interest rate and economic shocks.

 Historically government policies have created a market that has ensured FNM’s viability and strong economic return. GSE’s benefit by their securities being designated “government securities”, they are exempt form state and local tax (though not property tax), assigned low risk based capital and thrift diversification to their securities and the treasury stands committed to purchase $2.25bn of the companies securities.

            Apart from symbolic and historic involvement, the government (and the people of the US) have a strategic need to support the GSE’s and their special status. The FDIC requires banks a very low capital charge against GSE obligations. A material change in the credit quality of the GSE’s or the capital charge required to hold GSE obligations would cripple the US banking system and likely result in large losses realized by the FDIC (which is explicitly guaranteed by the Federal government). So, it is in the government’s (and citizens) interest to see the GSE’s thrive and retain the highest credit standing possible.

During this downturn, the GSE’s importance has been proven as it is the only functioning portion of the mortgage market. Given the recent credit crisis GSEs are enjoying renewed popularity with both Democrats and Republicans.

FNM History

Fannie Mae was created in 1938, to expand the flow of mortgage funds in all communities, at all times, under all economic conditions, and to help lower the costs to buy a home. In 1968, Fannie Mae was re-chartered by Congress as a shareholder-owned company, funded solely with private capital raised from public markets.

“The impetus for creation of Fannie Mae was twofold: the national commitment to housing and the inability or unwillingness of private lenders to ensure a reliable supply of mortgage credit throughout the country. The primary purpose of Fannie Mae was to purchase, hold, or sell FHA-insured mortgage loans that had been originated by private lenders. After World War II, Fannie Mae's authority was expanded to include VA-guaranteed home mortgages. The Charter Act of 1954 provided the basic framework under which Fannie Mae operates today but did not remove it from direct federal control. It stipulated that Fannie Mae be exempt from all local taxes except property taxes, and provided for the Federal Reserve Banks to perform various services for Fannie Mae. The 1968 Charter Act split Fannie Mae into two parts: Ginnie Mae and a reconstituted Fannie Mae. Ginnie Mae would continue as a federal agency and be responsible for the then-existing special assistance programs, and Fannie Mae would be transformed into a "government-sponsored private corporation" responsible for the self-supporting secondary market operations. The reconstituted Fannie Mae was to be stockholder-owned and managed. Fannie Mae retired the last of its government stock on September 30, 1968, and transformation to a government-sponsored private corporation was completed in 1970. The 1968 Act provided the authority to issue Mortgage-Backed Securities (MBS). The Act also established a regulatory structure to ensure Fannie Mae's adherence to its public purpose. It provided for continuing HUD oversight of Fannie Mae, granting "general regulatory power ... to insure that the purposes of this Title are accomplished." The Emergency Home Finance Act of 1970 created Freddie Mac and authorized it to create a secondary market for conventional mortgages. Parallel authority and limitations to deal in conventional mortgages were given to Fannie Mae. To alleviate credit concerns raised by acquisition of conventional mortgages (that lack federal backing), several eligibility restrictions and/or risk sharing requirements were imposed on the mortgages Fannie Mae could buy. The new law also required the HUD Secretary to provide prior approval of Fannie Mae's "purchase" or "dealing in" conventional mortgages (later interpreted by HUD regulations in 1995 to require specific approval of new and different conventional "programs"). The Federal Housing Enterprises Financial Safety and Soundness Act ("FHEFSSA") of 1992 modernized the regulatory oversight of Fannie Mae and Freddie Mac. It created the Office of Federal Housing Enterprise Oversight ("OFHEO") as a new regulatory office within HUD with the responsibility to "ensure that Fannie Mae and Freddie Mac are adequately capitalized and operating safely." OFHEO is funded by assessments on Fannie Mae and Freddie Mac and is authorized to act without HUD oversight on a range of regulatory issues enumerated in the statute. FHEFSSA established risk-based and minimum capital standards for Fannie Mae and Freddie Mac. And, it established HUD-imposed housing goals for financing of affordable housing and housing in central cities and other rural and underserved areas.”

Recent Events

Due to GAAP losses in the 3^rd Q and likely continued GAAP losses, FNM issued $7bn of preferred equity in December. The preferred is expensive, 7.75% and 4.23 over Libor. This capital is expected to cover any needs driven by credit deterioration and allow the company to grow during the downturn. In addition the preferred is redeemable in 2010. If the company’s results improve, they will be able to retire the preferred in a few years.  

Catalyst