RD's Picks

Buy Fannie Mae??? My initial reaction to Ken's question of the week was very similar to toroandbruin's. But, a quick look at the numbers is in order to see if there might be a good deal here.

From Yahoo's profile page, "Fannie Mae provides funds to mortgage lenders through the purchase of mortgage assets, and issues and guarantees mortgage-related securities that facilitate the flow of funds into the mortgage market in the United States." Not the best of businesses to be in lately. Some fundamentals - fwd PE of 10.22, return on assets 0.48%, return on equity 10.02% and a dividend yield of 4.2%.

FNM issued a news release on 9 Nov summarizing results for the first three quarters of 2007. Year over year comparisons are pretty ugly, $1.5 billion in net income for the nine months compared to $3.5 billion a year.

FNM has over $76 billion of securities backed by subprime and Alt-A on the books. As we're all well aware, these securities have not been good to financial firms lately and present a big risk of markdowns going forward.

Since the market is well aware of the risks associated with anything related to the mortgage business, the valuation question a buyer needs to address whether the market has overly discounted the risks and 'thrown out the baby with the bath water.'

Some will point to the implied government guarantee as a risk reducer. That may prevent FNM ever going belly up and may protect bondholders, but it certainly doesn't protect shareholders from loss. I believe there's an additional risk that goes with Fannie's government sponsorship. There could well be significant political pressure to help bail the industry out by buying less than stellar paper.

For valuation, lets compare FNM to a bank I have in both SLO and real life - Wells Fargo (WFC). WFC trades at a forward PE of 11.39, return on assets is 1.7% and return on equity is 19.4% with a yield of 3.8%. The market values it at a slight premium to FNM, but I would argue that premium is well deserved due to the better returns and, more importantly, a much more diversified business model. For another data point, JP Morgan trades at a forward PE of 9.4 with return on assets of 1.2% and return on equity of 14% with a yield of 3.6%. For a financial more levered to the mortgage business, Washington Mutual (WM) trades at a forward PE of 9.1, return on assets is 0.73%, return on equity is 9.8% and has a dividend yield of 10.8% (which is either a fantastic bargain or will be cut soon).

If you want a concentrated bet that the mortgage business has bottomed, WaMu looks like a better buy than Fannie. Since today's market isn't charging a premium to invest in a big diversified bank like WFC or JPM, they look like better investments than Fannie.

Given the problems in valuing mortgage securities, I just don't see any reason to buy FNM when it isn't trading at a substantial discount to financials with better returns and more diversified revenue bases.

In this case, I stick by my initial reaction.

FWIW, my track record with financials isn't so great. I boldly proclaimed Mastercard fully valued 40 bucks ago. Hope nobody listened to me on that one.

Comments: View Comments |  Wednesday November 14, 2007