August 25, 2008
The debate is escalating. Wall
Street wants to know if the government is going to bail
out Fannie Mae and Freddie Mac. The following
article should be considered an opinion. Given the
current financial condition of these companies and
the integral part that they play in our currently
struggling economy, the government's hand is being
forced.
The government must
step in to protect the solvency of these companies.
Most economists and market analysts
would agree with the above statement. Some pundits
would argue that these firms should be allowed to fail,
but the repercussions would devastate our economy and
therefore failure is virtually out of the question.
The main concern for Fannie Mae and
Freddie Mac is spread risk. Fannie Mae, in my
opinion, is the better of these two companies. The
observations below will focus on Fannie Mae.
The recent share price declines have
raised the perceived risk levels for Fannie Mae.
As perceived risk increases the cost of capital
increases along with it. The main concern is the
increasing cost of capital given current market
conditions. Moreover, the risk of default coverage
seems less of a concern because Fannie Mae seems to be
well-capitalized and able to handle more than 100% of
the potential defaults from the subprime mortgages on
its balance sheet.
The concerns then revert back to
profitability and debt coverage. Spread risk is
the difference between the amount Fannie Mae earns from
the mortgages that it provides versus the amount Fannie
Mae has to pay to issue debt in the open market.
The profitability of Fannie Mae is dependent on an
adequate spread.
With declining spreads, profit margins
decline and the risk of default begins to escalate. the
government can alleviate this problem.
In my opinion the government should
step in and secure all of the current and future debt
obligations of Fannie Mae. This should allow
Fannie Mae to secure lower costs of capital going
forward and it should solidify the spread which directly
influences profitability. This move would not only
resonate well with bondholders, but shareholders will
also be pleased.
Fannie Mae earned over $2 billion last
quarter if Market related losses are factored out.
Although the mortgage crisis is far from over, if light
can be seen at the end of the tunnel, if shareholders
realize that profit risk is limited to defaults and
current market conditions which FNM is capitalized to
handle, valuation begins to become much more attractive
at current levels because shareholders can focus on
future profitability.
If perceived risk is limited to
defaults and if Fannie Mae has adequate capital to cover
more than all of the potential defaults on their books,
then investors reasonably could expect profitability
again once this mortgage mess is put behind us.
This, of course, would require the government to back
Fannie Mae's debt obligations as noted above. In
addition, shareholders would carry a different tone.
Fair value, based on current market
conditions, is approximately $14 per share in my opinion
if the government indeed steps in to secure this debt.
Good Trading.
Sincerely,
Thomas H. Kee Jr.
Thomas H. Kee Jr.
President and CEO
Stock Traders Daily
http://www.stocktradersdaily.com
1.866.213.2067
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