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The Sad Conclusion



The following reflects our firm's current view of Fannie Mae (FNM:NASD). It is offered as an assimilation of our thought process and not intended as advice.

Fundamental: The company has always had a poor business model. It is one that is based on leveraging very small spreads. The company is extremely vulnerable to small increases in their expenses. The primary expense (risk) is higher volatility in the bond market where they must constantly re-hedge their duration risk. These risks are now being slowly discounted by the markets. Bond holders are realizing that there should be a higher risk premium associated with their corporate debt. As the costs to the company rise, the business model becomes almost untenable. Their regulator correctly is requiring the company to maintain a higher capital base. This should preclude the company from making money in the future. What is the equity really worth then? In our estimation, not much.

Technical: This company is perhaps the most important company to an over-indebted economy and is probably most responsible for the recovery: home re-financings have been the primary fuel of liquidity. For that reason, it will not be allowed to fail, at least in the short term. Add to that the fact that three large mutual funds own nearly 25% of the company (two of the three have bought 15 million shares or 1.5% of the float more over the last three months), and you get a confluence of events.

The power of these three mutual funds will probably preclude the company from issuing equity to raise capital. They are more likely to raise capital by just slowing the growth of their balance sheet. As the three large mutual funds "support" the stock by buying more (they own too much to sell it anyway), the stock will grind higher given no new supply.

Of course this is the worst thing for the company in the long run and should provide a "slow death" scenario for the stock. But these large mutual funds "hope" to be bailed out over time. Watch to see if they turn net sellers once the stock climbs over $70.

This, as an aside, shows why non-linear models built around "phi" are more relevant than fundamental analysis. Even though there are serious fundamental deteriorations at work, the stock is climbing higher as "real" forces in the markets work the stock price. Scotty Reamer's work reflects the above analysis.

Of course anything could happen. We have adjusted our position to reflect some of the above, but are still reticent to ignore the downside risk. We have been long longer term options, and remain buyers of them, but have sold a fair amount of short term options at very high prices. If the stock grinds higher we will just break-even, having made some money in the past month. If the stock collapses we will not make as much as we would have previously.

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