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The Nine Lives of FNM


Flawed logic...


Morgan Stanley's mortgage analyst raises Fannie Mae (FNM) to over-weight from equal weight. He now joins 13 of 15 sell side analysts who have already been recommending the stock from much higher levels.

There was little financial analysis to back up the decision. This is natural because absolutely no one really knows the financial condition of the company since most of their old management is gone and there have been no financial statements issued since I can remember. The basis of the analyst's decision comes down to the following nebulous claim:

"In a bear housing scenario (their case is a 25% decline in housing sales and flat prices over the next two years), incremental credit risk would be offset by enhanced revenue growth resulting from capital market dislocation."

The analyst is saying that as the housing market declines and volatility picks up (in bonds), this is good for the GSEs because other originators will back away from making new loans.

This is very flawed logic. It may be true that FNM will lose less than other originators in such a scenario as GSE costs may not rise as much and they will capture market share (that is if Congress lets them, which is doubtful in itself), but it is not good.

Capturing market share in a declining market is only relatively good. It most likely will actually result in lower revenues for FNM, or at best stable ones, so it is not absolutely good.

As bond volatility picks up (using the analyst's scenario), this will be a much larger cost to FNM than he alludes to because the GSEs are inherently short bond volatility (described many times before in how they hedge their pre-payment risks). FNM already makes razor thin margins; an increase in bond volatility eats into those.

A declining housing market is not good for any of these stocks. FNM itself said that if housing prices decline 5% it would cost them $1.1 billion.

In the analyst's scenario, it is much more likely to see the stock prices of originators down 20% while FNM might only be down 15% (although I really think all these stocks would go down more). Perhaps this is what he means by saying "over-weight": Relative to the group essentially means the analyst would be long FNM and short other originators like Washington Mutual (WM) equal dollars. I might go for that as I operate a hedge fund and can do that. But all a mutual fund can do is to sell WM and buy FNM.

Why not just get out of the group.

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Position in FNM and WM

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