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Equity Research

Equity Research

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Published by BronteCapital

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Published by: BronteCapital on Oct 28, 2009
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11/22/2010

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Please refer to important disclosures and analyst certification information on pages 12 - 15.
Company Update
Rating ChangePrice Target ChangeBose George
212-887-3843bgeorge@kbw.com
Frederick Cannon
212-887-3887fcannon@kbw.com
Jade J. Rahmani
212-887-3882 jrahmani@kbw.com
Mortgage Finance
October 19, 2009
 An Augean Task: A Government Exit Strategy to Recap FNM & FRE 
Summary--
Fannie Mae and Freddie Mac have been at the heart of the U.S. housing boom,bust and recovery. As the mortgage market moves away from crisis mode, thefuture of the government-sponsored enterprises (GSEs) has to be addressed. Inorder for the GSEs to survive going forward, we believe they need to berecapitalized through investments from the banks that benefit from their role inthe secondary market. Additionally, we believe the ownership structure shouldbe shifted over time to a cooperative of banks similar to the Federal Home LoanBank (FHLB) system.
 Key Points--
s
There have been many recommendations made about potential structures forthe GSEs. The most noteworthy is the Government Accountability Office(GAO) report which presents options for the companies ranging frombecoming full government entities to returning to being stock-holdercorporations. What all the recommendations to date have not done—includingthe ones in the GAO reports—in our view is address the most crucial issueregarding the agencies: how to recapitalize them.
s
In our view, in order for Fannie Mae and Freddie Mac to survive goingforward, they need to be recapitalized through investments by the banks thatbenefit from their guarantee. Under such an approach, any bank that originatesan agency conforming loan and wishes to sell the loan to the GSEs would berequired to retain 5% of the loan balance as an equity investment in the GSEs.Thus, the new agencies would be recapitalized at a solid 5% level of the newexpanded balance sheets under FAS 166/167.
s
In this scenario, both the common and preferred equity of the GSEs should beworthless. Our bad bank analysis suggests that the companies will still owe thegovernment almost $100 billion by the end of year ten. As a result, we aredowngrading FNM and FRE common shares to Underperform and are cuttingour price targets to $0.
MarketRatingTargetCurrentQtr.2009EEPS2010EEPSSymbolPriceToFromToFromToFromToFromToFrom
FNM$1.46UnderperformMarketPerform$0.00$1.00($4.09)($4.09)($11.21)($11.21)($6.90)($6.90)FRE$1.72UnderperformMarketPerform$0.00$1.00($3.14)($3.14)($5.99)($5.99)($2.85)($2.85)
Equity Research
 
Please refer to important disclosures and analyst certification information on pages 12 - 15.Page 2
The Future of the GSEs: A Government Exit Strategy to Recapitalize Fannie Mae and Freddie Mac
Fannie Mae and Freddie Mac have been at the heart of the U.S. housing boom, bust and recovery. Since being put intoreceivership last summer, the U.S. government has put $98 billion of capital into the two organizations and their guaranteehas become more explicit. The combination of increased support for the GSEs and the slowdown in originations in theprivate sector has resulted in the GSE volume growing sharply. Fannie Mae and Freddie Mac accounted for 68% of alloriginations in 2009. (The government's Federal Housing Administration program accounted for a large percentage of theremainder.) Exhibit 1 shows the historical market share of the GSEs.
Exhibit 1: GSE Market Share Growth
0%20%40%60%80%100%90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09
 Note: 2009 data is for 1H09.Source: Inside Mortgage Finance.
As James B. Lockhart III—the Director (CEO) and Chairman of the Oversight Board of the Federal Housing FinanceAgency that was the regulator of Fannie and Freddie at the time of conservatorship—stated when the U.S. governmentseized them, "Fannie Mae and Freddie Mac are no longer in the business of maximizing shareholder value." Rather, in ourview, the two agencies are now in the business of stabilizing the U.S. housing market.Thus, Fannie Mae and Freddie Mac today are acting as a direct arm of the federal government providing massive federalaid to support and revive the U.S. housing market in the midst of a crisis. At the same time, their operating structure is asprivate companies operating under the conservatorship of the U.S. government. This is not a sustainable structure as isdocumented in a recent report from the Government Accountability Office ("Fannie Mae and Freddie Mac: Analysis of Options for Revising the Housing Enterprises' Long-term Structures" dated September 10, 2009).
The Problem of Capital
The GAO report presents options for Fannie and Freddie ranging from becoming full government entities to returning tobeing stock-holder corporations. What the GAO report is missing, in our view, is addressing the most crucial issueregarding the agencies: how to recapitalize them.There are three financial issues of note that we believe help define the restructuring needs of the two agencies:
s
Operating under conservatorship, Fannie and Freddie create an unlimited government liability, as evident by the GAOestimated need of $389 billion government support;
s
Accounting changes will balloon the balance sheets of the two companies to approximately $5.5 trillion in 2010 fromunder $2 trillion today as a result of FAS 166/167, illustrating the capital needs of the companies; and
October 19, 2009An Augean Task: A Government Exit Strategy to Recap FNM & FRE
 
Please refer to important disclosures and analyst certification information on pages 12 - 15.Page 3
s
Large banks are generating large amounts of mortgage banking income as a result of the government operations in themortgage business. Wells Fargo, now the nation's largest mortgage lenders, had mortgage banking income in excess of $3.5 billion in the first half of 2009.In our view, the only viable option to limit taxpayer expense and recapitalize Fannie Mae and Freddie Mac is to set up aBad Fannie and Bad Freddie with the existing portfolios, and a new Fannie Mae and Freddie Mac as cooperatives of bank mortgage lenders, along the lines of the other GSEs—the Federal Home Loan Banks.
 New Agencies as Cooperatives of Mortgage Banks
There is general consensus that the primary role of the agencies in the future is in the loan guarantee business and not inthe investment business. By creating "bad banks" of the existing portfolios and putting the existing portfolios intoreceivership, the government can limit its losses and define its role in supporting the mortgage industry through the crisisand create an exit strategy.In order for Fannie Mae and Freddie Mac to survive going forward, we believe they need to be recapitalized throughinvestments from the banks that benefit from their role in the secondary market. Additionally, we believe ownershipstructure should be shifted over time to a cooperative of banks similar to the Federal Home Loan Bank system. Under suchan approach, the banks that originate an agency conforming loan would be required to retain 5% of the loan balance as anequity investment in either Fannie Mae or Freddie Mac. Thus the new agencies would be recapitalized at a solid 5% levelof the new expanded balance sheets under FAS 166/167. The capital would provide a significant buffer to bondholders inthe new agencies from future losses. Further we expect that this level of capital would allow the government to sunset anexplicit guarantee of the new agencies' debt over time. We would expect the government to initially guarantee the debt of the new agencies for a period, possibly up to five years, in order to establish the credibility of the new agencies.We recognize that the returns on the stock investment in the new agencies would be modest given the high level of capitalization. In Exhibit 2, we present the "normalized" balance sheet and earnings of the new agencies, assumingguarantee fees are kept modest, investment portfolios are strictly limited to liquidity needs, and credit quality is maintainedat historically high levels. As shown, the return on the stock investment we estimate is under 5%. We believe that thiswould be acceptable to the bank owners if structured correctly for three reasons:
s
By participating as owners the mortgage banks generate significant fees;
s
Risk weightings of 100% on the stock would allow leverage to the banks (currently FHLB stock is risk weighted at just20%); and
s
The new agencies would have very limited investment portfolios. Historically, the retained portfolio growth at the GSEswas something that banks resented.
October 19, 2009An Augean Task: A Government Exit Strategy to Recap FNM & FRE

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