I remain somewhat baffled at the lack of real, visceral anger about what's taking place at Fannie Mae (NYSE: FNM ) , but perhaps I should not be. The numbers are too big ($1 trillion plus in assets), the pain thus far has been limited to a 16% decline for shareholders from before the scandal, and perhaps most important, what the company has done wrong is deeply complicated and esoteric.
Confusion and complexity reign at Fannie Mae, though. In fact, I'm willing to say something that analysts will likely find scandalous: I believe that Fannie Mae is unanalyzable. Fannie Mae, like its sister company, Freddie Mac (NYSE: FRE ) , uses extraordinarily complex financial statements, layers of derivatives, and has enjoyed years of poor regulatory oversight. Even before Fannie received a stunning and long overdue rebuke from its governmental overseers, it took a Herculean effort to be able to determine how much actual cash flow the company made in a given year.
Greed and avarice in Fannie's executive offices have brought scandal down on a setup that should have been by all rights pretty tough to screw up. What staggers me, though, is the fact that of 21 Wall Street analysts who cover Fannie Mae, 11 still recommend it as a "buy" to their clients. That's unbelievable to me. This is a company that in the best of times has financial statements a Turing machine couldn't decipher, is at the very beginning of uncovering a scandal that goes who knows how deep, is facing what could be a multiyear reformation, and has a management team that looks unlikely to survive the probing. It's not so much that I think that most investors have no idea how to analyze Fannie Mae, it's that I don't believe that the analysts have much of a clue, either.
After my article last week, I received a great number of questions on Fannie Mae, most of which belied a basic misconception of what the company is -- and what it does. Herewith is a necessarily simplified explanation. Please keep two things in mind: First, though the company's position may be simplified, the devil is in the details. And second, the numbers that we're talking about for Fannie Mae are nearly incomprehensibly large.
What is that thing?
Fannie's full name is the Federal National Mortgage Association, and it was founded in the 1930s and privatized in the 1960s. It is a federally chartered corporation, owned by shareholders, that serves as a quasi-governmental agency. The company's charter gives it the objective of making sure there is money available for Americans who want to buy a home to get mortgages, but you cannot simply call up Fannie Mae and ask its loan officers about the going rate on a seven-year ARM; it doesn't loan money to retail home buyers. Instead, it provides liquidity for lenders by providing liquidity in the secondary mortgage market.
It works this way. Let's say that you get a mortgage on your new home from Wells Fargo Bank (NYSE: WFC ) . Wells Fargo, like any bank, has limitations on how much money it can lend as a function of its asset base. If your loan sits on Wells Fargo's books, it constricts how much the bank can loan. But if Wells Fargo sells the rights to Fannie Mae, it turns that loan back into cash, which it can then go out and loan again. You keep making your loan payments to Wells Fargo, and it passes these funds on to Fannie Mae. Fannie Mae makes money because it can borrow funds at a lower interest rate than you can. So instead of a single loan tying up Wells Fargo's capital, it can turn around and make multiple loans all from the same original capital base. This, the theory goes, increases banks' willingness to loan in good times and in bad. As a result, nearly 70% of American families own their homes.
Sorta like a chop shop. But legal.
Fannie Mae doesn't just hold onto all of these mortgages, though. It will take your loan and package it up with hundreds of others and market them as mortgage-backed securities (MBS) that it then sells to investors (for example, insurance companies, pension funds, or even mortgage REITS like Annaly Mortgage (NYSE: NLY ) ). Fannie Mae provides a guarantee to these investors that they will receive timely principal and interest payments, no matter what happens with the underlying mortgages. If there are large numbers of defaults, Fannie Mae will have to make the investors whole. If there is a massive crash and defaults overwhelm Fannie Mae, it has an ace in the whole: your tax dollars. Even though the company's debt offerings clearly state otherwise, the financial markets believe that Fannie Mae's status as a government-sponsored enterprise implies that the government will provide full faith and credit for Fannie's debt. It is for this reason that Fannie Mae maintains a AAA credit rating, even though at a 78:1 debt-to-equity ratio it is levered many times what is allowed international banks. (Debt is defined as mortgages on its books plus the value of its guarantees.)
Fannie is exempt from regulation by the Securities and Exchange Commission (though Fannie Mae has in the last few years begun filing 10-Ks and 10-Qs), it is also exempt from state and local taxes. The U.S. president gets to appoint several board members, and the U.S. Treasury Department approves Fannie Mae's debt issuance. And it has approved and approved and approved. Fannie Mae and Freddie Mac have virtually unlimited access to capital, at funding costs that are below the rates otherwise available on the market. As Fannie and Freddie have approached saturation in their core businesses, they've branched out, basically by taking on more risk. Fannie and Freddie have been arguing against the need for statutorily required mortgage insurance for loans above 80% of the value of the home, the bailiwick of private mortgage insurance providers like MGIC (NYSE: MTG ) , Radian Group (NYSE: RDN ) , and PMI Group (NYSE: PMI ) . Why would they do this? Because Fannie and Freddie want to cut out the expense of paying the PMI providers, even though it increases the risk of their overall portfolio.
You may, between the last two paragraphs, already be able to discern how it is that avarice at the top could maul Fannie Mae. It has a AAA credit rating, despite the fact that its debt levels in no way warrant such a rating, and it has a nearly limitless channel to capital, at interest rates that are below market. Add to these elements the fact that Fannie Mae is not a governmental operation, but a for-profit corporation, and you have the recipe for -- well, for what's going on right now. Why worry about risks when you have the implied backing of the federal government? Why worry about capital structure when no matter what your cost of debt is fixed at a below market rate?
Want to know why Fannie Mae is in trouble? It's simple enough: This company, more than any other in America, is run by, in the interests of, and with the protection from politicians, not businesspeople. Yes, I know that it seems crazy, given the shambles of ethics extant in Corporate America, to crave their leadership, but there you go. There is no company that has more powerful lobbying in Washington than Fannie Mae. Really, the only thing more absurd than Corporate America wagging its finger about shareholder interests is a bunch of politicians wagging their fingers about crooked accounting. Fannie Mae's long been a cat in desperate need of having a bell tied to it.
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