Is a Sagging Fannie Attractive?

Even with the recent upticks, shares of the ailing mortgage giants Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE) are both down over 80% from their 52-week highs.

Fannie and Freddie are government-sponsored enterprises (GSEs) that play a central role in buying loans from lenders and providing liquidity for the mortgage industry. The GSEs can also be credited with bringing a significant amount of standardization to the mortgage origination process, which facilitates even more liquidity and enables an active securitization market.

How big is big?
How wide have Fannie and Freddie been spread? According to the OFHEO 2008 Annual Report to Congress, the two companies combined have over $1.5 trillion of mortgage assets on their books. There is another $3.5 trillion of mortgage-backed securities that the two have sold, with varying guarantees for payment. Any time a discussion of a business (or industry, for that matter) rounds to the trillions, you can be sure they carry a lot of heft, in every sense of the word.

Look at the list of the top 10 mortgage lenders from Q1, according to National Mortgage News. All of these companies are major customers of the GSEs and would be significantly and immediately affected if the GSEs are forced to trim their appetites or become more selective on what they buy:

*Bank of America has purchased Countrywide.

It is hard to overestimate the importance these two organizations play in our economy. Throw in the once implied but now explicit backing of the federal government, and it is not surprising that some will look at the twosome's flabby condition and think that with a little more discipline, greater patience, and a few butt crunches, these two could regain their youthful form.

Too big to fail?
As a potential investor, why worry about the risk now? The government has made it clear that the GSEs are too big to fail. On one level, I totally agree. After spending ten years working for large mortgage companies, it is easy for me to appreciate how integrated and central the GSEs are to the industry. But while the role of the GSEs will survive, there's no guarantee that their common stockholders will fare as well. There is a huge difference between propping up a company and propping up a company's stock. Just ask the shareholders of Bear Stearns or Kmart or countless other companies that were rescued by white knights, to the detriment of common stockholders.

The Fed's GSE bailout plan is not about protecting investors. It is about protecting taxpayers, stabilizing financial markets, and preserving liquidity. More pointedly, the Fed's plan includes a provision allowing the government to invest in the GSEs. While the specifics of that potential investment are not detailed, you can bet your bottom dollar that the investment, if it happens, will be dilutive at best and will put more downward pressure on their stock prices.

Investing versus gambling
Speaking of betting, buying stock in Fannie or Freddie today is more akin to spinning the roulette wheel than investing. For those who want to "invest," read Fannie's latest annual report, and keep in mind that the business environment has deteriorated since then:

• Read the part where it says Countrywide was its largest customer.
• Scan through the risk factors and see if you get the feeling that many of the risks don't seem so far-fetched and hypothetical.
• Form an opinion on the politics of GSEs and decide whether the current situation makes it more or less likely that they will be nationalized.
• Oh, and please help me quantify the risks imbedded in guaranteeing trillions of dollars of off-balance sheet mortgage-backed securities.

To be clear, taking a chance on a miracle lift for the sagging Fannie is fine, but please do not bet the house.

For related Foolishness:

• Freddie and Fannie in Free Fall
• The Financial System Is Cracking
• Please Learn From My Stupidity