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Are Fannie-Freddie Headed Towards Another Bailout? - Analyst Blog

Zacks Equity Research

Federal National Mortgage Association FNMA and Federal Home Loan Mortgage Corporation FMCC have been undertaking various initiatives to boost earnings by offering the homeowners of foreclosed properties a chance to buy their homes back at lower prices as well as tempting the first-time as well as low-income home buyers with the offer of reduced down payments.

However, the efforts do not seem sufficient considering the new report released by the Federal Housing Finance Agency’s (FHFA) Office of Inspector General. The report states that both the housing mortgage giants could lapse to a similar undermined phase in spite of the appreciable improvement in their financial performances since the financial crisis of 2008.

Impending Issues

Per the report, Fannie Mae and Freddie Mac need to cutback the size of their retained investment portfolios over the next few years as required by the U.S. Department of Treasury and the FHFA. This will result in a fall in portfolio earnings impacting profitability in the upcoming period.

Also, core earnings of both the entities signal the need to exercise caution. In 2013, only 40% of net income came from core earnings with the figure rising to 55% in 2014. The remaining net income comprised of unsustainable sources like non-recurring tax-related items, hefty legal settlements and business disputes. This demonstrates the still struggling fundamentals of the firms, which remain vulnerable to the changing economic conditions.

Further, the firms have to pay the Treasury every quarter a dividend equal to the excess of their net worth over an applicable capital reserve amount. The applicable capital reserve amount would decline to zero by Jan 1, 2018. The lack of adequate reserve poses a big challenge for Fannie Mae and Freddie Mac.

Moreover, the stress test conducted last year revealed that both Fannie Mae and Freddie Mac were at risk of another bailout of either $84.4 billion or $190 billion (depending on the treatment of deferred tax assets) in case the previous unfortunate events recur.

Our Take

Fannie Mae expects to record profits consistently in the long run. However, the company also concedes that fall in home prices and changes in interest rates along with the provisions of the Treasury agreement may instead cause losses.

Though Fannie Mae and Freddie Mac have come a long way since the financial crisis, their financials are expected to remain under pressure due to the complex, cyclical and sensitive (to mortgage rates as well as house prices) nature of the mortgage industry.

While Fannie Mae currently carries a Zacks Rank #3 (Hold), Freddie Mac holds a Zacks Rank #2 (Buy). Other stocks in the mortgage investment industry include Essent Group Ltd. ESNT and The J.G. Wentworth Company JGW. Essent Group sports a Zacks Rank #1 (Strong Buy), while J.G. Wentworth holds the same rank as Freddie Mac.

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