Fannie Mae

Moat: 1/5

Understandability: 4/5

Balance Sheet Health: 2/5

Fannie Mae is a government-sponsored enterprise (GSE) that operates in the secondary mortgage market, providing liquidity to mortgage lenders by purchasing mortgages from them, securitizing the mortgages, and selling those securities to investors.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Moat Analysis: 1/5 Fannie Mae’s moat is effectively non-existent, scoring a 1/5. While Fannie Mae plays a crucial role in the US housing finance system, it lacks the durable competitive advantages that define a strong economic moat.

Absence of Intangible Assets: Fannie Mae’s brand, while well-known, doesn’t command a pricing premium, nor does it create customer captivity. Consumers and mortgage lenders don’t choose Fannie Mae’s products based on brand strength. Its function is largely administrative, and thus, it doesn’t create a meaningful advantage that cannot easily be replicated.

Lack of Switching Costs: Switching costs for lenders are low, and they can easily use other GSEs or private securitization options without large hassle. This provides no competitive protection for Fannie Mae.

No Network Effects: Fannie Mae’s operation doesn’t benefit significantly from network effects. The more lenders that use it doesn’t directly increase value for other lenders or investors (they just become a big client to them rather than having network effects). This distinguishes it from businesses that derive a moat from network effects.

Limited Cost Advantages: While Fannie Mae is large, it doesn’t have a clear and strong cost advantage. Its cost structure is largely replicated by other mortgage players, which erodes any potential economic moat related to cost. It operates in a highly competitive field where the price for each loan will be more or less set by other players and other GSEs.

Risks to the Moat and Business Resilience Fannie Mae faces several risks that undermine its potential to build and maintain a moat and threaten the business, all because the business is tied to policy decisions made by governments, which are unpredictable.

Regulatory Risk: The greatest risk is its dependence on government regulation and support. Changes in regulation, like capital requirements, or even calls for restructuring or privatization, could disrupt Fannie Mae’s business model and profitability. Also, regulators might decide to force the company to change its strategy, to limit the profit margin, or to completely shut it down or break it apart. The US Treasury can also potentially interfere and take away its profits.
Political Risk: Political sentiment and government priorities toward the housing market and GSEs can change frequently. For example, a desire to increase competition in the mortgage industry could result in policies designed to diminish Fannie Mae’s market share. This risk is particularly important given the current political tensions in the country and how Fannie Mae’s performance might be judged.
Economic Sensitivity: Fannie Mae’s performance is heavily tied to the health of the U.S. housing market and the overall economy, creating a cyclicality in its business and making results difficult to predict and plan for. Downturns in home prices and the economy can lead to increased loan losses and lower returns.
Competition: As a secondary market actor, Fannie Mae faces competition from the Federal Housing Administration (FHA), private mortgage insurers, investment banks, and other GSEs (such as Freddie Mac) who can act as substitutes.
Interest-Rate Risk: Fluctuations in interest rates can affect Fannie Mae’s profitability and value of holdings. Fannie Mae relies on a somewhat constant interest rate to turn a profit and changes might put them at risk. Even though it utilizes multiple tools to lessen this impact, its overall operation is highly dependent on interest rates.
Credit Risk: Defaults on mortgage loans, especially those without credit enhancement, can erode value, therefore credit losses can also have a large impact on profits.

Despite the risks, Fannie Mae does have a few things going for it to increase resilience.

Government Backing: As a GSE, Fannie Mae has implicit backing from the U.S. government, leading to investor confidence that will prevent the company from failing suddenly, increasing its attractiveness for lenders to interact with it.
Large Scale: Fannie Mae’s huge operations can create scale efficiencies and can potentially provide a degree of cost control. This means that is can undercut competitors with lower rates because of its size.

Business Description

Fannie Mae operates in the U.S. secondary mortgage market. This means that the core functions of the company are:

Purchasing Mortgages: Fannie Mae buys mortgages from lenders (primarily from large banks) across the U.S. These loans can be either single-family or multifamily residences. This process provides lenders with liquidity, so they can continue to originate more mortgages.
Securitization: After purchasing mortgages, Fannie Mae bundles them into mortgage-backed securities (MBS), allowing investors to obtain a stake in the payments for these loans. This is essentially a way for Fannie Mae to have low risk to its operations.
Issuing Debt: Fannie Mae funds its operations by issuing various debt instruments. This allows it to continue buying mortgages and securitizing them.
Guarantor of Loans: It issues loans that are guaranteed by the U.S. government. Therefore, this puts the government at some level of risk from its financial instruments.

Revenue Distribution: Fannie Mae generates revenue from two main sources:

Guarantee Fees (G-fees): These are fees charged to lenders for backing mortgage loans against future defaults.
Interest Income: Earnings on mortgage and investment portfolios, as well as the returns on its own debt. Fannie Mae holds a lot of mortgage-backed securities on its books, thus, the performance of the mortgage market directly affects its balance sheet.

Trends in the Industry:

Interest Rate Volatility: Fluctuations in interest rates have been a major factor. Rising rates mean that Fannie Mae faces large losses on its securities portfolio. Conversely, lower rates will increase income for the business.
Housing Market Slowdown: Rising home prices and a slow down in the housing market has been reducing mortgage origination activity which impacts the volume of Fannie Mae’s business. This also causes stress in borrowers, which leads to defaults.
Regulatory changes: Constant discussions surrounding capital adequacy, conservatorship reform, and risk management requirements are constantly ongoing and may radically change the structure of Fannie Mae or even its continued existence.

Margins Fannie Mae operates with tight margins. Since it has little control over its pricing, it has limited means to grow its margins. Margins can be impacted greatly by changing economic and financial conditions as well as governmental regulations.

Competitive Landscape:

Other GSEs: Fannie Mae’s primary competitor is Freddie Mac. Both GSEs perform similar functions in the secondary mortgage market and are subject to similar regulatory constraints. There’s a constant push for both of them to capture larger portions of the mortgage market.
Private Mortgage Insurers (PMIs): These companies provide insurance for mortgages not guaranteed by GSEs or FHA. It competes with Fannie Mae for the market of privately-issued mortgages.
FHA: The FHA provides insurance for mortgages, particularly those of lower-income homebuyers. It represents a portion of the market Fannie Mae doesn’t necessarily reach.
Investment Banks: These firms originate and securitize mortgages. In this role, they often compete with Fannie Mae.

What Makes the Company Different: Fannie Mae’s unique role as a GSE distinguishes it. While other players in the mortgage industry are primarily for profit, Fannie Mae also has a public mission to ensure credit availability and affordability. Its implicit government backing gives it an operational advantage over its competitors, even though this could be removed at any time. This allows it to compete in a market that would otherwise have high barriers to entry. However, its reliance on governmental support is a double-edged sword, as it can be changed with little warning. Also, there are often government-imposed social targets that it has to meet, making some operations unprofitable. This makes its value hard to quantify.

Financial Analysis

Fannie Mae has several important characteristics that you must look at:

Revenues: Fannie Mae has volatile and unpredictable revenues. In general, its revenues are greatly dependent on the mortgage market and the housing market. Any change to the demand for housing, or increase in rates will directly impact the revenues of the business. Note that the revenue can easily be distorted because of complicated accounting techniques and a lot of other items.
Profit Margins: Because it doesn’t have control of its pricing, Fannie Mae has limited control of its margins and profits. This often leads to wide changes, as there are very big fluctuations in revenues.
Balance Sheet: In times of high rates, its assets will quickly decrease in value, eroding its balance sheet. Its assets are primarily a reflection of the mortgage market, so any shock in the housing market will likely reduce its assets. Its reliance on debt means it has little flexibility to change directions quickly.
Debt Load: Fannie Mae is financed primarily by debt, so it always has a large amount of debt in its balance sheet. This high leverage can lead to volatility in earnings and a higher chance of bankruptcy during bad periods of the cycle.
Dependence on the US Government: Fannie Mae relies heavily on the US Treasury and any change to governmental support or regulation could potentially decimate it.
Accounting: Due to a lot of mark-to-market accounting and very large volumes, its balance sheet is often hard to understand as there are various assets, liabilities, and complicated transactions on its books.

From the latest 10Q:

Net income decreased $6.9 Billion in the nine months of 2023 compared with the same period in 2022. Driven mainly by the decrease in credit related income and the change in net gains on single-family loans, which were partially offset by a decrease in other expenses.
Net worth increased to $7.7 billion at the end of September 30, 2023, from $6.8 Billion on December 31, 2022. This is due to a positive mark-to-market accounting adjustments.
The total guarantee book of business, both single and multifamily was at 3.476 trillion at the end of September 30th, 2023, which decreased by 1.5% compared to December 31, 2022.

Understandability Rating: 4/5 While the underlying concepts and processes of a GSE aren’t that hard to understand, the accounting, regulations, and risk factors involved in Fannie Mae’s operations are highly complex making it hard for a layman to understand the nuances of the business.

The secondary mortgage market can be confusing and hard for some people to wrap their heads around, therefore, the core business model isn’t immediately clear to the uninitiated.
The company’s financial statements, due to the massive size and large number of assets, are highly complex. Some important elements, such as the “economic” value of assets are often difficult to determine, and it is not always clear if earnings are real or mostly from one time accounting tricks.
Regulations and governmental backing are a heavy part of understanding how Fannie Mae works and can change the situation drastically. Investors need to understand the implications of different governmental policies and how they would affect the business.
The implications of interest rate movements are hard to understand for most people, especially with their impact on Fannie Mae.
While generally an easy concept, the underlying risk, business strategy, and long-term outlook can be very hard to understand because of many moving parts that affect this business.

Balance Sheet Health Rating: 2 / 5 Fannie Mae has a weak and volatile balance sheet that gets affected by housing market conditions and the decisions of the US Treasury and the government, earning it only a 2/5. The business has a relatively big debt burden compared to its earnings, and it lacks the strong tangible value to compensate for losses in its assets.

High Leverage: Fannie Mae uses debt to purchase mortgages, and it has a very high leverage ratio. The problem with this is that its equity is relatively small and its liabilities are large. Therefore, its ability to manage risk is reduced.
Interest Rate Exposure: Fannie Mae’s assets, such as mortgages and mortgage-backed securities are extremely sensitive to interest rate changes. During periods of rising rates, their book value might drop drastically.
Accounting Complexity: As discussed, the company’s financial statements include complex accounting measures, such as the use of fair value and extensive debt write-offs, which makes their health status difficult to ascertain.
Low-Quality Assets: A large portion of its assets are mortgages and mortgage-backed securities, which carry large credit risk. A housing downturn can hurt these greatly.
Dependence on the Government: Although it provides an advantage by supporting the business, the government’s actions in setting regulations might affect financial flexibility and the sustainability of its operations and financials in a bad way.

The recent credit crisis, alongside the government’s conservatorship, showed some of the shortcomings of the business and how vulnerable it can be, given adverse economic conditions and governmental changes. It also showed the limits in its ability to influence its financials.

In conclusion, Fannie Mae is a very complex government-sponsored enterprise with very little or even no moat, a vulnerable balance sheet that can be greatly affected by the economic environment, and a business that is highly controlled by regulations and politics. Although it does provide value in the housing market, investors should not assume it’s a great investment for the long-term.