With all the new legislation being proposed, much of the discussion around Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) has centered on what the future of the US mortgage market should look like and to what extent the US government should be involved. But Rafferty Capital Markets LLC vice president of equity research Richard X. Bove is also concerned about Fannie Mae as an investment.

Fannie Mae Freddie Mac FHFA Federal National Mortgage Assctn Fnni Me (FNMA)

Insurance activity may grow as Fannie Mae’s core portfolio shrinks

Bove drops his earnings estimate for Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) from $1.53 per share to $1.52 per share for 2014, from $1.51 to $1.42 per share in 2015, and from $1.64 to $1.32 per share in 2016. “The sharp reduction in the 2016 forecast is due to the expected reduction in fees from mortgage put-backs,” explains Bove in a March 28 report.

Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) core portfolio is composed 68.6% of mortgages, 11.9% mortgage-backed securities, 7.5% Treasuries and other securities, 11.2% Fed funds and repo, and 0.8% advances to lenders. In line with Treasury and Federal Housing Finance Agency agreements, Bove assumes that the mortgages and MBS will be liquidated at 15% per year, but he also expects some of that money to be re-invested in Treasuries and the Fed Funds/repo portfolio. As this core portfolio shrinks, Fannie Mae will also be able to increase the size of its insurance operations, improving net interest margins every quarter for the next few years.

Aside from net interest income, Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) main source of income is from fees, and this is where Bove sees a dip in 2016.

“In recent years the enterprise has been putting back mortgages to loan originators and this has resulted in substantial new “fee” income,” writes Bove. “In 2016, it is assumed that fee income will decline meaningfully as put back collections decline. This causes a drop in the company’s earnings per share in that year.”

Fannie Mae EPS estimates are ‘hypothetical’

“This is a hypothetical model. The reality is that the U.S. Treasury will take 100% of Fannie Mae’s earnings under the Third Amendment agreement,” writes Bove, underscoring the political risk inherent in any investments in Fannie Mae or Freddie Mac. “The company will be fortunate if it earns $0.01 per share per quarter. Moreover, the firm will cease to exist by 2017.”

Estimating EPS for a company you expect to disappear in the next couple of years might sound like an exercise in futility, but Bove has been open about the speculative nature of this investment since he first floated the idea last year. While there is no movement to restoring dividends to private shareholder in Congress, there is a real chance that the lawsuits against the government force its hand.

Bove is also less convinced than other analysts that Crapo-Johnson has the momentum to push through both houses and become law. He sees serious differences between the Senate proposal, Representative Maxine Waters’ (D, CA) recent House proposal, both of which would replace the GSEs with new structures, and notes that more House proposals are apparently in the works. All of this, “suggests that Congress is a long way off from passing final legislation on this issue.”