The long thesis on Fannie Mae rests on the idea that if shareholders can get rid of the US Treasury’s full income sweep, then the common stock price could increase five-fold, ten-fold or even more depending on who you ask. So when John Carney at the Wall Street Journal did his own valuation of Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac (OTCB:FMCC) assuming that the full income sweep would come to an end but still came up with essentially zero valuation, it ruffled a few feathers.

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“Under what we believe are reasonable assumptions for commitment fee charges, regulatory capital levels, preferred redemption scenarios and under very conservative growth rates, Fannie Mae shares we estimate are worth $7.11 at an absolute minimum and at current prices offer possible gains of more than 250% or more,” writes Fairlight Capital in a November 13 report.

Pricing Fannie Mae as a zero stock

Carney’s valuation highlights the importance of three factors that have nothing to do with the controversial third amendment (full income sweep). First, even if Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) doesn’t have to pay all of its profits to Treasury it’s still on the hook for a 10% dividend and if the sweep were to be reversed it seems reasonable that Fannie Mae would still have to pay dividends for last year’s high, mostly non-recurring, profits. Second, if Fannie Mae is going to start operating as a private company it is going to have to set aside some amount of regulatory capital, which Carney sets at 5%. Finally, after paying the ongoing 10% dividend to Treasury and building up its regulatory capital, the government is still entitled to take a 79.9% stake in Fannie Mae, leaving the current common stockholders with about 20% of profits, which Carney figures leaves a value of about $0.15 per diluted share (currently $2.05). Take the position of junior preferred shareholders into account as well, and Fannie Mae common stock looks pretty bad.

[drizzle]Fairlight’s three objections to Carney’s valuation

Fairlight, which is long on Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA), takes issue with three parts of Carney’s valuation. It believes that Fannie Mae can grow faster than 2% over the next five years, which may be true but is difficult to forecast. Its other two objections, however, seem overly optimistic. Fairlight thinks that investors should assume that Fannie Mae will only have to set aside 2.5% regulatory capital because it’s more like an insurance company than a bank. But right now there are no specific rules governing systemically important insurance companies, and it’s hard to imagine that Fannie Mae, with its multi-trillion dollar portfolio, will get off much easier than SIFI banks.

Finally, Fairlight thinks that Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) might be able to redeem the senior prepared stock back from Treasury, but this really shows why the long case looks so stretched. Treasury has been a political opponent of Fannie Mae’s for a long time, well before the US financial crisis, and has a clearly stated goal of winding down both Fannie Mae and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC). For Fairlight’s thesis to make sense it has to both win in the courts and then overcome years of hostility against the idea of a private corporation with a government mandate.

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