Model Portfolio rmcduff:RMG1

Federal National Mortgage (nyse: FNM) Right-Sized for Growth

Shares Outstanding: 973 million.
Shareholders Equity (12/31/06): $41.5 billion.
Share Price/2006 Shareholders Equity: 1.58x

Federal National Mortgage is the largest single family & multi-family mortgage buyer in America.

The firm buys secondary mortgage loans, primarily of a long term fixed nature and packages them into mortgage backed securities. The pools are then resold to the capital markets, producing stable fee revenue.

Fannie Mae also holds a portfolio of mortgages for its own account. Income is generated based upon the spread between its own costs of capital vs. the income received from the mortgages. Revenue from this division in Fannie Mae's financial statements, as well as related activity income, are grouped under the heading "capital markets".

According to recent Fannie Mae filings, mortgage problems in the market started to show up around mid 2006.

Based upon present trends, US home sales may now tracking at an annualized pace similar to 2001.

Management of FNM anticipates a further decline in net interest income, a potential doubling + of guaranty contract losses as well as an increase in the overall credit loss ratio. This should imply a reduction in projected 2007 earnings vs. 2006. Earnings may fall by a further 20% this year, possibly to below levels last seen in 1999.

The well documented problems in the mortgage markets may NOT have as pronounced an impact upon Fannie Mae, as at many firms.

I believe that the sub prime mortgage debacle will widen and spill into more traditional mortgages. The current confidence crisis in the capital markets has exacerbated the issues in the short term. I do not consider "Fed" moves to inject liquidity as being a sign of an economic turn for the better. Rather, liquidity injections are generally short term, and allow a more measured approach for the repositioning of investment portfolios. This probably spells bad news for the majority of financial service businesses with assets in North America, and could potentially result in a mild recession.

Conventional long term fixed mortgages will likely experience higher defaults than in the last several years, This should not prove any more problematic for FNM than in previous interest rate cycles. Fannie Mae has demonstrated an ability to grow throughout prior downturns through capturing new market share. While some firms may not survive a protracted downturn in the housing market, Federal National Mortgage considers the current environment to be very much "business as usual".

There are a host of reasons to explain why Fannie Mae stock is pushing toward 52 week highs, in a worsening housing market.

1. Fannie Mae is prepared to expand its retained portfolio, as the firm is overcapitalized.

A 36 month period of downsizing, which shrunk the mortgage portfolio by 26%, has ended. A total financial statement recalculation was begun in 2004, after it was disclosed that FNM was improperly accounting for derivative gains/losses from its capital markets division. In the aftermath of this disclosure, it became evident that FNM had used derivatives to leverage its balance sheet beyond prudent levels, relative to its capitalization.

It was also determined that the capital markets subsidiaries had strayed far from their original corporate objectives. Fannie Mae had become a securities trading firm disguised as a government sponsored agency. A major restructuring of these business lines has largely been completed.

In hindsight, it seems evident that FNM was able to sell down its mortgage portfolio at relatively high prices. Now, unlike many firms in the mortgage related business, Fannie Mae now finds itself with a balance sheet capable of growing in the months to come. Bargains may be plentiful which would allow Federal National Mortgage to be one of the few firms able to "buy low".

In addition to growing the mortgage portfolio, I also sense that FNM management might see financial benefits from purchasing a large bankrupt (or near bankrupt) national mortgage originator. There may be some surprisingly good candidates available soon, for a mere assumption of liabilities.

2. Fannie Mae could be benefiting from a "flight to quality".

Portfolio managers permitted to own FNM stock, and those with a mandate requiring ownership of mortgage related stocks, may be selling riskier (more leveraged) investments, and replacing them with shares of Fannie Mae. This "sell the weak, buy the strong" approach may continue through 2008.

3. Some are buying Federal National Mortgage in anticipation of the firm becoming a timely SEC filer.

While the accounting scandal unfolded, many securities houses had to remove or restrict coverage on Fannie Mae. This greatly limited the number of investors capable of holding FNM shares.

Individual investors at major wirehouses are often discouraged from owning securities where official investment coverage is restricted. Numerous institutions are also prevented from owning shares in companies which do not have current financial filings.

On June 30th, 2007, there were just 19,000 registered shareholders of Fannie Mae. By contrast, American Express (with a similar market cap) reports over 51,000 shareholders of record. In the near future, I expect that a wide range of investors will be able to add FNM to portfolios

4. Interest spreads should rise over the next 12 months.

In 2003, Fannie Mae earned an interest spread of 2.12% on its retained mortgage portfolio. In each subsequent year, interest spreads have narrowed. They averaged just .85% for 2006. As the housing slowdown impacts other sectors of the economy, interest rates should decline. I believe that expanding spreads for FNM will result, which could produce dramatic profit growth.

5. Interest sensitive stocks are often counter intuitive.

In a traditional housing market cycle, defaults peak while the market is already turning for the better. Should this be the case, then by late 2008, Fannie Mae's business may show an accelerating rate of growth. Recovery in share prices often tends to anticipate these trends.

Fannie Mae looks to be a value from both a historic point of view as well & a balance sheet perspective.

Core single housing and HCD business have shown total revenue increases of almost 16% since 2004. FNM has greatly reduced its reliance upon the capital markets trading desk activities as a profit center. The balance sheet is stronger than at any time during the past decade, and management now seems opportunistic. Expectations from shareholders are remarkably low. Upside earning surprises are possible going into 2008.

Presently, FNM presently trades at 1.58X the 2006 reported shareholders equity. This compares very favorably to the 3 year "pre-scandal" share price which averaged 2.7X shareholders equity.

I expect Fannie Mae to be a winner as both housing market and capital market conditions normalize.

In the long run, business conditions in ANY industry are seldom as strong as market bulls play them up to be during good timesnor as bad as pessimists pan them out to be in bad times. While Fannie Mae is predicting further contraction in the housing markets, it holds a dominant position in the safest sector of the mortgage markets. This, and a uniquely overcapitalized balance sheet, should position the firm extremely well for the inevitable recovery. If/when interest rates decline in the US; widening credit spreads could lead to exponential profit growth.

Importantly, FNM should NOT require dilutive capital infusions to weather the current storm. While many financial institutions will sharply curtail mortgage activities in the coming months, FNM may be in a position to act as a predator.

Conclusion

Resumption of full SEC reporting status, coupled with my belief that balance sheet growth of up to 10% is possible within the next 12 months, could make for a compelling investment case. Should my thesis prove out, a year end 2008 fair market value of 2.5X estimated 2007 shareholders equity, or $110 per share, is certainly possible. The recently increased dividend looks safe, and may add to the overall return.