Federal National Mortgage Association, the mortgage giant better known as Fannie Mae (FNMA:OTCMKTS), recently released its financial data for the first quarter of 2024. On the surface, things seem rosy. The company boasts a market capitalization exceeding $5 billion, a profit margin of 0.54%, and a 5% quarterly earnings growth year-over-year. But beneath this veneer of success lies a disconcerting truth: Fannie Mae's "profitability" is built on a foundation of sand, a mirage fueled by accounting intricacies and a unique position within the U.S. housing market.

The heart of the issue lies in the nature of Fannie Mae's business. It doesn't lend money directly to homebuyers. Instead, it purchases mortgages from lenders, packages them into mortgage-backed securities, and guarantees these securities against default. This securitization process is vital to the smooth functioning of the mortgage market, ensuring liquidity for lenders and making homeownership more accessible. However, it also creates a complex accounting environment where profits can be misleading.

A particularly alarming aspect of Fannie Mae's financial data is its negative book value of -$10.1. Book value, in essence, represents the net worth of a company if it were to liquidate all its assets and pay off all its debts. A negative book value, therefore, suggests that Fannie Mae's liabilities outweigh its assets. This isn't a new phenomenon for Fannie Mae; it's been in this precarious position for years, a lingering consequence of the 2008 housing crisis and its subsequent government bailout.

While a negative book value raises eyebrows, it's not necessarily a death knell for a company. Fannie Mae's gargantuan size and implicit government backing provide it with a degree of stability that most companies with negative book values can only dream of. Yet, it underscores the fragility of Fannie Mae's financial position.

Furthermore, the company's substantial long-term debt, hovering around $4.2 trillion, casts a long shadow on its future. This debt, primarily comprised of mortgage-backed securities, is sensitive to interest rate fluctuations. In a rising interest rate environment, the value of these securities can decline, potentially leading to significant losses for Fannie Mae.

Is Fannie Mae's Profit an Illusion of Low Interest Rates?

Here's where the hypothesis comes in. What if Fannie Mae's reported profits are simply an artifact of low interest rates? As interest rates remain historically low, the value of its mortgage-backed securities holdings stays inflated, creating a paper profit. However, this profit is unrealized and could evaporate if interest rates rise.

Consider this: Fannie Mae's net interest income, the difference between interest earned on its assets and interest paid on its liabilities, stands at $7.7 billion for the quarter. This is a sizable chunk of its overall profit. But if interest rates were to rise, this income stream could shrink rapidly, dragging down profitability.

Hypothetical Scenario: A 2% Interest Rate Hike

To illustrate this point, let's assume a hypothetical scenario where interest rates increase by 2%. Given the size and composition of Fannie Mae's debt, this could potentially translate into billions of dollars in losses on its mortgage-backed securities holdings, offsetting any gains from increased interest income.

Note: This is a simplified illustration and actual impacts would depend on various factors beyond interest rate changes.

Navigating the Tide of Rising Rates

This is not to say that Fannie Mae is on the verge of collapse. Its role in the housing market is too critical, and the government has a vested interest in its survival. However, its continued reliance on low interest rates to prop up its financial performance is a cause for concern. It's akin to a house built on stilts over a rising tide; eventually, the water will reach the floorboards.

Fannie Mae's current "profitability" is a product of favorable market conditions, not a reflection of its intrinsic financial strength. While the company is unlikely to face an immediate crisis, its long-term sustainability hinges on navigating the treacherous waters of rising interest rates. Its ability to do so remains an open question, one that investors and policymakers would be wise to ponder.

"Fun Fact: Fannie Mae's original name was the Federal National Mortgage Association, which is why its stock ticker is still "FNMA"."