Fannie Mae (FNMA)

What it is:

Fannie Mae (OTC: FNMA) is the nickname for the Federal National Mortgage Association (FNMA).

Established in 1938, Fannie Mae's purpose is to create a secondary market for the purchase and sale of mortgages. In 1968, Fannie Mae ceased to exist as a government entity and became a quasi-governmental, federally chartered corporation in order to buy mortgages other than those insured by the Federal Housing Administration (FHA).

How it works/Example:

Fannie Mae purchases pools of mortgages from lenders and resells them in the form of mortgage-backed and other securities to investors. Purchases are generally restricted to conforming loans, which are loans that meet certain size limits and other conditions.

The concept behind Fannie Mae seems complicated, but it's actually quite straightforward. Fannie Mae purchases mortgages from banks, bundles them and sells them off on the market as larger, consolidated financial instruments. This process was established by the federal government to enable banks to wipe debt off of their books, while at the same time allowing Fannie Mae to profit from relatively low investments.

Fannie Mae's mortgage-backed securities are similar to bonds and have varying maturities and coupon rates. The securities generally pay interest as well as principal to the investor monthly, which means investors earn interest on a decreasing principal amount over time.

Fannie Mae is exempt from Securities and Exchange Commission regulations and is not subject to state or local income taxes. Further, the U.S. president appoints five of Fannie Mae's 18 board members, and the U.S. Treasury Department approves all Fannie Mae debt issues.

Why it Matters:

Fannie Mae's purchasing activity increases the funding available for mortgage lending by providing lenders with cash to make additional loans. As a result, Fannie Mae's conditions for loan purchases affect the availability and interest rates on certain types of conforming and nonconforming loans.

Fannie Mae guarantees the payment of interest and principal on its mortgage-backed securities; if there are defaults on the underlying mortgages, Fannie Mae will make the required monthly payments on the securities. It is important to note, however, that Fannie Mae securities are not guaranteed by the U.S. government. This means that investors may have no recourse if Fannie Mae cannot fulfill its responsibilities as a guarantor.

Shares of Fannie Mae are traded on the OTC under the ticker FNMA. Fannie Mae shares generally have an inverse relationship with interest rates; its stock typically increases when interest rates fall, and vice versa. Fannie Mae frequently attempts to hedge its exposure to interest rate changes by purchasing derivative securities, such as interest rate swaps.

There are huge barriers to entry that protect Fannie Mae from competition. Considering the sheer amounts of capital needed to get into this market, Fannie Mae is largely protected from competition. The ruinous after effects of the 2008-2009 credit crisis also make it unlikely that major competitors will emerge. That said, Fannie Mae remains troubled, even after shedding much of its toxic securities. As of this writing, it has gone from a blue-chip "safe" investment to a highly risky penny stock.

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