Fannie Mae's Fearsome Challenge

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The past year has been truly awful for Freddie Mac (FRE), but 2004 could easily turn out worse for its larger sibling, Fannie Mae (FNM).

In 2003, Freddie revealed that it had manipulated earnings over at least three years and ended up shedding nearly all of its top management team as the result of its accounting scandal. Fannie Mae has gotten through the Freddie fracas relatively unscathed. Fannie trades, for example, at a stunning 3.7 times its book value, compared to 1.3 times at Freddie.

But Fannie, which has a much weaker balance sheet than Freddie, faces some nasty challenges in 2004 that could knock the stuffing out of its stock, and even lead to the sort of management cleanout seen at Freddie. In 2004, Congress will likely enact new laws aimed at toughening up the regulation of Fannie and Freddie, and the reformers could remove some of the very lucrative government-granted advantages that both companies operate under.

While any legislation will affect both companies, the high valuation on Fannie's stock makes it vulnerable to a steep decline if the political threat heats up. Moreover, Fannie's markedly weaker equity position means that any interruption to earnings or business could put the company in dire financial straits.