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Fannie Mae and Freddie Mac: Fear Not
The recent hysteria about worst-case scenarios ignores the solid business principles that support both institutions


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In recent weeks, Fannie Mae (FNM ) and Freddie Mac (FRE ) have been under fire both in the press and in Congress over their unique position among financial institutions. Various critics have charged that the two control too much of the mortgage market, use derivatives too indiscriminately to hedge against interest rate movements that could hurt their earnings -- and that they get an unfair advantage from their aura as quasi-government institutions.

Their detractors want Fannie Mae and Freddie Mac to disclose more about the inner workings of their businesses, to distance themselves from the government, and even to give up some of their business to someone else -- presumably to banks or savings and loans.

This hailstorm of controversy has put a lid on the stock prices of Freddie Mac and Fannie Mae -- which nonetheless rank No. 2 and No. 7, respectively, in this year's BusinessWeek 50 list of the best-performing companies. Fannie's stock is frozen at around $80 at the moment, and Freddie's at around $65.

UNDERVALUED?  Rather than be scared away, however, savvy investors might be better off thanking the critics for creating a buying opportunity. During the economic slump of 2001, Fannie and Freddie achieved record earnings growth of around 20% and 25%, respectively, thanks to the red-hot housing market -- increases that aren't yet reflected in the price of their stocks.

It's true their earnings growth probably will moderate this year, along with the recent mortgage refinancing boom. Still, the consensus on Wall Street is that both organizations' earnings will grow faster than those of most companies in the Standard & Poor's 500. Analysts predict 14% earnings growth for both. That would translate into operating earnings per share of $5.92 for Fannie, up from $5.20 in 2001. For Freddie, operating earnings per share would grow to $6.79, from $5.96.

That's why many analysts are projecting gains of more than 20% for each of these stocks over the next 12 months, to as high as $105 for Fannie and $80 for Freddie. That assumes, of course, that the fuss on Capitol Hill blows over. Largely because of it, both stocks rose only about 6% in 2001.

UNIQUE TIES.  What few investors realize is that Freddie and Fannie don't lend money directly to homeowners. Rather, they gather a quarter to a third of their revenues and profits from fees they charge for guaranteeing mortgage loans that banks have made to individuals -- and that meet Freddie and Fannie's credit requirements. The rest of their take comes from interest income on mortgages and mortgage-backed securities that they buy from banks. Fannie's and Freddie's margin is the difference between the interest they have to pay for money and the interest they earn on the mortgages and securities they buy.

Critics see several problems with this way of doing business. One is the unique relationship with the federal government that makes Freddie's and Fannie's business so lucrative. Congress created them decades ago to be the funding mechanism that would allow as many Americans as possible to own homes. Thanks to the manner in which Freddie and Fannie were born, Uncle Sam implicitly -- though not contractually -- guarantees debt that they issue to the bond market.

This enables them to borrow money for a quarter-point less than they would otherwise -- saving them billions of dollars in interest on the vast sums they borrow and then use to buy up mortgages. Together, Freddie and Fannie now own or guarantee about 40% of the $6 trillion in mortgages that meet their credit standards.

OVERBLOWN ARGUMENTS.  In the event of a housing market meltdown, detractors say, Freddie and Fannie might fail -- and leave the government to foot a huge bill. They also argue that Freddie and Fannie have an unfair advantage over commercial banks when it comes to borrowing money, though that conveniently ignores the fact that much of the money banks use to make loans comes from nearly free, federally insured deposits.

Though these arguments have gotten lots of attention lately, they're most likely overblown. With an economic recovery under way, the likelihood that Fannie and Freddie will go bust -- or even suffer much -- is remote. In fact, Fannie and Freddie have the best mortgage portfolios of just about any financial institution, thanks to charters that strictly govern what they're allowed to buy: mortgages of less than $300,700, that have at least a 20% downpayment, and fit a whole group of other criteria the institutions have established.

In reality, their portfolios have an even bigger cushion: Their average ratio of the loan to the value of the underlying property is 60%. Their delinquency rate -- late payments -- on these loans is around half a percent. And both have default rates of 1% or less -- the lowest they've ever been. "Wall Street generally misses how safe these loans are," observes Bruce Harting, an analyst at Lehman Brothers. "Most lenders on average probably have an 80% loan-to-value ratio, with half their loans above that and half below. In Fannie Mae's case, everything has to be at or above that."

SHAVING POINTS.  Fannie and Freddie have managed to ensure that every loan among the ones they own or guarantee meets these criteria through their automated underwriting systems. In addition to making it easy for lenders to plug in data and be sure they've met the Fannie and Freddie standards, these systems create a huge database the two can use to predict the behavior of their portfolios. This has helped them to continue to shave basis points off their default rates.

Analysts believe that the critics will fade away in no small part because Freddie's and Fannie's credit is so solid -- and because their earnings prospects are among the best in the S&P 500. Last year, Freddie expanded its total investment portfolio by 27%, to $494 billion, as it improved the net interest margin it earns on these investments by 0.03%, to 0.80%. Fannie's portfolio grew by 15%, to $705 billion, while its net interest margin improved by 0.11%, to 1.11%. These may sound like slim margins, but about 90 cents of every dollar goes straight to their bottom lines.

This year, their portfolio growth probably won't be as strong, and their margins will likely tighten -- to around 1% in Fannie's case -- as the Federal Reserve adopts a more neutral monetary stance. Fannie expects this to push up both its cost of funds and mortgage rates -- to between 7% and 7.5%. As a result, Fannie projects that total refis may drop to $721 billion in 2002, from $1.1 trillion last year.

"WE'RE HEDGED."  Still, the prospects for Freddie's and Fannie's earnings growth are decent. They make money only on refinancings in which homeowners increase the size of their mortgages -- about 10% of all refis last year.

To minimize the effect of rising interest rates on their margins, Freddie and Fannie use interest rate swaps and options. That's why their returns on equity and earnings growth have been stable over the years. "We don't position ourselves on what rates are going to do," says Mary Lou Christy, vice-president for investor relations at Fannie Mae. "We're hedged regardless." In addition, both outfits match the funding of their assets and liabilities within a strict band. The average overall maturity of assets and liabilities, taking into account prepayments, has to be within six months of each other.

The amount of money involved in Freddie's and Fannie's hedging has raised fears in some quarters that they're vulnerable to an Enron-type collapse. But Freddie and Fannie argue that they have safe guidelines. Together, the two have a derivative position of about $1.4 trillion, a mere 1.2% of the total $113 trillion derivatives market. In addition, they have collateral of cash or Treasury securities on many of their contracts.

NO GUARANTEES.  "When you net away the collateral, if all of our derivatives counterparties defaulted at once, we estimate that would cost us $110 million," says Christy. "That's less than 2% of our pretax net income last year." As for complaints that the public has the right to know who their derivatives counterparties are, "no U.S. financial institutions divulge that," points out Joe Amato, vice-president for finance at Freddie Mac.

Of course, no one can guarantee that the housing market couldn't at some point collapse, wreaking havoc on Fannie's and Freddie's portfolios. But it would have to be a heck of a downturn to put them out of business. "We have capital that is 250 times the credit losses we've recorded in 2001," says Jamie Gorelick, vice-chairman of Fannie Mae. "Banks don't have capital that is 250 times their credit losses."

That's why many analysts say they're not worried about Freddie's and Fannie's dominance of the mortgage market. "What's the alternative to them owning everything?" asks Moshe Orenbuch, analyst at Credit Suisse First Boston. "Where would the loans be? On the books of [a commercial bank] or a bunch of thrifts? The evidence is that [in the past] those alternatives went substantially less well." And in reality, it will be a while before Freddie and Fannie really do "own everything." Currently, Freddie owns about 9% of the qualifying mortgage market, Fannie about 11%.

FAVORABLE DEMOGRAPHICS.  Between their rock-solid credit, hedging techniques, and strong capitalization, Freddie and Fannie seem well-positioned to continue their growth for many years. Demographic trends such as the echo baby boomers who are moving into their home-buying years and increased immigration continue to work in their favor.

On the strength of these trends, some analysts say Freddie's and Fannie's earnings growth could stay in the mid-double digits for the next decade. It's most likely only a matter of time before the post-Enron hysteria dies down and their stock prices begin to reflect their earnings potential.


MARCH 25, 2002



By Margaret Popper

Edited by Beth Belton

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