Fannie Mae Has Been Wearing Her Thinking Cap

For most players in the residential mortgage market, this era of rising interest rates is beginning to take on a passing resemblance to Gehenna. With rates on 30-year mortgages spiking and expectations of even higher ones to come, lenders have been dumping their fixed-rate loans at fire-sale prices. And investors in mortgage-backed securities, who had bet on lower rates, have sustained fierce losses. With those players pulling back, the demand for mortgages has plummeted further. But the Federal National Mortgage Assn., which buys one out of every four mortgages made today, is riding high.

As the markets went through spasms, Fannie Mae was bargain-hunting--a strategy that will help it boost profitability even as total growth of its investment portfolio slows compared with last year's explosive volumes. In March, Fannie Mae cut deals to buy $8.7 billion worth of loans on single-family homes and apartment buildings, a stunning 79% hike from February. When market turmoil provides an opportunity for profits, "we go after it," says Fannie Mae Chairman and CEO James A. Johnson.

Indeed, despite the nasty spike in rates and withering of the refinancing boom, the federally chartered Washington (D.C.)-based company is poised to post double-digit earnings increases this year, as it has for the last 25 quarters. But Fannie Mae's record goes far beyond market savvy. As housing lenders come under increasing scrutiny for ignoring low-income families and minorities, Fannie Mae has also demonstrated political acumen. To assuage lawmakers and regulators, the company has launched a $1 trillion initiative to promote home ownership among low-income families. "Their record for managing all these risks is absolutely platinum," says Sanford C. Bernstein & Co. analyst Jonathan E. Gray. Fannie Mae's opportunistic shopping helped send first-quarter earnings for this year up 15% over the same period in 1993--a stunning performance given the violent changes in interest rates.

CLUMSY START. Fannie hasn't always been such a consistent money machine. Created in 1938 by Congress to help provide capital to the housing market, Fannie Mae buys mortgages made by banks, thrifts, and brokers and either holds them for investment or sells securities backed by the mortgages. After becoming a public company in 1970, Fannie Mae stumbled badly with poor interest-rate risk management and shoddy credit controls. David O. Maxwell, who took over as chairman and chief executive in 1981, changed all that. The company, which had been losing $1 million a day, overhauled its credit standards and matched the maturities of its assets and liabilities far better. It was a remarkable turnaround. Last year, the company made $1.9 billion on $16 billion in revenues. And a $1,000 investment in Fannie Mae stock in 1981 is now worth about $30,000.

Fannie owes its success to some smart balance-sheet maneuvering. In 1988, the company began developing a market for callable debt, which gives it the right to pay off the debt before maturity. Fannie pays a slightly higher rate than it otherwise would to compensate investors for the risk of a call, but Fannie starts out with a built-in rate advantage--its debt is backed implicitly by Uncle Sam. Currently 58% of its $164 billion in debt is callable.

Fannie Mae's flexibility was critical during the recent refinancing boom. As homeowners rushed to lock in lower rates, Fannie Mae was forced to replace older, higher-yielding mortgages with loans that earned less interest. So it did some refinancing of its own to protect the margins on its $200 billion portfolio of mortgages. Fannie called $13.6 billion of its debt and replaced it at last year's lower rates. If rates still climb, the company simply won't call in more debt and can extend the average maturity of its borrowings. Analyst Gray figures the refinancing and savvy purchases will send earnings to $2.1 billion this year.

Even the growing pressure to help finance lending in potentially less lucrative areas isn't likely to dim Fannie Mae's prospects. In 1992, Congress passed legislation requiring tighter oversight of Fannie Mae and Freddie Mac, another secondary market corporation created by Congress. For Fannie, this included new targets for the business they do with underserved markets.

Even before Congress acted, Fannie was burnishing its political image. In 1991, Johnson, a former managing director at Lehman Brothers Inc. and onetime aide to Vice-President Walter F. Mondale, established a business division to try to find ways to buy more loans in poor neighborhoods and capital-starved rural communities. The division--which has its own building across from Fannie's headquarters--has also started programs aimed at buying loans on apartments that house poor families and mortgages on homes for disabled people.

In March, the company announced with great fanfare that it would provide $1 trillion in financing over the rest of the decade for these groups. In fact, the company concedes that $850 billion of that money would already be available under Fannie's current guidelines. But the program has been a PR coup for Fannie, winning praise from Congress and the Housing & Urban Development Dept. "We applaud the initiative," says HUD Assistant Secretary Nicolas P. Retsinas. "Now, we look forward to a fleshing-out of the plan."

TEST RUNS. The details of the plan demonstrate once again the company's business and political finesse. The riskiest of the new businesses--such as loans with just a 3% down payment--will be tested in a series of small pilots before being rolled out nationwide. And the company is aggressively exploring partnerships with local housing authorities, nonprofit housing groups, and mortgage insurers to spread the risks on some of these loans. "It's an R&D effort," says Ann D. Logan, Fannie's chief credit officer. "We don't want to expose ourselves to large losses."

The timing of the initiative couldn't be better for Fannie Mae. Its back-office operations are automating some of the duplicative steps in the mortgage process. Johnson figures the new software and network systems will cut $1,000 out of the cost to originate an average mortgage. These advances will make the smaller loans generated by the low-income initiative more profitable. And Fannie Mae will also earn fees when originators use the new system. "We can ensure our competitive position and, when all is said and done, have a more efficient housing-finance system," Johnson insists.

By homing in on such win-win opportunities, Fannie Mae will continue to be as popular on Wall Street as it is in Washington. And if rates stabilize and housing activity picks up, the company will truly be holding a first mortgage on Easy Street.

                      IN TUMULTUOUS WATERS
                              CHALLENGE       RESPONSE
      INTEREST        Rising rates choke      Through the use of
         RATES        off the refinancing     callable debt, Fan-
                      boom and could          nie refinanced
                      squeeze margins.        its debt to better
                                              match its assets
                                              and liabilities.
      POLITICAL       Pressure is mount-      Fannie announces
           HEAT       ing from Congress       a $1 trillion initia-
                      and HUD to be-          tive in March to
                      come more social-       lend to low- and
                      ly responsible in       moderate-income
                      lending.                borrowers over
                                              the next decade.
      CREDIT          Moves into low-         Fannie does the
        RISK          income lending          riskiest new busi-
                      could send credit       ness in a series of
                      losses soaring.         small pilots. Plans
                                              to look for part-
                                              ners who will
                                              share risk of any
                                              potential losses.
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