Fast Times for Fannie and Freddie
By Margaret Popper
These days, it's hard to find a sector whose stocks haven't been hit hard by lower earnings forecasts and a slowing economy. Even the supposedly "defensive" stocks -- oil companies, independent power producers, and financial-services firms -- have been feeling the heat.
But two quasi-government agencies could easily be overlooked by investors looking for safe harbor -- the Federal National Mortgage Assn. (Fannie Mae) and the Federal Home Loan Mortgage Corp. (Freddie Mac). Both offer financing for residential mortgages of less than $275,000.
Their stocks are publicly traded and, at around $75 and $60 a share, respectively, they're hovering about where they started out the year. They're a little off their respective 2001 peaks of around $82 and $68, but not far off. Still, compared to the rest of the market, these stocks stand to be outstanding performers again in 2001, many analysts believe.
MORE UPSIDE POTENTIAL.
Both have risen at an almost constant double-digit rate annually over the past decade. With all that appreciation behind them, can they have much upside left? The short answer is yes.
Given the surprisingly resilient growth of the mortgage market and the cost-saving efficiencies Fannie Mae (FNM ) and Freddie Mac (FRE ) have achieved with their computerized underwriting approach, it looks like they'll be able to turn in double-digit earnings growth for a few more years, at least. According to analysts' consensus estimates, there's a minimum of 20% upside potential for 2001 on the price of either stock at current levels.
Driving Fannie's and Freddie's relentless growth is the residential mortgage market. These two agencies buy pools of high-quality mortgages from banks and either keep them on their books to earn interest or package them into mortgaged-backed securities (MBSs) that can be sold to investors in the public bond markets.
NO SIGNS OF SLOWING.
On the securitization side, Fannie and Freddie earn a spread on the sale, as well as management and guarantee fees. Between their on-balance sheet -- or retained portfolio -- and their off-balance sheet -- or MBS portfolio -- Freddie Mac accounts for about 17% of the total residential mortgages outstanding and Fannie Mae, probably something like 25%.
Despite the economic slowdown, this business shows no signs of abating. "We're in a healthy and rapidly growing residential mortgage market," says Timothy Howard, chief financial officer of Fannie Mae. "We have every reason to believe the residential mortgage market will continue to grow at between 6% and 8% [a year] in the future, as it has done over the past decade."
Fannie Mae's and Freddie Mac's loan portfolios have grown even faster than the overall market. Freddie Mac's grew 12% in 2000. The key reason: In the early 1990s, the agency began keeping more mortgages on its books rather than issuing mortgage-backed securities. That's because Congress allowed the agencies to be able to call -- or buy back -- their debt. This gave them more financial flexibility, crucial to the agencies' profitability.
Before the approval, Fannie and Freddie were at a competitive disadvantage with private-sector mortgage lenders. On-balance-sheet mortgages are where the growth is. With that part of the portfolio having grown 19%, to $386 billion, in 2000, it now accounts for about 40% of Freddie Mac's total mortgages, including those in MBSs, according to CFO Vaughn Clarke. Fannie Mae has about $700 billion of off-balance sheet loans and about $607 billion of loans on the books.
This asset growth has translated into significant earnings growth. The past decade, Freddie Mac's earnings per share have grown 19% annually. The past 19 years, its return on common equity has topped 20% every year, according to Clarke. Analysts' First Call consensus predicts Freddie Mac's earnings will grow 18% in 2001, to hit $3.98 per share. If that consensus is right, earnings next year will increase 14%, to reach $4.53 per share, despite a worsening economic slowdown. The same consensus estimates that Fannie Mae's earnings per share will grow 16%, to $4.97, and next year will increase an additional 13%, to $5.64 a share.
The slightly slower earnings growth has to do with the current interest rate environment, which could put some pressure on margins. As rates fall, mortgage prepayments tend to rise because borrowers rush to lock in lower fixed-rate mortgages. In an attempt to maintain their margins, Fannie and Freddie will refinance their own debt at the new lower rates as well.
To do so, they'll have to call their old bonds and pay extra principal to the bondholders as a penalty for repaying early. Even though the agencies' refinanced debt is at a lower rate, that extra penalty payment will lower the margin between their refinanced debt and the revenues they earn from lower fixed-rate mortgages.
"We have given guidance to Wall Street that we might see a little margin compression this year," says Freddie Mac's Clarke. The good news is that mortgage borrowers' preference for fixed-rate debt in a falling interest rate environment means more business for Fannie and Freddie. So they could make up some of their lost earnings on volume.
There is one other cloud on the horizon: persistent gripes from the banking community -- and now echoed in Congress -- that Freddie and Fannie are unfairly pushing out competitors. Among others, Wells Fargo (WFC ), GE Capital (GE ), JP Morgan Chase (JPM ), and insurer AIG (AIG ) have complained about "mission creep."
These lenders claim that Fannie Mae and Freddie Mac are overstepping the bounds of their congressional mandate to help ensure affordable financing for decent housing. Instead, claim their rivals, they have moved into mortgage origination. The fear is that by giving their automated loan-processing tools for mortgage underwriting to originators -- like mortgage brokers and credit unions -- the agencies are eliminating the role of traditional lenders.
Defenders say Fannie and Freddie are complying with their federal mandate. Besides, the agencies have no interest in loan origination. "They don't want to deal with the consumer and service loans," says David Graifman, analyst at Keefe, Bruyette & Woods. In fact, evidence indicates that the two agencies have made the under-$275,000 mortgage market more efficient.
If you look at rates for mortgages that size, they're lower than those for jumbo mortgages, defined as more than $275,000, points out Seth Elan, a vice-president and analyst at Arlington (Va.)-based investment bank Friedman, Billings, Ramsey. "That's an empirical confirmation that they are doing their job," he adds.
Fannie and Freddie say they're cooperating with congressional critics who demand more transparency and accountability. Both agencies are publishing mortgage data more frequently and having their debt, which in fact is not directly guaranteed by the federal government, rated by Standard & Poor's Corp. and Moody's Investors Corp., says Freddie Mac's Clarke. He believes the political flap has unfairly depressed his stock price.
If he's right -- and it looks like he is -- that could be good news for investors looking for double-digit earnings growth at a reasonable price.
Popper covers the markets for BW Online in our daily Street Wise column
Edited by Beth Belton
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