Voice from the Past: Lynch on Fannie and Freddie ($FRE, $FNM)

by PlanMaestro

After realizing that one of the potential outcomes of this Freddie Mac preferred case is the possible conversion of the preferreds to equity, I decided to investigate how good was the GSEs business. I understand that many are skeptical of the GSEs’ future but I argue that you do not need to bet on their success. You just have to make sure that the prefereds are grossly undervalued relative to the common and do a market neutral pair trade. Word of advice before you try this at home. This is my first one and waited for years for a no brainier and still, I am  using puts on the short side to avoid nasty surprises.

While doing my research, I stumbled upon Peter Lynch that wrote a whole chapter on Fannie Mae in his book “Beating the Street”. Most value investors have a world view based on Buffett, Klarman and Graham. They have shaped my way of thinking too. However my hero in the 90s was Lynch. Yes, he was a little of a momentum investor but how well he played the auto, retail and financial sectors and his books have plenty of excellent advice. Here are some quotes rearranged and classified. Just swap the references to Fannie Mae for Freddie Mac and enjoy.

Description

  • Every year since 1986, I‘ve recommended Fannie Mae to the Barron’s panel.
  • It’s no accident that there’s a snapshot of Fannie Mae headquarters alongside the family photographs on the memento shelf in my office
  • Maxwell was determined to put a stop to Fannie Mae’s wild swings…This he hope to accomplish in two ways: by putting an end to borrow short – lend long, by imitating Freddie Mac
  • Freddie Mac has stumbled onto the newfangled idea of packaging mortgages
  • Before mortgage-backed securities (MBS) came along, banks and S&Ls were stuck with owning thousands of little mortgages. It was hard to keep track of them, and it was hard to sell them in a pinch
  • There were two different businesses here: packaging mortgages and selling them, and originating mortgages and holding on to them.

Competitive Advantages

  • It occurred to me that Fannie Mae was like a bank, but also had major advantages over a bank. Banks had 2-3 percent overhead. Fannie Mae could pay its expenses on a .2 percent overhead
  • Thanks to its status a quasigovernmental agency, Fannie Mae could borrow money more cheaply than any bank, more cheaply than IBM or GM or thousands of other companies.
  • No bank, S&L, or other financial company in America could make a profit on a 1 percent spread
  • As long as people were paying on their mortgages, Fannie Mae would be the most lucrative business left on the planet

Credit Risk

  • A new fear crept in: not interest rates, but Texas. Crazy S&Ls down there had been lending money in the oil-patch boom. People in Houston who’d gotten mortgages with 5 percent down were leaving the keys in the door and walking away from their houses and their mortgages. Fannie Mae owned a lot of these mortgages
  • While banks like Citicorp were making it easier to get mortgages with little documentation -no-doc mortgages, low-doc mortgages, call-the-doc mortgages- Fannie Mae was making it harder. Fannie Mae did not want to repeat the Texas mistake. In that state, it was promoting the no-way-Jose mortgage
  • With fewer competitors buying and selling mortgages, the profit margins on loans had widened. This would boost Fannie Mae’s earnings.
  • Thirty-eight Fannie Mae employees were working in Houston alone to get rid of these houses. The company had to spend millions on foreclosure actions, and million more to cut the grass and paint the stoops and otherwise maintain the abandoned houses until buyers could be found.
  • What was the worst that could happen to it? A recession that turned into a depression? In that situation, interest rates would drop, and Fannie Mae would benefit by refinancing its debt at lower short-term rates
  • Even if new houses weren’t selling, the mortgage business grows. Old people would move out of old houses and new people would buy the old houses, and new mortgages would have to be written
  • I couldn’t imagine a better place to be invested in the twilight of civilization that Fannie Mae

Interest Rate Risk

  • Borrow short and lend long….When interest rates went up, the cost of borrowing increased, and Fannie Mae lost a lot of money
  • You can’t get very far by borrowing at 18 to make 9 (In 1981)
  • This one of those rare periods when a homeowner could say: “My house is OK, but my mortgage is beautiful” (the complete opposite of today)
  • Fannie Mae had begun to “match” its borrowing to its lending. Instead of borrowing short-term money at the cheapest rates, it was offering 3-, 5-, and 19-year bonds at higher rates.
  • Management now talked about “the old portfolio” and the “new portfolio”
  • Fannie Mae was reducing its interest rate risk by issuing callable debt. Callable debt gave Fannie Mae the right to buy back its bonds when such a move would be favorable to the company, especially when interest rates fell and it could borrow more cheaply.

The Stock Performance

  • When a company can earn back the price of its stock in one year, you’ve found a good deal
  • Was Fannie Mae an obvious winner? In hindsight, yes, but a company does not tell you to buy it. There is always something to worry about.
  • For a stock to do better than expected, the company has to be wildly underestimated
  • You have to know the story better than they do, and have faith in what you know I was comforted by the fact that whereas Fannie Mae’s foreclosure rate was still rising, its 90-day delinquencies were falling. Since delinquencies lead to foreclosures, this fall in the delinquency rate suggested that Fannie Mae had already seen the worst (this is the indicator to follow!)
  • The stock rose from $16 to $42, a two-and-a-half-bagger in one year. As so often happens in the stock market, several years’ worth of patience was rewarded in one.
  • I’m submitting this result to the Guinness Book of World Records: most money ever made by one mutual-fund group on one stock in the history of finance
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