The Rock
money.cnn.com
November 27, 2001: 6:45 p.m. ET
Under CEO Franklin Raines, mortgage financer Fannie Mae looks nearly invincible.
By Jon Birger
NEW YORK (CNN/Money) - At a time of unease, Franklin Raines of Fannie Mae may well be the most confident CEO in America. And why not? Spitting in the face of recession and war, his company just produced perhaps its most impressive quarter ever.
Earnings soared 22 percent at the nation's largest buyer of home mortgages, and would have been up even more were it not for some deft financial maneuvers that pushed $134 million in current profits into future quarters. That's right: Fannie Mae (FNM: down $0.86 to $80.64, Research, Estimates) is actually making too much money. Things are going so well that when asked if there is any realistic economic scenario that keeps him awake at night, Raines barely hesitates before answering no.
"People will give up a lot of other things before they give up their homes," he explains. "That is what makes this such a good business to be in."
It's also what makes Fannie Mae such a great company to own. "What other value stock has 15 percent a year earnings growth going back three decades?" asks fund manager David Dreman of Scudder-Dreman High Return Equity. Companies with consistent double-digit earnings growth don't often trade at value multiples, which is why Fannie Mae is so attractive at its Nov. 1 price of $82.63 a share and 16 times projected 2001 earnings.
Not only are concerns about a real estate bubble overblown - average U.S. home prices have yet to fall in the 26 years the federal government has been tracking them - the fact is, Fannie doesn't even need a robust new-mortgage market to continue generating double-digit earnings growth.
The world's largest hedge fund
Fannie is essentially a gigantic hedge fund (albeit an extraordinarily safe one) that profits from the difference between its incredibly low borrowing costs (a byproduct of its bonds being implicitly backed by the government) and the much higher yield of its $680 billion mortgage portfolio. When the home loan market is flush with refinancings, as it is today, Fannie expands its portfolio mainly by buying new mortgages from lenders.
When new mortgages are scarcer, Fannie picks up the slack by buying mortgage-backed securities in the secondary market. So long as Fannie's borrowing costs stay low and the mortgage-backed securities market remains open, Fannie can grow its portfolio - and thus its earnings - at virtually any rate it chooses.
Unfortunately for shareholders, there is a mathematical limit to how long Fannie can achieve 15 percent annual growth this way. (We'll get into the details a little later.) There are other risks as well. For example, Congress could someday repeal the government charter responsible for Fannie's low borrowing costs.
Also, Fannie has been tiptoeing into subprime mortgages, a move that may have caused Warren Buffett to dump his Fannie stake last year. "We felt that the risk profile had changed," Buffett said at Berkshire Hathaway's annual meeting - a remark that prompted Raines to pay Buffett a visit in Omaha.
These are legitimate concerns. But to put them in perspective, consider the following tidbit from the company's third-quarter earnings report: Credit losses from delinquent mortgages were so low they could double during the next five quarters without affecting Fannie's earnings guidance for 2002. "Our expectation is that in almost any environment, we can produce earnings growth in the mid-teens," says Raines.
Such resilience is nothing new. Even in the recession year of 1991 and the skyrocketing interest-rate environment of 1994, the company managed annual earnings growth of 11 percent and 14 percent. Says Fannie fan Tom Goggins, manager of John Hancock Financial Services fund: "They've always done well regardless of what's happened to housing starts or interest rates." Fannie has been so consistent for so long that 2001 will mark its 15th consecutive year of double-digit earnings growth. Among Standard & Poor's 500 companies, that's a record expected to be matched only by Home Depot and Automatic Data Processing.
Investors typically pay a premium for this kind of consistency, which is why Fannie's 16 P/E strikes us as low. General Electric has a comparable record, yet fetches a multiple of 27. The market's longstanding bias against financial stocks means Fannie will probably never own a 27 P/E, but even when compared with other financials, Fannie's modest valuation is hard to justify. Most banks and brokers have had earnings shortfalls this year, yet Fannie trades at a zero premium to the S&P financial index. If its P/E merely rebounded to its five-year average of 18, Fannie would be a $93 stock.
Here's its real edge
Attractive as it is, this is not a stock you can lock in your portfolio and throw away the key. Owning Fannie requires vigilance because so much of its success is tied to the low borrowing costs that come with being a government-sponsored enterprise. Established by Congress in 1938 as the Federal National Mortgage Association, Fannie was charged with encouraging home ownership among middle- and low-income Americans. Like its smaller sibling, Freddie Mac, Fannie accomplishes this by buying mortgages from banks and other lenders, freeing up their capital for further loans, and in the process lowering mortgage rates for all of us.
Shareholder-owned since 1968, Fannie continues to operate under a congressional charter that limits its activities to mortgages but also grants it valuable perks, such as exemption from state taxes and a line of credit with the U.S. Treasury. The credit has never been tapped, but its symbolic value cannot be overstated. Despite official pronouncements to the contrary, bond investors and rating agencies believe Fannie's debt is backed by the government. Consequently, Fannie enjoys borrowing costs at least a percentage point below those paid by other blue chips.
Some serious foes
Fannie's advantages are none too popular with its rivals in financial services, some of whom - including Citigroup, GE Capital and Wells Fargo - have been trying to rein in Fannie through their lobbying group, FM Watch. Their cause has support from some members of Congress who believe Fannie is profiting at taxpayers' expense. Even Federal Reserve chairman Alan Greenspan is said to have doubts about Fannie's outsize influence in the credit markets.
All companies have their critics, of course, but when Fannie's go public, they have a disproportionate impact on its stock. Last year, hearings held by U.S. Rep. Richard Baker - a Louisiana Republican who fears an S&L-type bailout were Fannie to get into trouble - caused wild swings in Fannie's price. Even quiet chatter can be costly. Last August, a Treasury Department undersecretary's use of the word "skeptical" in a news story about Fannie caused a quick sell-off that lopped $1.6 billion from the company's market cap.
The good news for shareholders is that Fannie's sway on Capitol Hill is legendary, making it highly unlikely that Congress would sever the government ties. Fannie and its nonprofit foundation have spent an estimated $75 million on advertising since 2000, mostly on feel-good television commercials that link Fannie to home ownership.
And if funding the American Dream weren't protection enough, Fannie's ranks of current and former executives are filled with Washington insiders from both parties, ranging from former Fannie executive vice president Robert Zoellick - now U.S. Trade Representative for the Bush Administration - to the CEO himself. A Harvard-educated lawyer and investment banker, Raines took a two-year leave from Fannie's vice chairmanship in 1996 to serve as budget director under President Clinton; he returned in 1998 as CEO-elect.
As good as Fannie is at managing political risk, there will come a time when defending the status quo won't be enough to maintain a mid-teens growth rate. To understand why, you need to understand what's driving Fannie's earnings expansion. The assets in its mortgage portfolio have grown at a 20 percent annualized clip over the past three years, which is almost three times the growth rate of outstanding mortgage debt. While outpacing the market is great for current earnings, Fannie and Freddie Mac cannot grow their portfolios at two or three times the rate of the market indefinitely. At some point, their combined portfolios will own every mortgage and mortgage-backed security they're allowed to under the law.
When this happens, their earnings will be hostage to the future growth rate of outstanding mortgage debt - a rate most analysts peg at about 7 percent. Fannie's only recourse would then be to ask Congress for permission to enter new businesses, perhaps credit-card finance or even direct lending to consumers - a request that FM Watch would obviously fight to the death.
While Raines acknowledges the general problem, he insists Fannie has no interest in diversifying and argues it'll be 30 years before its portfolio outgrows the mortgage market. (Freddie takes a similar position.) Raines' estimate is based largely on demographic factors that he thinks will push up mortgage-market growth to about 9 percent a year. Should this happen - and it very well could - Fannie would be able to slow its annual portfolio growth to 15 percent, since there would be more money coming in from other businesses, such as insuring the interest and principal on new mortgage-backed securities. But if the mortgage market were to grow at a more modest 5 percent to 7 percent rate, Fannie would need to increase its portfolio 20 percent to 25 percent a year to produce mid-teens earnings growth. Under that scenario, Fannie and Freddie would own the entire mortgage market within 10 or 15 years.
The actual day of reckoning would probably come even sooner, since the cost of cornering the last 25 percent of any market is usually quite expensive. Already, says Sanford C. Bernstein analyst Jonathan Gray, there's some early evidence that aggressive buying by Fannie and Freddie has eroded their profit margins by driving up prices - and driving down yields - on mortgages and mortgage-backed securities.
So why then is Gray still recommending the stock? Simple: He's not looking 10 years down the line. "The behavior of earnings this year and next will have much more impact on the stock price than what might happen in 2003 and beyond," he says. For now, at least, Fannie Mae may be as sure a thing as today's market has to offer. |
