A Look at Fannie Mae
How Does It Do It?
by Dale Wettlaufer ([email protected])
ALEXANDRIA, VA (July 28, 1998) -- One of the companies that we were going to consider for the Drip portfolio is Fannie Mae (NYSE: FNM). The company has been a huge contributor to the wealth of its shareholders, having generated a 10-year yearly compounded return of 34.5%. That means a $10,000 investment made in July 1988 would have been worth $178,999 as of the end of this June. Pretty nice returns. How does Fannie Mae do it?
Well, to the best of my analytical abilities, the company does it through asset growth, low funding costs, low credit costs, and a general inflation of the company's value over the last couple years. With the company's equity trading just above 7% of assets at the end of 1994 and above 15% now, returns over the last 3 1/2 years have been geometric, with a higher valuation being accorded an asset base that has nearly doubled and an earnings base that grew at an annual rate of 13.4% between the end of 1993 and 1997. But that's nowhere near the entire story.
The company has a near natural monopoly, along with Freddie Mac (NYSE: FRE), in serving as a buyer of mortgages that conform to standards that it sets. It then packages the mortgages it buys into securities, which it then sells to investors such as bond funds and insurance companies. The company then collects the principal and interest from the mortgage pools that it manages and is paid by the investors buying Fannie Mae securities for doing so. The company's loan losses are very low, although I think its accounting is somewhat different than other mortgage lenders. Its credit losses as a percentage of loans and of net interest income is much lower than other mortgage lenders, but its foreclosed property expenses are much higher. I think by combining those two categories, its total credit loss experience adds up to 19 basis points of loans, which is right around what savings & loans experience in this asset class.
Asset backed securities provide a cheaper way to lend money to people, since the credit risk can be spread across a number of different lending sources while lenders perceive less risk lending to people from a number of geographies and circumstances. Normally, this isn't the most profitable business in the world, but Fannie Mae gets to borrow below AAA rates. This allows the company to make a wider spread on the mortgages it keeps in its portfolio and offer the best price to anyone looking to sell their conforming mortgages.
The combination of growth in asset backed securities and mortgage originations in general has propelled Fannie Mae. However, I'm not a fan of the huge leverage of the company and its really poor return on assets (ROA). ROA is below 1 and return on equity (ROE) is above 20, which means the company has to leverage the heck out of itself. Sure, mortgages are insured, but I can't appreciate the idea that humans have conquered all forms of financial risk. Sorry about that, that's just not the case. The company can continue to generate tons of cash, generate a fine return on equity, and continue to buy back shares, but it's not really my cup of tea.
Fannie Mae will likely retain its privileged status under which it doesn't have to pay state and local income taxes, and it will continue to benefit from the perception that its debt and securities are implicitly guaranteed by the U.S. government. So I don't see the story changing, and I can see the company being able to turn even single-digit gains in assets into double-digit advances in earnings per share. But I'm not an EPS growth investor -- I like robust capital productivity, and I don't get it here, not riding on the sliver of equity this company does. There are lots of other solutions to investing needs out there, at least for the Drip portfolio.
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