Beating the Street (39 page)

By 1990, sales of privatized companies worldwide had reached $200 billion, with more to come. The French have sold their electric utilities and their trains, Scotland has sold its hydroelectric plants, the Spaniards and the Argentinians have parceled out their oil companies, the Mexicans their airlines. Britain may someday sell its railways and its ports, Japan its bullet trains, Korea its state-run bank, Thailand its airline, Greece a cement company, and Portugal its telephones.

In the U.S. there hasn't been as much privatizing as we've seen
abroad, because there isn't as much to privatize here. Our oil companies, phone companies, and electric companies were private to begin with. The biggest recent deal was Conrail, or, more formally, the Consolidated Rail Corporation, which was assembled from the wreckage of Penn Central and five other bankrupt lines in the Northeast. For several years the government ran Conrail at a deficit, until the Reagan administration decided that taking Conrail private was the only way to stop it from seeking more government handouts, which already had exceeded $7 billion.

Some political factions favored selling Conrail to an existing railroad, with Norfolk Southern the most likely buyer, but after much congressional wrangling, a plan to sell it to the public prevailed. In March 1987, Conrail became the largest public offering in U.S. history, $1.6 billion. The government spent a fortune gold-plating this railroad, upgrading the rails and equipment, and pumping in money. The initial price was $10 a share, and as of this writing that same share is worth $46.

At a gathering to celebrate the Conrail deal, President Reagan quipped: “OK, when do we sell the TVA?” Of course, no serious attempt has ever been made to privatize the Tennessee Valley Authority, but if it happened, I'd be standing in line for the prospectus. There was talk, once, of privatizing Amtrak, and also the naval petroleum reserves in California and Wyoming, and I'd stand in line for those prospectuses, too. Maybe someday they'll sell off the National Gallery or the Marine Band or Niagara Falls.

As it was, there were no exciting new privatizations coming to market at the time I was looking for stocks for the
Barron's
panel. The old ones that I follow, such as the Mexican telephone company (the original Taco Bell) and the Spanish telephone company (Flamenco Bell), had made big gains in the prior year and seemed to be getting ahead of themselves. Did this mean there was no way for an investor to profit from government giveaways in 1992? Not as long as we've got a Resolution Trust Corporation.

We've already discussed one way to take advantage of the S&L mess—buying shares in the healthy S&Ls that are acquiring the branches and the deposits of their failed brethren. Another way was to buy stock in a company called Allied Capital II.

Allied Capital is one of the few venture capital firms that is publicly traded. It lends money, mostly to small companies, and in return gets a relatively high rate of interest plus a “kicker” (stock options,
warrants, etc.) that gives Allied a stake in the profits if the venture succeeds. This strategy has been so productive that a person who invested $10,000 in Allied Capital I when it came public in 1960 is sitting on a $1.5 million nest egg today.

One tangible result of an Allied Capital start-up loan is the air purifier that sits in our bedroom in Marblehead. This amazing piece of equipment removes so much grit from the air that our bedroom has the air quality rating of a genetic engineering lab. I've given one of these units to my mother-in-law and one to my secretary so they, too, can rid their lives of dust. The machine is made by Envirocare, a high-tech firm in which Allied Capital now has a large equity interest to go along with its loan.

Recently, the people from Allied Capital decided to perform an encore. They created a second pool of money ($92 million) by selling shares in Allied Capital II, which now trades on the over-the-counter market. The basic idea was the same as for the first Allied. The company borrows against its pool of money, in this case $92 million, to raise another $92 million. Now it has a pool of $184 million. It uses this $184 million to buy loans that pay, say, 10 percent interest.

If Allied II's own cost of borrowing is, say 8 percent, and it acquires a portfolio of loans that pay 10 percent, it can make a comfortable spread for its shareholders, plus the occasional equity “kicker” as described above. The company has few employees and few expenses.

The key to Allied's success has been the management's ability to get its money back. Unlike bankers, the lenders at Allied have been very picky about who can borrow the money, and very stringent about how much collateral the borrowers must put up. Allied Capital II, I'd heard, was using a portion of its pool of money to buy loans from the Resolution Trust Corporation.

We normally think of the Resolution Trust Corporation as selling condos, golf courses, gold-plated flatware, overpriced artwork, and corporate jets once flown by the owners of the bankrupt S&Ls. But the RTC also sells loans that were made by those wild and crazy guys. Among the many bum loans in these S&L portfolios, there are actually some good ones advanced to reputable borrowers with solid collateral.

Wall Street investment houses and the big banks have bought up many such loans in the multimillion-dollar category, but the loans of $1 million or less have not been so easy for the RTC to unload.
It's here that Allied Capital II had planned to enter the auction.

I called the company to assure myself that the same team that ran the original Allied Capital was also making the decisions at Allied Capital II. It was. Shares in Allied II were selling for $19, with a 6 percent dividend. Investing in Allied II seemed like a simple way to turn the S&L fiasco into something advantageous. Here was a chance to make back some of the taxes we all have to pay to finance the S&L bailout.

Every year since 1986, I've recommended Fannie Mae to the
Barron's
panel. It's getting to be boring. I touted it in 1986 as the “best business, literally, in America,” noting that Fannie Mae had a quarter of the employees of Fidelity and 10 times the profits. I touted it in 1987 as the “ultimate savings and loan.” In 1988, I said it was “a much better company than it was a year ago, and the stock is eight points lower.” In 1989, when Alan Abelson asked, “What is your favorite stock?” I answered, “A company that you have heard of before, the Federal National Mortgage Association.”

It's no accident that there's a snapshot of Fannie Mae headquarters alongside the family photographs on the memento shelf in my office. It warms my heart to think of the place. The stock has been so great they ought to retire the symbol.

During my final three years at Magellan, Fannie Mae was the biggest position in the fund—half a billion dollars' worth. Other Fidelity funds also loaded up on Fannie Mae. Between the stock and the warrants (options to buy more shares at a certain price), Fidelity and its clients made more than $1 billion in profits on Fannie Mae in the 1980s.

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.

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. There are always respected investors who say that
you're wrong. You have to know the story better than they do, and have faith in what you know.

For a stock to do better than expected, the company has to be widely underestimated. Otherwise, it would sell for a higher price to begin with. When the prevailing opinion is more negative than yours, you have to constantly check and recheck the facts, to reassure yourself that you're not being foolishly optimistic.

The story keeps changing, for either better or worse, and you have to follow those changes and act accordingly. With Fannie Mae, Wall Street was ignoring the changes. The old Fannie Mae had made such a powerful impression that people had a hard time seeing the new Fannie Mae emerging in front of their eyes. I saw it, but not right away. Not right away was still soon enough to make a sixfold profit on a $200 million investment. This is my Fannie Mae diary.

I took my first position in this $5 stock. What did I know about the company? It was founded in 1938 as a government-owned enterprise and then was privatized in the 1960s. Its function in life was to provide liquidity in the mortgage market, which it accomplished by buying mortgages from banks and S&Ls. Its motto was “Borrow short and lend long.” Fannie Mae borrowed money at cheap rates, used the money to buy long-term mortgages that paid higher fixed rates, and pocketed the difference.

This strategy worked OK in periods when interest rates were going down. Fannie Mae earned a lot of money during such times, because the cost of its borrowing decreased while the proceeds from its portfolio of fixed-rate mortgages stayed constant. When interest rates went up, the cost of borrowing increased, and Fannie Mae lost a lot of money.

I sold the stock a few months after I bought it, for a small profit. I saw that interest rates were going up.

Fannie Mae had a lot in common with the heroine of
The Perils of Pauline:
it was trying to avert the latest calamity. All the long-term mortgages it had bought in the mid-70s were paying from 8 to 10
percent. Meanwhile, short-term rates had skyrocketed to 18–20 percent. You can't get very far by borrowing at 18 to make 9. Investors knew this, which is why the stock, which sold for as much as $9 a share in 1974, fell to a historic low of $2.

This was one of those rare periods when a homeowner could say: “My house is OK, but my mortgage is beautiful.” Out the window there might be a slag heap, but people didn't want to move. They were staying put for the sake of their beautiful mortgages. This was bad for the banks, and terrible for Fannie Mae. There were rumors the company would go out of business.

Under my nose, Fannie Mae was about to undergo a major personality change. Some people noticed. Elliot Schneider of Gruntal & Co., an analyst who was known as the world's most dedicated Fannie watcher, predicted to his clients: “Fannie Mae will become the kind of girl you bring home to mother.”

The company we all thought we understood as an interest-rate play, losing millions one year, making millions the next, was trying to reinvent itself. A guy named David Maxwell was brought in. Maxwell was a lawyer and former insurance commissioner of Pennsylvania who earlier had started his own mortgage insurance company and made a success of it. He knew the industry.

Maxwell was determined to put a stop to Fannie Mae's wild swings. He wanted to turn the company into a stable, mature enterprise with reliable earnings. This he hoped to accomplish in two ways: (1) by putting an end to borrow short-lend long and (2) by imitating Freddie Mac.

Freddie Mac, formally known as the Federal Home Loan Mortgage Corporation, was also started by the federal government. Its mission was to purchase mortgages exclusively from S&Ls. Freddie Mac became a publicly traded company in 1970. In addition to simply buying mortgages and holding them, Freddie Mac had stumbled onto the newfangled idea of packaging mortgages.

The idea was simple: buy a bunch of mortgages, bundle them together, and sell the bundle to banks, S&Ls, insurance companies, college or charitable endowments, etc.

Fannie Mae copied the Freddie Mac idea and began packaging mortgages in 1982. Let's say you had a mortgage on your house that
came from Bank X. Bank X would sell your mortgage to Fannie Mae. Fannie Mae would lump it together with other mortgages to create a “mortgage-backed security.” It could then sell the mortgage-backed security to anybody, even back to the banks that had originated the mortgages in the package.

Fannie Mae got a nice fee for doing this. And by selling mortgages that it used to hold in its own portfolio, it passed the interest-rate risk on to new buyers.

This packaging service was very popular in banking circles. Before mortgage-backed securities 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. Now the banks could sell all their little mortgages to Fannie Mae and use the proceeds to make more mortgages, so their money wasn't tied up. If they still wanted to own mortgages, they could buy a few mortgage-backed securities from that same Fannie Mae.

Soon there was a market for the mortgage-backed securities, and they could be traded instantly, like a stock or a bond or a bottle of vodka in Moscow. Mortgages by the thousands, and later by the millions, were converted into packages. This little invention, if you could even call it that, was destined to become a $300-billion-a-year industry, bigger than Big Steel or Big Coal or Big Oil.

But in 1982, I was still looking at Fannie Mae as an interest-rate play. I bought the stock for the second time in my career, as interest rates were falling. In the notes I took after calling the company on November 23, 1982, I wrote: “… I figure they'll make $5 a share.” That year the stock rebounded in typical Fannie Mae fashion, from $2 to $9. This is what happens with cyclicals: the company loses money in 1982 and the stock increases fourfold, as investors anticipate the next golden age.