Beating the Street (40 page)

When I called in February, the company was doing $1 billion a month in these new mortgage-backed securities. 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. It didn't have a blimp. It didn't give away toaster ovens. It didn't pay Phil Rizzuto to advertise mortgage-backed securities on TV. Its entire payroll was around 1,300 people,
spread out in four offices located in four different cities. The Bank of America had as many branches as Fannie Mae had employees.

Thanks to its status as a quasigovernmental agency, Fannie Mae could borrow money more cheaply than any bank, more cheaply than IBM or General Motors or thousands of other companies. It could, for instance, borrow money for 15 years at 8 percent, use the money to buy a 15-year mortgage at 9 percent, and earn a 1 percent spread.

No bank, S&L, or other financial company in America could make a profit on a 1 percent spread. It doesn't sound like much, but a 1 percent spread on $100 billion worth of loans is still $1 billion.

Fannie Mae had begun to chip away at what it called the “block of granite”—the portfolio of long-term mortgages it had acquired in the mid-1970s at unfavorable rates. This was a slow process. The mortgages would roll over and Fannie Mae would replace them with mortgages that paid higher rates of interest. Still it owned $60 billion worth, yielding a collective 9.24 percent, when the average cost of its debt was 11.87 percent.

The company had gotten the attention of Thomas Hearns at Merrill Lynch, Mark Alpert at Bear Stearns, and Thomas Klingenstein at Wertheim. A lot of analysts were saying good things about it. They saw that further declines in interest rates would, as one of them said, “explode the earnings.”

After eight straight quarters of losses, Fannie Mae actually posted a profit in 1983. The stock went nowhere.

My commitment to the stock was a whopping .1 percent of Magellan's assets. But even a small position enabled me to keep in touch. I increased it, gingerly, to .37 percent by the end of the year. The stock fell in half again, from $9 to $4, and in typical old Fannie Mae style—interest rates rose and earnings fell. The benefits of mortgage-backed securities were still outweighed by the block of granite.

To avoid this predicament in the future, 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 10-year bonds at higher rates. This increased Fannie Mae's cost of money, penalizing earnings in the short term. But in the long run it made the company less vulnerable to the swings in rates that had been its bugaboo in the past.

The potential of these things was beginning to dawn on me. Mortgage-backed securities could be a huge industry—Fannie Mae was now packaging $23 billion of these a year, twice the number in 1983-84. Big pieces from the block of granite were being chipped away. Management now talked about “the old portfolio” and “the new portfolio.” There were two different businesses here: packaging mortgages and selling them, and originating mortgages and holding on to them.

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.

In May, I visited the company in Washington and spoke to David Maxwell. Several important competitors in the mortgage business had dropped out. With fewer competitors buying and selling mortgages, the profit margins on loans had widened. This would boost Fannie Mae's earnings.

I must have been impressed with Fannie Mae's progress. I bought more stock—enough to make Fannie Mae 2 percent of the fund, one of my top 10 holdings.

Beginning in July, I called Paul Paquin at the investor relations department for regular updates. The two numbers that appeared most frequently on my office phone bills were for Fannie Mae and my house in Marblehead.

Here's the key question to ask about a risky yet promising stock: if things go right, how much can I earn? What's the reward side of the equation? I figured that if Fannie Mae could pay for its overhead on the proceeds from mortgage-backed securities and then make 1 percent on its own $100 billion portfolio, it could earn $7 a share. At 1985 prices, that gave the stock a p/e ratio of 1. When a company can earn back the price of its stock in one year, you've found a good deal.

At first, I took pages and pages of notes on my conversations with Fannie Mae, but now I knew the company so well I could jot down the new developments on a single sheet.

Fannie Mae lost 87 cents a share in 1984 but made 52 cents in 1985. The stock rebounded from $4 to $9.

I retreated a bit. Now only 1.8 percent of the fund was invested in Fannie Mae. Wall Street was still worrying about Texas and the keys in the doors. Here in my notes of May 19 was a more important development: Fannie Mae had just sold $10 billion of its block of granite, and only $30 billion of these unfavorable loans remained. For the first time, I told myself: “This stock is a buy on the mortgage-backed securities alone!”

Another new card that turned up: Fannie Mae was tightening its lending standards on new mortgages. This turned out to be a very smart move, because it protected Fannie Mae in the next recession. 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-José mortgage.

The blemishes on Fannie Mae were obscuring the beauty of the mortgage-backed securities. This business was sure to grow, as refinancing turned into the national pastime. Even if new houses weren't selling, the mortgage business would grow. Old people would move out of old houses and new people would buy the old houses, and new mortgages would have to be written. Many of these would end up in Fannie Mae's packages, and Fannie Mae would get more fees.

The company had remade itself, and was on the verge of the great explosion that Thomas Klingenstein foresaw in 1983, yet most analysts were now skeptical. Montgomery Securities told its clients that “Fannie Mae is overvalued relative to the average thrift in our coverage.” Was this really an average thrift? “The significant recent drop in oil prices,” Montgomery continued, “could negatively impact the firm's $18.5 billion in mortgages exposed to the [Southwest] region.”

Fannie Mae was chipping away at the block of granite. It sold another $10 billion of its old mortgages that carried interest rates unfavorable to Fannie Mae.

In the last five months of 1986, the stock rose from $8 to $12. The company earned $1.44 for the year.

Between 2 and 2.3 percent of Magellan was invested in Fannie Mae throughout the year. The stock seesawed from $12 to $16, back to $12, back to $16, and then suffered a setback to $8 in the Great Correction of October. Wiggle watchers were befuddled.

I'm getting ahead of myself. In February, I talked to four Fannie Mae executives on a conference call. I learned that foreclosures on houses with Fannie Mae mortgages were still on the rise. Fannie Mae had taken back so many houses in Texas that it had become the biggest real-estate mogul in Texas, literally by default.

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 millions more to cut the grass and paint the stoops and otherwise maintain the abandoned houses until buyers could be found. At the moment, buyers were scarce.

The housing market in Alaska had also deteriorated. Fortunately for Fannie Mae, the Alaska housing market is very small.

In my mind, these negatives were overshadowed by the amazing success of mortgage-backed securities—$100 billion worth packaged in this single year. Also, Fannie Mae had solved the problem of ups and downs. It no longer qualified as a cyclical. It was beginning to resemble Bristol-Myers or General Electric, a steady grower with predictable earnings. But it was growing much faster than Bristol-Myers. Its earnings had jumped from 83 cents to $1.55.

On October 13, days before the Great Correction, I called the company again. David Maxwell, the CEO, made an interesting statement that confirmed my suppositions: if interest rates were to rise 3 percent, he said, Fannie Mae's earnings would decline by only 50 cents. Never could such a thing have been said about the old Fannie Mae. This was a watershed—the company was telling us that the transformation had succeeded.

Along with the rest of the stocks, Fannie Mae got clobbered on October 19. Investors were panicky and commentators predicted the end of the world. 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.

I reminded myself of the Even Bigger Picture, that stocks in good companies are worth owning. I was convinced Fannie Mae was a
good company—what was the worst thing 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. As long as people were paying on their mortgages, Fannie Mae would be the most lucrative business left on the planet.

As the end of the world approached and people stopped paying their mortgages, Fannie Mae would go down with the banking system and all the other systems, but it wouldn't happen overnight. The last thing people would give up on (except in Houston, apparently) would be their houses. I couldn't imagine a better place to be invested in the twilight of civilization than Fannie Mae stock.

Fannie Mae must have agreed with me. In the aftermath of the Great Correction, the company announced it was buying back up to 5 million shares.

There are different shades of buys. There's the “What else I am going to buy?” buy. There's the “Maybe this will work out” buy. There's the “Buy now and sell later” buy. There's the “buy for your mother-in-law” buy. There's the “Buy for your mother-in-law and all the aunts, uncles, and cousins” buy. There's the “Sell the house and put the money into this” buy. There's the “Sell the house, the boat, the cars, and the barbecue and put the money into this” buy. There's the “Sell the house, boat, cars, and barbecue, and insist your mother-in-law, aunts, uncles, and cousins do the same” buy. That's what Fannie Mae was becoming.

I boosted Magellan's holding to 3 percent throughout most of 1988. The company earned $2.14, up from $1.55. Sixty percent of its mortgage portfolio had been acquired under the new, tougher standards.

Fannie Mae's foreclosures had dropped for the first time since 1984.

In addition, the government had new accounting rules on the mortgage business. Heretofore, mortgage commitment fees were “booked” as income as soon as Fannie Mae received them. The company might receive $100 million in fees one quarter and $10 million the next. This accounting system caused severe fluctuations in Fannie Mae's quarterly earnings. It was not uncommon for Fannie
Mae to report a “down” quarter, which would scare investors and create a sell-off in the stock.

Under the new rules, commitment fees had to be amortized over the life of each new mortgage loan. Fannie Mae has not suffered a down quarter since these rules went into effect.

I noted that great investor Warren Buffett owned 2.2 million shares. I talked to the company several times. July showed a major improvement in nonperforming assets. There was a small problem with defaults in Colorado, but the Texas problem was going away. Miracle of miracles: house prices were on the rise in Houston.

From the National Delinquency Survey, my latest bedside entertainment, I learned that Fannie Mae's 90-day delinquency rate had dropped again, from 1.1 percent in 1988 to .6 percent in 1989. I also checked the “price of the median house” statistic to reassure myself that home prices weren't collapsing. They weren't. They were rising, as usual.

This was the year I backed up the truck. “Backing up the truck” is a technical Wall Street term for buying as many shares as you can afford. Now 4 percent of Magellan's assets were invested in Fannie Mae, and toward the end of the year I reached my 5 percent limit. It was my largest position by far.

Fannie Mae was now packaging $225 billion worth of new mortgage-backed securities. It would now earn $400 million a year from a packaging business that didn't exist in 1981. Not an S&L in the universe wanted to own a mortgage now. They shipped them all off to Freddie Mac or Fannie Mae.

Finally, Wall Street was catching on to the idea that this company could continue to grow at a 15–20 percent rate. 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.

Even at this higher price, Fannie Mae was still undervalued, with a p/e of 10. A negative article on the housing market, called “Crumbling Castles,” appeared in
Barron's
in December. The tag line read: “The Recession in Real Estate Has Ominous Implications.” The
illustration showed a two-story house with a sign in the front yard that pleaded: “For Rent, for Sale, for Anything!”

If it weren't for the housing fear that refused to die, Fannie Mae would have been a $100 stock.

I tried to maintain the 5 percent limit, the maximum allowed by the SEC. Fannie Mae's shares had increased in price to the point that for a short period the holding actually represented 6 percent of the value of the fund. This was OK, as long as the 5 percent limit had been exceeded because the stock price had gone up, and not because I'd bought more shares.