What Reforming Fannie Mae and Freddie Mac Could Mean for Your Portfolio

By Randall Rohn
Analyst, mPower

In This Story Expansion Raises Questions Competitive Advantage over Other Lenders Reform Implications Political Gridlock amid Solid Fundamentals

The ongoing controversy surrounding the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) was re-ignited following a recent study by Federal Reserve Board economists. The study questions whether Fannie Mae and Freddie Mac actually help lower the cost of borrowing for homebuyers, as supporters of these quasi-government organizations have long contended.

Many mutual fund managers control stock in these two Fortune 100 companies and are closely tuned to reform initiatives proposed by members of Congress and competing financial services firms.

minute: read this article at a glance.

Technical Terms Federal Reserve Board Large-cap funds Secondary market

These uniquely structured businesses are government-sponsored enterprises (GSEs) created by Congress for the explicit purpose of improving the mortgage markets. Fannie Mae (FNM) and Freddie Mac (FRE) buy certain mortgages from lenders and bundle them into securities they then sell to investors. This process — known as securitization — lowers risk through diversification and offers an element of standardization. Because their shares are publicly held, however, Fannie Mae and Freddie Mac are accountable to shareholders and thus charged with maximizing profits and shareholder value.

Expansion Raises Questions

There is an inherent tension between the firms' distinct structures, their mandates, and their responsibility to shareholders. While this tension is not always obvious, its corollaries have led some to call for the privatization of the companies and the end of government support. The Federal Reserve study concludes that "mortgage securitization does not necessarily lower" mortgage rates. The lenders' supporters dispute the study's conclusions, maintaining that Fannie Mae and Freddie Mac make lower rates possible by enhancing stability and liquidity in the secondary market for mortgages.

The remonstrations from various groups respond to the GSEs' efforts to enter new markets. Examples include their expansion into mortgage insurance, subprime mortgages and nonmortgage investments. Because their charters don't explicitly prohibit these activities, Fannie Mae and Freddie Mac argue that their expansion efforts are legal. Financial services firms, however, balk at the prospect of competing with the two lenders.

Competitive Advantage over Other Lenders

Fannie Mae's and Freddie Mac's ties to the government result in a lower cost of capital, enabling them to borrow at lower rates than conventional banks. In addition, their privileged status provides them access to a $2 billion line of credit with the Treasury Department, an advantage not enjoyed by their competitors.

The complaints stem from claims that Fannie Mae and Freddie Mac enjoy unreasonable advantages over other firms operating in the private sector. The list of advantages usually centers on the special "government securities" status of securities issued by the two. Such securities are exempt from Securities and Exchange Commission (SEC) requirements as well as state and local taxes. Moreover, the lenders' ties to the government result in a lower cost of capital, enabling them to borrow at lower rates than conventional banks. In addition, their privileged status provides them access to a $2 billion line of credit with the Treasury Department, an advantage not enjoyed by their competitors.

Others perceive the potential for moral hazard stemming from the quasi-government status bestowed by government sponsorship. Critics claim that the implied full backing of the government has led the GSEs to take greater risks than they otherwise might, exposing their shareholders — and ultimately, the U.S. taxpayer — to potentially damaging losses.

Setting aside for a moment the arguments for and against reforming the secondary mortgage market, investors should explore what effect such reform would have on the business models of Fannie Mae and Freddie Mac — and by extension, their market valuations.

Reform Implications

The shares of Fannie Mae and Freddie Mac are widely held and many portfolio managers include them as core positions in their portfolios. The types of funds owning these stocks vary across the spectrum. Vanguard and Fidelity, the two largest mutual fund companies, are each among the top 10 institutional holders of both.

Thus, many mutual fund investors, whether aware of it or not, have a financial stake in the future of the two lenders. These investors should consider the potential implications of the reforms now being weighed by lawmakers. While it is impossible to surmise the precise outcome of any potential reform, one can look to recent market activity for indications.

Rival lenders and a bloc of reform-minded lawmakers in the House of Representatives last year mounted a campaign to reform the two agencies. The movement called for tightening financial oversight and ending some of the privileges now enjoyed by the quasi-government lenders. The dispute weighed heavily on both Fannie Mae and Freddie Mac, which watched as their stock prices languished. In a reflection of the uncertainty surrounding the quarrel, the firms also saw their cost of borrowing increase.

Large-cap funds of all stripes buy Fannie Mae and Freddie Mac to gain exposure to the financial sector and to the mortgage lending space in particular. But, savvy investors would do well to keep a cautious eye on Washington, where the movement to reform these agencies continues.

The two companies subsequently made efforts to mute the offensive and toward the end of October, both sides reached a compromise. The agreement focused on making the firms disclose their loan purchase process but made no fundamental changes to the structure or status of the lenders.

The market watched these developments closely and beginning in September, shares in both companies began to rise. Apparently sensing that any agreement between the two sides would be relatively ineffectual, investors bid up the lenders' shares by roughly 50 percent over the two month period ending Nov. 1, 2000.

The consensus within the investment community is that Fannie Mae and Freddie Mac will retain their status and attendant privileges inherent in their unique structure. Meanwhile, the congressional campaign to reform the agencies rolls on, led by Rep. Richard Baker, a Republican from Louisiana.

Political Gridlock amid Solid Fundamentals

With political gridlock being the norm in Washington, however, most analysts discount the possibility of comprehensive reform legislation being pushed through Congress and signed by the White House. Investors and portfolio managers seem to agree, as shares of Fannie Mae and Freddie Mac continue to be widely held. Their conviction is that solid fundamentals, growth in earnings and expanding margins portend attractive market opportunities.

Related Reading Field Guide to Large-cap Stocks How the Election Might Affect the Markets Financial Services Transformed: The New Economy Makeover

In the near term, there is a compelling case for considering funds that invest in these stocks. Large-cap funds of all stripes buy Fannie Mae and Freddie Mac to gain exposure to the financial sector and to the mortgage lending space in particular. But, savvy investors would do well to keep a cautious eye on Washington, where the movement to reform these agencies continues. If historical market behavior is any guide, such efforts could have a corrosive effect on the valuation of these stocks. 

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.

What Reforming Fannie Mae and Freddie Mac Could Mean for Your Portfolio

By Randall Rohn
Analyst, mPower

In This Story Expansion Raises Questions Competitive Advantage over Other Lenders Reform Implications Political Gridlock amid Solid Fundamentals

The ongoing controversy surrounding the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) was re-ignited following a recent study by Federal Reserve Board economists. The study questions whether Fannie Mae and Freddie Mac actually help lower the cost of borrowing for homebuyers, as supporters of these quasi-government organizations have long contended.

Many mutual fund managers control stock in these two Fortune 100 companies and are closely tuned to reform initiatives proposed by members of Congress and competing financial services firms.

minute: read this article at a glance.

Technical Terms Federal Reserve Board Large-cap funds Secondary market

These uniquely structured businesses are government-sponsored enterprises (GSEs) created by Congress for the explicit purpose of improving the mortgage markets. Fannie Mae (FNM) and Freddie Mac (FRE) buy certain mortgages from lenders and bundle them into securities they then sell to investors. This process — known as securitization — lowers risk through diversification and offers an element of standardization. Because their shares are publicly held, however, Fannie Mae and Freddie Mac are accountable to shareholders and thus charged with maximizing profits and shareholder value.

Expansion Raises Questions

There is an inherent tension between the firms' distinct structures, their mandates, and their responsibility to shareholders. While this tension is not always obvious, its corollaries have led some to call for the privatization of the companies and the end of government support. The Federal Reserve study concludes that "mortgage securitization does not necessarily lower" mortgage rates. The lenders' supporters dispute the study's conclusions, maintaining that Fannie Mae and Freddie Mac make lower rates possible by enhancing stability and liquidity in the secondary market for mortgages.

The remonstrations from various groups respond to the GSEs' efforts to enter new markets. Examples include their expansion into mortgage insurance, subprime mortgages and nonmortgage investments. Because their charters don't explicitly prohibit these activities, Fannie Mae and Freddie Mac argue that their expansion efforts are legal. Financial services firms, however, balk at the prospect of competing with the two lenders.

Competitive Advantage over Other Lenders

Fannie Mae's and Freddie Mac's ties to the government result in a lower cost of capital, enabling them to borrow at lower rates than conventional banks. In addition, their privileged status provides them access to a $2 billion line of credit with the Treasury Department, an advantage not enjoyed by their competitors.

The complaints stem from claims that Fannie Mae and Freddie Mac enjoy unreasonable advantages over other firms operating in the private sector. The list of advantages usually centers on the special "government securities" status of securities issued by the two. Such securities are exempt from Securities and Exchange Commission (SEC) requirements as well as state and local taxes. Moreover, the lenders' ties to the government result in a lower cost of capital, enabling them to borrow at lower rates than conventional banks. In addition, their privileged status provides them access to a $2 billion line of credit with the Treasury Department, an advantage not enjoyed by their competitors.

Others perceive the potential for moral hazard stemming from the quasi-government status bestowed by government sponsorship. Critics claim that the implied full backing of the government has led the GSEs to take greater risks than they otherwise might, exposing their shareholders — and ultimately, the U.S. taxpayer — to potentially damaging losses.

Setting aside for a moment the arguments for and against reforming the secondary mortgage market, investors should explore what effect such reform would have on the business models of Fannie Mae and Freddie Mac — and by extension, their market valuations.

Reform Implications

The shares of Fannie Mae and Freddie Mac are widely held and many portfolio managers include them as core positions in their portfolios. The types of funds owning these stocks vary across the spectrum. Vanguard and Fidelity, the two largest mutual fund companies, are each among the top 10 institutional holders of both.

Thus, many mutual fund investors, whether aware of it or not, have a financial stake in the future of the two lenders. These investors should consider the potential implications of the reforms now being weighed by lawmakers. While it is impossible to surmise the precise outcome of any potential reform, one can look to recent market activity for indications.

Rival lenders and a bloc of reform-minded lawmakers in the House of Representatives last year mounted a campaign to reform the two agencies. The movement called for tightening financial oversight and ending some of the privileges now enjoyed by the quasi-government lenders. The dispute weighed heavily on both Fannie Mae and Freddie Mac, which watched as their stock prices languished. In a reflection of the uncertainty surrounding the quarrel, the firms also saw their cost of borrowing increase.

Large-cap funds of all stripes buy Fannie Mae and Freddie Mac to gain exposure to the financial sector and to the mortgage lending space in particular. But, savvy investors would do well to keep a cautious eye on Washington, where the movement to reform these agencies continues.

The two companies subsequently made efforts to mute the offensive and toward the end of October, both sides reached a compromise. The agreement focused on making the firms disclose their loan purchase process but made no fundamental changes to the structure or status of the lenders.

The market watched these developments closely and beginning in September, shares in both companies began to rise. Apparently sensing that any agreement between the two sides would be relatively ineffectual, investors bid up the lenders' shares by roughly 50 percent over the two month period ending Nov. 1, 2000.

The consensus within the investment community is that Fannie Mae and Freddie Mac will retain their status and attendant privileges inherent in their unique structure. Meanwhile, the congressional campaign to reform the agencies rolls on, led by Rep. Richard Baker, a Republican from Louisiana.

Political Gridlock amid Solid Fundamentals

With political gridlock being the norm in Washington, however, most analysts discount the possibility of comprehensive reform legislation being pushed through Congress and signed by the White House. Investors and portfolio managers seem to agree, as shares of Fannie Mae and Freddie Mac continue to be widely held. Their conviction is that solid fundamentals, growth in earnings and expanding margins portend attractive market opportunities.

Related Reading Field Guide to Large-cap Stocks How the Election Might Affect the Markets Financial Services Transformed: The New Economy Makeover

In the near term, there is a compelling case for considering funds that invest in these stocks. Large-cap funds of all stripes buy Fannie Mae and Freddie Mac to gain exposure to the financial sector and to the mortgage lending space in particular. But, savvy investors would do well to keep a cautious eye on Washington, where the movement to reform these agencies continues. If historical market behavior is any guide, such efforts could have a corrosive effect on the valuation of these stocks. 

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.