Friday, December 8, 2006

Lessons learned; Fannie Mae and Freddie Mac

Now that we are in the final innings of the "accounting restatements" with both Freddie and Fannie for the most part rehabilitated in the eyes of the Street, it would do investors well to reflect upon what actually transpired during this last two decades in the mortgage industry . This long period saw the most explosive growth in the mortgage industry this century, and investor sentiment swing from utter fascination with the two behemoths Freddie and Fannie in the late Nineties, to total disgust beginning in the earlier part of this decade, as investors saw the excess stock returns frittered away (first Freddie) by new revelations about management transgresssions and poor board and regulatory oversight.
Wall Street's obliviousness to relative risk and realizable long-term returns was never so obvious as here. The stocks galloped ahead in the late Nineties reaching a nose-bleed price/book valuation of more than six times book, despite the ceiling on its ROE. It was effectively capped as leverage reached 97%/98%. There was nowhere to go but down from here, and the forced shrinkage of the mortage book and additional capital retention imposed since the "scandal" erupted is testament to this. With both stocks now trading much closer to fair value, one might ask where is the opportunity. While these stocks are not "cheap" after the recent double digit runup, the relative play would probably continue to favor both these stocks over virtually all of the banking sector, given the annuity stream quality of the earnings, minimal credit risk, and comparable but more enduring ROEs. Thus a long/short paired trade through 2008 would allow investors to nimbly get through the coming turmoil in a weakening credit environment
with minimal exposure to a more severe downturn in the US economy.

1 comment:

Asif said...

Interesting thoughts. With all the accounting restatments and the unraveling of the housing bubble, most investors would have considered staying away from Fannie and Freddie.

I look forward to checking out your blog more often in the future.