Tough Job for Fannie, Freddie: Boosting Profit Amid Rising Rates

Higher mortgage rates will make it harder for Fannie Mae and Freddie Mac to increase their earnings in the second half of the year at the current double-digit pace, analysts said.

To make up for the higher rates, they said, both mortgage agencies will divert their capital from mortgage purchases to share repurchases. The boards of directors at both companies recently authorized each to repurchase $1 billion of common stock.

These and other moves to restructure capital were intended to "set themselves up for tough times," said analyst Thomas O'Donnell of Smith Barney. "They should be a lot better able to protect themselves than they have in the past."

"There are tricks that a good chief financial officer will have up his sleeve," added Jonathan Gray of Sanford Bernstein & Co. In 1995, the last time high rates slowed earnings growth, Fannie Mae used a major accounting change for the way investment conduit fees are handled to offset the effect of higher rates, he said.

As the second-quarter earnings reports demonstrated, growth at Fannie and Freddie is powered by their loan investment business.

In the past year, Freddie Mac - formally the Federal Home Loan Mortgage Corp. - has added $40 billion of home loans, bringing its portfolio to $120 billion at the end of June. Fannie Mae - the Federal National Mortgage Association - added $38 billion of loans, a 17% increase, bringing its far larger loan portfolio to $269 billion.

Profits at Fannie Mae rose 14% over the comparable period last year, to $667.8 million, and 17% at Freddie Mac, to $309 million. Earnings per share were up 17% and 19% respectively, boosted by stock buybacks.

But with the 30-year fixed-rate mortgage edging toward 8%, and more increases looming, the companies' cheap and abundant supply of fixed-rate home loans is expected to shrink. By Freddie Mac's estimate, conventional loan originations will drop, from $360 billion in the first half of 1996 to between $275 and $300 billion in the second half.

In 1994, Fannie and Freddie coped with the shortage of new fixed-rate loans by buying mortgage-backed securities they had already guaranteed. This time around, Mr. O'Donnell is putting his stock in share repurchases.

Indeed, in a conference call with analysts on Tuesday, Freddie Mac chairman Leland C. Brendsel said his agency would repurchase common stock in the third and fourth quarters with the $250 million it raised earlier this year by issuing preferred stock.

Mr. Brendsel said the pace of the buybacks would be dictated by market conditions, but he predicted that Freddie will repurchase the authorized $1 billion within two to three years.

At Fannie Mae, stock buybacks began early this year. So far, Fannie Mae has purchased $40.7 million shares.

Still, the analysts emphasized that the accounting measures do not take away from the skill both companies have shown in managing interest rate risk and softening the effect of rising rates on underlying earnings.

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