Results at Fannie, Freddie Are Fodder for the Bulls

Strong fourth-quarter results have prompted a raft of adjustments in analysts' earnings projections for Fannie Mae and Freddie Mac.

"High-quality earnings, strong asset growth, improving credit quality, stable net interest margins. This momentum plus the more vibrant mortgage markets that began to surface in late 1997 will set the tone for the 1998 earnings and outlook for the companies," said Robert G. Hottensen, Jr., an analyst at Goldman Sachs & Co.

Mr. Hottensen lifted his 12-month price target on Fannie Mae stock to $68 from $65 after seeing the report. He lifted his target for Freddie to $55 from $53.

Fannie Mae reported fourth-quarter earnings of 74 cents a share, a 13.8% gain from the 65 cents earned in the year-earlier quarter. Fannie's net income rose to $794 million from $712.1 million.

Freddie Mac reported fourth-quarter earnings of 51 cents a share, a 19% gain from 43 cents in the 1996 quarter. Freddie's net income for the quarter rose to $372 million from $321 million.

The agencies, which buy loans and package them into securities, will benefit from increased mortgage lending and widening spreads between mortgage and Treasury rates, Mr. Hottensen predicted.

The revival in mortgage portfolio growth in the second half was the most important development of last year, said Thomas O'Donnell of Salomon Smith Barney. In early 1997, some pessimism emerged, but the fourth-quarter reports have "discredited the bear case" on Fannie and Freddie, he said.

Both agencies reduced credit losses by implementing better and more proactive servicing programs and deeper mortgage insurance coverage. Mild but consistent housing appreciation, a relatively strong national economy, and low mortgage rates also helped, Mr. Hottensen said.

Mr. O'Donnell lifted his stock price targets to $68 for Fannie Mae and $52 for Freddie Mac, from $66 and $47 respectively.

"An improvement in credit quality at both Fannie and Freddie has essentially baked in strong earnings per share growth for the next two years at least," Mr. O'Donnell said.

He set earnings estimates for this year and next to reflect a growth rate of more than 13% for Fannie Mae and 15% for Freddie Mac.

Jonathan P. Adams, senior analyst at Prudential Securities, increased his target price for Fannie to $70 from $64, and to $54 from $49 for Freddie.

Mr. Adams said he was "bullish" on both companies because he said they're going to do well in the short-term but also "because they're clearly developing products that will serve them well in the long-term," in less-favorable interest rate environments.

Fannie Mae reported $1.8 million in chargeoffs for the fourth quarter, a fraction of the $48.4 million for the same period a year ago. It took no loss provisions, compared to $50 million a year earlier. This indicates that "credit quality is improving rapidly," Mr. O'Donnell said.

"On a longer-term basis, Freddie Mac has probably gotten more benefit from improving credit costs because the run rate of credit costs embedded in current operating results is higher at Freddie Mac-so there is more to gain over time as industry credit improves," said Mr. Hottensen of Goldman Sachs.

Freddie Mac's use of automated underwriting in the mortgage market and its emphasis on purchasing loan pools through risk-based pricing-pricing for risk on a loan-by-loan basis-give it some competitive advantages, Mr. Adams said.

Fannie's introduction of a five-year benchmark note will provide the company with an important tool for reducing Fannie's funding cost, he said.

Fannie is focused on expanding its mortgage portfolio, and many of its fourth-quarter purchases were from seasoned securities, Remics, or alternative products, Mr. Adams said.

"They were able to find other product in the more generic mortgage market without relying on new product," he said. And in the first quarter of 1998, there may be a much greater supply of fixed-rate mortgages, which will be good news for Fannie because as supply increases the spreads will widen and Fannie can book that new production at a favorable yield, he added.

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