Analyst Less Concerned Over Agencies' Pricing

Analyst Jonathan Gray has revisited his controversial position that profit margins on mortgage purchases by Fannie Mae and Freddie Mac are in a long-term decline - and this time he sees a brighter picture.

"New evidence on mortgage spreads mutes our concern that a secular decline in the spread on new mortgage investment might be under way," the Sanford C. Bernstein & Co. analyst wrote in a report last week.

Last summer, Mr. Gray argued that aggressive loan purchases by the agencies was driving down mortgage prices and return on equity more than expected. He predicted depressed earnings growth as a result.

What has changed his thinking?

Consumers are indeed paying less for their mortgages in relation to borrowing costs at the two agencies, Mr. Gray writes. But the decline in margins is eating into the profitability of mortgage bankers and other lenders, not mortgage investors such as the agencies, he says.

By focusing on the yields of Fannie Mae mortgage-backed securities rather than the rate paid by consumers, Mr. Gray concludes that while margins on agency mortgage purchases have shrunk since 1994, the declines are not alarming, and probably not long term.

The spread between investor yields and debt costs declined to 1.14% in 1994, against an average of 1.33% over the preceding eight years. It fell to 0.83% in the first quarter, but rebounded smartly to 1.02%.

By contrast, the spread between consumer mortgage rates and debt costs has fallen more drastically - to 0.95% in 1994, against an average of 1.31% from 1986 to 1994. It fell to 0.68% in the first quarter and has recovered only sluggishly to 0.77% in the third quarter.

Interest income from mortgages held in portfolio accounts for 70-75% of earnings at the agencies - formally the Federal National Mortgage Association and Federal Home Loan Mortgage Corp. - and they are building their portfolios vigorously. Each agency will purchase about $32 billion in mortgages this year, boosting Fannie Mae's portfolio to an estimated $252 billion and Freddie Mac's to $106 billion.

Spreads continue to be at risk, however, if rates rise and adjustable- rate mortgages become more popular with consumers.

This would "lead to a replay of the 1994 environment with elevated ARM share constricting the supply of loans sold to the agencies, leading them to bid up prices, driving down yields and spreads on new mortgage investment, and precipitating a deceleration in loan growth as well," Mr. Gray writes.

If there is a cloud on the horizon for Fannie Mae and Freddie Mac, it is credit risk, according to Mr. Gray. Overall, he predicts higher mortgage delinquencies from 1996 to 1998, as loans with low down payments made in 1994 and this year - an unusually high volume - enter their peak delinquency years.

But Fannie Mae and Freddie Mac will largely be shielded from higher delinquencies, because this year they hiked their requirements for mortgage insurance on low-down-payment loans, Mr. Gray writes.

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