The mortgage agencies Fannie Mae and Freddie Mac have exhibited extraordinary finesse in managing through the largest refinance boom in history and then through an abrupt transition to a rapidly rising rate environment.

Yet despite prospective earnings-per-share growth of 10% to 11% for the Federal National Mortgage Association and 13% to 14% for the Federal Home Loan Mortgage Corp., valuation remains below the historic level of 65% of the market multiple.

Although the growth rate in earnings per share at Fannie Mae is likely to be below the 12% to 15% trend rate during 1995 and 1996, double-digit growth through a credit crunch would seem a performance worthy of a standing ovation, and is consistent with our earlier research.

Both agencies are fueling earnings through aggressive loan portfolio growth, fed with purchases of their own mortgage-backed securities and funded by equity reinvestment rates of 17% to 18%.

Although new mortgage originations may fall from $1 trillion in 1993 to perhaps $600 billion in 1996, and fixed-rate originations from $800 billion to $300 billion, the agencies are no more confined to originations for loan growth than an equity investor is tied to the new-issue markets. The agencies can and do purchase their own mortgage-backed securities in the open market. Roughly $1.5 trillion of mortgage-backed securities are outstanding (Fannie, Freddie, and Ginnie combined), and turnover is as high as 400% annually, or $6 trillion.

Thus, while net growth in mortgage-backed securities, net of purchases for their own portfolios, is forecast at just 5% annually, or just half to one-third the projected growth rate in earnings per share, retained loan portfolio growth is forecast at 18% for Fannie Mae and 25% for Freddie Mac, well above the projected rate of growth in earnings per share.

This rapid loan growth is enough to offset sluggish mortgage-backed securities growth, net interest margin contractions, and declines in real estate mortgage investment conduit fees, and deliver double-digit earnings growth.

Net interest margins at Fannie Mae, which declined from 1.37% in 1993 to an estimated 1.24% in 1994, are likely to decline modestly from 1.19% in fourth-quarter 1994 to an estimated 1.17% in 1995, and 1.14% in 1996, assuming an incremental 150 basis point increase in the fed funds rate by late 1996.

Net interest margins have been affected by a decline in the percentage of assets funded with interest-free funds (equity, reserves, and float), thinner-than-normal spreads on new mortgage purchases, and some compression of the spread on fixed-rate mortgages held in portfolio as debt costs are likely to have risen faster than mortgage yields.

Net interest spreads at Freddie Mac are also declining for the reasons cited above, and because debt maturities have been lengthened. However, float income generated by Freddie Mac's mortgage-backed securities portfolio was depressed during the refinance boom, and has recovered with the end of refis and a flattening of the yield curve. As a consequence, earnings per share are expected to grow somewhat faster than for Fannie Mae over the 1995-6 time frame.

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