Stock performance improved in February for Fannie Mae and Freddie Mac, but Sallie Mae, after rallying early in the month, ended February at $36.88, a half-point below where it started the month.

While Fannie Mae outperformed the market and Freddie Mac nearly matched the market's 3.9% rise during the month, the government-sponsored enterprises underperformed a large number of financial stocks that rallied as interest rates declined.

For the shares of Fannie Mae and Freddie Mac, the correlation between stock prices and 30-year Treasuries declined again during February, though the link is still stronger than it was in early 1994. While the impact of changes in interest rates on the two companies' earnings should be slight over time (gains in market share - and retained portfolio growth - will drive earnings), there are benefits associated with lower long-term interest rates. The principal benefit should be the gradual shift in originations from adjustable-rate mortgages to fixed-rate loans.

In addition, lower rates should reduce borrowing costs, which in turn should help margins. We continue to wait for a change in ARM pricing, which should further boost fixed-rate originations, but there has been little change so far.

We are a bit concerned that some S&Ls may actually begin to lower introductory rates again to make their ARMs more attractive relative to the current lower rates on 30-year fixed-rate loans (well under 9% again). This would make portfolio growth a little more difficult in the second quarter than we'd hoped, but we continue to expect increased sales of seasoned ARMs by S&Ls later in the year, as rates on the loans adjust up to market levels.

Increased volumes of mortgages are necessary for continued earnings growth, but so are reductions in borrowing costs. We continue to believe that recoveries both in volume growth and in margin could occur at roughly the same time, resulting in an accelerating recovery.

January's growth was anemic, as expected, and there is little reason to expect much change in February. March could be better, but it is too early to tell. Our estimates assume a difficult first half, but with operating conditions gradually improving. This still seems reasonable.

Sallie Mae shares were essentially unchanged during February, reflecting the minimal benefit to the company from the decline in interest rates and the lack of change on the regulatory front.

While we expect a Senate bill that proposes restrictions on direct lending to be forthcoming, the introduction of legislation, even if it matches the House bill, does not ensure a change.

Due to budget accounting, reductions in direct lending will require other savings to be found that could put further pressure on Sallie and other Federal Family Education Loan Program participants' margins. As a result of this risk and the negligible earnings growth we expect, we maintain our neutral rating.

This analysis originally appeared as a research report from Bear, Stearns.

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