Tuesday, October 09, 2007

Appreciating Fannie and Freddie

Reflections on Value Investing recently put up "An Interview with Richard Pzena" conducted in 2006. In it, he shares some great insight into the Government Sponsored Entities(GSEs), Fannie Mae and Freddie Mac:

Take Fannie Mae and Freddie Mac: nobody would touch these stocks. Why? There was potentially bad accounting, and the government could have pulled the plug because of the bad accounting. Did anybody ever sit there and say, “Does the accounting matter in this business.” I mean how many people looked at this and said, “You can’t use generally accepted accounting principles for this business.”

You can’t. The fact that anybody is even looking at GAAP earnings is ludicrous, including it’s a hedge fund. What are Fannie and Freddie? They’re a small number of people sitting in Washington DC who buy mortgages and fund them with debt. And the reason they make more money than anybody else doing this is because their status allows them to borrow long-term, and no financial institution can borrow long-term. Not even Citibank. If you look at Citibank’s balance sheet there’s not a lot of long-term debt on it. Fannie and Freddie’s long-term debt is callable debt, so they can pretty much match the duration of the asset and the liability side and take very little interest rate risk. Nobody else can do that so they make a spread. The regulators understand that nobody else can do that so they have a low capital requirement and earn a high return on equity. So if you invested in that fund, let’s say it was a fund instead of a stock, if you invested in that fund it would have returned 20-25% per year after-tax for the last 20 years. Pretty good business.

This is a very great advantage. In fact, almost all the problems in the banking industry come from the mismatch of short term borrowing and long term lending. Add to that the GSEs special status which makes investors feel it is essentially backed by the US government. This allows them to borrow at the rate of the US government, plus about 10 to 15 basis points. These two benefits give a huge moat around the company. But perhaps the most interesting statement is this:

"And the stock gets killed. So where does it go? It actually trades below the liquidation of their portfolio. Forget accounting, I could stop the business and earn a profit. And people are saying, “Oh my god, the business is going to stop. I don’t want to own the stock.” But it’s already selling for below what it’s worth if the business stops. And if doesn’t stop, you’re making a fortune."

Since this interview, the share prices of both companies have gone essentially nowhere, while the businesses have continued to operate, so I can only assume the discount has increased. If so, this might still be a great opportunity to get into a wide moat company at a very cheap price.


Anonymous said...

Going through the intelligent reasons of why to sell a holding, why do we think that Buffett sell his Freddie Mac holding?

Was it (1) a valuation decision? (2) level of complexity in new instruments was uncomfortable and risky, or Freddie Mac took a turn outside his circle of competence? (3) based on the World changing, Freddie Mac no longer had a durable competitive advantage? (4) he had better things to do with the money? (5) he had made a mistake in the first place when buying it? (#5 seems unlikely...)

Nnejad said...

That's a very interesting question. Gut feeling makes me want to say 2 because I've been looking into it lately and still feeling pretty lost. I'm going to have to spend some more time but hopefully I can post something about this soon.