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Peter Lynch (Index)
Federal National Mortgage Association (Fannie Mae)
1977-1993
Industry: Mortgages & MBS
Category: Cyclical/Product Innovation/Low Cost Operator
Context
Fannie Mae is a formerly government-owned business, privatized in the 1960s, functioning as a liquidity provider to banks by buying their mortgages.
The idea is to borrow at short-term rates, buy the mortgages from banks yielding long-term rates, and pocket the difference.
Most people understood Fannie Mae as an interest rate play.
When interest rates go down, Fannie Mae earns more money than usual because their cost of borrowing decreases, while fixed-rate mortgages stay constant.
When interest rates go up, Fannie Mae earns less money people their cost of borrowing goes up, while the fixed-rate mortgages stay constant.
In the mid-1970s, Fannie Mae had bought long-term mortgages paying 8-10%.
In 1981, since inflation was amass, the short-term interest rates skyrocketed to 18-20%.
There were rumors Fannie Mae would go bankrupt. The share price fell to $2/sh.
Why the Company is Mispriced
There were several reasons why the company was mispriced over the years.
People were fearful of a recession in real estate and disregarded Fannie Mae by association.
Many viewed Fannie Mae as a cyclical interest rate play, not recognizing that the company had been growing a thriving MBS business.
Many probably disregarded the company because it's a lot to understand.
Alternative View
Lynch took his first position at $5/sh in 1977.
In 1986, Lynch said Fannie Mae was the best business in America
In response to the 15%+ interest rates of the early 1980s, Fannie Mae reinvented itself.
It began to imitate Freddie Mac, creating Mortgage-Backed Securities (MBS).
For a nice fee, Fannie Mae packaged mortgages and sold them as an MBS, passing on the interest rate risk to the buyer.
Banks loved them because they could sell their mortgages and use the proceeds to create more mortgages.
Buyers loved them because they were diversified and a liquid security.
Fannie Mae had 2 competitive advantages. Fannie Mae didn't need a lot of overhead. Banks had 2-3% overhead while Fannie Mae only had 0.2% overhead.
Secondly, Fannie Mae's quasigovernment status allowed them to borrow money more cheaply than any bank.
These two advantages made Fannie Mae's cost so low, that they could make money on a 1% spread. No bank, S&L, or financial company can do that.
In 1986, Lynch realized that the company was a buy on it's MBS business alone.
The company was growing that business by 20%+ every year and looked like it could package 300b worth of MBSs a year.
Furthermore, Lynch figured if that company could earn a 1% spread on a 100b mortgage portfolio, the company would earn $7/sh, or a 1x PE.
Given the company was in the process of chipping away at it's mortgage portfolio, converting unfavorable mortgages made in the 1970s with higher interest mortgages.
A further interest rate decline would explode Fannie's earnings.
Lynch said, "There are different shades of buys.
There’s the “What else I am going to buy?” buy.
There’s the “Maybe this will work out” buy.
There’s the “Buy now and sell later” buy.
There’s the “buy for your mother-in-law” buy.
There’s the “Buy for your mother-in-law and all the aunts, uncles, and cousins” buy.
There’s the “Sell the house and put the money into this” buy.
There’s the “Sell the house, the boat, the cars, and the barbecue and put the money into this” buy.
There’s the “Sell the house, boat, cars, and barbecue, and insist your mother-in-law, aunts, uncles, and cousins do the same” buy.
That’s what Fannie Mae was becoming."
Result
Using Lynch's initial cost of $5/sh in 1977, to 1993's price of 78.50/sh, Fannie Mae was a 16x, or a 17% CAGR.
Notably
Warren Buffett owned Fannie Mae at a similar time as Lynch.