Fannie, Freddie still favorites in some funds

Although the stock prices of mortgage giants Fannie Mae and Freddie Mac were bruised, a handful of mutual funds continue to hold the securities, either because they underestimate the risk or because they are smarter than the average bear.

For example, the Fidelity Select Home Finance Fund (FSVLX) has a 23.6% combined weighting in the two government-sponsored enterprises as of May 31.

The fund’s benchmark, the MSCI U.S. Investable Market Thrifts & Mortgage Finance Index, has a 44% weighting in the two mortgage companies.

The Fidelity sector fund, managed by Fidelity Investments in Boston, had declined by more than 42% this year through last Wednesday.

This compares to a 15% drop in the Standard & Poor’s 500 stock index over the same period.

Shares of Fannie Mae and Freddie Mac, which have declined 76% since the start of the year, dropped 52% during the first two weeks of July.

The Touchstone Large Cap Value Fund (TLCAX), managed by West Conshohocken, Pa.-based JS Asset Management LLC, on March 31 reported a 13.5% weighting on the two mortgage companies, and it has declined by 37.5% so far this year.

The Morgan Stanley Financial Services Fund (FSVBX), from Morgan Stanley Investment Management in New York, reported on March 31 having an 11.9% combined Fannie Mae and Freddie Mac weighting, and the fund is down 39.6% from the start of the year.

The Schneider Value Fund (SCMLX), from Schneider Capital Management Co. in Wayne, Pa., reported a combined 9% weighting in the mortgage companies on April 30, and it has declined 25.8% since the start of the year.

Much of the July market reaction was linked to fears that a government rescue plan might wipe out the value of the mortgage companies’ stock, but share prices rebounded last Wednesday following a move by the Securities and Exchange Commission that restricts short selling of the stock.

While most portfolio managers and analysts have grown suddenly silent with regard to Fannie Mae and Freddie Mac, which combine for an estimated 80% share of the secondary-mortgage market, some financial advisers interpret the share price implosion as a no-brainer.

“You can’t have loose lending practices and soaring real estate prices, and not expect some kind of a problem,” said Clinton Struthers, president of Struthers Financial Services in Midland, Mich.

“It’s unfortunate that we never seem to learn anything, but it is this kind of situation that leads to changes and improvements,” said Mr. Struthers, who oversees $100 million in client assets. “I doubt the federal government is going to let either of those companies go out of business.”

That point was driven home last week by the SEC, which issued an emergency order against naked short selling of Washington-based Fannie Mae and McLean, Va.-based Freddie Mac, along with primary dealers at commercial and investment banks.

Naked short selling involves selling a stock short without first following the more traditional practice of borrowing the stock from a brokerage firm.

“The government is stepping in and saying, ‘Please don’t short-sell our private enterprise,’” said Sam Jones, president of All Season Financial Advisors Inc. in Denver.

“I wouldn’t be surprised to see more of those kinds of Mickey Mouse mandates, because the federal government can’t afford to have those companies go under,” added Mr. Jones, whose firm oversees $115 million for clients.

One portfolio manager, who spoke on the condition of anonymity, defended his Fannie Mae and Freddie Mac allocations despite what some critics have described as an illogical strategy.

“We’ve done the work, and we think they’re going to be fine,” the portfolio manager said. “Right now, there’s just a lot of panic and the question of how much these stocks can decline.”

According to the portfolio manager, the market is missing the fact that the 90-day mortgage delinquencies at Fannie Mae and Freddie Mac stood at less than 1% at the end of the first quarter.

Even if that rate doubles, the portfolio manager said, the increasing fees will more than cover any losses that might result from foreclosures.

“The writing was on the wall back in December when the [Fannie Mae and Freddie Mac] share prices were down more than 30%, and it’s gotten a lot worse,” said David Kathmann, a fund analyst at Morningstar Inc. of Chicago.

He reviewed those funds with the largest exposure to both Fannie Mae and Freddie Mac on Morningstar’s website in December, and then again earlier this month.

“It’s always hard to tell whether a 30% drop is a bottom or not, and these managers probably figured the stocks would rebound eventually,” Mr. Kathmann said. “They had plenty of time to get out, but even the best managers can get things wrong sometimes.”

While some advisers view the troubles of Fannie Mae and Freddie Mac as an endorsement for broad diversification, others see it as an opportunity to take advantage of a normal market cycle.

“We have been shorting those two stocks since February,” said Ralph Parks, chief executive of Ralph Parks Investment Group LLC in Pittsford, N.Y.

The firm manages $78 million.

“There’s a problem, and it will be resolved, and they will recover,” Mr. Parks added. “But if a little guy like me can figure this out, why can’t the big guys?”

E-mail Jeff Benjamin at [email protected].