Washington Research Group

Financial Services Bulletin

Steve Blumenthal
June 18, 2001
Page 1 of 4

GSE Profits and Long Term Political Risk

Do Fannie Mae and Freddie Mac have to be perpetual motion growth machines?

Summary: Although our opinion that the government sponsored enterprises face no
real political risk in the short- to mid-term (1 Yz-3Yz years) remains unchanged, this
report asks whether the longer term political risk for Fannie Mae (FNM 81)2 and
Freddie Mac (FRE 65)2 may be tied to the performance of their stocks. It could be.
Should FNM or FRE stock prices drop precipitously, the political environment in
which these companies operate could change dramatically. Do they have to be
perpetual motion growth machines to avoid otherwise inevitable congressional
involvement in their affairs and regulation?
The Senate change in control underscores what WRG has been saying for the last two
years: there is currently little or no real political risk to the government sponsored
enterprises (GSEs) of Fannie Mae (FNM 81)2 and Freddie Mac (FRE 65)2. That
remains our position for the year and a half that remains in the current congressional
session. Depending upon the outcome of the 2002 elections, our opinion could
extend unchanged into the next two-year congressional session leading up to the
presidential election of 2004.
However, we think it may be time to begin looking beyond the short and mid-term in
which we see only noise and no real risk of congressional interference with the GSEs.
Is the longer-term political risk for Fannie Mae and Freddie Mac tied to the
performance of their stocks in the marketplace? What troubles us is that,
indeed, it could be. Let Fannie Mae or Freddie Mac stock drop precipitously, and it
could trigger a series of events that could significantly change the political
environment in which these companies operate.
Instead of looking at how political risk can threaten performance, which has
been the focus of attention of many Street analysts, we suggest that in fact poor
stock performance could increase political risk in the future.

In the past five years, Fannie Mae's earnings have grown at approximately 14 percent
annually and Freddie Mac's at about 20 percent per year. First Call data suggests
that analysts expect EPS growth of 14-15 percent per year for both companies during
the next five years. Therein lies the rub. Wall Street apparently has come to expect
the earnings of the GSEs to grow at approximately these rates and has built this into
valuation for the stocks, with both stocks now trading at 14-15x 2002 estimated
earnmgs.
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Financial Services Bulletin

Steve Blumenthal
June 18, 2001
Page 2 of4

Still, year-to-date the shares have traded at a discount relative to the S&P 500,
perhaps because investors realize that, in order to maintain these rates of growth, the
GSEs will have to expand into potentially more risky lines of business. They will
likely have go further down the credit chain, get more into subprime lending, go into
marginally related businesses, lift mortgage caps, perhaps underwrite private
mortgage insurance, and so on. The American Enterprise Institute monographs on
"N ationalizing Mortgage Risk" raise the issue of potential GSE expansion as a
concern for policy makers.
Putting aside the focus on public policy considerations flowing from
concentration of the mortgage backed securities market and turning instead to
the relationship of stock performance to political risk, we think that the threat
to the GSEs in the long term may be real and perhaps inevitable.
If the GSEs were to miss their earnings targets or projected growth rates, we would
expect the stocks to sell off substantially. Thus, the GSEs are likely to remain under
pressure to continue business expansion, which in turn raises risk. A further squeeze
could then come from the debt markets, if concerns about higher operating risk (as
opposed to concerns about potential legislative risk) increased the cost of capital for
the GSEs. The much vaunted ability of the GSEs to hedge interest rate risks in the
derivatives markets has a cost which itself reduces margins. Thus a drop in the price
of the stock could create a cycle of higher risk, higher costs, and lower margins,
which could in turn lead to reduced earnings and further stock pressure. The problem
could be exacerbated by risk-based capital requirement formulas that require the
GSEs to put more into their capital base.
At some point Congress would notice "the problem at the GSEs" and feel the
need to get involved to avoid "another savings and loan crisis." As we have
already seen, the threat of congressional involvement can be expected to impact share
prices negatively, perhaps exacerbating the political problems by creating a
downward price spiral.
Congress rarely acts pre-emptively to pass legislation to head off a problem
before it occurs. In this case, however, the transmission of political momentum
from falling stock prices could create its own reality, with a sharp sell off of GSE
shares sending enough fear to the elected representatives to get them moving. In
our view, "forbearance" died with the savings and loan bailout.
If such a sell off occurs, we shudder to think what the congressional response might
be. Although it may be counter-intuitive, experience tells us that rather than
stimulation, the political response to concerns about slowing growth at the GSEs
will in fact be restriction, which would itself further exacerbate the problem.
Schwab Capital Markets L.P. Member SIPC/NASD
1000 Thomas Jefferson Street, N.W., Suite 606, Washington, D.C. 20007
Tel (202) 298-6226 Fax (202) 298-6146
Trading: East (800) 543-7995 West (800) 446-9843 BostonlNortheast (800) 637-8442

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Financial Services Bulletin

Steve Blumenthal
June 18, 2001
Page 3 of4

In that environment the political forces that could arise to bring about
legislation restructuring GSE regulation are not only those generated by
Washington think tanks, anti-GSE lobbyists, and competitors/critics ofthe
GSEs but also, and perhaps most importantly, the influence of Fannie and
Freddie themselves. While discussions occur on an irregular basis all the time, we
would not expect to see the GSEs move in support of legislation until they either
have to or can foresee the ripening of political problems as the result of market
valuation problems becoming a reality.

If Congress feels a need to act, our experience in watching the politically savvy GSEs
tells us they will try to lead the parade rather than have a legislative solution imposed
on them. The political timing of managing this process can be tricky, and our
antennae are out monitoring the current debate for signs of a GSE pre-emptive move.
Finally, there is the issue of regulatory, not legislative, action. Office of Federal
Housing Enterprise Oversight (OFHEO) oversight leaves little doubt that the GSEs
are "safe and sound." Politicians, like old generals, fight the last war. However,
instead of worrying about GSE failure, WRG sees political risk arising from the
political response to naturally flattening growth curves.
With the adoption of risk-based capital standards likely only weeks away, OFHEO
will have established the framework for assuring adequate capitalization of the GSEs
in the future. In effect, OFHEO has already anticipated additional risk in the
current or expanded future operations of the GSEs and is putting a regulatory
framework in place to deal with it. The implementation of risk-based capital
standards by OFHEO addresses the near and mid-term regulation of the GSEs. It also
goes a long way toward eliminating the perception of current political risk.
What does the future hold? What does OFHEO look at after and in addition to the
risk-based capital rules? Can any of the players in this game risk opening Pandora's
box by asking Congress to enact legislation for them to meet business-induced safety
and soundness considerations?
All this, of course, is long term. We believe that until such time as the GSEs are
unable to meet growth targets, or otherwise experience a significant and/or
precipitous drop in share prices, the path of least resistance for their
congressional overseers is to leave them alone.

***
Schwab Capital Markets L.P. ("SCM") is a member of the NASD and SIPC and is a market maker in over 5,000 securities. Schwab Capital
Markets L.P. is a subsidiary of The Charles Schwab Corporation which is listed on the NYSE and trades under the symbol "SCH".

Schwab Capital Markets L.P. Member SIPC/NASD

1000 Thomas Jefferson Street, N.W., Suite 606, Washington, D.C. 20007
Tel (202) 298-6226 Fax (202) 298-6146
Trading: East (800) 543-7995 West (800) 446-9843 BostonlNortheast (800) 637-8442

Highly Confidential

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Financial Services Bulletin

Steve Blumenthal
June 18, 2001
Page 4 of4

Charles Schwab & Co., Inc. ("Schwab") is a member of the NYSE, SIPC and other major U.S. Securities Exchanges, and is a specialist in various
securities on the Boston and Cincinnati Stock Exchanges. Schwab is also a subsidiary of The Charles Schwab Corporation.
The information contained herein is obtained from sources believed to be reliable, but its accuracy or completeness is not guaranteed. This report
is for informational purposes only and is not a solicitation, or a recommendation that any particular investor should purchase or sell any particular
security. SCM does not assess the suitability or the potential value of any particular investment. All expressions of opinions are subject to
change without notice. SCM and/or any of its affiliates, its officers, directors, employees, consultants and/or members of their families may have
a position in, and may from time to time, purchase or sell any of the mentioned or related securities including derivatives in such securities. At
any given time, SCM market makers, Schwab specialists, or any affiliate, may have an inventory position, either "long" or "short" in any security
mentioned in this report as a result of their market making, or specialist functions, respectively. Additionally, SCM or Schwab may be on the
opposite side of orders executed in the over-the-counter market, or on the floor of the Cincinnati or Boston Stock Exchanges respectively, as
well. SCM (or persons related thereto) or consultants may perform or solicit investment banking or other business from any company mentioned
in this report. 2001 Schwab Capital Markets L.P.
I) Schwab Capital Markets L.P. makes a market in this security.
2) An affiliate of SCM is a specialist in this security.
3) An affiliate of SCM has managed or co-managed a public offering in this security within the last three years.
4) An officer of an affiliate is a Director of this company.

Schwab Capital Markets L.P. Member SIPC/NASD

1000 Thomas Jefferson Street, N.W., Suite 606, Washington, D.C. 20007
Tel (202) 298-6226 Fax (202) 298-6146
Trading: East (800) 543-7995 West (800) 446-9843 BostonlNortheast (800) 637-8442

Highly Confidential

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