- By Holly LaFon
Though he declined to help bail them out when they neared failure, Warren Buffett (Trades, Portfolio) at one point owned shares of two of the entities at the epicenter of the financial earthquake that shook markets in 2007 and 2008, Fannie Mae (FNMA) and Freddie Mac. His discussion of why he disposed of the holdings also provides insight into his thinking on investments in financials.
The intrinsic value of FMCC
Federal Home Loan Mortgage Corp. (FMCC) (Freddie Mac), a government-sponsored home mortgage lender, was delivering 23% returns on equity and trading for less than eight times estimated earnings when Buffett touted the investment to Fortune Magazine in 1988.
"'You've got a low price/earnings ratio on a company with a terrific record," Buffett told the magazine. "You've got growing earnings. And you have a stock that is bound to become much better known to equity investors.''
The article cited more reasons he found the stocks attractive: a hot market for residential mortgages, low delinquency rates and the entities' near monopoly on the market. Buffett's partner at Berkshire Hathaway (BRK-A)(BRK-B), Charlie Munger, was candid about their prospects.
''I can't think of a more tangible compliment to the stock than to buy every damn share we are allowed to," he said.
On Aug. 11, 1989, the earliest data available, Freddie Mac traded for around $6.63 per share.
By 2000, Buffett was the largest shareholder of Freddie Mac, whose stock had soared to between $41 and $64 per share, for a sizable gain. His view on it changed, though, and he unloaded nearly all of his Freddie Mac and Fannie Mae shares that year, according to his testimony to the U.S. Financial Crisis Inquiry Commission in May 2010.
When Brad Bondi, deputy general counselor of the commission, asked if he sold because the stocks were no longer good investments, Buffett responded that he "didn't know they weren't going to be good investments" but became "concerned" about their management.
"They were trying to -- and proclaiming that they could increase earnings per share in some low double-digit range or something of the sort," Buffett said. "And any time a large financial institution starts promising regular earnings increases, you're going to have trouble, you know?"
Management's promises seemed impossible to keep, and the doubt it cast on their ability to make scrupulous decisions in the future was enough for Buffett to sell.
"I mean, it isn't given to man to be able to run a financial institution where different interest-rate scenarios will prevail on all of that so as to produce kind of smooth, regular earnings from a very large base to start with; and so if people are thinking that way, they are going to do things, maybe in accounting -- as it turns out to be the case in both Freddie and Fannie -- but also in operations that I would regard as unsound," Buffett said. "And I don't know when it will happen. I don't even know for sure if it will happen. It will happen eventually, if they keep up that policy; and so we just decided -- or I just decided to get out."
In addition to management, another point sparked doubt in Buffett's mind: Freddie Mac invested in bonds of a cigarette maker, Phillip Morris or R.J. Reynolds, a move he called "totally unrelated to the mission."
"Now, they are dealing essentially with government-guaranteed credit, so we know about that and we had it ratified subsequently about what has happened. So, here was an institution that was trying to serve two masters: Wall Street and their investors, and Congress."
When he questioned the lender about its decision, Buffett did not like the response.
"And then they gave me some half-baked explanation about how it increased liquidity, which was just nonsense."
Then, he used the same insect metaphor he would apply when Wells Fargo (WFC) was discovered to have created fake accounts for its customers in a scandal years later.
"And the truth was that they were arbitraging the government's credit, and for something that the government really didn't intend for them to do," he said. "And, you know, there is seldom just one cockroach in the kitchen. You know, you turn on the light and, all of sudden, they all start scurrying around. And I couldn't find the light switch, but I had seen one."
Freddie Mac and Fannie Mae's stock prices did not begin to crash until seven years later in 2007 when mounting home foreclosures led to unsustainable losses. In 2008, Buffett passed when Freddie Mac approached him about participating in a capital infusion.
"They're looking for help, obviously. And the scale of help is such that I don't think it can come from the private sector," Buffett told CNBC.
Freddie Mac closed at $1.51 per share Thursday, down 46% for the year.
This article first appeared on GuruFocus.
The intrinsic value of FMCC