Fannie, Freddie red flags profited alert managers

Clearly, some mutual fund managers saw the writing on the wall. Over the 36-month period leading up to the government's takeover of Fannie Mae and Freddie Mac — a period during which the mortgage giants' problems first began to surface — some managers cut back or eliminated their investments in the two companies. "It just looked to us like there were more questions than answers," said Ronald Muhlenkamp, manager of the $969 million Muhlenkamp Fund (MUHLX), which reduced its position in Washington-based Fannie Mae (FNM) from 2.88% of its portfolio in the first quarter of 2006 to zero by the end of that year, according to Morningstar Inc. of Chicago. Mr. Muhlenkamp, who is the founder of Muhlenkamp & Co. Inc. of Wexford, Pa., is not the only manager with the foresight — or just plain dumb luck — to bail before the United States' seizure of Fannie Mae and Freddie Mac.
The $1.04 billion Weitz Partners Value Fund (WPVLX), from Weitz Securities Inc. of Omaha, Neb., reduced its holding in Fannie Mae from 6.29% of the portfolio in the fourth quarter of 2005 to zero by the second quarter this year. The $1.72 billion Clipper Fund (CFIMX) from Davis Selected Advisers LP of Tucson, Ariz., slashed its holdings in McLean, Va.-based Freddie Mac from 10.39% of its portfolio in the fourth quarter of 2005 to zero the very next quarter.

NO SURPRISE

The government's bailout of Fannie Mae and Freddie Mac came as no surprise to Matthew Norris, manager of the $60 million Ivy Value Fund (IYVAX) and the $421 million Waddell & Reed Advisor Value Fund (WVAAX), which are both owned by asset management units of Waddell & Reed Inc. of Overland Park, Kan. The funds no longer owned Freddie Mac by the first quarter of this year and got out of Fannie Mae completely about 30 to 60 days ago, said Mr. Norris. "We've been talking about the possibility here for about nine months," he said of the bailout. Even so, dumping the two companies prior to the government's move was no easy decision, said Mr. Norris, adding that to a value manager, the stocks looked attractive because they had gotten cheap. In recent months, however, they had become so cheap "there was no possible way to raise capital without diluting shareholder value," he said. Mr. Norris isn't the only manager to struggle with the decision to pare back on investments in Fannie Mae or Freddie Mac. As they are government-sponsored enterprises, many managers expected it to intervene if the companies got into too much trouble. Few, however, predicted that the companies would be completely taken over and the value of their shares made worthless, said Kevin Toney, co-manager of the $318 million American Century Mid Cap Value Fund (ACMVX) from American Century Investments of Kansas City, Mo. But as the months wore on, it became apparent that something drastic was going to happen, said Michael Liss, another co-manager of the fund. "When we started to comb though their portfolio, we determined that that [subprime-mortgage] exposure relative to their capital base was much higher then we thought," he said. "I don't think [Fannie Mae and Freddie Mac] managers had a clue how risky their portfolios had gotten."

RED FLAGS RISING

It raised a red flag for the team managing the American Century Mid Cap Value Fund. Managers cut back exposure to Fannie Mae from a high of 1.2% of the portfolio in the third quarter of 2006 to zero the next quarter and cut exposure to Freddie from a high of 3.77% of the portfolio in the third quarter of 2007 to zero by the first quarter of this year, according to Morningstar. The government takeover of Fannie Mae and Freddie Mac, however, was apparently a big surprise to some big-name mutual funds. The Legg Mason Value Trust (LMVTX) from Legg Mason Inc. of Baltimore didn't appear to own Fannie Mae but actually increased its exposure to Freddie Mac from zero in the second quarter of 2007 to 3.02% by the second quarter of 2008, according to Morningstar. The Dodge & Cox Fund (DODGX) from Dodge & Cox of San Francisco didn't own Freddie Mac but did increase its stake in Fannie Mae from zero in the fourth quarter of 2007 to 1.47% by the second quarter of this year. Failing to foresee the fate of Fannie Mae and Freddie Mac will certainly tarnish the funds' reputations, industry experts said. But it is something from which managers can learn. Funds offered by Weitz Securities "took a bath" because of their stake in Countrywide Financial Corp. of Calabasas, Calif., said Mike Breen, a senior analyst with Morningstar. Formerly a stand-alone company, Countrywide is now a unit of Bank of America Corp. (BAC) of Charlotte, N.C. That experience probably helped Mr. Weitz realize that holding onto Freddie Mac and Fannie Mae was a mistake, Mr. Breen said. "We still think very highly of the funds," he said. E-mail David Hoffman at dhoffman@investmentnews.com.