Bets on Fannie and Freddie Hit Home at These Funds

Last week was a bad week for Fannie Mae FNM and Freddie Mac FRE, the government-sponsored enterprises (GSEs) that buy and package mortgages and then sell them on the open market as mortgage-backed securities.

Fannie and Freddie together back about half of the mortgages in the U.S. market, providing much-needed liquidity, so if anything happened to them, the damage would be significant and far-reaching. That's why the stock market has been reacting so negatively to reports that Fannie and Freddie are facing a solvency crisis that will require them to raise new capital or take even more drastic measures, including a possible bailout by the federal government. Both stocks have plunged over the past week as the news has continued to get worse, and are now down around 80% for the year to date. That's on top of significant declines in the second half of 2007.

In December, we took a look at which mutual funds had the largest percentage of their portfolios in Fannie Mae and Freddie Mac stocks. (Also click to see a list of top fund owners as a percentage of Fannie and Freddie shares held.) Now that the situation has deteriorated so dramatically, we thought it would be a good idea to take a fresh look at the funds with the largest Fannie and Freddie positions in their most recent portfolios. This time, we singled out those funds with the largest combined percentage, rather than considering the two stocks separately, and we also eliminated clone or near-clone funds run by the same managers. The following table shows each fund's category, the size of its asset base, the percentage of the portfolio in Fannie Mae, the percentage in Freddie Mac, the combined percentage in the two stocks, and the fund's total return for the year to date through July 10.

Biggest Combined Fannie Mae and Freddie Mac Holdings
	Category	Size($Mil)	FNM (%)	FRE (%)	Total (%)	YTD Ret (%)
Fidelity Sel Home Fin FSVLX	Financial	110.4	10.88	12.73	23.62	-40.34
Touchstone Lg Cp Val TLCAX	Lg Value	25.8	6.46	7.08	13.54	-35.69
Morgan Stan Fin Serv FSVBX	Financial	64.1	6.13	5.76	11.88	-38.59
Schneider Val SCMLX	Lg Value	257.9	3.83	5.25	9.08	-24.07
Fidelity Sel Banking FSRBX	Financial	234.9	4.39	4.14	8.53	-33.64
JHancock Classic Val PZFVX	Lg Value	3,929.8	3.34	4.65	7.99	-25.08
Thompson Plumb Gr THPGX	Lg Blend	272.5	3.88	3.00	6.88	-22.79
DWS Dreman Con Val LOPEX	Lg Value	43.8	3.43	3.39	6.82	-22.38
AIM Fin Serv FSFSX	FInancial	278.2	4.90	1.78	6.68	-34.99
Harbor Global Val HAGVX	World Stk	66.0	2.42	3.51	5.93	-21.48
Data as of 07-10-08

Most of these funds are diversified, which should help limit the impact of one or two sinking stocks, but they've suffered deep losses anyway. Although their stakes in Fannie and Freddie have certainly hurt, they've felt a lot of pain across the board. The hardest-hit fund on our list, Fidelity Select Home Finance FSVLX, has nearly one-quarter of its portfolio in Fannie and Freddie. That big stake, combined with the fund's narrow focus on the hardest-hit area of financials, has led to a loss of 40% for the year to date through July 10, putting it behind 96% of its peers in the specialty-financial category. The three other financials funds are all in the bottom quartile of that category as well, and the six diversified funds on the list are all in the bottom 10% of their categories for the year to date, with every fund on the list having lost more than 20%.

Some well-known value managers with good long-term records are represented here, notably David Dreman of DWS Dreman Concentrated Value LOPEX, Richard Pzena of JHancock Classic Value PZFVX, and John C. Thompson of Thompson Plumb Growth THPGX. The top two diversified funds on the list are Touchstone Large Cap Value TLCAX, managed by John Schneider, and Schneider Value SCMLX, managed by his brother Arnie Schneider. Both brothers also have put together pretty good records in the past, Arnie at his current fund and John at Allianz OCC Renaissance PQNAX from 1999 to 2005, but they've suffered this year, with both funds ranking near the bottom of the large-value category.

Almost all of these funds were among the largest holders of Fannie and/or Freddie in December, suggesting that the managers have stuck with these beleaguered stocks. For most of these funds, the most recent available portfolio is from March 31, so we can't be certain that they still hold all of their Fannie and Freddie stakes, but the damage has clearly been done. (For the two Fidelity funds, the most recent portfolio is from May 31, and for the Dreman fund it's from April 30.)

Bond investors haven't been as worried about the fate of the GSEs. Though yields on Fannie and Freddie debentures have risen (and prices have fallen) during the past 12 months, they are around the same levels that they were in March before the Bear Stearns rescue. These agencies are very large issuers in the bond market, and its participants seem to be thinking that their failures would have far-reaching consequences for the U.S. economy (and hence they cannot and will not be allowed to collapse). Asset manager MetWest, manager of Analyst Pick Metropolitan West Total Return Bond MWTRX, has penned a thoughtful memo on the situation. Bill Gross of PIMCO has been adding to his positions in mortgage bonds recently, too.

David Kathman is a fund analyst with Morningstar