Peter Lynch's Fannie Mae Diary: His Biggest Winner

Book: Beating the Street by Peter Lynch with John Rothchild | ISBN: 978-0-671-75915-5

Lynch recommended Fannie Mae to the Barron’s panel every single year from 1986 to 1992. It got boring, he admits. But it kept working. There’s a snapshot of Fannie Mae headquarters alongside his family photos on his office shelf. That’s how much the stock meant to him.

During his final three years at Magellan, Fannie Mae was the biggest position in the fund. Half a billion dollars’ worth. Between the stock and the warrants, Fidelity and its clients made more than $1 billion in profits on Fannie Mae in the 1980s. Lynch submitted that result to the Guinness Book of World Records as the most money ever made by one mutual fund group on one stock.

Here’s his year-by-year diary of how it happened.

1977: The First Buy

Lynch took his first position at $5 a share. Fannie Mae was founded in 1938 as a government enterprise, then privatized in the 1960s. Its job was to buy mortgages from banks and S&Ls, providing liquidity to the mortgage market. The strategy was simple: borrow short, lend long. Borrow at cheap rates, buy mortgages that pay higher fixed rates, pocket the difference.

It worked when interest rates fell. It was a disaster when rates rose. Lynch saw rates going up. He sold a few months later for a small profit.

1981: Near Death

Interest rates hit 18 to 20 percent. Fannie Mae’s old mortgages were paying 8 to 10 percent. You can’t borrow at 18 to make 9. The stock fell from $9 to a historic low of $2. Rumors swirled that the company would go out of business.

1982: The Transformation Begins

A new CEO named David Maxwell came in. Maxwell wanted to end the wild swings. He had two big ideas. First, stop borrowing short to lend long. Second, copy Freddie Mac’s new trick: packaging mortgages.

The concept was simple. Buy a bunch of mortgages. Bundle them together. Sell the bundle to banks, insurance companies, and endowments. Fannie Mae got a nice fee for doing this. And by selling mortgages instead of holding them, it passed the interest-rate risk to someone else.

Lynch bought again as rates were falling. The stock went from $2 to $9 in one year. But he was still thinking of it as an interest-rate play. He hadn’t yet grasped the bigger story.

1983-1984: Slow Progress

Fannie Mae was now doing $1 billion a month in mortgage-backed securities. Lynch noticed the company had huge advantages over banks. Banks had 2 to 3 percent overhead. Fannie Mae ran on 0.2 percent. No blimp. No toaster giveaways. About 1,300 employees total. Bank of America had as many branches as Fannie Mae had employees.

But the old bad mortgages, what Lynch calls “the block of granite,” were still dragging the company down. In 1984, rates went up and the stock fell from $9 back to $4. Lynch held a tiny position, about 0.37 percent of Magellan.

1985: The Dawn of Understanding

Now Lynch started to get it. Mortgage-backed securities could be huge. Fannie Mae was packaging $23 billion a year, double the prior period. The block of granite was shrinking.

A new worry appeared: Texas. S&Ls had been lending wildly in the oil-patch boom. Houston homeowners were leaving their keys in the door and walking away. Fannie Mae owned a lot of those mortgages.

But Lynch visited the company, talked to Maxwell, and liked what he heard. Competitors were dropping out of the mortgage business. With fewer competitors, profit margins widened. He increased his position to 2 percent of the fund.

He ran the numbers. If Fannie Mae could cover its overhead from mortgage-backed security fees and then make 1 percent on its own $100 billion portfolio, it could earn $7 a share. At 1985 prices, that was a P/E of 1. When a company can earn back its stock price in a single year, you’ve found something special.

1986: The Real Story Emerges

Fannie Mae sold $10 billion of its bad old mortgages. Only $30 billion remained. For the first time, Lynch told himself the stock was a buy on the mortgage-backed securities business alone.

The company also tightened its lending standards. While banks like Citicorp were making it easier to get mortgages with almost no documentation, Fannie Mae was making it harder. In Texas, Lynch joked, they were promoting the “no-way-Jose mortgage.” This would protect Fannie Mae in the next recession.

The stock rose from $8 to $12. Earnings hit $1.44.

1987: The Crash Test

The stock bounced between $12 and $16 all year, then crashed to $8 during the October correction. Lynch didn’t flinch. Fannie Mae had packaged $100 billion in mortgage-backed securities in a single year. The company had solved the ups-and-downs problem. CEO Maxwell told Lynch that if interest rates rose 3 percent, earnings would only drop 50 cents. The old Fannie Mae would have been destroyed by that. The transformation had worked.

After the crash, Fannie Mae announced it was buying back 5 million shares. The company was betting on itself.

1988-1989: Backing Up the Truck

Lynch describes different levels of conviction. There’s the “maybe this will work out” buy. There’s the “buy for your mother-in-law” buy. And then there’s the “sell the house, the boat, the cars, and the barbecue, and insist your mother-in-law, aunts, uncles, and cousins do the same” buy. That’s what Fannie Mae had become.

He pushed Magellan’s position to his 5 percent SEC limit. Fannie Mae earned $2.14 in 1988. Foreclosures dropped for the first time since 1984. Warren Buffett owned 2.2 million shares.

In 1989, the stock went from $16 to $42. A two-and-a-half-bagger in one year. Several years of patience were rewarded all at once. And even at $42, the P/E was only 10.

1990: Fear Returns, But the Story Holds

Saddam Hussein invaded Kuwait. The worry was that a national depression in real estate would cause hundreds of thousands of people to walk away from their homes. Fannie Mae would become the country’s landlord. The stock fell from $42 to $24.

Lynch thought it was absurd. Fannie Mae’s delinquency problems were tiny. Its average mortgage was $90,000, nowhere near the troubled luxury market. It had tightened underwriting standards years ago. The mortgage-backed securities business was still growing fast.

The stock bounced back to $38. The National Association of Realtors reported that average house prices actually increased in both 1990 and 1991. The housing depression never happened.

1991-1992: Record After Record

Lynch left Magellan, but his successor kept Fannie Mae as the number-one holding. The stock rose from $38 to $60. Earnings hit a record $1.1 billion.

By 1992, Lynch recommended it for the sixth straight year in Barron’s. The stock was at $69, earning $6 a share. A P/E of 11 when the overall market’s P/E was 23. The company was still growing 12 to 15 percent a year. Still undervalued, just as it had been for eight years.

The Lesson That Took 15 Years

Lynch’s Fannie Mae story isn’t about finding a hot stock and riding it for a quick profit. It’s about understanding a business, watching it change, and having the patience to hold through multiple panics.

He bought and sold too early in 1977. He started small in 1982. He gradually built conviction as the company proved itself year after year. He held through the 1987 crash, the Texas real estate scare, the Saddam Sell-off, and the housing fear that never materialized.

The stock went from $2 to $69 during the period Lynch tracked it. But you didn’t need to catch the bottom. If you understood the business and bought at almost any point along the way, you made excellent money. The key was knowing enough about the company to hold on when everyone else was selling.

That’s the real edge in investing. Not speed. Not timing. Knowledge and patience.

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