Updated from 12:14 p.m. EST

Fannie Mae

rode an explosion in mortgage refinancing to another year of strong earnings growth, and said the party should continue through 2002.

The flurry of mortgage refinancing sparked by low interest rates helped generate strong loan volume for the No. 1 U.S home loan financing company in 2001, contributing to better-than 20% earnings growth for the year. While the refinancing boom is expected to peter out by June, mortgage loan growth should continue to benefit from a strong market for new homes, while profitability is expected to remain high as long-term interest rates rise, boosting the company's net interest margins, analysts said.

In addition, the company has locked in 4%-5% mortgage portfolio growth for 2002 by rolling forward settlement of $39 billion in mortgage loans due last year -- compared with just $16 billion in commitments outstanding at the end of 2000 -- while credit costs are not expected to rise significantly. The company, which buys mortgage loans from banks and repackages them as securities, grows its earnings through the volume of loans purchased and the spread between its borrowing costs and the interest rate on the loans.

"While the most favorable phase of the mortgage cycle, namely a refi boom, will burn out over the next 3-6 months, Fannie Mae's earnings per share growth is likely to average 15% through 2003 and perhaps 13-14% through 2006," said Jonathon Gray, a Sanford Bernstein analyst. The firm forecasts just 6% earnings growth for the S&P 500 over that period, by comparison.

Pony Up

Several Wall Street analysts raised their earnings estimates and price targets after Fannie Mae announced the strong fourth quarter results and said earnings growth for 2002 will be better than expected.

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Excluding the effect of a change in the market value of purchased options, plus a one-time accounting change, Fannie Mae said it earned $1.44 billion in the fourth quarter, or $1.40 a share, a penny above the average analyst estimate, according to Thomson Financial/First Call. For all of 2001 Fannie Mae reported net income of $5.19 a share.

Analysts at UBS Warburg, Lehman Brothers, Credit Suisse First Boston and Sanford Bernstein raised their earnings estimates for 2002 and 2003 by around 5 cents to 10 cents and hiked their price targets to between $100 and $105. The shares closed Monday at $79, up 95 cents.

Sean Ryan of Fulcrum Global Partners was less sanguine about the prospect for the stock. While he raised his earnings estimate by 5 cents to $5.95 for 2002, he maintained a sell rating on the stock. "As rosy as its outlook is, it's hard to find a portfolio manager in this hemisphere who's not aware of it," he said. Fannie Mae's stock is about 9% below an all-time high of $86.75, hit in December of 2000.

Spread Capture

Fannie Mae's mortgage investments grew $101 billion to $698 billion in 2001, while net interest margins surged to 121 basis points from 98 basis points a year ago. The company's net interest income, which accounts for two-thirds of total profits, rose 62% in the fourth quarter to $2.4 billion while its guaranty fee income rose 17% to $398 million.

Sanford Bernstein's Gray projected that Fannie Mae's mortgage investments would grow 25% in the first half of 2002, and 21% in the full year, up from 16% growth in 2001, as a result of the $39 billion in debt outstanding that the company pulled forward.

While the surge in net margin in 2001 reflected "transitory benefits that accrue from the use of elevated levels of low-cost, short-term debt during refi booms," the steepening of the yield curve in recent weeks should prolong this benefit by delaying the pace at which mortgages prepay in the first half of this year, Gray wrote in a report. Gray forecast that net interest margins would average 106 basis points this year and decline to decline to 101 basis points in 2003.

Fannie's net interest margins are based on the spread between Fannie Mae's borrowing cost, which is linked to 10-year treasury rates, and the 30-year mortgage rates it purchases.

The company said credit losses could rise somewhat but noted that its book of business is backed by homes with an average equity exceeding 40% of the market value, while 35% of the mortgages the company owns or guarantees are backed by some form of third-party credit enhancement.

The biggest risk Fannie Mae faces is a rapid economic recovery. If growth picks up substantially, and the Fed responds by raising interest rates by 200-300 basis points, Fannie Mae's earnings growth could drop to 8% to 10% from 14% to 16%, wrote Gray.