The story of Charlie Munger, Freddie Mac and Mutual SavingsRupert Hargreaves
I have recently been going through the historical annual reports of Wesco Financial Corporation in an attempt to learn something from the wit and wisdom of its former Chairman, Charlie Munger.
Charlie Munger was the CEO and chairman of Wesco from 1984 to 2011, when the company was fully acquired by Berkshire Hathaway. Wesco was originally the holding company for Mutual Savings, a savings and loan association, although over the years it grew into a sort of miniature Berkshire Hathaway (a comparison that Warren Buffett and Charlie Munger discourage). For a long time, the company owned 80% of Blue Chip Stamps as well as insurance subsidiaries, Precision Steel Warehouse, a real estate business and a portfolio of Securities.
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One of the stocks Wesco owned during the course of its life was Freddie Mac. Through its savings and loan business, Wesco acquired a substantial stake in the business in the late 80s, and in the company’s full-year 1989 annual report, Munger provides an interesting discussion on why he decided to take this action:
“The savings and loan association described in the foregoing paragraphs, quite different from most other associations for a long time, added a significant new abnormality during 1988. Mutual Savings increased its position in the stock of Federal Home Loan Mortgage Corporation (widely known as “Freddie Mac”) to 2,400,000 shares. This is 4% of the total shares outstanding, the legal limit for anyone holder at the time the shares were purchased. Mutual Savings’ average cost is $29.89 per share, compared to a price of $67.12 per share in trading on the New York Stock Exchange at the end of 1989. Thus, based on 1989 year-end trading prices, Mutual Savings had an unrealized pre-tax profit in Freddie Mac shares of about $89.4 million. At current tax rates, the potential after-tax profit is about $52.6 million, or $7.39 per Wesco share outstanding.”
The reason why Munger and team decided to initiate this position, is, it seems because investing in Freddie stock was a much more effective and efficient way to generate a return on capital rather than taking on additional risk in the savings and loan portfolio. As Munger describes:
“Freddie Mac supports housing primarily by purchasing housing mortgage loans for immediate transmutation into mortgage-backed securities that it guarantees and promptly sells. In the process, Freddie Mac earns fees and “spreads” while avoiding most interest-rate-change risk. This is a much better business than that carried on by most (or indeed most of the top 10% of) savings and loan associations, as demonstrated by Freddie Mac’s high percentage returns earned on equity capital in recent years.”
“At Freddie Mac’s current dividend rate ($1.60 per annum per share), Mutual Savings’ pre-tax yield is only 5.35% on its $29.89 average cost per share. Post-tax, the dividend yield is only 4.4%, but this amounts to about 75% of the current after-tax yield from very high-grade mortgages. Moreover, Freddie Mac has a very credible history of avoiding significant loan losses and increasing its earnings and dividend rate, thus contributing to increases in the market price of its stock. Following are figures for 1985-1989:”
As well as Freddie’s attractive qualities, there was another factor at play here. In the late 1980s, the US government was in the process of pushing through a series of adjustments to savings and loan laws under the acronym FIRREA, which, in the words of Munger turned the “almost-no-brainer,” non-home-mortgage deposit-gathering niche into a “brutally competitive market” with the ” resulting squeeze on interest rate ‘spread'” combined with “normal competitive disadvantages of associations” leaving the “average well run association with a likely future which should not excite its owners.”
Against this backdrop, in the letter, Munger speculated that Wesco might leave the savings and loan business altogether, as the economics deteriorate beyond a point at which an attractive return can be achieved. “If, as seems likely, Mutal Savings stays in the savings and loan business,” Munger opines ” it will retain a business even more mediocre than before, with only two interesting near-term prospects.”
One of these was a selection of Santa Barbara property acquired through foreclosure and “its Freddie Mac stock if, as anticipated, Freddie Mac pays ever-higher dividends and the price of the stock also rises.”
In fact, Freddie was actually better positioned to weather the changes to the industry better than Wesco, and possibly even profit as its size allowed it to capture new business and easily meet new regulatory capital requirements.
“Of course, a “by-product” of law revision Sometimes helps, instead of hurts, some participant in a market. New “risk-based” capital requirements under FIRREA have such an effect, as they give associations new incentives to transfer monies they otherwise would have earned to Freddie Mac, through exchange of mortgages for credit-enhanced, mortgage-backed securities. (Although the securities then provide less income, they help satisfy regulatory capital requirements, because the securities require less owners’ equity to hold.) This income-transfer effect should help Mutual Savings, through its large shareholding position in Freddie Mac.”