In a move that could influence others in the mutual fund industry, Fidelity Investments has dumped a large portion of its holdings in mortgage companies Freddie Mac and Fannie Mae.

The Boston-based fund giant ditched 48% of its holdings in Freddie Mac and about 17% of its holdings in Fannie Mae during the second quarter, according to filings with the Securities and Exchange Commission. While a Fidelity spokeswoman said the firm does not comment on its holdings and would not discuss any specifics, Fidelity's actions are closely watched by those in the industry and could cause others to follow suit.

Fidelity had previously owned a reported 8% of Freddie stock, while others such as Putnam owned 7%, and Alliance Capital and Barclay's Global Investors both had more than 4%. Fannie Mae and Freddie Mac are essential components to the nation's more than $3 trillion residential mortgage business. The pair were created by Congress, at different times, to act as middlemen between mortgage lenders and investors. Freddie Mac is the nation's fourth-largest corporation, while Fannie Mae is second behind only Citigroup, so the apparent lack of endorsement can send a message to others in the industry. Together the pair makes up 40% of the U.S. home mortgage market.

"The mutual fund industry in the past has suffered from the herd mentality," said Fred Siegel, author of Investing for Cowards and president of The Siegel Group, a New Orleans investment advisory firm with $1.2 billion in assets under management. Siegel explained that when an industry leader, such as Fidelity does something major, historically, other fund complexes have moved in step with the giant.

"Investors sometimes read into this what they want to believe, but it's difficult to know what the motives of an institutional seller are," said Jay Baris, a partner with Kramer, Levin, Naftalis & Frankel of New York. "It's hard to read the tea leaves when an institution makes a move like that." However, he said the move could reflect a concern in interest rates. "Interest rates have been volatile, and the market for mortgages has been challenging. It's difficult to know if this is a long-term or short-term trend. It's not a real time trade so it's difficult to say."

While the exact motivation for the move is unknown, Freddie and Fannie have had a lot of negative press lately. The most recent controversy has surrounded the firm's new Chief Executive Officer Greg Parseghian and the timing of his sale of shares of Freddie stock. A lawsuit filed recently by a pension fund for West Virginia alleges that Parseghian sold about 42,000 shares, or $2.7 million worth, of Freddie stock in June while he knew of improper accounting at the firm.

Parseghian issued a statement saying that he had nothing to hide and that his stock movements were within the guidelines of his deal with the company and in full compliance of the law. He also said he remains heavily invested in the mortgage giant.

Revelations of accounting problems were reported to the public earlier this summer (see MME 6/30/03). The news came about when Freddie conducted an internal investigation that showed irregularities in relation to its use of derivative contracts. Following the news, the firm indicated it would have to restate its earnings upwards for the last three years, by between $1.5 billion to $4.5 billion. This will hurt future earnings, Freddie said. Its net profits were reported as $5.8 and $4.2 billion, in 2002 and 2001, respectively.

Prior to the announcement, Freddie fired President David Glenn for not cooperating with the board's audit committee. The firm also announced the resignations of CEO Leland Brendsel and financial chief Vaughn Clarke. Parseghian, who was the firm's chief investment officer at the time, was chosen as successor to Brendsel because he was familiar with Freddie and was not at fault for the firm's poor accounting, according to the investigation. Brendsel, Glenn and the firm's former accountant Arthur Andersen were at fault, the investigation found. Shares of Freddie plummeted about 16% the day the news was announced.

The dismissal of three of the firm's top executives then caused regulators to launch an investigation into the way the McLean, Va.-based firm conducts its accounting of derivatives. While all this negative press surely could be a factor for the stock to fall out of favor with a fund giant such as Fidelity, some theorize the news is unrelated to the move. "The only reason I can think that they might want to [dump Freddie and Fannie stocks] is because of the capital requirements," Siegel said. "Regulators have increased capital requirements. This has happened before. Fidelity could simply be trying to reposition its assets."

Siegel said it could be an asset allocation move out of the financials. "Typically that happens when an investor such as Fidelity feels interest rates are ready to go higher," but Freddie and Fannie are good at hedging interest rates risk, he said.

Ted Parrish, co-portfolio manager of the Henssler Equity Fund, said that although Fidelity carries a lot of weight in the industry, the company's portfolio managers do not get their information on Freddie any faster than any of the other firms and that decisions should be based on sound research.

Parrish's fund has about $82 million in assets and owns Fannie stock. He said he thinks the recent news about the accounting and worries about the two giants are a bit overblown and that what's happening now is "short-term noise" for a long-term investment. "The mortgage market is large, but the two companies facilitate the American dream and provide liquidity for the housing industry."

Copyright 2003 Thomson Media Inc. All Rights Reserved.

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