Fannie Mae Soothes the Street

Fannie Mae's worse-than-expected first-quarter loss, reported on May 6, shouldn't come as a surprise to anyone who has followed the news of continuing declines in home prices across the U.S.

Still, the mortgage giant was able to offer some glimmers of hope to Wall Street: While its credit quality is expected to keep falling into next year, revenues are up and its liquidity position is improving with the help of loosening regulatory requirements and an effort to raise $6 billion in capital.

Shares Gained
Fannie Mae (FNM) reported a net loss of $2.2 billion, or $2.57 per share, for the first three months of 2008, vs. a profit of $961 million, or 85% per share, a year ago, on a 38.2% rise in revenue, to $3.78 billion.

The higher revenue came from a $131 million increase in guaranty income and a $554 million hike in net interest income, reflecting growth in the guaranty business, higher guaranty fees, and the lower cost of debt.

The rise in revenue was offset, however, by fair value losses and credit-related costs that stemmed from adverse market conditions, including a widening of credit spreads and higher-than-expected declines in home prices and loan loss severity during the first three months of the year.

The net loss was sharply wider than an 81% loss forecast by analysts, but investors may have been relieved it was smaller than Fannie's loss of $3.80 in the fourth quarter. The shares gained 8.9% on May 6, to close at 30.81.

A Nod from OFHEO
The government-sponsored enterprise ended the March quarter with $42.7 billion in core capital, $5.1 billion over the company's current regulatory requirement that it maintain a 20% cash surplus on its balance sheet.

Washington-based Fannie Mae also said it will raise $6.0 billion in capital through public offerings of common stock, mandatory convertible preferred stock, and nonconvertible preferred stock. It will also cut its quarterly dividend to 25% per share, starting in the third quarter, which will free up about $390 million in cash per year.

Fannie Mae's quarterly release coincided with an announcement by the Office of Federal Housing Enterprise Oversight, or OFHEO, that it had lifted the May, 2006 consent order, which required that the company strengthen its accounting procedures, internal controls, and corporate governance, among other things. Investors heaved a sigh of relief after a similar announcement when Fannie announced its fourth-quarter 2007 results in February.

On May 6, OFHEO said it plans to lower its capital surplus requirement from 20% to 15% once the company completes its capital-raising effort and to reduce it further to 10% in September as long as Fannie can maintain excess capital well above OFHEO's requirement and keep up its regulatory compliance. OFHEO reduced its cash surplus requirement to 20%, from 30%, on Mar. 19.

Mark-to-Market Loss
Once the surplus cash requirement falls to 10%, that should allow Fannie and its main competitor, Freddie Mac (FRE), to invest in at least $350 billion of additional mortgages, says Robert Napoli, an analyst at Piper Jaffray (PJC) in Chicago.

While he expects Fannie's credit losses to get larger into 2009, the more important point for investors is that Fannie, between its revenue growth, efforts to raise capital, and lower cash surplus requirements from OFHEO, is likely to have more than enough balance-sheet strength to "reduce the need for them to raise substantially more dilutive capital," he says. "Credit losses are going to go up in 2009, but people feel they have far more than enough capital to manage their credit losses."

Napoli says his neutral rating on the stock has been based on the uncertainty surrounding credit losses, which he now expects to peak in 2009. [Piper Jaffray makes a market in the securities of both Fannie Mae and Freddie Mac.]


While the revenue increase was positive, the biggest negative surprise was a $3.2 billion mark-to-market loss related to a drop in interest rates during the first quarter, says Gary Gordon, an analyst at Portales Partners in New York. He found the charge especially jarring after hearing Freddie Mac say in March that it expected its interest rate mark-to-market to be close to zero.

The reason for the difference: Fannie has only now qualified for hedge accounting on the credit derivatives it uses to protect itself from big swings in interest rates, while Freddie has been using the accounting method for some time. [Freddie Mac, which is slated to report results May 14, saw its shares rise 7.1% on May 6, to 27.33.]

The Housing Slump's Effect
Under hedge accounting, any mark-to-market losses or gains would go through Fannie's balance sheet instead of its quarterly income statement, reducing the impact on earnings from volatility in interest rates. Over time, those losses and gains on the balance sheet are expected to balance out to zero. That means Fannie wouldn't be able to record an expected gain from a narrowing in credit spreads so far in the second quarter, says Napoli.

Fannie also recorded a $1.1 billion charge in the first quarter on mortgage-related securities backed by Alt-A and subprime loans that were classified as trading securities.

Ironically, the deepening of the housing slump has worked to Fannie's benefit, as reflected in rising revenue. The growing number of mortgage delinquencies and defaults has driven some of the weaker mortgage lenders out of the market, enabling Fannie and Freddie to increase their market share and raise their mortgage guaranty fees, says Gordon at Portales. Fannie estimated its market share of new single-family mortgage-related securities issued at 50.1% for the first quarter, up from 48.5% in the fourth quarter of 2007.

A Likely Profit in 2009
Fannie Mae said it now expects home prices across the U.S. to fall by an average of 7% to 9% this year, having already dropped 3% in the first quarter. With credit losses now expected to be bigger due to a sharper decline in home prices, the company now estimates charge-offs will equal 0.13% to 0.17% of its asset portfolio instead of the 0.11% to 0.13% it projected in February.

The ongoing deterioration in the company's credit quality, a research note from Fox-Pitt Kelton Cochran said, stems from three factors: worse-than-expected declines in home price and loss severity; geographic exposure to California, Florida, Michigan, and Ohio, where defaults have risen most; and exposure to Alt-A mortgages, which account for 11.2% of Fannie's credit book but 42.7% of its credit losses. [Fox-Pitt Kelton or its affiliates may seek compensation for investment banking services from Fannie within the next three months.]

Piper Jaffray's Napoli said he expects charge-offs to equal about 0.20% of Fannie's portfolio by the end of 2008 and top out between 0.26% and 0.29% sometime in 2009 before they start to come down.

Home Prices Stabilizing?
"Even with credit losses that high, they should generate a profit in 2009," with a significant bump-up in earnings not coming until late 2009 or early 2010, Napoli predicts. He expects Fannie to have a loss of about $3.00 per share in 2008.

While the accounting issue will work out over time, the bigger problem for Fannie is how bad the housing market will get, says Gordon. There's still no sign of when home prices will begin to stabilize, and much of that depends on the direction of the economy and how many more jobs are lost, since jobs are critical for homeowners to be able to continue to make their mortgage payments, he adds.

Napoli agrees there's no visibility yet on when the housing market will hit bottom, but he thinks the extent of the downside risk is starting to crystallize. "By the end of this year, it's going to be pretty clear where the possible worst-case scenarios lie for losses," he says.

He expects home prices to continue to fall for another year but sees them starting to decline at a slower pace than they have been until now. Prices shouldn't have to fall more than another 10% in order to attract people who have been sitting on the sidelines waiting for lower prices, he says. A further decline in home prices should also make it that much easier to secure adequate financing for those people to afford to buy a house, he adds.

Government Input
To date, the federal government's lifting of the caps on Fannie and Freddie's loan portfolios hasn't helped very much, analysts say. And the main benefit of raising the limit on conforming loans, which qualify for lower mortgage rates, from $417,000 to $729,750 as of Apr. 1, has been to allow the GSEs to buy bigger mortgages, which should aid workout programs designed to prevent distressed homeowners from losing their homes, says Napoli.

Otherwise, he doesn't see a need for any further efforts by the government to ease the country's housing troubles.

Gordon says it's not enough for the government to offer help only to "wholesome" home buyers who played by the rules in applying for mortgages.

"The biggest problem we have is that in the [housing] bubble we had all these speculators buying in and people lying on their mortgage applications," he says. "You're going to have to help those groups" in order to stabilize home prices and avoid more foreclosures, he adds.

He doubts that will happen, however, mostly because the government doesn't want to send a signal to encourage that kind of behavior in the future.