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Fannie Mae's Risk Casts a Large Shadow

J.P. Morgan's (JPM) steep profit warning stirred echoes of Long Term Capital Management we mused last week.

Other observers see similarities between the infamous hedge fund and Fannie Mae (FNM).

What the three entities have in common is tremendous size and a reliance on financial models that seem unable to adequately deal with "100-years flood"-type events. For Long Term Capital Management, it was Russia's debt default in 1998. For J.P. Morgan, the event was the bursting of the telecom bubble and resultant bear market.

Fannie Mae, meanwhile, is struggling with this year's historic plunge in interest rates, which has been a boon for homeowners, but has upset the balance between the firm's $747 billion portfolio of mortgages, as of Aug. 31, and its debt liabilities of $789 billion as of June 30.

"The models they're using to figure out when people will refinance aren't working as well as they should be," said Jim Bianco, president of Bianco Research in Barrington, Ill. "The fear is they're like LTCM, they're behind the eight ball [and] their sheer size can impact everybody."

Fannie Mae's primary job is to buy mortgages from banks and other mortgage brokers. By providing cash to the primary lenders, Fannie Mae helps "more families achieve the American dream" of homeownership, as the government-sponsored entity (GSE) proudly boasts. In the process, Fannie Mae has become one of the nation's most successful and admired companies.

But critics worry that the firm is taking on undue risk to meet CEO Frank Raines' targets of doubling earnings per share in the five years ending in 2003. They note Fannie Mae's mortgage portfolio has grown at a far more aggressive rate this year than its sister GSE, Freddie Mac (FRE).

Others complain Fannie Mae is too miserly with its disclosures, a particular focus of The Wall Street Journal's op-ed page. Hard-core skeptics say Fannie Mae is the illegitimate child of socialism and capitalism, given its simultaneous ability to borrow money at advantageous rates -- due to its implied government backing -- and to book profits as a private company.

All worthy issues, but the greatest concern is how Fannie Mae's internal problems could have far-reaching implications, including prompting a sharp spike in interest rates. Such a development would be most unwelcome, given the economy's main engines of growth are contingent on low rates. Sharply higher rates also would put the billions investors had poured into bond funds at risk, put downward pressure on the dollar, and place the stock market at even-greater risk.

Seeing Ghosts, Part 2

Last Monday, Fannie Mae announced the "duration gap" between its assets and liabilities had expanded to 14 months for the month ended Aug. 31, the highest level the firm has ever reported. The widening duration gap resulted from a record level of refinancing activity, which caused shrinkage in the average life, or duration, of mortgages owned by Fannie Mae. The company gets the cash when refinancings occur, but also finds itself with a mismatch between its assets and future liabilities, namely the agency securities it has issued.

In a research report late last week, Bianco recalled that LTCM was "a bunch of 'smart investors' that thought they understood the markets [who]overleveraged themselves," not fraud, a la Enron. "Likewise, we do not believe that Fannie Mae is fraudulent."

Rather, he believes problems with the life span of Fannie Mae's portfolio are causing it to be "frantically buying long-dated assets to replace lost duration [which] could be pushing interest rates much lower then they should be," at least for now.

On Monday, the yield on the benchmark 10-year Treasury note fell under 3.70% today, the lowest level since August 1958. The 10-year's yield has fallen from 4.14% on Aug. 30, which is disconcerting to Fannie Mae watchers. At the end of 2001, a 100 basis-point "shock" of falling rates would have caused a 23% decline in Fannie Mae's total net asset value, which was $23 billion on Dec. 31, according to the firm's own estimates.

Meanwhile, Bianco argued "the economic and fundamental news over the last few weeks has not been bad enough to justify such a move" in Treasury yields. "Up until [last] Tuesday, the stock market was OK. So what's behind rates plunging off the map?"

Admittedly, this could be a case of an observer not wanting to take the bond market's message at face value. But Bianco contends "the market trades like it has a huge buyer." He believes it is Fannie Mae, rather than others buying in anticipation of Fannie Mae's needs, as some postulate.

Bianco estimates Fannie needed to buy $80 billion to $100 billion of 10-year Treasury equivalents to get its duration gap within the target range of six months. Fannie Mae's most likely purchases were 10-year fixed-rate swaps. But the broker/deal who sold them the derivative product (and J.P. Morgan is the biggest dealer) would hedge themselves by buying Treasuries. Fannie Mae is not directly buying Treasuries, "but they're having a big influence" on that market, Bianco said.

A Fannie Mae spokeswoman did not respond to several requests for comment. In a statement last week, Fannie Mae CFO Timothy Howard stressed that a widening duration gap is "not unusual" during periods of heavy refinancing and that its strategy is to "rebalance quickly but in a manner and at a pace that does not put undue demands on the market."

Bianco suggested that was Fannie Mae's preference but contends the firm is facing a stiff cocktail of regulatory pressure and a jittery stock market. The GSE's shares tumbled more than 11% last week in reaction to its duration gap news, but were up slightly in recent trading, by 56 cents, or 0.9%, to $65.16 after setting a 52-week low intraday at $62.05.

Also Friday, the Office of Federal Housing Enterprise Oversight received a request by Rep. Richard Baker that Fannie Mae provide weekly updates on its duration gap.

Bianco believes the GSE is determined to avoid that fate and present heathier duration-gap data for September, which only has one week remaining, and is engaging in a form of month-end "window dressing" for its regulator. Thus, Fannie is willing to risk a "cure" that might worsen its illness. By aggressively buying Treasury equivalents to get its duration back in line, the firm puts further downward pressure on rates, which ultimately will put its duration gap out of balance again. "They're caught in a vicious cycle," he said.

The real problem for financial markets, the economy, et al, arises if and when interest rates start to rise, which would curtail refinancing demand and cause Fannie Mae's duration gap to shrink to more normal levels. In such a scenario, Fannie Mae would have to "get rid of all that stuff they've bought," Bianco said, forecasting the "sheer volume" of such selling could cause a sharper rise in Treasury rates then the one that occurred last November-December.

"They're going to skyrocket rates on the other side, like we saw last year," Bianco said, recalling when 10-year Treasury yields rose 122 basis points in less than five weeks, its fastest rise since 1987.

Big Bubbles, No Troubles

Of course, Fannie Mae's many defenders say all this concern is preposterous, noting the company had $813 million in loss reserves as of June 30 and that its total capital exceeded OFHEO's mandated standards by over $6 billion, or 23%. Additionally, Fannie Mae's credit-related losses fell to 0.4 basis points in the second quarter vs. 0.5 basis points a year prior while its "at-risk single-family serious delinquency rate" fell to 0.42% as of May 31 vs. a first-quarter high of 0.49%.

Another sign of its fundamental strength was the firm's ability to successfully issue $5 billion of securities last week, despite the news frenzy.

The duration gap "has little to do with Fannie Mae's safety and soundness, but rather their earnings," said one company supporter, who requested anonymity. "It really measures the extent to which net interest income is at risk ... not the entity itself. With more cash on hand from refinancings, FNM is actually a safer entity than it was a few months ago."

Last week, Fannie Mae said net income at risk rose to 6.7% in August from 5.1% in July, although the company also reiterated earnings guidance for 2002 and 2003.

Additionally, "a negative duration gap poses a risk only in a falling rate environment; the likelihood of rates falling significantly [further] appears low," commented Jonathan Grey of Sanford Bernstein, who has an outperform rating on Fannie. Sanford Bernstein does no underwriting. (Of the 24 sell-side analysts who follow Fannie Mae, 22 have either strong or moderate buy recommendation.)

Grey observed the refinancing activity that caused the troubling widening of Fannie's duration gap "will [also] result in an enormous volume of fixed-rate mortgages available at attractive spreads."

Indeed, in its statement last week, Fannie Mae discussed the "offsetting positives" that occur during periods of heavy refinancing activity. Namely, the firm can purchase mortgages at wider-than-normal spreads, which it did in August, growing its book of retained commitments (or mortgages it plans to acquire) to $41.3 billion from $29.7 billion in July.

Even some of Fannie's staunchest critics aren't overly concerned about the duration gap, itself.

"It's not good for earnings or the stock multiple, but it's not life or death," commented Doug Noland, financial markets strategist at David Tice & Associates, a Dallas-based investment research and management firm.

However, "Fannie (and the GSEs generally) has zero room for error ... and there is absolutely no way to control this monster," Noland wrote. "It must expand or die."

The question becomes, if Fannie Mae runs into serious trouble like Long Term Capital, who's big enough to bail them out?

People say 'How can the Bank of Japan be buying big banks' stocks?,'" said David Hendler, an analyst at CreditSights, an independent fixed-income research firm. "Let's not condemn Japan so early."

The Federal Open Market Committee is widely expected to leave rates unchanged at Tuesday's meeting. But it's a good bet the FOMC's internal debate is very likely to include a discussion of Fannie Mae, because what's good for the GSE is good for America, and vice versa.

Aaron L. Task writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in TheStreet.com. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to Aaron L. Task.

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