Fannie Deserves Another Haircut

It's not that Wall Street can't do the numbers properly. For example, in his Tuesday research note, Smith Barney analyst Matthew Vetto calculates theoretical book value numbers that rightly leave out the $9 billion that Fannie is expected to remove from earnings. But when it comes to setting a price target, Vetto uses what he calls a "pre-restatement" book value that doesn't take into account the $9 billion worth of losses that Fannie wrongfully kept out of earnings. (Vetto rates Fannie outperform, and Citigroup has done recent underwriting for Fannie.)

The $9 billion is losses on derivatives. The bulls often like to argue that those losses represent just a "mark-to-market" snapshot of what a derivatives portfolio looks like at a given point in time and that moves in interest rates can reduce the loss. There are many problems with this point of view. First, there is a wealth of evidence that Fannie in the past locked in losses on derivatives but made it look like they were still open and thus capable of changes in value. Second, even if a derivative really is truly open, it can just as easily slip further in value, rather than rise. As a result, it makes a lot of sense to feed the losses in question through earnings when they occur.

What's strangest is that Wall Street banks themselves have no real problems implementing this type of derivatives accounting and seem quite prepared to reflect these types of derivatives losses in their own income statements. But for some reason they suggest Fannie should be exempt.

So where should Fannie trade, then? Well, how about the same multiple-to-book value as Freddie Mac, whose own accounting scandal was nowhere near as bad as Fannie's and which has a much lower-risk portfolio than Fannie?

Freddie trades at 1.55 times its end-2003 book value, according to generally accepted accounting principles and after subtracting the value of preferred shares. The $31.5 billion book value figure used for Freddie is for end-2003, as that is the most recent GAAP number available. The $4.6 billion of preferred stock is then subtracted to allow for analysis relevant to common stock comparisons. At $41.6 billion, Freddie's market worth is 1.55 times its end-2003 book value. But if we add 2004 earnings, its net worth (excluding preferreds) could have been $32 billion at the end of last year, which is only 1.3 times book value.

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In keeping with TSC's editorial policy, Peter Eavis doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He welcomes your feedback and invites you to send any to [e-mail].