Fannie Mae's Equity Falls Again - TheStreet

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Despite reporting seemingly blowout profits in the third quarter,

Fannie Mae

(FNM)

saw its net value plunge yet again, indicating that this government-protected financial giant is being seriously weakened by moves in interest rates.

Fannie reported earnings of $2.67 billion in the third quarter, up from the $994 million for last year's third quarter, in which the company reported large losses on financial instruments called options. Third-quarter earnings were also up a lot from the $1.1 billion reported in the second quarter of this year.

Yet, even with these hefty profits, the net value of Fannie, which includes retained earnings, fell by a billion dollars. Shareholders equity, which measures the difference between a company's assets and liabilities, and thus its net value, dropped to $16.4 billion in the third quarter, from $17.4 billion in the second.

How? Because Fannie has been taking large losses on its balance sheet that do not hit its income statement all at once.

Most of Wall Street is comfortable with those losses, believing them to be recoupable and the result of an arcane accounting rule. However, just as analysts and investors ignored and misunderstood the deterioration in Enron's balance sheet while earnings growth was strong, they take a similarly deficient approach to Fannie's accounts. Fannie shares were up 16 cents at $72.73 Thursday.

Fair and Balanced?

The fact is, many of the losses on the balance sheet are

not

recoupable. But rather tellingly, Fannie refuses to publicly disclose how much of them are realized.

The disputes over Fannie could all be settled in five minutes if the company provided something called a fair value balance sheet, which would show if these large losses were offset by gains elsewhere on the balance sheet. But, again rather tellingly, Fannie declines to release a fair value balance sheet more than once a year. Outsiders can take a stab at calculating a fair value balance sheet, and Detox calculates that Fannie took a $3.7 billion hit to its fair value equity in the third quarter -- even with the stellar earnings growth. In fact, its assets could have declined by more than $8 billion in the third quarter, partially offset by a hard-to-calculate gain in the fair value of its liabilities.

Testifying further to Fannie's highly selective disclosure practices, the company also didn't comment on the value of its $9 billion portfolio of mobile-home-loan backed bonds in its earnings release. In its earnings statements, Fannie didn't state whether it had written down these bonds in the quarter, and its numbers suggest it did not. Judging by a charge recently taken on similar assets at the Federal Home Loan Bank of New York, Fannie should be taking a hit of over $1 billion.

Regarding the value of mobile-home assets in the third quarter, Fannie Mae spokeswoman Janis Smith comments that the company "did record some impairments in the third quarter, but the total was a small amount that was not material to our financial statements."

She added: "With respect to your attempt to draw comparisons to the FHLB of New York, it's critical for you to understand an important difference. The Federal Home Loan Bank of New York reported they sold all of the uninsured manufactured housing bonds in their portfolio. In contrast, Fannie Mae is primarily a hold-to-maturity investor. We have not sold our manufactured housing bonds. We are holding these bonds, and they are performing -- Fannie Mae is receiving the principal and interest payments on them."

Tunnel Vision

Before looking more closely at the balance sheet damage, investors need to understand the limited role that earnings play in gauging the health of a fast-growing financial company. Banks and institutions like Fannie borrow money at a cost and then lend it on or buy financial assets that yield more. Fannie borrows much more cheaply than other financials because it has been given special government-granted advantages. The more it borrows, the more mortgages it can buy, and if the spread between Fannie's borrowings and its assets stays constant, it grows earnings just by borrowing more to buy more mortgages.

But the soundness of a financial company rests on its capital ratios -- and those are very slim at Fannie Mae, using shareholders' equity. If the assets decline in value by a large amount, or liabilities go up by a large amount, equity can get quickly crushed. And interest rate movements have created that effect at Fannie, causing its equity to keep shrinking. A large amount of those asset-and-liability moves don't end up in income, but it is clear that they are critically important for measuring the health of the company.

Look at the third quarter. Capital should've leaped higher, considering the fact that earnings were $2.67 billion. Indeed, there was another positive in equity in the quarter: A certain class of derivatives, which are financial instruments whose value rests on the value of an underlying asset or liability, showed a gain of $860 million. These derivatives are meant to hedge movements in interest rates, and have been the source of huge losses in the past. However, with the rise in rates in the third quarter, these losses actually declined to $16.1 billion from over $16.9 billion to produce the $860 million equity gain.

But what were the hits to equity?

With the introduction of a new accounting rule, called FAS 149, the company took a hefty $2.4 billion hit to equity to reflect a decline in commitments to purchase mortgages at a future date. The hit most likely reflects the decline in the value of the assets affected by FAS 149 in the third quarter.

How seriously should we take it? Fannie's Smith's says that gains or losses related to FAS 149 will "be precisely offset by discounts or premiums recorded on the balance sheet." That means the $2.4 billion decline will be made up elsewhere in the balance sheet.

But hang on. Before the introduction of this rule in the third quarter, was Fannie booking gains and losses on the hedging instruments for the mortgage purchase commitments? Indeed, was it even hedging them at all? If it was booking, say, gains on the hedging but not recording a decline in purchase commitment values, Fannie's balance sheet was getting a boost. Now, FAS 149 gives us a more realistic valuation of what's going on in Fannie's balance sheet -- and thus is an important addition that should be tracked.

Fannie also had to mark down the value of certain assets by $1.5 billion. These assets, likely all mortgages, were classified as available for sale, and have to be valued each quarter. The sharp move up in interest rates in the third quarter would have hurt them.

To His Coy Lender

But this asset movement shows just why Fannie needs to stop being so coy and start publishing a fair value balance sheet on a quarterly basis, not just once a year. What investors need to know was the impact of the rate move on all of Fannie's mortgages, not just the roughly $150 billion of available-for-sale ones. Indeed, as much as 80% of Fannie's mortgages are not classified as available for sale. Another $670 billion are classified as held to maturity -- and their valuation doesn't go through equity at all, unless there is a permanent decline in their value.

A similar 1% decline to the held-to-maturity assets would've meant a $6.7 billion hit to equity in the third quarter. Add that to the $1.5 billion decline in available for sale, for an $8.2 billion decline. Of course, this decline in assets would be somewhat offset by a decline in liability fair values.

However, we know that Fannie's liabilities were less sensitive to a rise in interest rates than its assets in the third quarter. The indicator, known as the duration gap, is not given for the whole quarter, just on a monthly basis, so it is impossible to work out the net hit from both assets and liabilities to equity with great accuracy for the third quarter. However, the net hit could've been about $3.7 billion, according to Detox's figures.

If that were so, it is still $1 billion more than the addition from the $2.67 billion of earnings in the quarter.

Why does this all matter? It's devastatingly simple. If Fannie's shareholders' equity keeps declining at the rate it is, the company will become technically insolvent. There is no way Fannie could avoid making the mother of all equity issues to bolster its equity, diluting existing investors. And there is no way Washington, eager to protect the U.S. housing market, would leave Fannie unscathed if equity keeps slipping. At the very least, the pols could remove Fannie's special advantages, pushing up costs, and put it under tough new restrictions, impeding growth.

True, all this balance stuff is arcane. But the devil, in this case, is most certainly in the details.

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

peter.eavis@thestreet.com.