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Fannie Mae's

(FNM)

net worth actually dropped in 2002 despite the firm's massive leverage, according to a closely watched balance sheet measure that portrays an alarming drop in shareholder wealth.

Fannie's regular balance sheet, released quarterly, had already shown a massive decline throughout 2002 in shareholders' equity -- or assets minus liabilities -- as Fannie failed to financially insure itself against interest rate risk. But the company's supporters had hoped that a special version of its balance sheet, released yearly in its annual financial statement and designed to offer a more accurate portrayal of asset and liability values, would present a healthier picture. That didn't happen.

This so-called fair-value balance sheet, released in a filing Monday, showed that the wealth left over for shareholders actually declined in 2002, falling 2% from the prior year to $22.1 billion. And if Fannie hadn't sneakily included a new asset called mortgage purchase commitments in the fair value balance sheet, shareholders' equity would've fallen far more steeply -- dropping some 12% to $20.5 billion.

Off Balance?
Fannie stock stumbles

Clearly, if Fannie were the hedge fund its critics claim it to be, its managers would be looking for a job Monday after shortchanging shareholders so sharply. When asked for comment, a Fannie spokeswoman pointed to a press release trumpeting Monday's first-ever 10-K filing and explaining the fair value balance sheet. It says: "Because the methodology for calculating the fair value balance sheet does not include future business opportunities and only represents existing business, Fannie Mae's management does not believe this measure represents a reliable estimate of Fannie Mae's value as a going concern."

Here, Fannie is probably referring to the belief that losses in equity resulting from heavy mortgage prepayments can be partially or fully recouped over time by new business that Fannie gets. But it's not at all clear if the new business is as profitable as the old, and a

recent Detox showed that a good chunk of the losses reflected in the 2002 balance sheet may be locked in and impossible to recoup.

Fannie makes money mainly by buying mortgage-backed bonds that pay more in interest than it has to pay to borrow money in the market. However, maintaining that profit margin can be tough when the mortgage-backed bonds pay off early because so many people are refinancing their mortgages as rates tumble. Fannie has $800 billion of mortgages. Its stock, 22% off its 52-week high, fell $1.35, or 2%, to $65.35 Monday.

Hedging and Bustling

Investors focusing solely on Fannie's income statement will ask how shareholders' equity can have declined when the company reported net income of $4.6 billion in 2002. That's because losses linked mainly to financial instruments called derivatives, which are used to insure against adverse changes in interest rates, show up only on the balance sheet. When those losses are included, Fannie actually posted a so-called comprehensive loss of $108 million in 2002.

In trying to downplay the significance of the large equity decline reflected on the 2002 balance sheet filed according to generally accepted accounting principles, Fannie defenders said the decline would be reversed on the fair value balance sheet, mainly because Fannie's assets would be repriced upwards in a lower interest rate environment. This was never in doubt, but longer-term fixed liabilities also rise in a lower rate environment, offsetting a good chunk of the asset fair value gain.

This is clearly seen on the 2002 fair value balance sheet. Fannie Mae could, like

Freddie Mac

(FRE)

, have bought more derivatives to protect itself against a decline in interest rates, but that would have cost money that could have eaten away at profit margins. Yet skimping on the hedging caused a crushing $8.8 billion of derivatives losses in 2002.

The Fannie bulls' final retort is that these are not real economic losses and should be ignored. But that overlooks the fact that Fannie's minimum capital -- a measure of equity considered important by Fannie's hawkish regulators -- was only $877 million above the regulatory minimum at the end of last year, while Freddie Mac's was $2.2 billion higher. Moreover, Fannie has reconfigured its balance sheet so that it will benefit much less from a rise in interest rates.

Sure, the effective 12% drop in fair value equity pales next to the drops experienced by your average tech fund last year, but the result is very bad for a government-coddled institution that plays such a massive role in supporting the U.S. housing market. How long before Fannie CEO Franklin Raines does what all poorly performing hedge fund managers do?

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.