Hedges Go South on Fannie, but Core Earnings Soar

The company's earnings before derivatives losses rise 20% on a per-share basis. Guidance comes down.
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A big swing in the market price of the book of derivatives it uses to hedge its bond portfolio caused bottom-line second-quarter profits to tumble at

Fannie Mae

, but excluding those volatile instruments, per-share earnings rose 20% on year-over-year basis.

The big mortgage merchant also said it would strengthen some of its control procedures following an internal investigation, and trimmed guidance for the second half of the year.

Bottom line, using standard accounting, net income was $1.1 billion, or $1.09 a share, compared with $1.46 billion, or $1.44 a share, a year earlier. In the latest quarter, Fannie booked $1.88 billion of mark-to-market losses on purchased options, compared with $498 million a year ago. Excluding the options losses, the company earned $1.86 billion, or $1.86 a share, compared with $1.57 billion, or $1.55 a share, last year.

Analysts surveyed by Thomson First Call had been calling for core EPS of $1.87 in the second quarter.

Regarding the derivative book, Fannie said: "The increase in unrealized losses was due to the declining interest rate environment and an increase in the balance of purchased options used to hedge interest rate risk."

Fannie Mae is a government-sponsored entity charged with making a secondary market in home mortgages, and earns money off of the spread between the cost of financing its portfolio of mortgage-backed securities and their yield. It also collects fees for putting together and backing mortgage securities, known as guaranty income.

On a core basis, net interest income was $2.78 billion, up 26.5% from a year ago, while guaranty fee income was $632.3 million, or 49.3% from a year ago.

"Each of our primary businesses delivered exceptional financial performance in the second quarter, including substantial increases in both core net interest income and guaranty fee income," Fannie said. The company cited "very low mortgage rates and high levels of refinancing, which resulted in a further temporary increase in the company's net interest margin during the second quarter, to an average of 130 basis points. As a consequence, core net interest income during the second quarter of 2003 was 26.5% above the second quarter of 2002."

"Rapid refinancings not only fueled extremely strong MBS growth, but also led to a rise in the effective guaranty fee rate, to an average of 21.2 basis points, as rapid prepayments caused deferred guaranty fee revenues to be recognized more quickly," it said.

Looking ahead, the company expects core per-share earnings in the second half to be slightly below the $3.70 a share it put up in the first six, citing the "additional repurchase of high-cost fixed-rate debt." Analysts surveyed by Thomson First Call were calling for a combined $3.71 a share in the second half.

Reacting to the discovery of accounting problems on the books of its main peer,

Freddie Mac

, Fannie Mae said it would step up risk management procedures in its credit guaranty business, "explicitly monitoring the potential income variability stemming from its highest-risk loans ... using pricing, credit enhancements and other techniques to manage this variability."

Regarding its so-called "duration gap" between the lifespan of liabilities vs. assets, Fannie said it is "timing its rebalancing actions with the objective of maintaining the portfolio's duration gap within a range of plus or minus six months substantially all of the time." Before, the company would allow the gap to exceed this goal "about one-third of the time." The gap narrowed to an average of minus-one month in June from minus-five months in May.

Fannie said the new duration policy "should reduce potential core business earnings variability, but also could produce a somewhat lower net interest margin over the longer term."