Fannie Mae Gets Harder to Figure
By Peter Eavis
Senior Columnist
04/15/2003 07:00 AM EDT
thestreet.com
It still would be unwise to go betting the house on Fannie Mae (FNM:NYSE) .
Despite strong bottom-line growth that elicited applause from Wall Street, Monday's first-quarter earnings blowout offered precious little insight into the mortgage giant's true performance. More ominously, a look through the company's cryptic numbers suggests that Fannie has yet to fully emerge from its season of turmoil.
The first quarter's headline figures were, of course, fantastic. Net income jumped 65% from a year ago, to $1.93 a share. Operating earnings rallied too, rising 22% to $1.84. CEO Franklin Raines boasted that Fannie has "a record of financial performance that few other companies have matched."
You can understand Fannie's ebullience. Last year was a difficult one for supporters of the Washington, D.C.-based company: Questions were raised about the stability of Fannie's balance sheet, and its risk managers had to deal with a tsunami of mortgage prepayments as interest rates fell. Prepayments are a headache for Fannie, because mortgages on its books get paid off and replaced with lower-yielding ones, potentially hurting margins.
The uneventful but solid earnings will lead some to believe that the tough times are over for Fannie. The stock rose $2.48, or 3.59%, to $71.49 Monday.
But the bullish case assumes that the strong earnings reflect Fannie's health. They don't. In fact, Fannie's accounting makes it well-nigh impossible to rely on the income statement as a meaningful yardstick. And a look at other indicators serves up a potentially distressing view of the company's health.
Golden Goose
Bear in mind that Fannie's main advantage is its government-sponsored status. That enables it to borrow more cheaply than other banks. When it raises billions of dollars to buy mortgages, it enjoys a huge cost advantage that effectively bloats the profit margin that represents the difference between Fannie's borrowing costs and the yields on the mortgages it buys. And far from having shown some special talent in this regard, Fannie's managers appear to have exploited the government-favored status by making big interest rate bets to goose earnings.
One must take Fannie's earnings with a grain of salt in part because of that and in part for two other reasons. The first is that accounting rules give Fannie leeway to put certain costs on its income statement while keeping other similar costs off, muddying the picture for investors.
Take debt retirement costs, for instance. When a mortgage is prepaid and is replaced with a lower-yielding asset, Fannie must be able to issue new, lower-cost debt to maintain its profit margin. The costs of extinguishing bond debt are included in the income statement. These created a $392 million expense in the first quarter, far higher than in previous periods.
But Fannie uses derivatives like swaps and swaptions to help make its funding liabilities more flexible. And the costs of unwinding and replacing these instruments, when they are classified as a certain type of hedge, do not go through the income statement in one go. Instead, these costs are amortized into earnings over a considerable period of time, reducing their negative impact. How convenient.
Options
The second reason for doubting the income statement is Fannie's treatment of options expense and the company's failure to show investors precisely how various numbers are being arrived at.
In the operating data, the expenses related to options are amortized into earnings over their life. By contrast, the full impact of unrealized changes in something known as the "time value" of the options is included in earnings reported in accordance with generally accepted accounting principles, or GAAP.
It may make some sense for Fannie to prefer the operating earnings treatment. But regulators are keen that companies make it clear how operating numbers relate to GAAP figures. Fannie does provide a reconciling table to do this. But it is impossible from the outside to know how Fannie arrives at its numbers for its GAAP options expense. This expense swings around like crazy and doesn't seem to have any obvious, traceable relationship with interest rates, as one might expect.
In the first quarter, options expense was $625 million, compared with $1.9 billion in the fourth quarter. Fannie may not be able to predict what this expense is, but it does have a clear obligation to shareholders to explain how this number was arrived at for past quarters. It must have the numbers to do that. Absent this explanation, the suspicion will only grow that Fannie managers are taking advantage of options classification to bolster earnings.
Now This
Then there's the amortized options expense in the operating numbers. It was $764 million in the first quarter, compared with $774 million in the fourth quarter. Both numbers are way higher than amounts seen in the first three quarters of 2002.
What does that tell us? It could mean that Fannie has chosen to spend a lot more on debt options to hedge its interest rate risk. Last year, Fannie received a lot of flak when a big drop in interest rates ate a big hole in its shareholders' equity, a subject Detox examined closely earlier this month. The outcry may have caused Fannie to act more like its rival Freddie Mac (FRE:NYSE) , which has long appeared to spend more on hedging than Fannie. If it is following Freddie's example, it could mean substantially higher options expense going forward.
When there is this much uncertainty in a company's earnings, it makes little sense to value the stock based on earnings. Investors need to look at book value instead. According to GAAP, that was $18 billion in the first quarter. That GAAP number includes unrealized losses in certain derivatives, which leads some people to say it's not a fair figure to use. But as this column has argued, it is not clear how much of these losses are real economic losses. Moreover, the figure was boosted by over $4 billion last year by a one-off shift in the way some assets were classified. In other words, using GAAP is the most conservative approach. If Fannie were to trade at twice GAAP book, it would be at $38 -- barely half current levels.
Wall Street seems unfazed about the opacity and complexity of Fannie's financials. Which is exactly the reason you should be.
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