Fannie's Fans Must Be in Denial
By GRETCHEN MORGENSON
Published: December 19, 2004
THE Securities and Exchange Commission's smackdown of Fannie Mae should upset not only the company and its arrogant executives. It should also embarrass the Wall Street analysts who reassured investors last September that the S.E.C. would probably take a friendlier view of the company's accounting than did its other regulator, the Office of Federal Housing Enterprise Oversight. Instead, the S.E.C. said last week that Fannie Mae, the giant mortgage company, must restate its earnings for the past four years.
But because shame is simply not in the typical brokerage analyst's DNA, investors were given further assurances that all remained fabulous in the house of Fannie. According to one of the shills, removing $9 billion in earnings from Fannie Mae's results since 2001 (Fannie's own estimate, by the way) would have "no economic significance."
Of course, these are the same people who have never met a corporate management team they didn't like. And the steady stream of bounteous investment banking fees Fannie Mae provides to Wall Street probably doesn't hurt, either. In any case, the analysts' utterances had the desired effect: Fannie's stock fell only 0.5 percent by the end of the week.
A few analysts are not under Fannie Mae's spell, however, and they take a different view. One such skeptic, Josh Rosner, an analyst at Medley Global Advisors in New York, said that while the company's regulatory woes were the immediate problem, other forces out of Fannie's control would put significant pressure on its business of buying and selling billions of dollars in mortgages.
And on the subject of Fannie Mae, Mr. Rosner is worth heeding. For a year, he has been warning clients about coming Fannie Mae woes; his has been a lonely voice of reason on the company's prospects.
Mr. Rosner said that even after Fannie Mae works out its differences with legislators who want to rein it in and with regulators who want more conservative accounting, its troubles are far from over. That's because the mortgage market is changing, and those shifts are sure to lessen the company's dominance and, more important, cut into its income growth.
"We're not in Kansas anymore," Mr. Rosner said.
In making his case for why the landscape around Fannie Mae is forever changed, Mr. Rosner pointed to three major shifts. First is the fact that the 30-year fixed rate mortgage, the highly profitable loan that is Fannie Mae's stock in trade, appears to be losing some appeal among homeowners.
About 30 percent of the mortgage market is adjustable-rate mortgages. But so-called hybrid adjustables, which have a fixed rate of interest for a specified period and then move to a floating rate, are coming on strong. These hybrids make up almost three-quarters of the adjustable-rate mortgage market, up from 7 percent five years ago, Mr. Rosner said.
Consumers will be more likely to choose hybrid adjustable-rate mortgages in the future, Mr. Rosner reckoned, and not only because they are cheaper than 30-year fixed-rate loans. Increased family mobility has shortened the typical mortgage to five to nine years. So homeowners will figure that hybrid mortgages with fixed rates for 7 or 10 years are preferable. The only factor that could alter this trend would be a significant increase in interest rates.
Fannie Mae, of course, could compete in the adjustable-rate mortgage arena. But, Mr. Rosner noted, it would have a negative effect on the company's profit margins.
A second element that could undermine Fannie's business in coming years relates to new capital requirements expected in 2006 from the Bank for International Settlements. As Mr. Rosner explained, one of Fannie Mae's main roles is as a conduit for lenders seeking to free up both the capital to make additional loans and the reserves that must be held against those loans.
Lenders like to sell their loans to Fannie Mae because they can lend that money again, generating additional revenue. The banks can also swap loans for guarantees from Fannie Mae so that they have no exposure to the mortgages and do not have to add to reserves.
UNDER the new rules, capital requirements will move away from the one-size-fits-all attitude toward risk assessment. Now, all loans in an asset class have the same capital requirements. In the future, banks will be allowed to adjust their capital to reflect the risks in a particular loan. This change, Mr. Rosner said, will significantly increase the economic incentives for banks to hold onto mortgages, especially those with the most predictable credit and cash-flow characteristics. But it will also cut into Fannie Mae's growth.
Another worry is the prospect for a decline in the fees that Fannie Mae earns from banks for guaranteeing loans, a big source of its income.
Mr. Rosner said that if Congress created a new regulator to oversee Fannie Mae and its mortgage finance sibling, Freddie Mac, that new entity would also likely supervise the Federal Home Loan Banks, which compete with Fannie and Freddie. Such a regulator would probably bring into line disparate practices at the entities; one of these relates to the size of guarantee fees they charge their customers.
Fannie Mae charges guarantee fees that are roughly double those assessed by the home loan banks. Mr. Rosner said that this could soon change, further pressuring Fannie Mae's profit margins. Fannie Mae reaped $1.5 billion in such fees last year.
Mr. Rosner concedes that these may be longer-term concerns. More immediately, he fears a possible wave of mortgage defaults. After all, mortgage defaults typically occur from three to five years after the loans are written. The flood of refinancing in recent years means that a great majority of outstanding mortgage loans are less than three years old. Defaults could rise substantially.
A Fannie Mae spokeswoman said that the company would not comment, beyond its avowal to do what it must to comply with the S.E.C.'s findings on its accounting deficiencies.
Why Fannie Mae shareholders are so unfazed by the company's mounting problems is a mystery. Sean Egan, president of Egan-Jones, an independent debt-rating firm that does not receive payments from companies it analyzes, said he was surprised by the denial at work among Fannie Mae's investors and debt holders.
"All big failures are built on false assumptions," he said. "The tulips were always going to be in short supply, so prices were always going to go up. In the case of Fannie Mae and Freddie Mac, they have terrific assets - mortgages that have historically been a low-default asset. And the federal government is going to stand behind them."
What if one or both assumptions are false? "If Fannie Mae gets into difficulty," Mr. Egan said, "It's highly likely that current investors are not going to get paid back in full and on time by the federal government."
Ridiculous? Maybe not.
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