Analysis of FNM
Examining Fannie Mae
By: Nick Kalivas 3/19/04
Fannie Mae (FNM) is a stock fraught with controversy. On the surface, FNM appears strongly profitable. But, the company’s implied government guarantee, use of derivatives, and influence on the debt markets have made it a battle ground for bulls and bears. FNM recently released its 10-K detailing its financial position. RGR thought it might be worth examining portions of the 10-K for insights into FNM’s true profitability and risk.
Income Statement vs. Balance Sheet Profitability
In recent years, FNM has displayed very strong growth in earnings per share, but no growth in retained earnings per share. Accountants take net income from the income statement and transfer it to the retained earnings section of the balance sheet to close the books. As a result, a company which is showing consistent profitability should see its retained earnings rise over time. The graphic illustrates a steady increase in FNM’s earnings per share and retained earnings per share between 1990 and 2000. But, a large divergence develops in 2000 and has continued in recent years. Earnings have risen within the income statement, but turned flat in the balance sheet. According to its balance sheet, FNM has not shown a change in profit over the last few years. Accounting for derivative transactions requires the gains and losses of unclosed positions to run through the balance sheet as an offset to retained earnings. As a result, the full measure of derivative activity is failing to show up on the income statement and is playing out on the balance sheet. The lack of growth in retained earnings indicates that FNM is not as profitable as it appears on the income statement. FNM has failed to generate significant profits during a great housing booming. The price of FNM has traded flat to lower since late 2000. At some level, the market seems to have discounted sluggish earnings growth as defined by the balance sheet. FNM has downplayed the risks related to its derivative activity and played up its profitability on the basis of strong earnings growth. The company seems to imply that derivative losses will eventually unwind and become additive to retained earnings in the future. The difference between the trend in net income and retained earnings highlights the battle between bulls and bears. RGR sits in the bearish camp on this issue.
Fair Value Balance Sheet
FNM releases a fair value balance sheet in its annual 10-K. Assets and liabilities are stated, and the difference between the two items equals owners’ equity by definition. If FNM is a strong company, owners’ equity should rise through an increase in retained earnings as explained in the paragraphs above. The fair value balance sheet sheds light on the size of assets and liabilities under current market conditions. RGR finds two aspects of the balance sheet interesting:
1.Derivative activity has a substantial impact on FNM’s net worth. In 2003, derivative gains added $4.5 bln to assets, while subtracting $4.1 bln in liabilities. The net swing of $8.6 bln accounts for 77.8% of the change in net worth. Although FNM tries to downplay the impact of derivatives on its operations, they are clearly significant.
2.Last year mortgage assets rose $77 bln in value, while debt rose $96.9 bln in value. Although the non-mortgage investment category rose $20 bln and fills the gap, FNM is in the business of mortgages. In year prior, mortgage assets rose $127 bln, while debt rose $101.7 bln.
FNM Year End Fair Value Balance Sheet
Change '03/'02 2003 2002 2001
Assets
Mortgage Assets $77,061 $924,482 $847,421 $720,174
Non-Mortgage Investment $20,199 $59,493 $39,294 $74,716
Cash ($295) $1,415 $1,710 $1,518
Other Assets $1,680 $20,996 $19,316 $13,020
Derivative in Gain $4,525 $8,191 $3,666 $954
Sub Total $103,170 $1,014,577 $911,407 $810,382
Guaranteed Fee income $2,424 $7,570 $5,146 6451
Purchase Commitments ($1,650) $1,650 ($567)
Total Assets $105,594 $1,022,147 $916,553 $816,833
Liabilities
Senior Debt
Due within 1 YR $101,623 $484,076 $382,453 $343,648
Due after 1 YR ($8,186) $477,111 $485,297 $427,209
Subordinate
Due after 1 YR $3,480 $15,904 $12,424 $7,625
Debt Total $96,917 $977,091 $880,174 $778,482
Other Liabilities $1,672 $11,874 $10,202 $10,040
Derivative in Loss ($4,097) $1,600 $5,697 $5,069
Total Liabilities $94,492 $990,565 $896,073 $793,591
Equity $11,102 $31,582 $20,480 $23,242
Source: FNM’s 10-K
Capitalization
FNM’s capital base looks weak relative to its peers. Notice FNM’s liabilities are 44.1 times shareholders’ equity. The ratio is approximately four times that of Country Wide (CFC) and Wells Fargo (WFC). Citigroup (C) has a ratio of 11.9. Much smaller Doral Financial (DRL) has a ratio of 5.5. Given the swings in its derivative portfolio and relatively low capital base, RGR believes that FNM is unattractive and may need to raise capital at some future date. Government regulators could put pressure on FNM to boost its capital in 2005. RGR doubts politicians will want to rock the boat in front of the 2004 elections, although recent government studies (Federal Reserve and Congressional Budget Office) have downplayed the benefits of FMN to the housing market. The Congressional Budget Office recently said that FNM receives an implicit subsidy of $20 bln, and a significant portion goes to shareholders. An increase in the capital base is likely to be centered on equity and dilute current shareholders.
Our analysis may be extreme and overly simplistic, but FNM would have to more than triple its owners’ equity to knock its total liabilities/shareholder equity to 12.0 holding liabilities constant. Owners’ equity would need to rise to $82.2 bln from its current level of $22.3 bln. We don’t want to get into the hypothetical, but it is obvious that FNM would have to sell an off lot of stock to recapitalize in line with its peers.
A Derivative Time Bomb?
Fannie Mae is not completely clear on the derivative losses it has realized. FNM’s derivative activity is reported in the Accumulated or Other Comprehensive Income (AOCI) portion of the 10-K. The AOCI account displays outstanding gains and losses, additional gains and losses, and the movement of the gains and losses to the income statement. Gains or losses are moved into the income statement as a component of interest income every year. In recent years, derivative activity has been moved into the income statement as a loss. There appears to be a lot of discretion over the transfer of balances from the AOCI account to the income statement. In its 10-K FNM said it expected to amortize $6.3 bln in losses, net of tax, into the income statement during 2004. However, it said actual results may vary due to market conditions. At the end of 2002, FNM indicated it would amortize $4.7 bln in losses to the income statement in 2003. The actual amortization was $5.5 bln (see below).
FNM Accumulated or Other Comprehensive Income
(Values in Mlns $ and Net of Tax)
2003 2002 2001
Balance Jan 1st ($16,251) ($7,359) ($3,972)
Loss cash flow hedge related derivatives ($1,326) ($14,274) ($5,530)
Losses cash flow hedge related to mortgage commitments ($2,609)
Reclassification to earnings $5,536 $5,382 $2,143
December 31st ($14,650) ($16,251) ($7,359)
Source: FNM 10-K
Notice that FNMA has $14.6 bln in derivative losses outstanding. We don’t know how many are “locked” or how many will be unwound as interest rates change. None-the-less, the size is significant. It is interesting that FNM chose to put $5.5 bln and $5.4 bln into the income statement over the last two years. The high level of mortgage activity in recent years helped to create a bulge in income to offset the inclusion of derivative losses. One of the risks to FNM rests in a slowdown in mortgage activity which decelerates income growth. If there is no offset to derivative losses, the movement of AOCI losses to the income statement will significantly weigh on earnings. FNM’s earnings were $7.9 bln in 2003 and $4.6 bln in 2002. The derivative account balance was $14.6 bln at the end of 2003 and almost three years of earnings. Only time will tell how the AOCI balance unwinds.
FNM’s size and impact on the credit markets may pose a threat to its health and ability to unwind derivative activity easily. The graphic following displays the relationship between FNM’s duration gap and the 10-year treasury yield on a monthly basis. Duration gap measures risk via the difference between assets and liabilities. The company tries to keep its duration gap between +6 and -6. A positive gap indicates that inflows from assets outpace payments for liabilities, while a negative duration gap indicates payments on liabilities outpace inflows from assets. The duration gap has been fairly constant in recent months, but historically has shown volatility with interest rates. Notice that the duration gap tends to turn positive when interest rates rise and turn negative when interest rates fall. The direction of interest rates probably impacts the duration gap, but notice that the inflection point between interest rates and the duration gap are highly correlated. What if FNM, as a very large market player, influences the level of rates via its hedging operations? The recent drop in rates suggests that FNM’s duration gap will turn negative for March after a period of stability. We wonder if the recent treasury rally has been exaggerated by FNM’s positioning.
Conclusion
In conclusion, our study of FNM may have raised more questions than answers. However, RGR has a negative view toward the company for three reasons:
1. The divergence between income statement and balance sheet profitability is a turn off. Although FNM looks profitable on the income statement, it has not been profitable basis the balance sheet over the last few years. This is a red flag. The stock’s inability to make new highs in recent years suggests the market is troubled by differences in profitability measures.
2. There is considerable uncertainty over FNM’s ability to profitably unwind its hedging activity. The size of its derivative book is large relative to capital, and a change in the demand for mortgages risks slowing income growth. RGR is doubtful interest rates will stay low forever and supportive to FNM’s ability to generate heavy transaction volume. As an investor, one must have great faith in the company’s ability to handle derivative activity in markets which tend to be unforgiving.
3. FNM looks undercapitalized relative to its peers. The risk for a secondary stock offering appears significant, as regulators may want to protect the public and their reputations. Even though FNM is great at lobbying, budget risks, a large federal budget deficit, and growing hostility toward FNM on Capital Hill could lead to more supply. The country cannot afford a major financial bailout. Recent studies seem to imply that the government is subsidizing FNM shareholders unfairly.
RGR looks for FNM to underperform its peers and the general market. It seems like FNM will lose if interest rates fall, as hedges will limit its ability to take advantage of a lower rate environment and make a strong profit. On the flip side, higher rates risk slowing income growth, and exposing derivative losses. |
