Fannie Mae Posts Loss Despite Business Boom By Albert B. Crenshaw and David S. Hilzenrath Washington Post Staff Writers Wednesday, July 16, 2003; Page E01
Fannie Mae reported a big drop in second-quarter earnings due to changes in the value of derivatives contracts, even though its business expanded significantly. The mortgage-finance giant also said that it will reduce its interest-rate risk and that it will be less profitable in the second half of the year. The Washington-based firm, the biggest buyer of home mortgages, said the total volume of its business -- the amount of mortgages it owns plus the value of the mortgage-backed securities it has issued or guaranteed -- grew 29 percent in the second quarter as homeowners refinanced at record levels. But declining interest rates triggered a paper loss of $1.9 billion on Fannie Mae's portfolio of derivatives. The company said its "core business earnings," which exclude these paper losses, grew substantially. Fannie Mae earned $1.1 billion ($1.09 cents a share) in the three months ended June 30, down from $1.46 billion ($1.44) in the same quarter of 2002. Not including the accounting impact of the paper loss on its derivatives, which Fannie Mae uses to hedge against the risk of interest rate swings, the company said would have earned $1.86 billion in the quarter, compared with $1.57 billion a year earlier. Fannie said core business earnings better reflect the economic reality of its performance because the losses booked on its derivatives -- accounting rules require it to carry interest-rate hedges at market value -- are not realized. The "mark-to-market" accounting rule, since it was established in January 2001, has caused wide swings in the reported net income of Fannie Mae and its smaller rival, Freddie Mac. In the first six months of the year, Fannie earned $3.04 billion ($3.02), an increase of more than 13 percent from the same period a year ago, the company said yesterday. On a core business earnings basis, Fannie earned $3.71 billion in the first half, compared with $3.09 billion a year earlier. District-based Fannie Mae, formally known as the Federal National Mortgage Association, is a Congressionally chartered, shareholder-owned corporation that buys residential mortgages to supply cash to the nation's housing markets. The company, its profits and accounting practices have been in the spotlight in recent months as a result of the admission by Freddie Mac, a similar government-sponsored enterprise, that it improperly accounted for its derivatives and would be restating several years' worth of earnings. The companies finance their mortgage purchases by issuing debt of their own, and, as a result, must cope with the risk that changes in interest rates could leave them owning mortgages with lower rates than they must pay on their own debt. That happened to Fannie Mae when interest rates took off at the beginning of the 1980s, causing severe losses for several years. Fannie Mae uses a variety of techniques to deal with interest-rate risk, including issuance of callable debt that can be prepaid if interest rates fall and various options and derivatives that cause the duration of the company's debt to closely reflect that of its assets. Yesterday, Fannie Mae said in documents accompanying its earnings statement that the "effective duration gap" between its assets and liabilities has shrunk, meaning that the maturity of both its assets and liabilities are more closely matched. A wider gap means Fannie is taking on more risk from swings in interest rates. A smaller gap generally means less interest-rate risk, but potentially lower profits. The gap was as high as 10 months during 2002. The company has been working to minimize the gap and said it will attempt to keep it at less than six months in the future. The hedging that those efforts would entail could reduce future profitability, the company said. "They're trading lower earnings volatility for lower income but more smoother numbers going forward," said Paul J. Miller, a mortgage banking analyst at the Friedman Billings Ramsey investment firm. To maintain a strong credit rating, "we know we must . . . show a stable and predictable pattern of earnings as befits a well-managed and high quality company," Fannie Mae Chief Financial Officer Timothy Howard said in a conference call with analysts. Fannie Mae's stock closed at $69.06 yesterday, down $2.32 from the day before. The market was reacting in part to the company's prediction that as rates bottom out, its core earnings will be lower during the second half of this year than during the first half, analysts said. In addition, core earnings for the second quarter were a penny a share lower than the consensus expectations of Wall Street analysts.
