Dick Bove on Fannie Mae Q1 earnings

Fannie Mae reported first quarter earnings of $0.04 per share. This is $0.04 per share above my estimate and $0.11 per share above fourth quarter results. The new earnings forecasts are as follows: a) the 2016 estimate is being raised from negative $0.02 per share to positive $0.02 per share; b) the 2017 estimate is being raised to a loss of $0.01 per share from a loss of $0.02 per share; and c) the 2018 estimate is being increased similarly to a loss of $0.01 per share from a loss of $0.02 per share.

During the quarter, average earnings assets declined by 0.3% sequentially. This was due to a reversal in the company’s Federal Funds position. It dropped by 25.5% reversing the 24.4% increase in the fourth quarter. Owned, average mortgage loans fell by 3.0% while guaranteed loans increased by 0.3%. Fannie Mae is required to reduce its owned loans. There is no similar requirement on guaranteed loans so the company keeps increasing them. This policy allows Fannie Mae to reduce its capital requirements but it increases the firm’s risk.

The shift in mix lowers the company’s net interest margin despite the increase in interest rates set by the Fed in December. The margin fell by 5 basis points.

The lower rates led to lower net interest income. It was down 6.1% on a linked quarter basis and 5.9% year-over-year. The outlook is for further declines as the company keeps reducing the most profitable part of its balance sheet.
? Two other events had a much bigger impact on earnings, however. The company lost $2.8 billion in the quarter due to ineffective hedging and fair values accounting. It reduced its loan loss allowance by $2.1 billion despite having net charge-offs of $1.2 billion.

The reserve reduction allowed Fannie Mae to post a profit in the quarter. It did not stop a reduction in the firms’ retained earnings, however. They fell by $1.7 billion. This decline is not shown in the income statement due to changes in fair value accounting.

Fannie Mae’s remaining net equity is $2.1 billion. This equity, in theory, backs $3,046.1 billion in loans and supports $3,199.8 billion in debt. I would argue that no financial company in the world has such a sizable gap. The reasons this company is in a conservatorship and not a receivership is twofold

Its activities are required to maintain the housing markets in the United States. Without it housing prices and the economy would crater. Second, because of a belief (which I share) that the government is the real provider of Fannie Mae’s guarantees. The government does not acknowledge this responsibility, however.

Management does concede that the current situation cannot continue. It has indicated that if the company’s capital continues to deteriorate it will be forced to ask Congress for more money – money that Congress is obligated to provide. Should this request be made, a political firestorm could develop. It is unknown where this would lead.

Fannie Mae and Freddie Mac