Richard X. Bove, Vice President Equity Research at Rafferty Capital Markets, highlights Fannie Mae’s third quarter losses and its accounting and management inefficiency.
Fannie Mae reported a third quarter loss of $0.04 per share. This was $0.03 per share below my estimate and $0.09 per share below second quarter results. The new earnings forecasts are as follows: a) the 2015 estimate has been lowered to $0.02 per share from $0.05 per share; b) the 2016 estimate has been raised to a loss of $0.01 per share from a loss of $0.03 per share; and c) the 2017 estimate has been similarly increased to a loss of $0.02 per share from a loss of $0.04 per share.
There are three elements when reviewing Fannie Mae’s income. The first is actual business activities. Second is accounting. Third is government intrusion into the company’s cash flows. In this quarter, all three were negative.
Looking at business operations, first, it appears that there were declines almost across the board. Net interest income declined by 1.6%. The decline was driven by a 3.9% drop sequentially, quarterly, in mortgage loans held and a 6.5% in mortgage backed securities.
These loans are dropping due to mandated reductions by the Treasury and also due to shifts in the structure of the industry. Banks, in the main, are no longer willing to make FHA loans so that these credits are being originated by mortgage brokers and being sold to Ginnie Mae rather than Fannie Mae.
Moreover, a large segment of the home buying public has been pushed out of the market by the tougher requirements mandated by the qualified mortgage rules. Finally, it is unlikely that banks will originate and sell 3% down payment loans to Fannie Mae due to the likelihood that Fannie Mae will kick back the loans if they default.
Guarantee fees are increasing and the consolidated trust portfolios on average were up 0.6% linked quarter. The problem here is that the 10 basis point increase in the guarantee fees must be remitted to the Treasury for general government purposes. If the new highway bill is passed it is possible that another 10 basis points in guarantee fees will be taken to build and maintain roads.
The net result of these factors is that liability costs increased more than asset yields in the quarter and the company’s net interest margin fell by 1 basis point. Thus, net interest income declined. There were also declines in fee and other income, and investment gains.
Operating revenues viewed from these three revenue sources alone showed a decline of 8.9% linked quarter. Operating expenses jumped 40.3% due to administrative costs that were not defined. Management in its press call gave no indication that these trends would adjust upward and no reporter cared to ask about them (analysts are not allowed to speak). In its press release, Fannie Mae indicated that its earnings were likely to trend lower over time.
The accounting maneuvers were worse. Fannie Mae also mismatches its hedges. This results in a net unhedged position that swings widely based on the bets management is making on interest rates. Management has been consistently incorrect for virtually all of the past 2 years expecting interest rates to increase. Derivative revenues (called fair value adjustments) were down in 6 of the last 7 quarters. The aggregate loss in 2014 was $4.8 billion. The loss to date in 2015 is $1.9 billion.
In the third quarter, the pretax loss on derivatives was $2.6 billion. To offset this decline Fannie Mae reduced its reserves and took a loan loss recovery of $1.6 billion. It may be recalled that the government’s rationale for acquiring Fannie Mae and placing it in a conservatorship was that the entity’s loan losses had bankrupted the company. This view was the basis of eliminating the company’s deferred tax assets and increasing its loan loss reserves.
The reserves were jumped by $50.1 billion in the first quarter of 2010. In hindsight this reserving action was totally inappropriate and $31 billion of these reserves have been released with the likelihood that the remaining $19 billion will be released in the next few quarters. This is a big factor in Fannie Mae’s earnings.
What is interesting is that it would appear that the biggest shifts in Fannie Mae’s earnings – i.e., fair value adjustments and reserve releases — are non-cash events. Accounting adjustments are far more important than actual operations in determining the company’s earnings. Stated differently cash flows are unimportant relative to non-cash accounting manipulation in this company.
The U.S. Treasury tapped into Fannie Mae’s earnings in three fashions during the quarter. It took:
- The TCCA fees (10 basis points in guarantee fees) of $0.41 million;
- A tax payment of $1.07 billion; and
- A dividend of $2.20 billion.
In total this is $3.68 billion. To put that into perspective it is 59.9% of the company’s operating revenues as I calculate them. This is a cash on cash ratio.
The government is intent on destroying this company. However, Fannie Mae claims to have been responsible for funding 37% of the nation’s home mortgages in one form or another in the quarter. It is for this last reason that I believe that as the Treasury drives Fannie Mae toward extinction cooler heads will prevail and bring this company back to a more viable state.