What Does Fannie Mae's History Say about Your Future?

Fannie Mae, which is still some distance from coming current with its financial reporting, recently released earnings results for 2005. Ironically, that earnings report provides some insight into just how difficult interest-rate risk management has become, and it doesn't look like the challenges are going away anytime soon.

While Fannie Mae reported a big jump in earnings for 2005, the company's profit was largely driven by a decline in mark-to-market losses in the company's derivative portfolio.

That was good news, of course. But the company included a little warning along with the release of its 2005 results: don't expect 2006 to be so kind.

Fannie Mae warned that it expects to report a decline in net income for 2006, reflecting continued pressure on its net interest yield. Unfortunately, the conditions that are pressuring Fannie Mae's interest income for 2006 have persisted into this year. A flat yield curve has squeezed the difference between borrowing costs and the yield Fannie gets from its portfolio. That story is very familiar to mortgage lenders that hold loans on their balance sheets.

But the hedging of Fannie Mae's derivative portfolio, akin to the hedging most big servicers do to protect the value of their mortgage servicing rights asset, could again be something of a bright spot when Fannie Mae's 2006 results come in. Fannie said that since interest rates have generally trended up since the end of 2005 and remain at higher levels, it expects to report somewhat lower derivative fair value losses for 2006.

Because of accounting rules, Fannie Mae has little choice but to acknowledge that under Generally Accepted Accounting Principles, its earnings will be volatile from quarter-to-quarter and year-to-year depending upon what impact interest rate movements have on the value of its derivatives portfolio. Fannie Mae's top executives have been candid about disclosing this to the investment community, hoping to educate Wall Street and the public about how its "fair value" results, which may differ from GAAP, may provide a better gauge of its financial performance than the official results. Fannie Mae's leadership these days often bases business decisions on fair value analysis rather than trying to smooth out the accounting performance.

Big mortgage servicers are in a similar predicament. Accounting rules allow them to ditch the complicated hedge accounting rules previously required, but they then have to mark-to-market both their derivatives used to hedge the MSR asset and the MSR asset itself. While that is economically valid, it leaves servicers vulnerable to greater potential earnings volatility if they are not fully hedged or if their hedges do not perform as expected.

Some servicers might want to consider following Fannie Mae's lead. Rather than bending over backwards to avoid any earnings volatility that stems from marking assets to fair market value, maybe it would be wiser to accept some volatility and try to educate the investing public about why that makes sense in the long run. Sure, it leaves companies vulnerable to some headline risk when quarterly results come in weak because of an MSR valuation or hedging problem, but in the long run it might reflect a sound decision to accept some volatility in order to keep hedging costs under control and focus on business operations. Let's face it. The mortgage industry is always going to be a rate-sensitive, cyclical industry. Some degree of volatility will always be part of the game.

Snapshot: Fannie Mae's derivative fair value losses

2003 $6.3 Billion

2004 $12.3 Billion

2005 $4.2 Billion

Source: Fannie Mae (c) 2007 Mortgage Servicing News and SourceMedia, Inc. All Rights Reserved. http://www.mortgageservicingnews.com http://www.sourcemedia.com