Fannie Warns on Continuing Interest Margin Pressure

Fannie Mae's profit rose to $6.3 billion in 2005, up almost 28% from $5 billion in 2004, but the company advised that it expects to see 2006 earnings decline when it completes its financial report for last year.

Much of the increase for 2005 reflected lower losses related to the fair value of derivatives that are used to hedge Fannie Mae's interest rate risk, rather than improvement in operating income from its guarantee business or net interest income. Net interest income from Fannie Mae's portfolio actually declined in 2005. Guarantee income was up modestly.

Moreover, Fannie Mae warned that it expects further reductions in net interest income and net interest yield for the 2006 period. Fannie Mae also warned that its administrative expense ballooned to an estimated $3.1 billion last year as the company struggled to remediate its various accounting and control weaknesses and defend itself against litigation.

Fannie Mae said it expects 2006 results to show "continued strength in guarantee fee income" amid moderate increases in the provision for credit losses and a somewhat lower loss related to the fair value of derivatives.

On the positive side, Fannie Mae said it probably will file its 2006 results earlier than had been anticipated. Previously, Fannie Mae had been expected to post 2006 results near the end of this year. Fannie Mae hopes to give investors a clearer sign of when 2006 results will be ready sometime next month.

Many of the market conditions putting downward pressure on Fannie Mae's 2006 margins have persisted into 2007 as well.

Once again, Fannie Mae warned that changes in derivative values will lead to volatility in earnings from quarter-to-quarter and year-to-year. While earnings improved from 2004, the 2005 earnings were substantially below Fannie Mae's restated 2003 profit.

Earnings per share in 2005 totaled $6.01, up from $4.94 in 2004. While Fannie Mae has not released 2006 results due to the continuing earnings remediation of its accounting, the company did raise its second-quarter dividend by 25% to $0.50 per share, payable on May 25 to shareholders of record as of May 18. Asked during a conference call what sort of dividend yield Fannie Mae expects to pay in the long run, CEO Daniel Mudd said Fannie Mae expects its yield to be competitive with other large financial institutions.

Mr. Mudd said that Fannie Mae grew its book of business, its capital and its assets amid "solid performance" in the guaranty business during 2005.

"As we began getting our accounting right, we also kept our business steady in a year when Fannie Mae faced a myriad of challenges," he said during the conference call.

Mr. Mudd said that the fair value of Fannie Mae's assets increased by 5% last year and the company offers a "prudent and competitive" return of capital to investors.

He said Fannie Mae's credit loss exposure remains limited, with most of the increase in the provision for 2005 reflecting losses caused by Hurricane Katrina.

Mr. Mudd noted that Fannie Mae's loans have an average loan-to-value ratio of 55% and an average FICO score above 720.

Snapshot: Fannie Mae's 2005 Results

Item 2005 2004

Guarantee Fee Income $3.8 Billion $3.6 Billion

Net Interest Income $11.5 Billion $18.1 Billion

Derivative Losses ($4.2 Billion) ($12.3 Billion)

Fee and 'Other' $1.5 Billion $404 Million

Credit Loss Provision ($441 Million) ($352 Million)

Administrative Expense ($2.1 Billion) ($1.7 Billion)

Investment Losses ($1.3 Billion) ($362 Million)

Other Expenses ($251 Million) ($607 Million)

Net Income $6.347 Billion $4.967 Billion

Source: Fannie Mae

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