Dismal Science: Fannie Deserves a Smack
Fannie Mae, the mortgage company behemoth, is not having a good year. Shareholder equity has been evaporating -- down 27% at the end of the third quarter (or down 47% if one ignores Fannie's accounting shenanigan). Worse, there are more difficulties on the way. Aside from skating on thin ice with investors, there is political risk from politicians who are looking at its operations with growing crankiness.</br></br>In the immediate post-Enron period, investors went on orange alert when increased scrutiny revealed that Fannie has serious problems with corporate governance, financial disclosure and reporting. More recently came revelations that Fannie was having trouble managing its huge portfolio of assets. A bad guess on the direction of interest rates exposed a giant mismatch between the maturities of its assets and liabilities, and demonstrated how vulnerable Fannie is to interest-rate risk.</br></br>The bizarre thing is that Fannie willingly (and happily) exposes itself to interest-rate risk. There is nothing in its government charter that even remotely requires Fannie to borrow great gobs of money to purchase and hold a huge portfolio of mortgages. Fannie does it because it is wildly profitable. Because of the implied government guarantee of its debt, Fannie can borrow at very low rates and then lend out that money at higher rates by retaining or repurchasing the mortgages it has securitized. This opportunity to borrow low and lend high is so seductive for profits, it's almost a form of entrapment.</br></br>It's such a good deal, in fact, that Fannie has issued an amazing amount of debt. Currently its outstanding debt is around $800 billion. Moreover, Fannie's debt relative to its small capital base gives it enormous leverage. Fan's required core capital is 2.4% of on-balance sheet assets and 0.45% of outstanding mortgage-backed securities and other off-balance sheet obligations. This is well below levels necessary for FDIC-insured commercial banks; even government securities dealers carry capital around 5% of assets. Fannie is running with this huge leverage (about 54-to-1) because it can -- shareholders, at least until this year, didn't seem to care.</br></br>What about its creditors? Well, considering taxpayers are the ultimate creditors, they should probably care more than they seem to. At the end of the third quarter, Fannie's combined debt and its mortgage-backed securities held by outside investors totaled $1.8 trillion.