Gold''s slide seen ending amid inflation worries; physical demand ''fantastic''

Section:

Fannie Mae faces more income issues

By Rex Crum
CBSMarketWatch
Saturday, May 15, 2004

http://cbs.marketwatch.com/news/story.asp?guid=%7B31DC261A%2DBFD5%
2D4063%2D8788%2D8D6496968FD5%7D&siteid=mktw

In the latest criticism of Fannie Mae, this week's Barron's
says the mortgage finance behemoth is on shaky ground
regarding how it records billions of dollars of losses and
presents its financial appearance to Wall Street.

Barron's cover story says the root of the issue is how
Fannie Mae (FNM) and its cousin Freddie Mac (FRE)
manage to keep derivative financial holdings off income
statements.

With its 2003 core earnings of more than $7 billion
expected to grow even higher over the coming years,
Fannie Mae would appear to have little negativity on
its horizon.

Yet a Barron's analysis of Fannie's picture says the
company took a major hit to earnings as mortgage
rates dropped in recent years. Prepayments on
mortgages trimmed the portfolio gains that Fannie
would otherwise have received, and it was further
hurt by the locked-in rates of its financing sources.

To avoid recording a loss, says Barron's, Fannie
Mae used a series of legal mechanisms to transfer
negative numbers to its balance sheet under
"accumulated other comprehensive income," or
AOCI.

The AOCI strategy lets Fannie Mae "burn off" losses
over time. Without that, says Barron's, Fannie's 2002
earnings of $6.4 billion would have been overwhelmed
by $8.9 billion in cash-flow hedging losses.

Barron's says $3 billion in losses that were recognized
in 2002-2003 "pale against" $19 billion paid to settle
under-water interest-rate swaps in those years. Indeed,
a Barron's comparison of 10-K filings says the
company's interest rate swaps on its books rose from
$23 billion in 2002 to $149 billion in 2003. The aim of
the rising use of derivatives, says Barron's, was to defer
losses instead of recognizing them.

Fannie Mae can pull this off, notes Barron's, because it
has the legal status of a government-sponsored
enterprise, or GSE, and can exclude its AOCI numbers
from the calculations of capital that are used to support
its $1.35 trillion in mortgage-backed securities. The 1938
law setting up GSEs includes Freddie Mac.

Earlier this month, the federal Office of Federal Housing
Enterprise Oversight, or OFHEO, which regulates
Fannie Mae and Freddie Mac, said that a probe of
Fannie's financial records showed the company had
failed to follow generally accepted accounting principles
on obligations for manufactured homes and aircraft
leases.

In an agreement with OFHEO that avoids earnings
restatements, Fannie Mae will take a charge of up to
$260 million in the second quarter to account for the
losses. Barron's analysis of other manufactured
housing securities suggest more write-offs will be
needed in future quarters.

That OFHEO investigation followed on the heels of
Freddie Mac admitting last year that it used derivatives
to hide $5 billion of income so it could be reported as
profits in future years, which could dress up earnings
reports.

Critics of Fannie and Freddie say that any crisis they
suffer could rock the international finance system.

The companies make most of their money by borrowing
at favored rates as GSEs and using the capital to buy
mortgages from smaller lenders such as banks. Groups
of mortgages are packaged together as securities, and
in that system Fannie guarantees or owns about half of
the $7.8 trillion worth of U.S. residential mortgages.

The benefits of the security structure provide liquidity to
the original lenders and help make Fannie appear to be
one of the most-profitable public companies in America.

Barron's maintains that Fannie Mae has done nothing
illegal; that the company has just used financial
loopholes to adjust its books in order to solidify its
position in the eyes of Wall Street, investors, and federal
regulators.

But Barron's also says that as pressure continues to
mount on Fannie Mae to provide a clearer look at its
finances, the company could be on the brink of having
to disclose income restatements that bring an end to
its long run of unfettered profitability.

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