Fannie Mae may face $24bn derivatives losses

Financial Times ^ | March 9 2004 | Stephen Schurr

[M. Dodge Thomas]

Fannie Mae paid a net $25.1 billion on derivatives transactions in under four years - nearly all of which may represent losses that cannot be recouped, in turn depressing future earnings.

The potential scale of the liabilities, which have yet to be recognised in the company's earnings or in the minimum capital adequacy required by its regulator, raise fresh doubts about the financial health of the mortgage finance giant.

Regulation of Fannie Mae and its sibling Freddie Mac is rapidly moving up the agenda in Washington, amid concerns that the two goverment-sponsored entities have grown so big that they pose a systemic risk to the US financial system. The two entities own or guarantee mortgages totalling $4,000bn.

On Tuesday John Snow, US Treasury secretary, renewed the criticism, saying: "We don't believe in a too-big-to-fail doctrine, but the reality is that the market treats the paper as if the government is backing it."

[M. Dodge Thomas]

Also See:

Fannie Mae says that AOCI (Accumulated Other Comprehensive Income ) is irrelevant to current earnings or capital levels, saying it provides a misleading view of the company's fiscal health. Jonathan Boyles, Fannie Mae's vice-president for financial standards and taxes, argues that "every financial regulator always ignores the AOCI amount".

But Fannie Mae's critics say it does matter. Cliff Stearns, a Republican congressman, said in House testimony last year that Fannie complies with Financial Accounting Standards (FAS) 133, which governs derivatives accounting. But Mr Stearns says that in correctly applying this rule, Fannie Mae has "used the special hedge accounting rule to defer the billions of dollars in lost shareholder value to the future"...

http://news.ft.com/servlet/ContentServer?pagename=FT.com/StoryFT/FullStory&c=StoryFT&cid=1078381640936&p=1012571727088

- or -

http://tinyurl.com/3bl96

And:

Because Fannie Mae does not disclose the amount, it is impossible to determine the precise total. However, the company's reports offer several methods to assist efforts to determine a reasonable estimate.

The total cash flow hedge losses in AOCI are the sum of the realized and unrealized derivative gains and losses. Therefore, one can arrive at the realised losses by subtracting the unrealised amount from the total. Fannie Mae does not disclose the unrealised figure. However, the vast majority of its $1,072bn derivatives portfolio gets classified as cash flow hedges.

Fannie Mae breaks down the notional value of its various derivatives positions. The Financial Times concluded the best method of estimating the amount of realised cash flow hedge losses is to apportion gains and losses by notional value.

When net values are broken down by proportion in this manner, the unrealised cash flow hedge losses would total $1.1bn.

At the end of the third quarter, Fannie Mae's AOCI was negative $24.757bn on a pretax basis (on an after-tax basis, the total was $16.092bn). If AOCI is the sum of realised and unrealised derivatives positions, then subtracting the $1.1bn would mean Fannie Mae's total realised derivatives losses would be $23.653bn (or, on an after-tax basis, $15.375bn).

http://news.ft.com/servlet/ContentServer?pagename=FT.com/StoryFT/FullStory&c=StoryFT&cid=1078381650569&p=1012571727088

- or -

http://tinyurl.com/2j3py

[Dog Gone]

I'm afraid I don't understand how it could lose money at all. Massive defaults on home loans are not occurring.

[M. Dodge Thomas]

Interesting that this appeared (AFAIK) first in foreign press – it's the sort of thing that's making overseas invertors very nervous.

I can't help but wonder what else Greenspan had in mind when formulating his recent testimony

[Gunslingr3]

I'm afraid I don't understand how it could lose money at all. Massive defaults on home loans are not occurring.

The concern is with Fannie's derivative exposure. What triggers it remains to be seen.

[lelio]

I'm afraid I don't understand how it could lose money at all.

They made huge bets that interest rates wouldn't fall and they did.

[Dog Gone]

As I understand derivatives, which isn't much at all, they're a way of hedging risk of price or interest swings. It's like locking in a band of prices for the producer of a commodity. You don't get the advantage of a huge price increase, but you're similarly protected if the price falls.

So, if Fannie was doing this right, it would have been good insurance. If they were speculating in the derivative markets themselves, the controlling officers should be summarily shot.

[Ken H]

Who's going to jail over this?

[M. Dodge Thomas]

> I'm afraid I don't understand how it could lose
> money at all. Massive defaults on home loans are
> not occurring.

Poor derivative bets on cash flow hedging operations.

It's standard practice to not to report these losses (or gains) in statements of current financial position.

But some people (myself included) would argue that this misstates the long-term prospects of such organizations - especially if such losses (as in this case) are in the tens of billions of dollars and rising rapidly.

Greenspan and Snow (and the current administration, which really can’t be held responsible for this problem) are really over a barrel on this one – they don’t want to exacerbate te moral hazard inherent in investors believing that the government will provide unlimited support to such institutions if they get into trouble but also don’t want to spook (especially overseas) investors.

The bottom line is that taxpayers are probably on the hook for this one.

[M. Dodge Thomas]

"The concern is with Fannie's derivative exposure"

Useful link. Thanks.

[Servant of the 9]

I'm afraid I don't understand how it could lose money at all. Massive defaults on home loans are not occurring.

The concern is with Fannie's derivative exposure. What triggers it remains to be seen.

Do a Google Search on Barings Bank.

Barings was a 200 year old Merchant Bank that was so powerful that Bismark said "There are six great powers upon the continent of europe; England, France, Germany, Austria, Russia and Barings".
In 1995 one of their bond traders in Hong Kong trading futures/derivitives, bankrupted the bank with a few bad positions. There is no regulation at all on what Fannie Mae has been trading, no limits, and everyone in the world expects the govt. to back their play without limit.

So9

[TXLibertarian]

There is an article on CNNFN today that is relevant to this topic. It's scary stuff - here's an excerpt:

" U.S. Treasury Secretary John Snow took direct aim Tuesday at mortgage finance firms Fannie Mae and Freddie Mac, repeating previous warnings to investors that government-sponsored enterprises are not financially backed by the U.S. government. "

http://money.cnn.com/2004/03/09/news/companies/snow_gse.reut/index.htm

[groanup]

I got out of the derivatives business in the early 1990's. At that point world-wide derivative notional values were larger than the combined GDP of the G-7 countries. That exposure has grown exponentially since then.

[Blue_Ridge_Mtn_Geek]

I'm afraid I don't understand how it could lose money at all. Massive defaults on home loans are not occurring.

= = = = = = = = = = = = = = = = = = = = = = = = = = = = = =
The primary risk Fannie and it's companion agency Freddie Mac face is not default risk, but risk of losses due to fluctuation of market interest rates. Both of these firms "hedge" their interest rate risk by buying and selling interest rate derivatives (see, e.g.,
http://www.strategies-tactics.com/derivatives.htm

and, for some specific application to GSE's see discussion towards the middle of:
http://www.lewrockwell.com/north/north96.html

(with interesting reference sites linked, even if you blow off the alarmist rhetoric)

[M. Dodge Thomas]

"There is an article on CNNFN today that is relevant to this topic. It's scary stuff - here's an excerpt:

" U.S. Treasury Secretary John Snow took direct aim Tuesday at mortgage finance firms Fannie Mae and Freddie Mac, repeating previous warnings to investors that government-sponsored enterprises are not financially backed by the U.S. government. "

Well, Snow would no doubt like to convince international investors that such "guarantees" aren't worth the paper they aren't printed on, but that the case of actual US Government obligations is an entirety different matter.

Problem is, people running the sort of current accounts deficits we are don't have much room to maneuver, even a small decrease in overseas investors' confidence can translate into interest rates rises which dwarf the costs of bailing out Fannie Mae and Freddie Mac.

(The contra argument is that letting investors in these institutions take their lumps would demonstrate to investors the US is serious about getting it's house in order – the problem is that our current policy of big tax cuts *and* big deficits is a pretty convincing demonstration that ours is a disorderly house indeed.)

[ReleaseTheHounds]

That explains all the advertising and PR they've been buying/using recently.

[txzman]

Yet here in Texas they are running ads non-stop on both radio and TV. What the heck is going on?

[NRA2BFree]

It's just a matter of time until many lending institutions will probably have to start foreclosing on homes. The people who's jobs have been outsourced are going to be losing their homes before long. The states that have had huge losses of jobs to outsourcing are really going to get clobbered. If a lot of union factory workers got loans through their credit unions, It could put them on shaky ground too. With the factories gone there are no more workers to pump up their cash flow.

Many people have just about exhausted all of their resources trying to keep from losing their homes, while others may be in foreclosure right now. Fannie Mae and Freddie Mac will undoubtedly have their share of foreclosures too. No doubt these people have maxed out their credit cards trying to stay afloat, so those unsecured credit card balances will be a total loss to the credit card providers. Factor in auto and furniture loans going into default and the bottom could drop out of the credit industry. Just how bad it will be, I don't know. We'll have to wait and see.

I hope I'm wrong, but I don't see how these people are going to recover. It's probably too late for many of them already. IMHO.

[NRA2BFree]

You may want to see this. It's definitely not good news to an already shaky mortgage industry.

[Jimmy Valentine]

It isn't the mortgage defaults as much as the early payoffs that upset one side of the derivative package. This creates the prospective loss.

The question is whether rate increases will offset the prospective loss. Probably will, but if they are not careful they will trash the real estate market.

regards.

[petercooper]

Fannie and Feddie are houses of cards