Fannie Mae Practices a Bit of Accounting Legerdemain

As readers probably know, because Fannie Mae was found to have engaged in “extensive” fraud, its CEO and CFO were fired late in 2005 and the government sponsored agency was put on a short leash by its regulator, the Office of Federal Housing Enterprise Oversight.

So it is a bit surprising to learn in a Fortune article. “Fannie Mae’s Fuzzy Math,” by Peter Eavis (hat tip Michael Panzner) that the GSE may again be burnishing its numbers a bit. Oh, but it’s only one item, merely the so-called credit loss ratio, which is bad loans divided by total loans. That measure is an important window into the health of Fannie’s portfolio. And wouldn’t you know it, but the change in how the ratio was calculated had the effect of making the credit loss ratio look better. Funny, that.

From Fortune:

The mortgage lender has quietly changed the way it calculates its bad loans — and it could be camouflaging steep credit losses….

Fannie Mae’s potentially misleading disclosure comes at a crucial time for the company. Fannie Mae was severely penalized last year for overstating earnings and for a lack of oversight. As part of its punishment, the amount of home loans that Fannie Mae can make was limited.

But now influential members of Congress, including Senator Charles Schumer, want Fannie Mae’s watchdog, the Office of Federal Housing Enterprise Oversight (OFHEO), to temporarily lift the portfolio limits on the company and its rival Freddie Mac. Legislators want both lenders to buy more subprime mortgages to help stave off foreclosures….

It all comes down to what’s known as the credit loss ratio — a measure that Fannie Mae has consistently provided to investors to help them assess the credit quality of its mortgages. The credit loss ratio expresses bad loan losses as a percentage of Fannie Mae’s loans.

In August, Fannie Mae predicted its credit loss ratio would be 0.04-0.06 of a percentage point for all of 2007. (Wall Street generally refers to percentages in basis points, which each equal one hundredth of a percentage point. In Fannie Mae’s terminology, then, its 2007 loss ratio estimate is four to six basis points.)

A range of four to six basis points may not sound like a big deal for an institution involved in mortgages, but for Fannie Mae it is the norm.

What matters is if Fannie Mae goes above that range. And Fannie Mae appears to have already done that this year. But its disclosure change makes that worrying development very hard to see.

Here’s why: Last week, as part of its earnings report, Fannie Mae revealed that the company had changed the way it calculates the credit loss ratio. Under the new method, Fannie Mae’s annualized credit loss ratio was just 4 basis points in the first nine months of the year.

At first glance, four basis points looks to be at the low-end of Fannie Mae’s full-year forecast. Problem is, because the company is using a new methodology, the previous estimate no longer makes sense to use.

So what would have happened if the company had compared apples to apples — and stuck with the old method of calculating its loss ratio?

Under the previous method, Fannie Mae would have been well outside of its range. The company would have reported an annualized loss ratio of 7.5 basis points in the first nine months of this year…

Management acknowledges that credit losses are mounting. During an analyst call last week, Fannie Mae CEO Daniel Mudd warned that the company’s loss ratio could rise to eight to 10 basis points in 2008, due to a worsening housing market. It’s not clear whether that forecast is based on the old or new methodology.

The company may already be exceeding that 2008 guidance. Based on the old methodology for calculating the loss ratio for the third-quarter alone, the company’s annualized loss ratio is already at 14 basis points.

If so, Fannie Mae’s mounting losses are disturbing.

So what could a soaring loss ratio mean for Fannie Mae? Consider these numbers: At Sept. 30, Fannie Mae had exposure to $74 billion of loans with a FICO credit score below 620. Loans scored below 620 are generally classified as subprime. In addition, Fannie Mae has exposure to $196 billion of Alt-A mortgages, home loans for which the borrower doesn’t have to submit complete documentation for basic criteria like income.

At the same time, Fannie Mae has only $40 billion of capital.

Worst-case, credit losses from high-risk loans like subprime and Alt-A could eat away at that capital and leave the mortgage giant on an extremely weak financial footing.