Fannie Mae on life support

Several weeks ago Fed Chairman Ben Bernanke floated the idea of allowing Fannie and Freddie to temporarily lift loan limits with the assistance of the US taxpayer, I mean government. Charles Schumer of course took to this like a horse to water and immediately worked on a bill to stem foreclosures. Since that time, the ever so punctual Fannie Mae corporation finally filed quarterly financials using some past accounting from ex CEO Franklin Raines. According to a recent Fortune article written by our friend Peter Eavis, Fannie has quietly changed the way they compute their credit loss ratio or the number of bad loans as percentage of total.

In August, Fannie Mae predicted its credit loss ratio would be 0.04-0.06 of a percentage point for all of 2007. 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.

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.

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.

Ominous signs of the house of cards built by former CEO Franklin Raines?

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.

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.

My comments: This week Deutsche Bank analyst Mike Mayo estimated a default rate of 30-40% and a loss rate of 40-50% on subprime mortgages. Using the midpoint of both ranges, this implies a realized loss rate of 15.75% of principal (0.35 x 0.45). If Mayo is accurate the subprime/Alt-A exposure alone wipes out Fannie Mae’s equity.

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