What Does Fannie Mae's History Say about Your Future?

Fannie Mae, which is still some distance from coming current with its financial reporting, recently released earnings results for 2005. Ironically, that earnings report provides some insight into just how difficult interest-rate risk management has become, and it doesn't look like the challenges are going away anytime soon.

While Fannie Mae reported a big jump in earnings for 2005, the company's profit was largely driven by a decline in mark-to-market losses in the company's derivative portfolio.

That was good news, of course. But the company included a little warning along with the release of its 2005 results: don't expect 2006 to be so kind.

Fannie Mae warned that it expects to report a decline in net income for 2006, reflecting continued pressure on its net interest yield. Unfortunately, the conditions that are pressuring Fannie Mae's interest income for 2006 have persisted into this year. A flat yield curve has squeezed the difference between borrowing costs and the yield Fannie gets from its portfolio. That story is very familiar to mortgage lenders that hold loans on their balance sheets.

But the hedging of Fannie Mae's derivative portfolio, akin to the hedging most big servicers do to protect the value of their mortgage servicing rights asset, could again be something of a bright spot when Fannie Mae's 2006 results come in. Fannie said that since interest rates have generally trended up since the end of 2005 and remain at higher levels, it expects to report somewhat lower derivative fair value losses for 2006.

Because of accounting rules, Fannie Mae has little choice but to acknowledge that under Generally Accepted Accounting Principles, its earnings will be volatile from quarter-to-quarter and year-to-year depending upon what impact interest rate movements have on the value of its derivatives portfolio. Fannie Mae's top executives have been candid about ...