Fannie Mae, Q1 2008 Earnings Call Transcript

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 |  About: Fannie Mae (FNMA)
by: SA Transcripts

Fannie Mae (FNM) Q1 2008 Earnings Call May 6, 2008 10:30 AM ET

Operator

Okay. Next from the line of Howard Shapiro with Fox-Pitt, Kelton. Please go ahead.

Howard Shapiro - Fox-Pitt, Kelton

Hi. Just a question on the fair value and then a follow-up if I could. On page 16 and you talked a little bit about it in the presentation. You attribute about $17 billion of the declined fair value to the change in the GO, that’s about 25 billion I believe on a pre-tax basis. 40% of the increase in the fair value of the GO is due to an increase in the underlying risk in your credit guarantee book. Is that saying that your expectation of losses on your guarantee books has increased by 10 billion or is this just a reflection of wider spreads? And then I have follow-up?

Steve Swad

This is Steve Swad. Just the answer to your question is not a revision to our estimate of the expected losses. Just a few points on a fair value balance sheet, one is to remind you that it is a liquidation view of the company. Its as though we sell our assets and liabilities at current market prices. Second, probably the most significant theme is that moves it in the opposite direction of current business opportunities. And so the wider the spreads on the mortgage securities, the better is for new acquisitions, the worse it is for the existing portfolios. Similarly on the GO side of the business, the higher our ability to raise prices, the worst it is on the existing business. Now my last point is, as a long-term holder of this we expect to recover the spreads overtime.

Howard Shapiro - Fox-Pitt, Kelton

Okay. But that's on the 60%,,that change that’s resulted from new pricing, the 40% that's due to wider spreads. Do you also expect to recover that overtime?

Steve Swad

A portion of that will be incurred as losses and a portion is the markets estimate of variability around that number that we do not expect will be incurred.

Howard Shapiro - Fox-Pitt, Kelton

Okay. So that would be the market risk premium?

Steve Swad

That's correct.

Howard Shapiro - Fox-Pitt, Kelton

Okay. And then just a question on the change in accounting treatment for interest rates derivatives, I know you've said that it will substantially mitigate the volatility. Can you give us either more qualitatively or hopefully quantitatively what that would mean for example for a given basis point change in rates or some other measures that we could get a sense of how it has been mitigated?

Steve Swad

Let me direct you to slide 8. Slide 8 breaks out the $4 billion of market losses by interest rate and spread. And you can see on slide 8 that there is $1.2 billion of loss in Q1 relating to interest rate. The goal of our hedge accounting program is to reduce that number significantly.

Howard Shapiro - Fox-Pitt, Kelton

I'm sorry $1.2 billion is due to interest rate or due to spread?

Steve Swad

Due to interest rates, and its on slide 8.

Howard Shapiro - Fox-Pitt, Kelton

Okay. And then the $3 billion is due to what then?

Steve Swad

Spreads. I understand what your doing. The change in interest rate is 1.2 billion, it consists of two pieces, $3 billion of losses on derivatives and $1.8 billion of gains in the trading assets. The net affect of interest rate is 1.2 and all of this is on that slide 8.

Howard Shapiro - Fox-Pitt, Kelton

Okay. That's what you hope to minimize?

Steve Swad

That’s correct.

Howard Shapiro - Fox-Pitt, Kelton

Okay. Thank you.

Daniel Mudd

Howard let me just throw in one other point in terms fair value impacts, particularly with respect to GO. There is a lot of counter intuative movement in that, but the way that I kind of finally got it was to realize if you ever increase prices on a perspective basis. What that means is the entire book is trailing along behind you, is automatically under priced and flows through. So if you wanted to drive a fair value improvement through the GO line, the "smartest thing" you could do would be to decrease prices, which I think we could probably all agree on that one. It doesn’t make a lot of economic sense particular in this environment. So I zoom back up to 100,000 feet on the point here, we have said along these calls. I can almost quote myself that, change of fair value was one of the important measures to look at in the overall context for the company's in the current environment, blah, blah, blah. Well that's true and in this case, I think its important and particular to look at the environment and the economics and the situation we’re in, in the context of all the other disclosures and information we are providing. So thanks for allowing me to do that little advertisements. Let go to the next question.

Howard Shapiro - Fox-Pitt, Kelton

Thank you.

Operator

And next from Bruce Harting with Lehman Brothers. Please go ahead.

Bruce Harting - Lehman Brothers

Yeah, thank you. On page 6 the guarantee fee income. Can you give any kind of guidance in terms of where we go from here because it sounds like from Rob's comment the price increases is one is done, another maybe coming in June. And just in March alone it looks like it flipped flopped a little bit, was that just the average charge was 25.9 in the quarter, but ended the quarter at a slightly higher rate 27.6. So any kind of help you can give on a go-forward basis there and was that just because of the backing off of Alt-A, was the decline Alt-A decreased volumes?

Robert Levin

Bruce, let me have Tom Lund, who runs the single-family business, start with kind of the market dynamics and the structure on pricing. And then if there’s more, to a discussion of the accounting, therefore we will go Eric Schuppenhauer his CFO.

Eric Schuppenhauer

Okay. A couple of things, one is that as we have talked about in the past year we announced a couple of price increase that just took effect in the beginning of March. And you can start to see that in the numbers. If you turn to page 15 of the investor pack you will see for our flow business an isolation of that. We took to March pricing up to about 28.64 basis points versus 25 in the quarter and 23 all of 2007. But commensurate with that on that pace, we also have basically the credit quality associated with that. And if you look at the incredible improvement in both the credit scores, which is the quality of the borrower, as well as the amount of equity that they are putting in the property, you can see a dramatic shift in the credit quality. While the prices have improved significantly and therefore margins on this business are much improved.

Bruce Harting - Lehman Brothers

Thank you. And then in terms of your guidance saying that '09, I think you said '09 will be a little bit worse on credit than '08. Is that in reference to foreclosed property expense, is that the charge-off number, or the provisioning number, or all three? The way we kind of model it is we see -- you kind of provisioned in this quarter, if you will, at almost 40 basis point type annualized run rate, but you are saying charge-offs of 13 to 17 this year. So it seems as though you are front-end loading here. Is that the conclusion we should reach that you are going to use '08 to overbuild reserves such that even if charge-offs are higher in '08, provision comes down?

Steve Swad

I wouldn’t think of it quite like that. Let me direct your attention to slide 12, which breaks out the credit-related expenses. In Q1 we had $880 million of credit losses, that's 12.6 basis points. We guided that number to 13 to 17 basis points; that's point one. Point two is on that same page, in Q1 our credit-related expenses due to the increase in the allowance, went up by 1.8 billion. So the ending allowance is $5.2 billion. We guided that that number will increase throughout the year based on our delinquency trends, default trends, mix of business, and severity trends. And it is too early for us to predict exactly where that number would be, because those trends are not yet predictable. And then the third point we made was that the credit loss ratio going back up to the top, the ratio at the end of 2008 will be 13 to 17 basis points. We said 2009 will be greater than 2008.

Bruce Harting - Lehman Brothers

Okay. Thanks Steve.

Steve Swad

Thank you.

Operator

Your next question is from Paul Miller with FBR Capital Markets. Please go ahead.

Annette Frank - FBR Capital Markets

This is actually Annette Frank. Good morning. I have a followup question on the guarantee fee pricing. For the jumbo mortgage loans, the new pricing implementations, is that also applicable to the jumbo mortgage loans or are you using a different pricing methodology for the jumbo loans? And also are you expecting to keep some of the jumbo loans on the balance sheet or at this point are you expecting to sell off most of this product?

Daniel Mudd

Let me have Tom talk about it. What we're trying to accomplish, as just a way of background, is that we have been asked to play a role in certain high cost areas, so called conforming jumbo markets where actually have lot of the same credit characteristics that we see in the rest of our book. These are working families. They tend to be closer to metropolitan areas. Therefore the home prices tend to be higher. We've been asked to play a role in the market place and one of the things that is an issue affecting those jumbo markets is that there is not a lot of liquidity there. So we're basically going to absorb the liquidity premium and price not with respect to the credit piece of it, which is all individualized or the other risks, but the market liquidity premium we're going to price ourselves. That should translate into better pricing for the lenders and depending how the lenders price it on the street should provide a benefit to get some movement going to those markets. Tom?

Tom Lund

Dan hit most, but I would just add that we'll write price the risk on the product that’s coming in just the way we do today in our score business. We will look at the individual characteristic for the loans, the product types, and things of that nature and price that appropriately. And then Peter, do you want to talk to the portfolio purchase?

Peter Niculescu

Hi, Annette, this is Peter Niculescu. We were anticipating this product will come on balance sheet. At the moment there is not a strong securitization market there. We would love to see one develop, we think at some point it will. But at this point we plan to take this product on balance sheet and as you know we are committing to do this through the end of the year. So that’s the timeframe that we have in mind to see this product come on balance sheet.

Annette Frank - FBR Capital Markets

Okay. Thank you very much.

Operator

And next from the line of Brad Ball with Citi. Please go ahead.

Brad Ball - Citi

Thanks. My questions are on credit. I wondered if you could give us some sense as to what were the main factors that changed versus the end of February when you gave your prior guidance that caused you to update your guidance. Your new peak to trough loss expectations, that's probably part of it but you expect it to extend further than you had previously thought. I think you used to talk about the trough occurring sometime in late '09. I am just trying to get a sense as to how confident you are with the credit picture that you have now laid out or will we come back in August and get a new revised guidance once again?

Daniel Mudd

Well I don’t know whether you will come back and get a new revised guidance or not because what we are trying to do is provide the clearest, most accurate look of where the market is going to go based on all of the information that we have. And in that light, March was not a terrific month in the capital markets and the first quarter was not a terrific quarter in the housing markets. And so what has changed is that all of the data from the first quarter that represented an accelerating decline, if you think about that concept from those fronts, caused us to update two things: one is what we were going to see in the current year because you are already eaten the first quarter of the year. And secondly, what the implications would be for the peak-to-trough decline.

More broadly, our research indicates that over the long haul of time, literally going back toalmost the beginning of the 20th century, home prices appreciated about inline with GDP and at some points they overstriped that line and at some point they understriped that line. We got way over the line and now we are correcting back to the line, but what we are seeing doesn’t suggest that all of a sudden that home prices are going to decline and stop precisely on the line. There probably will be some overshoot in this context and our very best prediction as of now of where that’s going to be suggests the 13 to 17% peak-to-trough and 7 to 9% this year. The 7 to 9%, so you can calibrate by the way we just sort of use an algorithm to adjust ourselves to the Case-Shiller Index. That 7 to 9% decline will be a 12 to 14% Case-Shiller decline. So that is a pretty serious scenario.

We are sizing our capital and we are managing our risk to reflect actually being -- we have thousands of scenarios but think about it broadly as four or five scenarios. One scenario was things get better, not using that scenario. Another scenario was things stay flat, not using that scenario. The other scenario was our prior version, which has some declines in it and the next one shows about where we are right now. We are sizing capital to reflect home price declines that go beyond that. And that overall decline then produces a peak-to-trough number of 15 to 19% national home price average. And again to use the algorithm that puts you in a 25% plus Case-Shiller decline. So I think we are all kind of getting around to the same place on this with some adjustments on a quarter to quarter basis for any new data that we have. That is our best bet is their downside to it. Well the history has been that there has been more downside then upside recently. Yesterday's downside becomes today's base case. But I think as we move through it with this key variable being time, as time passes we have more data and we have more time for consumers and institutions to cure, for these policies to take effect, for the tie to stem some, and there is some very very early signs of that. I rather see conformation from a couple of months or a quarter before I go positive on you.

Brad Ball - Citi

Okay, fair enough. Just a quick follow-up. You highlighted Alt-A as a main source of deterioration more recently. Was that '06 and '07 vintages in particular or do you have Alt-A from other periods that are also performing weakly? And then the deterioration you saw in the Midwest, is that mainly driven by home price declines in that market, or is it unemployment, or is it a combination, what in particular is happening in the Midwest? Thanks

Dan Mudd

Okay, let me start and then I'll have Tom Lund jump in. With a four-year average book and with the product that we stopped largely doing Alt-A, a yearish ago, the concentration is late '05, '06 or early '07 kind of a book. And then we should just admit the fact, that the underwriting standards at the very peaky froth of the boom there were not everything that they should have been. So everybody has got a book and everybody has got a part of their book that worries them the most. In our case, it's the Alt-A book and we are focused on that. We put a lot of resources on it and that’s where we are seeing the disproportionate share of our losses. And the overall lost guidance that we've just been talking about incorporates that into it. Tom?

Tom Lund

Yeah, I will just say that in the Investor Presentation on pages 30 to 32, it gives you a lot of that detail and data. On the '06 and '07 are clearly the most problematic around that. It is correlated very much to the geographies and the home price declines taking place at that point in time. We have a significant emphasis on managing it and working these loans out. And you can also see that Alt-A book does have very different characteristics in the labor market in general. I would make a couple of comments.

When we did this business, we did it with our customers, we did with our guidelines, and we have a significant amount of credit enhancement on this. You can see on those graphs that it's performing better, it is much higher percent fixed rate than the general market and better overall characteristics. But it still is a problem, it represents about 47% of our credit losses. We are working it very very hard. We had basically mitigated any future exposure on new acquisitions. You can see there is very little coming in. We have made tremendous amount underwriting changes and pricing changes and I will just remind you that we also significantly price for this business and we will begin to get additional enhancement over time.

On the second piece of your question, the Midwest. That is currently being driven by the economy and it has been for a lengthy period of time, out migration and job losses are the biggest driver and my guess is that will continue for some period of time.

Brad Ball - Citi

Thanks.

Operator

Our next question comes from Gary Gordon with Portales Partners. Please go ahead.

Gary Gordon - Portales Partners

Okay, thank you. Question about the balance between your public policy role and your shareholder role. In two ways, one is keys to recovery program. For example, cutting pricing on the conforming jumbo would suggest there is public policies first before shareholders. Also the capital raise, to raise capital today and then to grow the current capital price of the stock would seem difficult to get a reasonable return on new business that wouldn’t dilute shareholders. How do you sort of think through that balance between, at this stage, between public policy and shareholders?

Daniel Mudd

Thanks for the question Gary. The two things go together actually and with us having the largest share of any component of the US mortgage that you want to look. As goes the market, so go we. So things that we can do to be helpful to the market generally accrue to us. If you take the two examples that you cited, on the jumbo pricing we have been asked to play a role in a market that we have not had access to before. Like in any other company when you enter a new market you want to get it going, you want to develop your position, you want to develop your products. In our case you certainly want to manage your risk prudently, but establishing that foothold probably cost you short term, but has enormous long term benefits.

Likewise, the types of opportunities that we are seeing to invest the capital that we are raising, we didn’t have access to before. We had a portfolio cap, we had limits on capital.

We were actually as you saw in the numbers, were liquidating on the portfolios side. Those things have changed and now we see access to opportunities that the portfolio hasn't seen since 1998 and the guaranty business hasn't seen since 2003. The odd things going on or they are both happening at the same time for the company and they are both also happening at the same time as we have the other half of our lives is managing the losses in the existing book. So with all of those things going on I kind of think of it as a bridge. We got to get across a bridge here, where we don’t miss the terrific opportunities we have. We are being prudent and we are being conservative and we are managing the capital because when we get to the other side of the bridge, I think our market position is very strong. We will feast off of this book of business that we are putting on for many years to come. We will have done our best in investing resources to mitigate the damage from the losses and fundamentally will have helped the market to recover sooner. And that’s all a good thing.

So I know there is a lot of noise in the marketplace about, are we are doing this because somebody is yelling at us, we are doing this because somebody is encouraging us to do this that and the other thing, and we are trying to keep everybody happy. And we are really not. We still look at all of these opportunities on a risk adjusted return basis whether that’s OAS spreads or on the guaranty side. And then we factor in like any other business would, are we prepared to invest to enter this market or to build up this position within the parameters and risk policies that we have. If the answer is yes, my argument would be we are doing a lot of things to drive the revenues and expenses in the short term, but we also have to not lose sight of the fact that we are also building a presence for ourselves in the marketplace longer term and that’s where those two things come together.

Gary Gordon - Portales Partners

Okay, thank you.

Dan Mudd

Thank you.

Operator

Our next question is from line of Bob Napoli with Piper Jaffray. Please go ahead.

Dan Mudd

Bob, you get the last one. We will be out and about discussing this capital raise with many of your firms and companies shortly and we look forward to continue those conversations, but go ahead, Bob.

Bob Napoli - Piper Jaffray

Great, thank you. On the net interest margin, I was wondering in the strategy, I think you got dinged a little bit on interest rate risk management from OFHEO. But interest rates right now are probably about as low as they are going to get at least on the short end of the curve and your margin. I was wondering if you can give a little bit of color on how much you expect the margin to go up if rates stay where they are today over the next several quarters? And thoughts on adjusting the mix of floating and fixed rate debt in order to maybe lock in, because the Fed isn't going on go any lower, and at some point housing prices are going to bottom out and there is inflation and the Fed fund rates could be 300 basis points higher than it is today two years from now. So what are your thoughts on managing that on improving the interest rate risk management as it relates to OFHEO and just broadly economically locking in attractive spreads for the longer term?

Steve Swad

This is Steve Swad. I will start and then I will pass it over to Peter Niculescu, who runs that business. From an net interest margin perspective, as you rightfully pointed out, it is very difficult to predict where interest rates are going to go and what margins we will be able to put on the book. If you look at page 5 of the investor pack, we highlight in gold net interest margin, excluding the if-effect of step rate debt and we had 69 basis points of spread in Q1. My comments said that that number was going to go up. In Q2 we are seeing wide spread business be put on our books. It's much more difficult to project beyond that. Peter, I don’t know if you have anything else to add?

Peter Niculescu

Yeah. Bob, thank you very much for the the question, I think it's a great question. First of all on the risk management side, we reported as you saw a duration gap of three months in March and we've noted in our investor analyst package. And it was two months in April and we stay in very close dialog with our regulator about risk management and interest-rate risk management, managed towards a great deal. As you can imagine the changing spread environment of the first quarter actually created some volatility to our duration that we haven't previously seen. Not some of rates, it was actually changing in spreads. But one of the important drivers here, I think you have noticed from our derivative are pay-fixed swap mark-to-market has rates for we've taken losses historically on pay-fixed swaps. But what that means is that our liability costs of funds drift down every time we take a loss. So, now we've locked in, with hedge accounting we have locked in a long-term cost of funds that is relatively low on our pay-fixed swap position and you are seeing that show up with higher margins.

In addition to that, we've been adding new business at starting quite attractive spreads. Although their sizes have been somewhat limited as liquidation is being somewhat limited, but that opportunity is there. I think you'll start to see more effect on margin in the future as we build the asset base with new investments at historically quite attractive spreads. I think that is something that will occur in the future.

Bob Napoli - Piper Jaffray

What were the spreads on loans for say originated in April?

Dan Mudd

I don't think we can breakdown on a monthly basis like that, but I think what we said before on this call is that we've been seeing option-adjusted spreads recently that are more than twice the sort of spreads that we saw in 2007. I think you can go to market indicators, I mean, we’re large enough. We sort of buying kind of the marketplace, that probably tells you what you need to know.

Bob Napoli - Piper Jaffray

Last question on credit losses and peak credit losses, in your base case or your most likely case, were 13 to 17 basis points. This year obviously you are at 12. So, you are looking for losses to move up through the year. When do you think credit losses from your forecast of housing for this year and next year – when do you think credit losses peak and can you give a range on the peak? Is the peak 20 to 30, is your best guesstimate today and where is that peak relative to what you're seeing in 2008 and when?

Steve Swad

This is Steve Swad. Let me start and then I’ll pass it to Dan. We gave current guidance of 13 to 17 basis points of credit losses for 2008. We also guided that 2009 would be above those numbers.

Bob Napoli - Piper Jaffray

Right.

Steve Swad

And that's really all we can do at this time. As I said earlier, these numbers are a function of defaults, severities, and a mix of product that comes through. And we're not able to really give more visibility at this time because those trends are not yet predictable. Dan?

Dan Mudd

The perspective I will give is really more historical. We're not going to try to call a moment at the bottom because quite frankly it's full variant. I think that from a historical perspective what we've seen here was a period of enormous volatility and unpredictability that extended from last July through March. If you say it was over in February you were wrong in March. It feels like a lot of those spikes have abated right now and we're sort of settling into working our way through the trough here. Our expectation based on what we've seen is that we'll go through that process. We'll see the 15 to 19 peak-to-trough declines. At the current rate is what underlies our expectation that '08 and '09 are going to be comparatively weak years, but it also suggests that some time toward the end of that period, some time in the early '10 period, you've worked your way through it and you are starting to see the various signs of life that re-enter the market through housing starts, inventories coming down, more movement, price go up, all of those type of things. So I'm not answering your question in terms of calling a spot, I'm just telling you here's how it might work out over time.

So, with that, let me just wrap up quite quickly. The summary I think to take away for today is the result showe we had another tough quarter although it was marginally better than the last. The results were really driven by the fair value and the credit losses. We have indicated that we will continue to build credit loss reserves because the housing forecast got worse. Revenues up, market share up, customer penetration up, and we continue to see lots of opportunities for high quality, well priced assets. We are raising 6 billion in capital, reducing the dividend, all to build capital to make sure we get through this belly in really impregnable shape. We will use this capital and protect the balance sheet through the downturn and we will use it to maximize these opportunities. We are happy that the regulator has helped us move back to a position of being in a more normal posture as a strongly regulated company, but out from other consent order and with some more capital to deploy in the market. And now, I think the question turns to both maximizing what we do with the business as well as helping the market recover, both of those things are interrelated.

So, thank you all very much for joining us today and we look forward to talking to you in the hours, days and weeks to come. Mary Lou?

Mary Lou Christy – Senior VicePresident of Investor Relations

You can actually read John the instructions for to call in.

Operator

Certainly. And, ladies and gentlemen, a replay of the call will be available for 30 days. That starts at 1:00 pm Eastern Time today May 6, through midnight Eastern Time on June 3rd. The replay number for the call is 1-800-475-6701 or for international callers 320-365-3844. The confirmation code is 920753. Miss Christy, any closing comments?

Mary Lou Christy – Senior Vice President of Investor Relations

No, thank you.

Operator

Again, ladies and gentlemen, that does conclude your conference for today. Thank you for your participation. You may now disconnect.

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