TEXT-S&P comments on Fannie Mae earnings report

(The following statement was released by the rating agency)

March 2 - Standard & Poor's Ratings Services said today that Fannie Mae's FNM.NFNM.P (senior unsecured debt: AAA/Stable/--) reported fourth-quarter and full-year 2009 earnings and credit costs are in line with our expectations. Fannie Mae reported a net loss of $15.2 billion in fourth-quarter 2009.

Fannie incurred the loss despite a sequential improvement in credit costs as the provision for credit losses declined to $12.2 billion from $21.9 billion in the third quarter.

Management states that serious delinquencies (more than 90 days past due) in its $3.2 trillion mortgage credit book of business are stabilizing and new serious delinquency rates are lower. Specifically, however, the serious delinquency rate in its single-family book of business increased to 5.38% from 4.72% in the third quarter.

Fannie’s allowance represents 2.10% of loans, down slightly from 2.14% in the third quarter. In the fourth quarter, Fannie Mae also wrote off all of its $5.0 billion low-income housing tax credit investments, which did not surprise us. The company was not permitted to monetize the tax credits, and it is unlikely Fannie will use them itself because its future profitability is uncertain.

Importantly, Fannie continues to execute successfully its primary public-policy mission of providing liquidity to the U.S. mortgage market. Persistent low funding costs have kept mortgage rates low for potential home buyers. Fannie has also experienced consistent demand for its securities from global investors and has gradually been able to issue in the two-to-five-year maturity range.

Effective Jan. 1, 2010, Fannie Mae brought an additional $2.4 trillion of its guaranty book of business on to the balance sheet under SFAS 166/167.

Therefore, Fannie Mae expects to reflect approximately 18 million loans on its books compared with approximately two million loans as of Dec. 31, 2009. Management estimates that the cumulative effect of adopting FAS 166/167 will boost its net worth by $2 billion to $4 billion in its first-quarter 2010 results.

We have four main observations on Fannie Mae’s full-year 2009 results. First, we expect credit quality to continue to deteriorate, albeit at a more modest rate during 2010.

Fannie Mae’s serious delinquency rate was 5.38%, an increase of 66 basis points from the third quarter. Total nonperforming loans represent a significant 6.7% of the $3.2 trillion mortgage credit book of business.

Net charge-offs increased to $32.5 billion in 2009 from $6.6 billion for 2008. Management significantly built reserves in anticipation of expected losses. We now expect the charge-offs to materialize and accelerate as more delinquent loans are moved through the loan resolution process, which includes modification attempts, and ultimately--if needed--foreclosure and real estate owned.

Although Fannie Mae has been building reserves ($64.9 billion at year-end 2009), they represent a modest 2.10% of the mortgage portfolio. We therefore believe provisioning could remain elevated during 2010. Second, we believe earnings could be challenged throughout 2010. Fannie Mae recorded a $74.4 billion net loss for 2009 after dividends to Treasury, compared to $59.8 billion for full-year 2008.

For 2010, we believe that pretax, preprovision income could still be lower than credit costs as funding costs stabilize and potentially increase, while credit costs will likely stay elevated. Third, we believe that Fannie Mae will need additional funding from the U.S. Treasury. Continued earnings pressure could result in additional draws under the Treasury’s Purchase Agreement.

Fourth, we believe that the dividend burden is not sustainable. The liquidation preference of the company’s senior preferred stock was $76.2 billion as of year-end 2009.

At a 10% rate, Fannie Mae’s Treasury dividends would be $7.6 billion. We believe that the dividend burden could increase substantially during the next few quarters, especially in light of further anticipated draws as the company’s credit costs remain elevated.