Fannie Mae Reports Record Third Quarter 2002 Operating Results
October 15, 2002
Operating Net Income of $1.631 Billion up 18.4 Percent over Third Quarter 2001
WASHINGTON, DC -- Fannie Mae (FNM/NYSE) reported operating net income for the third quarter of 2002 of $1.631 billion, an 18.4 percent increase compared with the third quarter of 2001. Operating earnings per diluted common share (operating EPS) of $1.62 rose 21.8 percent above the same period in 2001.
For the first nine months of 2002 Fannie Mae's operating net income was $4.722 billion, compared with $3.929 billion for the same period in 2001. Operating EPS for the first nine months of 2002 was $4.65, or 22.4 percent above the first nine months of 2001.
|Third Quarter||Nine Months Ended September 30|
|Operating Net Income (in billions)||$1.631||$1.377||18.4%||$4.722||$3.929||20.2%|
|Operating EPS (in dollars)||$1.62||$1.33||21.8%||$4.65||$3.80||22.4%|
Operating net income and operating EPS exclude the variability in earnings that results from including unrealized gains and losses from the change in the time value of purchased options as required under Financial Accounting Standard No. 133 (FAS 133). Also excluded is the one-time cumulative change in accounting principle from the adoption of FAS 133 on January 1, 2001. Operating net income and operating EPS provide consistent accounting treatment for purchased options and the options embedded in callable debt, and are the performance measures used by company management.
Net income on a Generally Accepted Accounting Principles (GAAP) basis for the third quarter of 2002 including the above FAS 133 items was $994.3 million, a decrease of 19.1 percent compared with the third quarter of 2001. GAAP EPS was $0.98, 17.6 percent below the same period last year. The decline in GAAP net income and EPS in the third quarter was due to a $965.2 million increase in unrealized losses in the time value of purchased options. This increase was driven by a change in interest rates that caused a shift in the value under FAS 133 between the time value and the intrinsic value of purchased options that is unrelated to portfolio rebalancing actions during the quarter. Moreover, because Fannie Mae holds options to maturity or exercise, mark-to-market losses in time value are never realized. The effects of FAS 133 are discussed more fully in the FAS 133 section later in this release. GAAP net income and EPS were $3.667 billion and $3.59 for the nine months ended September 30, 2002, and $3.925 billion and $3.80 for the nine months ended September 30, 2001. Page one of the attachments to this release provides a reconciliation of net income and operating net income.
Highlights of Fannie Mae's financial performance in the third quarter of 2002 include:
- Record commitments to purchase mortgages of $128.0 billion;
- Continued rapid growth in the combined book of business of 15.8 percent versus the third quarter of last year, and an annualized 13.8 percent versus the second quarter of 2002;
- Growth in guaranty fee income of 20.5 percent compared with the third quarter of 2001;
- An average net interest margin of 116 basis points, level with the second quarter of 2002 and 6 basis points above the third quarter of 2001;
- An increase in fee and other income of $43 million versus the third quarter of 2001; and,
- A further decline in credit-related losses to $13.9 million from $17.3 million in the second quarter and $18.7 million in the third quarter of 2001.
Timothy Howard, Fannie Mae's Executive Vice President and Chief Financial Officer, said that commitments to purchase mortgages for the company's portfolio were $57 billion for September and $128 billion for the quarter, both record amounts. Howard noted that because actual mortgage purchases had lagged well behind commitments -- at $34 billion for September and $74 billion for the quarter -- portfolio growth in the third quarter slowed to a 5.9 percent annual rate. Howard said that it was not unusual in a refinance period for portfolio commitments to outpace purchases, and added that the balance of outstanding commitments had risen to a record $84 billion at the end of September. Said Howard, "Given the large amount of commitments currently outstanding and the likelihood of a continued strong pace of commitments for at least another few months, the outlook for portfolio growth through the first part of 2003 seems very promising." Howard said that guaranty fee income had continued to increase at an exceptionally rapid pace. Fueled by very strong growth in outstanding MBS and a relatively stable average guaranty fee rate, the company's third quarter guaranty fee income was 20.5 percent above the third quarter of 2001.
Howard noted that as typically occurs in a period of very low interest rates, the duration gap on Fannie Mae's mortgage portfolio widened somewhat during the quarter. Howard said that the portfolio's duration gap fell from minus four months in June to minus fourteen months at the end of August, before narrowing to minus ten months at the end of September. Said Howard, "The movement in our duration gap last quarter is within the range of what we have experienced historically. As the refinance wave plays out, we expect it to return to a more normal level." Howard emphasized that the company's duration gap, which is not a reliable predictor of the company's net income, had no negative effects on Fannie Mae's financial results in the third quarter. Howard noted that Fannie Mae's primary portfolio risk management measure, four-year net interest income at risk, moved by considerably less than the duration gap -- from 2.4 percent in June to 6.7 percent in August, then back to 3.9 percent in September. Howard added that during the quarter Fannie Mae's percentage of option-based debt rose from 58 percent to 68 percent, reflecting increased portfolio rebalancing. Details of Fannie Mae's third quarter 2002 financial performance follow.
Fannie Mae's business volume -- mortgages purchased for portfolio plus MBS issues acquired by other investors -- totaled $186.8 billion in the third quarter of 2002, compared with $158.8 billion in the third quarter of 2001 and $159.8 billion in the second quarter of 2002. Business volume for the first nine months of 2002 was $544.4 billion, a 26.6 percent increase from $430.1 billion for the first nine months of 2001. Business volume in the third quarter of 2002 consisted of $74.2 billion in portfolio purchases and $112.6 billion in MBS issues acquired by investors other than Fannie Mae's portfolio, compared with $64.2 billion and $94.6 billion, respectively, in the third quarter of 2001. Retained commitments to purchase mortgages surged to $128.0 billion in the third quarter of 2002 from $54.1 billion in the third quarter of 2001 as a result of the lower interest rate environment and related increase in mortgage refinancings. Outstanding portfolio mandatory delivery commitments totaled $84.4 billion at September 30, 2002. Fannie Mae's combined book of business -- mortgages held in portfolio and outstanding MBS held by other investors -- grew at a compound annual rate of 13.8 percent during the third quarter of 2002, ending the period at $1.742 trillion. This growth resulted from a 5.9 percent annualized growth rate in the gross mortgage portfolio and a 20.4 percent rate of growth in outstanding MBS during the quarter. For the first nine months of 2002, the combined book of business grew at an annual rate of 15.4 percent.
Portfolio investment business results
Fannie Mae's portfolio investment business manages the interest rate risk of the company's mortgage portfolio and other investments. The results of this business are largely reflected in adjusted net interest income, which is net interest income less the amortization expense of purchased options. Adjusted net interest income for the third quarter of 2002 was $2.192 billion, up 15.9 percent from $1.892 billion in the third quarter of 2001. This increase was driven by a 9.9 percent rise in the average net investment balance and a 6 basis point increase in the average net interest margin. Adjusted net interest income for the first nine months of 2002 was $6.514 billion, up 22.1 percent from $5.335 billion during the comparable period in 2001. Concurrent with the effective date of Fannie Mae's risk-based capital requirement on September 13, 2002, the company elected to transfer $135 billion of portfolio and investment securities, classified as held-to-maturity, to the available-for-sale category. This change had no effect on net income. In conjunction with this change, Fannie Mae revised the calculation of its mortgage portfolio growth statistic to exclude the effect of any unrealized gains or losses. The calculation now will be based on unpaid principal balance, which also excludes deferred balances and the allowance for losses.
Fannie Mae's gross mortgage portfolio -- before unrealized gains or losses on available for sale securities, deferred balances, and the allowance for losses -- grew at an annual rate of 5.9 percent during the third quarter of 2002, ending the quarter at $751 billion. Portfolio growth in September rose to an annual rate of 8.9 percent, as mortgage purchases increased in response to lower mortgage interest rates and a high rate of mortgage refinance activity. The company's net mortgage portfolio -- including unrealized gains or losses on available for sale securities, deferred balances, and the allowance for losses -- was $758 billion at the end of the third quarter of 2002 compared with $741 billion at the end of June. Fannie Mae's net investment balance -- consisting of the net mortgage portfolio and the company's liquid investments -- averaged $803 billion during the third quarter of 2002 compared with $731 billion during the third quarter of 2001. The net investment balance was $811 billion at September 30, 2002.
The company's net interest margin averaged 116 basis points in the third quarter of 2002, equal with the second quarter and up 6 basis points from the third quarter of 2001. The company's net interest margin has averaged 116 basis points year-to-date, up from 107 basis points for the first nine months of 2001. Fannie Mae's net interest margin for the third quarter and first nine months of 2002 continued to benefit from an unusually steep yield curve and low short-term interest rates. For the third quarter of 2002, the company realized losses from debt repurchases and debt calls of $138.0 million compared with losses of $206.7 million in the third quarter of 2001. During the quarter the company realized $105.1 million of losses on debt repurchases and $32.9 million of losses on debt calls. Debt repurchased and debt called in the third quarter of 2002 totaled $0.8 billion and $65.4 billion, respectively. Fannie Mae regularly calls or repurchases debt as part of its interest rate risk management program.
Credit guaranty business results
Fannie Mae's credit guaranty business manages the company's credit risk. The results of this business are primarily reflected in guaranty fee income and credit-related losses. Guaranty fee income was $462.5 million in the third quarter of 2002, a 20.5 percent increase compared with the third quarter of 2001. The increase in guaranty fee income was driven by a 21.7 percent rise in average outstanding MBS, partially offset by a slight decline in the average effective guaranty fee rate compared with the previous year. The effective guaranty fee rate in the third quarter of 2002 was 19.0 basis points compared with 19.2 basis points in the third quarter of 2001 and 18.3 basis points in the second quarter of 2002. The effective guaranty fee rate in the third quarter of 2002 rose from the previous quarter as a result of higher fee rates on new business and lower fee rates on liquidating business in a period of heavy refinance activity, together with the faster amortization of deferred fees due to accelerated prepayments. Guaranty fee income for the first nine months of 2002 was $1.294 billion compared with $1.084 billion for the first nine months of 2001. Credit-related losses -- foreclosed property expense plus charge-off recoveries -- declined further, driven by a strong housing market and continued home price gains. Losses totaled $13.9 million in the third quarter compared with $18.7 million in the third quarter of 2001. Foreclosed property expense was $53.2 million in the third quarter of 2002 compared with $45.1 million in the third quarter of 2001. Charge-off recoveries were $39.3 million in the third quarter of 2002 compared with $26.4 million in the third quarter of 2001. Fannie Mae's credit loss rate -- credit-related losses as a percentage of the average combined book of business -- was 0.3 basis points in the third quarter of 2002, down from 0.5 basis points during the third quarter of 2001. Fannie Mae's conventional at-risk single-family serious delinquency rate, an indicator of potential future loss activity, was unchanged for the fourth consecutive month at .42 percent at August 31st, the latest date available.
Credit-related expense, which includes foreclosed property expense and the provision for losses and is the amount recorded on the company's income statement, totaled $13.2 million in the third quarter of 2002, in line with credit-related losses. Fannie Mae's loss provision was a negative $40.0 million in the third quarter of 2002, compared with a negative $30.0 million in the third quarter of 2001. The company's allowance for loan losses totaled $812 million at September 30, 2002 compared with $813 million at June 30, 2002 and $807 million at September 30, 2001.
Fee and other income
Fee and other income in the third quarter of 2002 totaled $91.6 million compared with $49.0 million in the third quarter of 2001. The increase from the third quarter of 2001 was primarily due to higher technology and transaction fees. Fee and other income for the first nine months of 2002 was $136.8 million compared with $100.8 million for the first nine months of 2001.
Fee and other income includes technology fees, transaction fees, multifamily fees, and other miscellaneous items, and is net of operating losses from certain tax-advantaged investments -- primarily investments in affordable housing which qualify for the low income housing tax credit. Tax credits associated with housing tax credit investments are included in federal income tax expense.
Federal income tax expense on operating net income was $649.7 million in the third quarter of 2002, compared with $454.4 million in the third quarter of 2001. The effective federal income tax rate on operating net income was 28 percent in the third quarter of 2002, compared with 25 percent for the same period last year. The increase in the third quarter of 2002 is attributable to lower tax credits from affordable housing investments. Federal income tax expense for the first nine months of 2002 was $1.7 billion compared with $1.3 billion for the first nine months of 2001. The effective federal income tax rate on operating net income was 27 percent for the first nine months of 2002, compared with 25 percent for the same period last year.
Administrative expenses totaled $314.6 million in the third quarter of 2002, up 15.5 percent from the third quarter of 2001. The above-average growth in expenses is related to Fannie Mae's reengineering of its core technology infrastructure to enhance its ability to process and manage the risk on mortgage assets. Due to this initiative, the company expects its administrative expenses to grow at a high-teens rate in 2002. The company's ratio of administrative expense to the average combined book of business in the third quarter of 2002 was .073 percent, down from the third quarter of 2001. Fannie Mae's efficiency ratio -- administrative expense divided by taxable-equivalent revenue -- was 10.5 percent in both the third quarter of 2002 and the third quarter of 2001.
Fannie Mae's core capital, which is the basis for the company's statutory minimum capital requirement, was $26.5 billion at September 30, 2002 compared with $23.8 billion at September 30, 2001 and $26.4 billion at June 30, 2002. Core capital was an estimated $729 million above the statutory minimum at September 30, 2002. At June 30, 2002, core capital was $1.155 billion above the statutory minimum. Total capital, which includes core capital and the general allowance for losses and is the basis for the risk-based capital stress test, was $27.3 billion at September 30, 2002 compared with $24.6 billion at September 30, 2001 and $27.2 billion at June 30, 2002. The risk-based capital standard utilizes a stress test to determine the amount of capital needed to protect against credit and interest rate risks, and requires 30 percent in additional capital to protect against unspecified management and operations risks. Office of Federal Housing Enterprise Oversight (OFHEO) will begin to use its risk-based standard for regulatory purposes for the third quarter and release the results in December. The higher of the risk-based or minimum capital standard will be binding.
The company repurchased 4.3 million shares of common stock during the third quarter of 2002 and has repurchased 15.0 million shares year-to-date. Common stock repurchases for 2001 totaled 6.0 million shares. Year-to-date repurchases include shares used to fund the company's $300 million commitment to the Fannie Mae Foundation made in the fourth quarter of 2001. At September 30, 2002 Fannie Mae had 988.7 million shares of common stock outstanding compared with 992.8 million shares at June 30, 2002. The company issued $1.5 billion of subordinated debentures in the third quarter of 2002 and has issued $2.5 billion year-to-date. Subordinated debt outstanding totaled $7.5 billion at September 30, 2002. Subordinated debt serves as an important supplement to Fannie Mae's equity capital, although it is not a component of core capital. After providing for capital to support its off-balance sheet MBS, Fannie Mae's capital and outstanding subordinated debt as a percent of on-balance sheet assets was 3.6 percent at September 30, 2002.
Howard confirmed that the outlook for the company's financial performance remains strong. Said Howard, "Our earnings guidance remains consistent with what we have provided all year. For 2002, we expect that growth in operating EPS will be above the company's very positive long-term trend. For 2003, although the combination of anticipated rapid portfolio growth at wider-than-normal spreads and liquidations at substantially elevated levels makes precise earnings estimates more difficult, we continue to expect strong financial performance." Howard noted that credit losses in 2003 are expected to increase only modestly from the extremely low levels experienced so far this year. Although the number of properties acquired through foreclosure has increased modestly throughout the year and is expected to continue increasing slowly, the company's loss per case on foreclosure is expected to remain historically low.
Howard said that after a likely high-teens rate of increase in 2002, Fannie Mae expected the growth in its administrative expenses in 2003 to return to a rate more in line with the trend of the previous few years. Howard added that the company still expects the net interest margin to move lower during the fourth quarter of 2002 and into next year, particularly if mortgage prepayments increase as anticipated over the balance of this year.
As part of Fannie Mae's voluntary market discipline, liquidity, and safety and soundness initiatives of October 2000, the company discloses on a quarterly basis its liquid assets as a percent of total assets along with the sensitivity of its future credit losses to an immediate 5 percent decline in home prices. At September 30, 2002 Fannie Mae's ratio of liquid assets to total assets was 6.4 percent, compared with 7.8 percent at June 30, 2002. Fannie Mae has committed to maintain a portfolio of high-quality, liquid, non-mortgage securities equal to at least 5 percent of total assets.
At June 30, 2002 the present value of Fannie Mae's net sensitivity of future credit losses to an immediate 5 percent decline in home prices was $465 million, taking into account the beneficial effect of third-party credit enhancements. This compares with $425 million at March 31, 2002. The June 30 figure reflects a gross credit loss sensitivity of $1,361 million before the effect of credit enhancements, and is net of projected credit risk sharing proceeds of $896 million. In previous quarters Fannie Mae has published whether it has passed or failed an interim version of the risk-based capital stress test, based on its interpretation of the Federal Housing Enterprises Financial Safety and Soundness Act of 1992. With the risk-based capital standard established by the OFHEO becoming effective as of September 13, 2002, Fannie Mae has ceased to calculate and publish this result. OFHEO will use its risk-based standard for regulatory purposes at the end of the third quarter, and release the third-quarter test results in December. OFHEO has reported that as of June 30, 2002 Fannie Mae's total capital exceeded the amount required by the OFHEO risk-based standard by $5.1 billion, or 18.7 percent of the company's total capital.
Fannie Mae's quarterly disclosures, together with the monthly interest rate risk disclosures, are included with the company's Monthly Summary statistics.
Derivatives and FAS 133
Fannie Mae primarily uses derivative instruments as substitutes for noncallable and callable debt issued in the cash markets to help match the cash flow characteristics of its debt with those of its mortgages and reduce the interest rate risk in its portfolio. Fannie Mae accounts for its derivatives under FAS 133, Accounting for Derivative Instruments and Hedging Activities, which was adopted on January 1, 2001. The implementation of this standard resulted in significant accounting presentation changes to both the company's income statement and balance sheet.
FAS 133 requires that Fannie Mae mark to market on its income statement the changes in the time value, but not the total value, of its purchased options -- interest rate swaptions and interest rate caps. The mark to market of the time value of Fannie Mae's purchased options during the third quarter of 2002 resulted in a net unrealized loss of $1.378 billion, which is reported on the purchased option expense line of the income statement. Purchased options expense in the third quarter of 2002 includes $399.2 million in amortization expense, which was included in net interest income prior to the adoption of FAS 133 and currently is included in adjusted net interest income and in operating earnings. This amortization expense represents the straight-line amortization of the up-front premium paid to purchase the options. The unrealized loss in the time value component of purchased options in the third quarter was driven by the significant change in interest rates during that quarter, partially offset by an increase in interest rate volatility. This unrealized loss in time value was more than offset by an increase in the intrinsic value of the purchased options, which is not reflected on the income statement. Because Fannie Mae holds options to maturity or exercise, the mark-to-market losses in time value will never be realized. The total purchased option expense recorded over the life of the options will be equal to the amortization expense.
FAS 133 also requires that the company record any change in the fair values of certain derivatives, primarily interest rate swaps it uses as substitutes for noncallable debt, on the balance sheet in accumulated other comprehensive income (AOCI), which is a separate component of stockholders' equity. For these types of transactions, FAS 133 does not require or permit noncallable debt to be marked to market. At September 30, 2002, the AOCI component of stockholders' equity included a reduction of $16.5 billion, or 2.2 percent of the net mortgage balance, from the marking to market of these derivatives, compared with a reduction of $9.5 billion at June 30, 2002. Partially offsetting the reduction in AOCI from the mark to market of derivatives was a $5.0 billion unrealized gain on the available-for-sale securities portfolio. Accumulated other comprehensive income is not a component of core capital. Fannie Mae's primary credit exposure on derivatives is that a counterparty might default on payments due, which could result in Fannie Mae having to replace the derivative with a different counterparty at a higher cost. Fannie Mae's exposure on derivative contracts (taking into account master settlement agreements that allow for netting of payments and excluding collateral received) was $2.723 billion at September 30, 2002. All of this exposure was to counterparties rated A-/A3 or higher. Fannie Mae held $2.322 billion of collateral through custodians for these instruments. Fannie Mae's exposure, net of collateral, was $401 million at September 30, 2002 versus $278 million at June 30, 2002. The replacement cost at September 30, 2002 represents about three weeks of annualized pre-tax operating earnings.
This release includes forward-looking statements based on management's estimates of trends and economic factors in the markets in which Fannie Mae is active as well as the company's business plans. Such estimates and plans may change without notice and future results may vary from expected results if there are significant changes in economic, regulatory, or legislative conditions affecting Fannie Mae or its competitors. Investors should review the most recent Information Statement dated April 1, 2002 and the Information Statement Supplements datedMay 15, 2002 andAugust 9, 2002 for a discussion of these factors.
Source: Fannie Mae