Note on SEC Statement on Fannie Mae Accounting

On Wednesday December 15, 2004, the Securities and Exchange Commission issued a statement on its review of accounting practices at Fannie Mae. The review was sparked by a September 17, 2004 report by the Office of Federal Housing Enterprise Oversight, in which the regulator of the Government Sponsored Enterprises questioned several of those practices and focused on their implications for Fannie Mae's regulatory capital, its quality of management and its overall safety and soundness. The outcome of the SEC's review was that "during the period under our review, from 2001 to mid-2004, Fannie Mae's accounting practices did not comply in material respects" with FAS 91 and FAS 133. FAS 91 has to do with accounting for prepayments in a changing interest rate environment. FAS 133 sets requirements for accounting for gains and losses on derivative contracts.

From a financial statement perspective, Fannie Mae will have to re-evaluate its information related to these accounting directives and restate its financial statements back to 2001. Fannie Mae had warned last month that the cumulative effect of such a restatement could be as much as $9 billion, which could result in the firm having less than its minimum capital requirement. Fannie Mae then would have to bring its capital levels up to the required level over a prescribed period of time, which it could accomplish through a number of different options, i.e., raising new equity capital, retaining more earnings, cutting its dividend, slowing its growth, selling assets or more.

There will be a reaction to this news. The equity market has punished the stock because all of the possible solutions will hurt the growth profile of the company. The senior executives at the company, most prominently CEO Franklin Raines and CFO Tim Howard, will likely have to resign. Lawmakers in Washington will increase the volume for a tougher regulatory regime for the GSEs. Depending on how deep these possible solutions cut into Fannie Mae's appetite for assets, there may be some effect on the prices of its debt and MBS, but that is hard to quantify. If at some point the ratings agencies downgrade the triple-A-rated senior unsecured obligations of Fannie, the value of the debt and MBS may be affected, but this is also an eventuality that is hard to forecast. So far we have seen no indication that this is being considered.

What hasn't happened is any significant selling in Agency mortgage-backed securities. Unlike the equity market, the MBS market sees the possible solutions as strengthening an already strong credit. Slower growth, more retained earnings, higher capital ratios and a stronger regulator are all developments that would help the company's risk profile. An interesting point to consider when thinking about the restatement is that it is a backward-looking exercise. If anyone is worried about the creditworthiness of a company that may have had less than the minimum regulatory capital, over the period in question Fannie Mae easily met all of its financial obligations as a guarantor of MBS and as a debt issuer.

To us, this highlights the fact that these issues are indeed accounting problems, not credit problems.

We make no apologies for Fannie Mae or its executives. From a business and moral point of view, the very worst accusation thrown at Fannie Mae-that senior management knowingly manipulated the accounting rules to ensure themselves of higher compensation-is reprehensible if true. However, we continue to believe that the guarantee provided by Fannie Mae and Freddie Mac is strong. Besides this guarantee, the MBS holder is secured by the actual loan-to-value rating of the home, mortgage insurance, the income verification and maintenance of the homeowner, property/casualty and life insurance, the rights of foreclosure and the settlement process, and the reduction in principal amount from monthly amortization.

This commentary is neither an offer to sell, nor a solicitation of an offer to buy, any securities of Annaly Mortgage Management, Inc. (“Annaly”), FIDAC or any other company.

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