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Last Thursday we discussed the discrepancy between Fannie Mae's quarterly balance sheet and income statement (declining shareholder equity not being consistent with reported profits). I was not satisfied with the excuse of "arcane GSE accounting" and I wanted to hear the opinion of some wall-street analysts who cover the stock. So I called them up to hear what they had to say.

The best way I can describe it is that they choose to ignore the current financial condition of the company. The objective of financial reporting is to determine and publicize the current financial condition of a company, so that investors (both debt and equity) are able to assess its ability to generate returns (after-tax retained cash flow) and the risks associated with those returns. In a rational world, a company's stock price is based on the balance between these two factors: a high return and low risk makes for a high stock price, while a higher risk associated with those same returns will lower the stock price.

While these analysts all admitted to lower margins and higher leverage at Fannie Mae, because of GSE accounting, they did not have to admit that some current costs were relevant to the company's ability to capture spreads on a long term basis.

For example, a primary source of the reduction in shareholder equity was the marking to market of certain derivatives. One analyst pointed out, rather condescendingly I might add, that the reason for the write down was that interest rates have gone lower. He did not believe that this current cost was relevant because, "if rates go back up they will recoup the value of these derivatives."


What if rates don't go back up? The value of these derivatives will be lost forever. And what if rates do go back up? The company will recoup the value of those derivatives, but will probably experience lower revenue due to lower mortgage activity and higher duration costs (this is why they have them in the first place-it is called a hedge). This is like a brokerage firm with corporate bonds in inventory and credit spreads widen. Is it not correct to force the broker to write the value of these bonds down to reflect a loss as if they had to sell them today? Our system is based on the fact that it is correct to reflect the current condition of a company as the best proxy for its future condition.

In our conversations I kept hearing things like, "we expect based on a multiple expansion from nine times to twelve times earnings and the growth of the mortgage market for FNM stock price to go to X". No one really cared about the risk associated with that growth. When I stated that the company could (and did) increase earnings by just increasing leverage I was met by silence.

When we begin to pick and choose which current items are relevant to the long term condition of a company we are truly on a slippery slope. In another environment those items could be crucial. Fannie Mae is perhaps the most important financial institution in existence. Is it not just a little disconcerting that so many financial analysts are not even allowed to see what is really going on there? When I ran derivatives at a large brokerage several years ago I was asked to help unwind a problem in the mortgage area. Believe me, this portfolio, a microcosm of what exists at FNM, concerns complicated option theory where there are many moving parts. Fannie Mae needs to be regulated much more closely by people experienced at such things to make sure a potential problem does not turn into a real one.

So when wall-street analysts ignore risk can we really say that they are "gatekeepers" or are they wolves watching over the flock? Has their agenda really changed that much when their employers earn huge profits from the companies they cover (FNM is one of the largest issuers of corporate bonds in the world).

So I am not incredulous, just disillusioned. I expected as much.

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