More doubts about Fannie Mae's disclosures

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(Fortune) -- Fannie Mae sought to reassure nervous investors Friday after questions arose about a key change in the way the mortgage lender discloses its bad loans -- and whether the shift is camouflaging mounting losses.

At issue is Fannie Mae's method for calculating its credit-loss ratio -- an important indicator of its bad loan losses as a percentage of its overall loans. Investors have used the credit ratio to assess the credit quality of Fannie Mae's mortgages.

But in announcing quarterly results Nov. 9, Fannie Mae (Charts) used a different methodology for calculating its credit-loss ratio -- one that had the effect of making the ratio appear more reassuring to investors than it is.

In response to investor concerns about the change, first reported this week on Fortune.com, Fannie Mae executives held a conference call with analysts Friday morning that did little to placate investors. Fannie Mae shares fell $2.32, or 5.39%, Friday. The company's stock price has plunged 17% since Fortune revealed the change in disclosure in a story posted online Wednesday.

For Fannie Mae, the timing couldn't be worse. Penalized last year for a lack of oversight and overstating several years of earnings, Fannie Mae's mortgage book is capped in size by its regulator. But a steep decline in house prices and mortgage lending had led several politicians and financial leaders to call for that limit to be lifted so that Fannie can buy more mortgages to stave off rising foreclosures.

Fannie Mae's latest controversy dates to August, when the company estimated that its credit-loss ratio for the year would be between four and six basis points (or, in layman's terms, between 0.04 and 0.06 of a percentage point). For Fannie Mae, a ratio of four to six basis points is nothing alarming.

And last week, Fannie Mae said it had an annualized credit-loss ratio of four basis points for the first nine months of the year, well within the company forecast.

But the company used a new method of calculation to get that number. If it hadn't changed methods, Fannie Mae would have had a credit loss ratio almost twice the four basis points. Recalculated under the previous method, the credit-loss ratio comes to 7.5 basis points, high enough to start making investors nervous.

The company and some analysts insist that Fannie Mae disclosed the change properly. However, none of Fannie Mae's financials for the third quarter ended Sept. 20 showed that 7.5 basis point number. Instead, enterprising investors had to parse the new disclosures and do some extra math to calculate the 7.5 basis point figure.

When companies typically provide new ways of calculating key metrics, they disclose the metric under both the old and new methods for a period, so investors can make an easy comparison.

On Friday, Fannie Mae executives spent most of the call defending why the company changed the way it disclosed the ratio. But chief financial officer Stephen Swad and other executives failed to answer some important questions about the company's loan losses -- and left many still in doubt about the company's financial footing.

Essentially, the company was able to lower the ratio by excluding a certain type of loss known as an SOP 03-3 loss.

Here's how SOP 03-3 losses work: Fannie Mae guarantees mortgages, which have been packaged and sold to investors as bonds. If a homeowner falls significantly behind on his payments, Fannie Mae has to buy back the loan from the bondholder. If the mortgage has an outstanding amount of, say, $100,000 and unpaid interest of $5,000, Fannie Mae would have to pay $105,000 -- its full value -- to make the bondholders whole.

However, the $105,000 loan may actually be worth less on the market. It is Fannie Mae's job to estimate the market value, or fair market value, of the loan and to record that price on its books. So if the fair market value is $80,000, Fannie Mae takes a loss of $25,000 (the difference between $105,000 and $80,000). That loss is considered an SOP 03-3 loss -- so named after the applicable accounting rule.

Until recently, Fannie Mae included SOP 03-3 losses as part of its credit-loss ratio. But here's the trick: Fannie insists that, based on past trends, it can recover a large part of that $25,000 loss by, for example, helping the borrower renew payments. So it simply decided to stop including SOP 03-3 losses in calculating its credit-loss ratio.

Investors have plenty of reasons to be spooked by that move.

1. The timing is suspect. Fannie Mae's decision to exclude SOP 03-3 losses coincide with their shocking rise: In the third-quarter ended Sept. 30, 2007, the company's SOP 03-3 losses came to $670 million, up from $37 million in the same period a year ago.

2. It's not clear why SOP 03-3 losses are skyrocketing, but it suggests that Fannie Mae is having credit problems and is having to buy a lot more bad loans back from bondholders.

Not so, counters Fannie Mae. The company argues that the increase in SOP 03-3 losses is driven chiefly by a decline in the fair value of mortgage loans in the market -- and not because the company has been forced to buy back a large amount of bad loans. However, when asked on the call, Fannie Mae executives did not provide numbers to back up that claim.

3. Some analysts doubt that Fannie Mae can, despite its claim, recoup most of its SOP 03-3 losses. Executives failed to provide numbers showing what proportion of those losses get recovered, but promised to disclose them in the future.

One possible reason why Fannie Mae doesn't want to provide data on recoveries is because it might be using assumptions that are too optimistic, potentially underestimating SOP 03-3 losses.

4. Also, why would Fannie Mae exclude SOP-3 losses at a time when balance sheet valuations are under the spotlight at some of the world's largest banks, from Merrill Lynch (Charts, Fortune 500) to Citigroup (Charts, Fortune 500) to UBS (Charts)?

Investors, regulators and auditors are pressing lenders to apply rigorous market values to assets like mortgages, even if the lenders don't like those values. Yet, Fannie is now excluding market values from its credit loss ratio.

5. Using fair value accounting, Fannie Mae's capital -- the company's net worth -- has declined sharply this year. According to a fair value version of its balance sheet contained in a recent filing, Fannie Mae's capital was $34 billion on Sept. 30, a 20% drop from the end of last year.

Capital is the key number to watch at Fannie Mae. The company can choose to keep those SOP 03-3 losses out of its credit loss ratio. But accounting rules prevent the company from leaving them out of capital calculations.

The fuzzy math goes only so far.