Fannie Mae could face more losses

(Fortune) -- Could Fannie Mae be the next large financial company to announce billions of dollars of market losses on bonds backed by distressed mortgages?

That certainly seems possible after the government-sponsored mortgage giant announced plans Tuesday to bolster capital by selling $7 billion of new stock and cut its dividend by 30%. In a statement Tuesday on the capital plan, Fannie Mae said it faced a range of mortgage-related losses, including market losses on the securities it holds.

The vast majority of Fannie Mae's mortgages are loans to borrowers with good credit, but over the past five years the government sponsored enterprise became exposed to mortgages that were made to people with poor credit - subprime mortgages - and to mortgages that were made with incomplete documentation of borrowers' income, called Alt-A mortgages in industry parlance.

One way that Fannie increased its exposure to subprime and Alt-A mortgages was to buy bonds backed with these types of loans. While these subprime and Alt-A mortgage-backed bonds are only a small proportion of Fannie's overall mortgage holdings, their combined value of $76 billion is almost double Fannie's $40 billion of capital, which is the net worth of a company and the last cushion against losses.

Losses are climbing on these loans as borrowers default, which has caused the market value of bonds backed with such loans to fall sharply. Investors are bidding down the value of mortgage bonds in anticipation that defaults will prevent many of the bondholders from being paid back in full.

Many banks have already taken large writedowns in the third quarter after marking down the value of the subprime and Alt-A-backed bonds they held - and banks are again expected to post large losses in the fourth quarter after more markdowns.

Because it's impossible to know exactly which Alt-A and subprime bonds Fannie owns, it is difficult to precisely predict losses on them. But if Fannie's bonds are similar to bonds for which price data exists, the company's market losses on these bonds this quarter could exceed $5 billion, which would be 12% of Fannie Mae's capital.

Fannie Mae's rival Freddie Mac last week issued $6 billion of new stock to bolster its capital position. Fannie Mae, (Charts) by contrast, issued only $500 million of fresh stock earlier this month. But if it does have to take substantial losses from writedowns on Alt-A and subprime-mortgage-backed bonds, it may have to come back to market and issue several billion dollars more of stock.

When asked to comment, Fannie Mae spokesman Brian Faith referred to comments made by company officials about the subprime and Alt-A bonds on a Nov. 9 conference call.

On that call, Fannie Mae CFO Stephen Swad said that the bonds had fallen in the fourth quarter, but they were trading, on average, in the "high 90s." Bond prices are often expressed in terms of cents on the dollar, with any price under 100 cents on the dollar representing a discount to the par value of the bond. Therefore, a bond trading in the high 90s has not fallen very far. As a result, Fannie Mae was saying on the call that it hadn't written down the market value of the subprime and Alt-A bonds by much.

This was a signal to investors that Fannie Mae thought it would not be taking large losses on those bonds if they remained at those prices.

But that looks implausible. Here's why.

Fannie Mae's quarterly financial filing for the third quarter said Fannie had $42.2 billion of private-label subprime securities and $33.8 billion of private label Alt-A securities.

Private label is the term Fannie Mae gives to bonds and mortgages bought from private sector banks, as opposed to those issued by government-sponsored entities like Fannie Mae and Freddie Mac, which both operate under advantageous Congressional charters.

Fannie Mae has taken some losses on those securities, but they're relatively small compared with the losses seen at other banks.

Fannie Mae said that in the nine months to Sept. 30, it had taken writedowns of $896 million on its subprime private label securities. That would work out to a 2% reduction in value of those securities.

Fannie Mae booked $285 million of the $896 million as a reduction to earnings, but accounting rules allowed the company to leave the remaining $611 million out of earnings calculations and book them only as a reduction to shareholders' equity.

One of the reasons that Fannie might have taken what appears to be a small percentage writedown is that these bonds are rated AAA, the highest rating possible. They get that rating because other investors in the bond have agreed to be the first to take a large amount of credit losses from the underlying loans.

But even with that protection, it's possible that the AAA subprime securities are trading at a much steeper discount - and therefore a lower price - than the 2% discount that Fannie Mae applied in the third quarter.

A Wall Street bank that trades AAA-rated subprime bonds is currently quoting prices for such bonds of around 88 cents on the dollar, or a 12% discount, for loans made in 2006, and 78 cents on the dollar, or a 22% discount, for loans made in 2007.

Fannie Mae's subprime exposure is likely to be concentrated in the 2006 and 2007 bonds, because earlier years' AAA bonds would have been largely paid down by now.

It's not disclosed how Fannie Mae's subprime bonds are split up between 2006 and 2007 bonds. A conservative estimate would be to assume they were all trading at 88 cents on the dollar, or a 12% discount.

Since Fannie Mae has already marked these bonds down by 2% in the third quarter, this exercise would mean marking them down by a further 10%. In turn, that would mean further writedowns potentially equivalent to 10% of $42.2 billion, which is $4.2 billion.

A similar exercised can be applied to the $33.8 billion of Alt-A securities. Many of these so-called "liar loans" are likely to go bad because borrowers used the low-disclosure requirements to cover up that they couldn't actually afford the loan payments.

Investors don't think much of them. For instance, as part of its rescue this week of online brokerage ETrade (Charts), hedge fund Citadel appeared to pay roughly 60 cents on the dollar for ETrade's Alt-A loans. That was a special deal in which Citadel was able to get seemingly attractive terms, but it shows the skepticism about the credit quality of Alt-A loans.

Alt-A loans are typically thought to be of better credit quality than subprime. If that principle is applied and the $33.8 billion of securities are marked down by another 5%, that could amount to another $1.7 billion hit.

What are the flaws of this approach to estimating Fannie's exposure? One may be that the private-label securities that Fannie Mae holds have a higher level of credit protection than the bonds that dealers are quoting prices for. But that doesn't seem to be the case.

Fannie Mae says that its credit protection on the bonds is, on average, equivalent to 32% of the bond. That means that other holders of the bond are first in line to bear bad loan losses - up to 32% of the value of the bond. Any losses above 32% would be borne by the AAA-bond holder, in this case Fannie Mae.

However, this 32% level of credit protection appears to be in line with the bonds that make up the ABX Indexes that track AAA-rated subprime-mortgage-backed bonds for 2006 and 2007.

So, it doesn't appear to be the case that Fannie has more protection on its bonds. If that's the case, Fannie Mae may have to mark down its securities by a large amount in the fourth quarter.