Aside from reporting higher-than expected earnings and lowering guidance for the remainder of the year, Fannie Mae last week discussed its decision to grow its portfolio in the second half of the year via lower-margin ARMs. The firm also expressed its concern regarding the credit risk found in private label mortgage-backeds, including Alt-A and subprime loans.

At Fannie's earning conference call held last Wednesday, there was considerable discussion about the shift in portfolio purchases toward ARM products, which will cause margin contraction. Loans Fannie currently places on the books have significantly less initial spread compared to the past, said analysts from Friedman Billings Ramsey (FBR). The increase in the cost of debt resulting from maturity extension will lead to increased margin compression sooner than expected.

Susquehanna Financial Group (SIG) gave two possible reasons why Fannie chose lower-margin ARMs as a strategy for growth. SIG analysts said that Fannie is concerned with the long term. Margins are higher in the early years of a 30-year fixed loan in a steep- curve scenario compared to an ARM in a flatter curve. "While the near-term comparisons are difficult, we believe the comparisons become more favorable in the later years, as fixed-rate assets begin to be funded at the steep end of the yield curve," they wrote.

SIG also said that Fannie's decision shows that the bid for fixed-rate mortgages is rich, and that there is currently sufficient ARM production to make returns attractive. This is because ARM products have less optionality risk, making return outcomes more predictable.

"Given Fannie Mae's skill at risk management, we understand its long-term preference for managing and distributing the risk associated with fixed-rate products, which offer Fannie Mae the opportunity to generate a higher return," said SIG analysts. However, they also argue that ARM collateral should meet Fannie's return hurdles. SIG argues that ARM products probably need less "cushion" capital compared to fixed-rate loans.

Fannie executives also talked about some credit concerns in private label MBS. They said that some homeowners might have assumed too much interest risk by moving into IO hybrid ARMs to keep up with increasing home prices. Fannie management also believes that credit risk in Alt-A and subprime loans has not been adequately priced in.

There is also the issue of lower mortgage-backed issuance caused by the tightening of credit spreads. Spreads between Fannie MBS and private label mortgage have lessened as the buyside has become more willing to take on credit risk, said FBR. Thus, private label issuance has surpassed Fannie and Freddie Mac. "We believe spreads will widen again, resulting in higher Fannie Mae MBS issuance," wrote equity analysts from FBR.

Aside from these issues, Fannie's portfolio growth in the second half of this year will likely be hindered by the strong demand from other investors as well as the unusually high percentage of ARMs in the market. Fannie predicts portfolio growth for the year to fall short of growth in mortgage debt outstanding of roughly 9% to 10%. It did not release any guidance for 2005.

FBR said that lower guidance is the result of lower-than-expected retained portfolio growth, as banks continue to be aggressive bidders for mortgages. If banks begin selling MBS earlier than anticipated, this would result in the widening of option-adjusted spreads, which means better investment opportunities for the GSEs, said FBR.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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