Fannie Mae Bold Recommendation 2003

7/29/2019 Fannie Mae Bold Recommendation 2003

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MDB Capital Group LLC 401 Wilshire Blvd., Suite 1020 Santa Monica, CA 90401 310-526-5000 www.mdbcapital.co

New Coverage FANNIE MAE (FNM $65.3Industry: Financial Services Sector: Mortgage Finan

PLEASE READ THE DISCLOSURES AT THE END OF THIS REPORT FOR IMPORTANT REQUIRED INFORMATION INCLUDINGRISKS, ANALYST CERTIFICATION AND THE RELATIONSHIP BETWEEN MDB CAPITAL GROUP, LLC AND THE SUBJECT ISSUER.

INITIATING COVERAGE WITH A SELL RATING AND PRICE TARGET OF $49/SHARInvestment opinion reflects our cautious outlook around consensus estimates, declining profitability and efficienmetrics and quality of earnings issues. Ongoing IRS investigation of synfuel tax credits not reflected in currentshare price which appear fully priced trading at 9.5x/8.6x adjusted FY2003/2004 consensus diluted Core EPS o$6.85/$7.60 net of synfuel tax credits. Price target of $49 assumes adjusted FY2005 diluted Core EPS of $7.20,

PE multiple of 8x FY2005 achieved at the end of 2004 and applying a discount rate of 12%.

Summary of Investment Opinion and Risks:

Declining long-term profitability, leverage and efficiency trends. Despite robust asset growth andabove trend 22% EPS growth over past 10 quarters, key long term profitability/efficiency metrics remabelow trend for same period.

Metr

Directional divergence between econometric forecasts and FNM guidance for 2003-2005increases likelihood of further downward revisions.Between 1995 and 2002, Fannie Mae grew assets from $316 billion to $887 billion (+16% CAGR) or4.3x real GDP growth rate and 1.8x the growth rate of the overall US residential mortgage market.The sustainability of this above-trend performance is now coming into sharp focus as investors seekto understand the secular growth story. Recent Mortgage Bankers Association of America reportMacroeconomic and Housing Finance Outlook 2003-2005, authored by MBAA Chief EconomistDouglas Duncan released July 14, 2003 forecasts modestly increasing mortgage rates with 30Y FRMat CY2003: 5.7%, CY2004: 6.1%, CY2005: 6.7%, maintaining +160-170 bps spread over the 10Ytreasury. Duncan and staff expect a concomitant sharp decline in mortgage volumes from 2003gold-rush levels of $3.39 trillion to $1.94 trillion for CY2004 (-43.0%) and $1.46 trillion for

Recommendation: SELL Peter Conley* (310) 526-5006 [email protected] Target: $49.00 Al Kaschalk, CPA (310) 526-5025 [email protected]

MDB-AnalytiqINSTITUTIONAL EQUITY RESEARCH July 22, 200

ic FY 2002 FY 2000 Change

Shareholder Equity ($ billion) 16.3$ 20.8$ (4.5)$

Return of Assets 0.54% 0.69% -0.15%Return of Capital 0.56% 0.72% -0.16%

Net Income/earned assets 0.55% 0.70% -0.15%

Loan reserves/loans 0.01% 0.03% -0.02%

Financial leverage 57.34% 35.83% 21.51%

Pre-tax margin 11.43% 13.57% -2.14%

Efficiency ratio 9.38% 14.49% -5.11%

Effective tax rate 23.63% 26.18% -2.55%


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2MDB Capital Group LLC 401 Wilshire Blvd., Suite 1020 Santa Monica, CA 90401 310-526-5000 www.mdbcapital.co

CY2005 (-25.0%), a -34.0% CAGR. This circumspect outlook from MBAA contrasts sharply withFNMs guidance on the Q2:03 earnings conference call characterizing the FY2004-2005 outlook tobe: The company expects the residential mortgage market to between 8 and 10 percent per yearduring the current decade (2003-2010). The company expects core EPS to return to a more

predictable growth path around or above its long-term expectation, which is somewhat faster thanthe growth in residential mortgage debt outstanding.

Aggressive growth assumptions and unwarranted Street optimism/complacency reachtipping point. Despite recent downward estimate revisions, current Thomson/First Callconsensus EPS estimates stand at $7.23/share and $8.02/share for FY2003/FY2004, respectively.This +10.9% EPS growth YOY reflects many investors glass half-full psychology. Of the 22analysts presently tracked by First Call, 16 analysts (73%) have a Buy Rating on FNM with pricetarget ranging from $90 - $100 per share. Six analysts have Hold ratings (27%) and none (0%) have aSell rating.

Current IRS investigation of Section 29 synthetic fuel tax credits pose direct and collateralrisks difficult to quantify for FNM in terms of adequacy of accounting disclosure, increasedregulatory scrutiny, potential for adverse tax ruling and related cost of capital andprofitability impacts. We estimate contribution to Core Business Earnings from synfuel tax creditsfor H1:03 to be approximately $0.19/share (5.2% of six months diluted EPS), up from an estimatedcontribution to FY2002 diluted EPS of $0.29/share (4.5% full year). Since 1998, Section 29 taxcredits utilized by FNM are estimated to be in the range of $500 million to $1.0 billion throughparticipation in such SPEs such as Pace Carbon Fuels, LP. Pace Carbon is presently being audited bythe IRS for compliance with synthetic fuel tax credit issues addressed in IRS Announcement 2003-46(www.irs.gov).

In summary, the scope and complexity of exogenous factors render prudent risk modeling a significantchallenge. On balance, investment risks outweigh rewards.

Key Investment Considerations:

Adequacy of financial disclosure and earnings quality taking center stage. With a reportedQ2:03 EPS of $1.86, FNM achieved 28 consecutive quarters of sequential EPS growth since Q2:96.We applaud this remarkable achievement and believe FNM may be one (if not the only one) of only afew companies that can lay claim to such a stellar record. With revised guidance, EPS outlook is nowrelatively flat over the next four-to-six quarters. However, we cant help notice the correlation in theslope of the effective corporate tax rate and the key profitability metrics. In reviewing financialstatement footnotes and tax disclosures, FNM has indicated that its tax credits have beenpredominately Section 42 Low Income Housing Tax Credits. Recently, FNM disclosures have beenmore forthcoming, i.e., tax credits related to losses on certain affordable housing tax-advantaged

equity investments and other investment tax credits.

Headline risk dominates reward. From a risk/reward perspective, the stock reward (principallyprice appreciation) appears to be well documented in the short-term. The bull case is predicated on ahistorically PE multiple of 9.3x on consensus Core Business EPS estimate for FY03 of $7.20 per share(PE was 9.2x in 1994 and a historical PE low of 7.9x in 1990), a history of increasing dividends and ashare buyback program (approximately 49 million shares remaining). However, we believe headlinerisk will continue to dominate the financial picture for FNM over the next several quarters and serve tofocus investor attention to investment risk. Accordingly, we believe the scope and complexity of riskfactors surrounding FNM will result in a shift toward lower valuation multiples.


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Section 29 Synthetic Fuel Tax Credits. Since 1998, we estimate that FNM has utilized synthetic fueltax credits in the range of $500 million to $1.0 billion. While arguably modest in dollar terms relative toFNMs assets and operating income, the attendant lack of disclosure and transparency around this issuebears understanding. On June 27, 2003, the Internal Revenue Service (IRS) announced (IRSAnnouncement 2003-46) that they were reviewing the use of Section 29 Tax Credits and that they hadsuspended the issuance of private letter rulings (PLR) pending the outcome of their investigation.Specifically, the IRS statement says: The IRS has reason to question the scientific validity of testprocedures and results that have been presented as evidence that fuel underwent a significant chemicalchange. A Section 29 tax credit is earned through the production of synthetic fuel and is from a 1980law signed by then President Jimmy Carter aimed at reducing dependence on imported oil.

Investors may be aware of the economic risks the current IRS investigation holds for companiesprimarily in the utility industry. Over the past four weeks, a number of utilities have filed Form 8-Kdisclosures revising financial guidance and quantifying the potential impact from the current IRS

proceedings. A partial list of recent corporate disclosures is included in the table below and illustratessynthetic fuel tax credits estimated contribution to 2004 EPS.

ND = Not disclosed.

Company Symbol Price Yield

Generated Tax

Credits($MM)

(1)

Est. EPS

benefit(2)

2004 EPS(9)

% of To

EPS

Fannie Mae FNM 65.32$ 2.8% 1,282 0.420$ (8) 8.02$ 5.2

Progress Energy PGN 40.96 5.5% 950 0.700 (6) 3.84 18.2

TECO Energy, Inc. TE 11.90 6.4% 250 0.057 (3) 0.97 5.9

PPL Corporation PPL 40.72 3.8% 120 0.150 (4) 3.75 4.0

Vectren Corporation VVC 22.73 4.8% 25 0.170 (9) 1.86 9.1

Marriott International MAR 38.22 0.8% ND 0.110 (5) 2.07 5.3DTE Energy DTE 36.79 5.6% ND 1.070 (7) 3.74 28.6

Prices as of closing on July 21, 2003.

1. Total synthetic fuel tax credits earned/generated from the sale of synthetic fuels.

2. Estimated EPS benefit based on net synthetic fuel tax credits available (generated less used).

3. Per July 3, 2003 press release, $10.0 million of tax credits used in Q1:03 net income or $0.057/share.

assuming 175.9 million of diluted common shares. Company reported EPS of $0.01 in Q1:03.

4. PPL estimates that tax credit faciltiy estimated to add $0.15/share per year through 2007.

5. Marriott's synthetic fuel business resulted in $159.0 millin of tax credits for 2002 and added $0.11 per share to profit.

The company recently announced that it sold 50% of its stake in the business.

6. Through 3/31/03, PGN had generated $950 million in tax credits, of which $503 million have

been carried forward ($447 million used). Estimated 240.0 million shares outstanding.

7. In 2002, DTE used approximatley $180 million of tax credits. DTE has approximately 168 million sshares outstanding.

8. Based on first half of 2003 percentage of EPS attributable to synthetic fuel tax credits.

9. Estimated based on net income contribution in 2004 of $12 million from synfuel tax credits on 68 million of common shares.10. Consensus EPS estimates for 2004 per I/B/E/S Earnings Estimates..


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The followingSummary Analysis of Tax Credits of FNMcovering the period of 1998 2003 is depicted below.

As the outcome of the IRS investigation remains to be seen, it is our view companies that utilized syntheticfuel tax credits bear exposure to a potential adverse tax ruling to include PLR revocation, thereby impactingfuture tax credit utilization as well as the possibility of the revocation of previously utilized tax credits. In theinterim, investors have begun to normalize EPS, PE multiples and price targets to reflect net income on anet of tax credit basis. In addition, credit rating agencies, notably Standard & Poors, have announced theyare following developments closely for credit implications. Of particular concern to us is the possibility,albeit remote, of tax credit revocation for FNM. In analyzing collateral risks, investors should seek tounderstand FNMs Enterprise Minimum Capital Requirements published by OFHEO on June 30, 2003. AtMarch 31, 2003, FNMs core capital was $29.5 billion and exceeded FNMs minimum capital requirement of$28.3 billion by $1.3 billon. This excess of $1.3 billion compares with a historical aggregate utilization of $1.0

billion in synfuel tax credits.

($ in Millions, except per share data) 1998 1999 2000 2001 2002 H1: 2003 Total (22 Qtrs)

Total Taxable Income 4,606$ 6,265$ 6,031$ 7,767$ 6,048$ 4,012$ 34,72$

Statutory Tax Liability (1) 1,612$ # 2,193$ # 2,111$ # 2,718$ # 2,117$ # 1,404$ # 12,15$

Total Taxes Paid 1,187 1,514 1,583 2,041 1,429 970 8,72

Difference between Statutory Tax Liability & Federal Taxes paid 425$ 679$ 528$ 677$ 688$ 434$ 3,43$

Effective Tax Rate (2) 25.8% 24.2% 26.2% 26.3% 23.6% 24.2%

Composition of Difference between Statutory Tax Liability & Taxes Paid:

Tax-Exempt Interest & Dividend Received Deductions (3) 216$ # 294$ # 302$ # 311$ # 302$ # 189$ # 1,61$

Equity Investments in Affordable Housing Projects (3),(4),(5) 208 # 384 # 226 # 367 # 385 # 246 # 1,81

Total Adjustments to Statutory Tax Liability 425$ # 679$ # 528$ # 677$ # 688$ # 434$ # 3,43$

Fannie Mae Section 42 Tax Credit Ceiling:

Section 42 Tax Credit Statutory Annual Ceiling (6) 380$ 380$ 380$ 380$ 400$ 220$ 2,14$

Fannie Mae Market share Section 42 Tax Credits (7) 25% 25% 25% 25% 25% 25% 25

Maximum Annual Fannie Mae Section 42 Tax Credits (in $) 95$ 95$ 95$ 95$ 100$ 55$ 53$

Imputed Section 29 Synthetic Fuel Tax Credits (8) 113$ # 289$ # 131$ # 272$ # 285$ # 191$ # 1,28$

Diluted Shares Outstanding 1,037.4 1,030.7 1,009.2 1,006.3 997.1 986.5 1,011

Section 29 Impact on a Diluted Share Basis 0.11$ 0.28$ 0.13$ 0.27$ 0.29$ 0.19$ 1.2$

3.23$ 3.72$ 4.29$ 5.72$ 6.31$ 3.70$ 26.9$

Estimated % of Reported "Core EPS" from Section 29 Tax Credits 3.4% 7.5% 3.0% 4.7% 4.5% 5.2% 4.7

Footnote Explanations:

1. Tax liability assuming federal statutory tax rate of 35%.

2. Effective tax rate calculated as the period's actual taxes paid divided by period's taxable income.

3. Per FY 2002 Form 10-K, Note 6 to the Financial Statements. For years 1998-1999, see Footnote 5.

4. Per Tax Reform Act of 1986 - Section 42 Low Income Housing Tax Credits.

5. For years 1998-1999, FNM disclosed that Investment Tax Credits related to "Equity Investments in Affordable Housing Projects. Per Form 8-K Current Report dated April 15, 2003, FNM disclosed per

Footnote 8 that such Investment Tax Credits include "Equity Investments in Affordable Housing Projects and "Other Investment Tax Credits."

6. Per the 2003 Federal Budget OMB.

7. Per Company reports.

8. Implied Section 29 Synthetic Fuel Tax Credits calculated as "Equity Investments in Afford. Housing Projects" less "Maximum Annual Fannie Mae Section 42 Tax Credits."

9. EPS reported per Fannie Mae 10-K for periods noted.

Fiscal Year

Reported Diluted "Core EPS" (9)

FANNIE MAE

Summary Analysis of Tax CreditsFor the period 1998-2003


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UPDATE:

Fannie Accounting Probes Turn Up New, Pervasive Errors

Wednesday September 28, 2005 9:15 PM EDT

(Updates with new information about Fannie's stock price and regulatory capital and commentsfrom the Treasury Department.)

By Dawn KopeckiOf DOW J ONES NEWSWIRES

WASHINGTON -(Dow Jones)- Investigators combing through Fannie Mae's (FNM) finances

have found new and pervasive accounting violations showing executives embellished thecompany's earnings over the years by overvaluing its assets, underreporting credit losses andmisusing tax credits - on top of what's already been disclosed, according to people close to orwho have been involved in the inquiries.

The company's stock fell by 10.7% - its single largest daily percentage drop since the stockmarket crash of 1987 - after the new findings were reported on this newswire Thursday afternoon.

Several of these people examining Fannie's books also said evidence indicates the companypurchased so-called finite insurance policies to hide earnings losses after they were incurred. Thatis one of several other issues that have surfaced as problematic in recent months. Securitiesregulators, including New York State Attorney General Eliot Spitzer, are cracking down on

corporations they say bolstered earnings by using abusive financial reinsurance policies that aremore akin to loans where little or no risk is transferred to the insurer.

These people said Fannie's accounting problems uncovered thus far stand in stark contrast tothose found at fellow government-sponsored enterprise Freddie Mac (FRE), whose earningsrestatement in 2003 showed the company deferred roughly $5.3 billion in excess, after-tax profitsto future quarters. The GSEs - which buy mortgages, guarantee their payment and bundle them assecurities that are sold off or held in portfolio - own or guarantee nearly half of the $8 trillionresidential mortgage market. Their accounting scandals, however, have left the companiesvulnerable to increasing criticism in Washington where lawmakers are considering legislation torein in the home financing giants.

At Fannie, much of the company's accounting violations have helped them to conceal losses overthe years, rather than delay gains, according to these people. In addition, they said Fannie'srestatement is likely to show that its total cumulative losses will be higher and will include more"realized" losses, as opposed to paper losses, than the company has previously disclosed andmany investors anticipate. That's attributed, at least in part, to new evidence that Fannie hasartificially pumped up the underlying value of its $768 billion mortgage portfolio and otherinvestments - compounding the size of the errors that need to be corrected. Unlike Freddie, thereal economic losses at Fannie won't be offset by corresponding gains in future quarters, in part,because the underlying value of their assets was inflated, these people said.

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Fannie Mae (FNM) officials declined to comment on specific accounting issues raised in thisstory. Fannie's stock closed down $4.99 on heavy trading Thursday at $ 41.71 a share. Bycomparison, the company's share price dropped 16.3%, or $4.40 a share, on Black Monday.Fannie's shares are at their lowest level since July 1997, and are down 41% this year.

The company's board of directors initiated its own review of Fannie's finances last year after the

Office of Federal Housing Enterprise Oversight, in a scathing report delivered to the board 12months ago, accused executives of manipulating accounting rules. Fannie vehemently defendedits accounting until the Securities and Exchange Commission sided with OFHEO last Decemberand directed the company to correct errors in its application of two rules under generally acceptedaccounting principles or GAAP. Fannie began its multiyear earnings restatement and oustedformer Chief Executive Franklin Raines and Chief Financial Officer Timothy Howard shortlythereafter.

In addition to the board's internal review, which is targeted for completion before the end of thisyear, OFHEO, the SEC, Justice Department, Internal Revenue Service and Labor Department areconducting their own separate Fannie probes.

A U.S. Treasury spokeswoman repeated the Bush administration's call to rein in Fannie andFreddie. "Treasury does not participate in any individual enforcement actions that may or may notbe undertaken by OFHEO or the SEC. However, the administration has long called for strongeroversight of the GSEs," she said.

OFHEO spokeswoman Stefanie Mullin would not comment on any aspects of its examination.She said the regulator expects to issue its final report on the matter by March 31, 2006.

The regulator, however, said both Fannie and Freddie had adequate regulatory capital on hand asof June 30 and that it believes Fannie successfully raised a targeted 30% surplus over itsminimum requirement, based on Fannie's current best estimates that have been "certified andrepresented" by its management. OFHEO imposed the extra capital surcharge, among otherthings, as part of a remedial plan Fannie's board agreed to a year ago Tuesday. OFHEO saidFannie's $ 5.9 billion surplus "is sufficient to absorb uncertainties in the estimated impact tocapital of the accounting errors, based on current information."

At the same time, the regulator stressed that Fannie's capital assessment - which was released afew days earlier than expected - could change "as additional information becomes available, suchas Fannie Mae's (FNM) certification of its financial statements; and OFHEO's completion of itsspecial examination of accounting policies and practices at the company."

Restatement Estimates Subject To Change

The company acknowledged earlier this year that it violated GAAP in recording its derivativesand a few other transactions, estimating a possible cumulative after-tax loss for the restatementperiod from 2001 through mid-2004 of as much as $10.8 billion based on the company's financesas of Dec. 31. Given the vast volume of data and transactions that need to be reviewed andrevalued, Fannie hasn't updated that estimate as it works through the restatement process - whichisn't expected to be completed until the second half of 2006.

The company has, in fact, warned investors that the 2004 numbers it used to calculate its originalrestatement estimates can no longer be relied upon and that the final tally is subject to change.

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Fannie also told investors last month that it continues to be plagued by poor internal controlsgiven the "magnitude of material weaknesses that currently exist" and that management is "likelyto conclude" that its financial reporting will also be "ineffective" for 2005.

Chief Executive Daniel Mudd, when asked last week whether the losses from Fannie'srestatement could be higher than previously estimated, told Dow Jones Newswires, "we are

current on all of our disclosures."

Fannie Mae (FNM) spokesman Chuck Greener said in a statement that the company's August 9SEC filing "provided our most recent update regarding the status of accounting issues underreview and the estimated impact of the most significant items affecting restated earnings. We willcontinue to provide updates through our regulatory filings as issues are identified and resolved."

Securities attorney John Coffee, director of Columbia Law School's Center on CorporateGovernance, said Fannie's most recent investor disclosures in early August gives the company"some legal cover," even if the final restatement significantly differs from prior estimates.

Fannie "gave the markets and investors no reason to expect a specific number and let them knowthat everything could change," he said. "The August 9 statement would not allow a reasonableinvestor to rely upon the previous estimates...when everything is up for grabs."

Company officials have made it clear that they expect to revise previous estimates as new issuesare identified and resolved.

GAAP Violations Found In Credit Losses

The way Fannie booked its credit losses and certain tax credits have both emerged in recentmonths as new, and potentially big, problems for the company, according to the people who havebeen involved with or are close to the investigations.

Historically, Fannie's exceptionally low losses on the mortgages it guaranteed gave the companybragging rights on Wall Street and positioned it as an industry leader in credit risk management.

Former CFO Howard boasted in a March 2004 investor speech that Fannie's credit losses hadfallen by more than half since 1990 while its credit book of business grew by roughly five times."These are truly remarkable numbers," he said, noting that Fannie's 2003 credit losses were justover half a basis point, or less than one-tenth of a percentage point, and were "less than 1/20th ofthe average losses reported for commercial banks." He continued, "our credit risk managementsuccess is not an accident. It stems from our disciplined approach to the business."

OFHEO, however, disagreed and forced the company in May 2004 to recalculate its credit losses

on a small portion of its total investments - $8 billion of securities backed by manufactured-housing loans and $300 million of securities backed by aircraft leases. Fannie took a $278.2million earnings charge during the second quarter of 2004 as a result and said it would recordanother $353 million in unrealized losses on its balance sheet over several future quarters tocorrect the accounting errors. The company hasn't filed an earnings statement since.

Investigators have since unearthed widespread problems and GAAP violations in how Fannie'sbeen reporting its credit losses that run much deeper and affect a far greater proportion of thecompany's assets than previously believed, according to these people.

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Tax Credits Scrutinized

(MORE TO FOLLOW) Dow Jones Newswires

09-28-05 2115ET

Investigators have additionally discovered accounting violations with the tax credits Fannie usesto lower its annual tab with the IRS, according to people who are close to or have been involvedwith the investigations. Fannie reduced its corporate-tax rate in 2003 from a statutory minimumof 35% to an effective rate of 26% by recording tax savings of $988 million in tax credits andanother $479 million from its tax-exempt investments, according to its year-end earningsdisclosure. The company further reduced its corporate-tax rate during the first six months of lastyear to 22%, attributing the drop to an increase in its affordable housing tax credits. It recorded$561 million in tax credits and another $238 million in tax savings from its tax-exemptinvestments during the first six months of 2004.

These people say Fannie specifically violated GAAP in using a controversial and lucrative taxcredit it collected as a minor investor in the synthetic fuel industry. The IRS has been conductinga broad review over the last two years of U.S. companies using the so-called synfuel tax credit -which was designed to promote alternative fuel production but is widely regarded as aboondoggle for coal producers. Fannie Mae (FNM) declined to comment on the issue.

In 2003, Fannie Mae (FNM) officials told Dow Jones the company's synfuel tax credits wereminimal and boosted 2002 earnings of $4.53 per share by just over a penny. At the time, thecredits had increased Fannie's earnings per share cumulatively since 1998 by about five cents,company officials said at the time, declining to elaborate.

Fannie's other tax credits, specifically those tied to its low-income housing investments, are alsounder intense scrutiny by investigators, according to these people. The company has disclosed in

the past that it might have to change its accounting for its tax-advantaged investments, which areprimarily ownership stakes in low-income housing tax credit partnerships. Some of thosepartnerships, Fannie said, had a "guaranteed economic return from investment gradecounterparties."

Though unlikely, the company said its "maximum exposure to loss" from its low- income housingtax credit partnerships included its equity investment of $4.7 billion as of J une 30, 2004 "plus therisk of recapture of tax credits previously recognized on these investments" if it was forced tochange that accounting.

The company didn't disclose the amount of tax credits at stake. But Fannie recorded $141 millionof tax "benefits" in 2003 and $214 million in 2002 from its tax-advantaged investments. Those

benefits, which company officials in 2003 said included both synfuel and low-income housingcredits, totaled $967 million from 1997 through 2003, according to Fannie's annual reports.

-By Dawn Kopecki, Dow Jones Newswires; 202-862-6637; [email protected]

(END) Dow J ones Newswires09-28-05 2115ETCopyright (c) 2005 Dow J ones & Company, Inc. All Rights Reserved.

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Today In:

Fannie Mae Says It Used

Tax Credit IRS Is Reviewing

By DAWN KOPECKIDOW JONES NEWSWIRES

WASHINGTON -- Fannie Mae acknowledged that it used a tax credit bescrutinized by the Internal Revenue Service, handing more ammunition toon toughening federal oversight of the huge mortgage company.

Fannie Mae said it made a "small" investment several years ago in three fuel ventures to take advantage of the now-disputed credit. The company

divulge details of the investments, which Fannie Mae officials said are dialong with some low-income housing tax credits -- as "tax-advantaged invunder "other income" in its financial reports.

"These are so small, it doesn't even have a large impact on our effective taFannie Mae Controller Leanne Spencer.

But the investments are likely to draw criticism in light of recent problemMae's smaller sibling, Freddie Mac, which is under federal investigation faccounting problems. Fannie and Freddie both are under pressure from la

who are weighing a number of bills that would increase federal oversight companies, which were created decades ago to buy home loans from bankthe U.S. mortgage market. To accomplish their mission, they are given nuadvantages, including exemptions from state and local -- but not federal -return, the companies are supposed to confine their operations to the mort

business.

Fannie Mae isn't the only entity that sought to take advantage of the credgiven to companies that invest in synthetic-fuel production. Scores of util


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Rep. Baker QuestionsFannie Synthetic FuelInvestmentAugust 13, 2003: 11:40 a.m. EST

WASHINGTON -(Dow Jones)- Rep. Richard Baker, R-La., questionedWednesday the appropriateness of an investment Fannie Mae(FNM) made in the alternative fuels industry given the company'sfederally mandated mission to boost the U.S. housing market.

Fannie Mae officials confirmed this week that the company made a

"small" investment in 1998 in three synthetic fuel limitedpartnerships to take advantage of a corporate tax credit which isnow under review by the Internal Revenue Service. The companyand fellow government-sponsored enterprise, or GSE, Freddie Mac(FRE) were chartered by Congress and given special federal perksto aid in their mission to lower borrowing costs for would-behomeowners.

"This disclosure raises the very troubling question of just howinvesting in alternative fuel helps Fannie accomplish itsgovernment-chartered mission of creating homeownershipopportunities for low-income families," Baker told Dow JonesNewswires in a statement. A spokesman for Freddie Mac saidFreddie has never invested in the synthetic fuel industry.

Fannie and Freddie's federal charters limit their activities to thesecondary mortgage markets, where they purchases home loansand repackages them as securities. But Fannie Mae officials said itscharter also gives the company " general investment powers" tocarry out its mission.

"These investments are well within our charter authority," FannieMae spokesman Chuck Greener said in a statement.

The issue came to light after Santa Monica-based research firmMDB-Analytiq initiated last month coverage on the company with arare "sell" rating, noting as key concerns the lack of disclosure

about the credits and their potential impact on earnings if revoked.

A Fannie Mae official, however, said the investment and its benefitsare minimal, although she would not divulge details of the financialarrangement. The little-known investments are disclosed--alongwith Fannie's low-income housing tax credits--as "tax-advantagedinvestments" under "other income" in its financial reports.

"The effects of these tax-advantaged investments are reflected inour financial statements as filed with the (Securities and Exchange


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Commission) in our 10Ks and 10Qs and prepared in accordancewith (generally accepted accounting principles)," Greener said.

"Other tax-advantaged investments, including the (synfuel) credits,preferred stock, and municipal bond income, only contributed 4%to the difference between our effective and statutory tax rates," hesaid.

The investments are drawing criticism in light of recent problems atFreddie, which is under federal investigation for a series of

accounting infractions. Fannie's stock dropped by more than $2 ashare in late-morning trading on news of the tax credit and theannouncement that one of its measures of interest rate riskwidened sharply in July. The stock, which closed Tuesday at $63.60a share, was at $62.28 a share in midday trading.

Fannie and Freddie both are under pressure from lawmakers, whoare weighing a number of bills that would increase federal oversightover the two companies.

"I can't think of a better example of why serious reform is neededto closely monitor Fannie and Freddie's mission compliance," saidRep. Baker, who chairs the House Financial Services subcommittee

that oversees the companies and is the chief architect of a Housebill that would move their regulator into the U.S. TreasuryDepartment. Treasury Secretary John Snow is scheduled to largelyendorse such plans in testimony before the full committee Sept. 10.

In 1999, the most recent year for which data is available, U.S.corporations claimed about $887 million in synfuel tax credits withfinancial companies using about $137 million of that--mostlythrough limited partnerships similar to Fannie Mae's investments.Analysts estimate that U.S. corporations now claim closer to $3billion annually in synfuel tax credits.

Tax credits are more valuable to companies than tax deductionsbecause credits actually reduce taxes paid--dollar for dollar.

The IRS launched an official investigation in June to determinewhether the tax credit is being abused, questioning the scientificvalidity of the procedures and tests used in making synthetic fuels.

MDB estimates that Fannie Mae's synfuels' interests have producedanywhere from $500 million to $1.2 billion in actual earnings sinceFannie's initial investment in 1998--numbers the companydisputes.

Fannie Mae officials said the company's synfuel tax credits areminimal, boosting 2002 earnings of $4.53 per share by just over apenny. The synfuel tax credits have increased EPS cumulatively

since 1998 by about 5 cents, they said, declining to elaborate.

"These investments are nonmaterial contributors to Fannie Mae'sperformance," said Fannie Mae spokesperson said. "The informationcontained in their report was materially false, it was not based oninformation provided by Fannie Mae."

Fannie's annual report said it reduced its corporate tax rate from astatutory minimum of 35% to an effective rate of 24% last year byrecording $214 million in benefits from its "tax-advantaged


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investments." Fannie officials said 96% of the difference betweenthe statutory federal tax rate and the effective tax rate were due tomortgage revenue bonds and low-income housing credits.

-By Dawn Kopecki, Dow Jones Newswires; 202-862-6637;[email protected]

Dow Jones Newswires 08-13-03 1540ET Copyright (C) 2003 DowJones & Company, Inc. All Rights Reserved.

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Fannie Mae Bold Recommendation 2003

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