NEW YORK May 19, 2008--Standard & Poor's Ratings Services said today that it affirmed its 'AAA/A-1+' senior unsecured debt rating and its 'AA-' subordinated debt and preferred stock ratings on Fannie Mae. At the same time, we lowered our risk-to-the-government rating on Fannie Mae to 'A+' from 'AA-'. The preferred stock, subordinated debt, and risk-to-the-government ratings were removed from CreditWatch Negative where they were placed on May 6, 2008. The outlook on all ratings except the senior unsecured debt rating is negative. The outlook on the senior unsecured debt rating is stable.
"The lower risk-to-the-government rating reflects Fannie Mae's weak earnings and pressured capital ratios, which are outside the tolerance for a 'AA-' rating," said Standard & Poor's credit analyst Victoria Wagner. Fannie Mae has posted three consecutive quarterly losses, ending with the $2.2 billion GAAP loss in first-quarter 2008. Based on our core earnings calculation (adjusting for the fair-value derivative losses), this number was much lower ($89 million). Earnings expectations for the remainder of 2008 and next year also remain challenged.
The affirmation of the senior debt rating and the stable outlook reflect the strong explicit and implicit support these securities carry in the marketplace as government-sponsored enterprise (GSE) securities. The negative outlook on the subordinated debt and preferred stock ratings reflects implicit support that these securities hold in the marketplace, especially at this time of renewed support for Fannie Mae's public policy role as a provider of liquidity to the secondary mortgage market.
Fannie Mae is facing the most challenging housing and mortgage cycle in more than three decades, and at a time when its core earnings are weakened both from higher credit-related expenses and significant spread widening on both agency and nonagency mortgage-backed securities (MBS). Its exposure to Alt-A mortgages, while only 11% of its mortgage book, made up 43% of total credit losses in the first quarter. Fannie Mae's total Alt-A mortgage exposure is $344.6 billion, of which 91% is in the form of guaranteed loans. Exposure to subprime mortgage risk is extremely low at 1.9% of the total single-family mortgage portfolio. We expect credit losses to reach a new peak for Fannie Mae by 2009 and the company expects credit losses to reach 13-17 basis points (bps) in 2008.
The lower earnings have pressured Fannie Mae's capital base. In response to this, Fannie Mae raised $7.2 billion of equity, which consisted of $2.6 billion of common stock, $2.6 billion of mandatory convertible securities, and $2 billion of noncumulative perpetual preferred stock. This significant capital increase lifts capital ratios slightly. On a pro-forma basis for first-quarter 2008, adjusted total equity (our capital definition) is $41.3 billion, or 3.5% of risk-weighted managed assets. Fannie Mae also raised $7 billion of noncumulative perpetual preferred stock in December 2007. Fannie Mae's regulator has reduced its regulatory surplus capital requirement to 20% from 30% over the minimum capital requirement, and upon successful completion of this most recent $7.2 billion capital raise, the regulatory surplus requirement will be further reduced to 15%. Also, since Fannie Mae has made significant progress on internal control deficiencies, its regulator terminated the May 2006 consent order on May 6, 2008. Core earnings are starting to benefit from stronger credit-pricing policies and the signs of net interest margin expansion in the first quarter that resulted from lower funding costs and a steep yield curve.
The ratings on Fannie Mae's senior unsecured debt reflect the company's very strong business franchise, its status as a GSE, its status as a public policy institution under our government-related criteria, and its key role regarding liquidity in the U.S. mortgage capital markets. The ratings also reflect the implicit U.S. government support for these securities, as it relates to Fannie Mae's charter and governing legislation. This support has been strengthened recently by the dislocation in the secondary markets for nonagency MBS and Fannie Mae's central role in the U.S. Treasury's economic stimulus program.
We expect higher credit losses and weak earnings during the next year, as Fannie Mae operates in the most challenging housing and mortgage cycle yet, to push loan losses to a new peak. Although the recent capital raise was quite sizable and Fannie Mae issued $2.6 billion of common stock, capital on a risk-weighted, managed-asset basis is low compared to that of other similarly rated large financial institutions. Also, when earnings are weak and pressured, we expect capital levels to be stronger to offset the lack of earnings growth and capacity to generate capital from retained earnings. Although capital levels will remain under pressure, we expect management to continue to build common equity as needed throughout the year, through both external and internal means. Fannie Mae's market position will greatly increase in 2008 as it will be one of the primary issuers of MBS in the U.S. market, because secondary market liquidity for nonagency MBS will continue to be constrained. If credit losses in 2008 exceed Fannie Mae's projection of 13-17 bps and lead to higher-than-expected operating losses, ratings could be lowered one notch. Alternatively, if core earnings increase more than anticipated from the higher credit pricing policies and continued net interest margin expansion, which would generate capital, then we could assign a stable outlook. However, given the highly stressed housing and mortgage markets, it is very unlikely that the outlook would return to stable before 2009.
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