NEW YORK Aug. 11, 2008--Standard & Poor's Ratings Services said today that it affirmed its 'AAA/Stable/A-1+' senior debt rating on Fannie Mae. At the same time, we lowered our risk-to-the-government rating on Fannie Mae to 'A' from 'A+', and our preferred stock and subordinated debt rating to 'A-' from 'AA-'. These ratings were removed from CreditWatch Negative where they were placed July 25, 2008. The outlook is negative.
The affirmation of the senior debt ratings reflects the strong explicit and implicit U.S. government support these securities hold in the marketplace, as evidenced by the recent U.S. Treasury actions. This underscores the key public policy role and the key liquidity role the congressionally chartered government-sponsored enterprises (GSEs) have in the U.S. mortgage market.
"The lower risk-to-the-government rating reflects the company's worsening financial profile, which is pressured by the continued home price declines in some of its key markets, higher credit related expenses, and capital challenges. The risk-to-the government rating measures Fannie Mae's "stand-alone" creditworthiness (i.e., its credit quality absent extraordinary government support). The lower preferred stock and subordinated debt ratings reflect the greater subordination risk to these securities, as Fannie Mae now operates under a new regulatory regime as outlined in the passage of the most recent legislation (HR 3221). These ratings also reflect the greater financial stress present in Fannie Mae's core business," said Standard & Poor's credit analyst Victoria Wagner.
The lower subordinated debt and preferred stock ratings reflect the introduction of notching below the risk-to-the-government rating, which we had not previously applied to the rating on these issues, due to heightened subordination risk. The passage of HR 3221 introduces a new regulatory structure, including among other features the application of a prompt and corrective action framework for the mortgage GSEs similar to the powers outlined in the 1991 FDICIA banking regulation for commercial banks and thrifts. Under a severe safety and soundness risk scenario, the regulatory authority now has receivership powers that would place the nonsenior creditors of Fannie Mae at a greater risk of nonpayment, especially the dividend payments on preferred stock.
The new legislation goes a long way in adding clarity to the regulatory framework of the GSEs, broadening the regulatory authority and power; this is positive for creditors. It also has a provision that protects the Fannie Mae charter even in receivership. Although they are effective immediately with the passage of the bill, it will take time to develop and implement some of the new regulations, including new capital requirements. Embedded in HR 3221 is the U.S. Treasury's temporary backstop liquidity plan, which expires on Dec. 31, 2009. Likewise, this backstop plan brings clarity to the liquidity support that Treasury would provide if needed. If Treasury actually provides equity support to Fannie Mae as authorized under this backstop plan, we believe that all Fannie Mae's subordinated creditors could be at an even greater risk of default.
Fannie Mae reported a loss of $2.3 billion for the second quarter 2008, bringing the after-tax loss for the first half of 2008 to $4.5 billion. The loss is due to higher credit expenses, including credit-related expenses of $5.3 billion in the second quarter, which included a $3.7 billion build of the loan-loss reserve in anticipation of additional future losses. Although net revenues were higher in the quarter due to wider net interest spreads, the rise of credit losses was even greater. The weak earnings outlook through 2009 indicates that capital levels will increasingly be pressured. The cut of the common dividend payment to $0.05 per share--expected to add $1.9 billion through 2009--and the restraint on balance sheet growth will help keep capital ratios above regulatory minimum requirements.
The financial stress continues to be heavy at Fannie Mae and the challenges in the external operating environment remain quite high. Credit losses remain above normal levels and at the end of this year, we expect them to reach a new all–time high of net credit losses in the range of 23 basis points (bps)-26 bps (compared to 15 bps for the first half of 2008). This surpasses the level of credit loss in the Texas banking cycle of the early 1980s. Fannie Mae's $340 billion Alt-A mortgage portfolio, which is 11% of its total single-family book of business, has accounted for more than 60% of their total credit losses.
Fannie Mae will, in our opinion, reach a new peak credit-loss ratio in 2008 and in 2009. We expect the 2008 ratio to be in the 23-26 bps range, and likely higher in 2009. We expect higher credit provisions in the second half of this year to further build the loan-loss reserve in anticipation of the peak net credit losses to be realized in 2009. This weak earnings outlook will continue to pressure capital ratios, which could necessitate additional capital issuance. Given the longer-term negative expectation for mortgage credit performance, we expect the outlook to remain negative until we see evidence of core earnings reverting to more normal levels. If capital ratios continue to be pressured beyond levels we now anticipate, or if capital-raising efforts fall short of the business needs, we could lower the ratings.
