By Mark Felsenthal
(Updates to market close, adds comment) WASHINGTON, Oct 15 (Reuters) - Fannie Mae (NYSE:FNM - News), the No. 1 U.S. home loan financing company, on Tuesday reported a 19 percent drop in third-quarter net income, as options it uses to protect itself from interest rate swings lost value.
The company said, however, that its operations benefited from falling interest rates, because they prompted consumers to take out mortgages or refinance their home loans.
Excluding the unrealized losses from the derivatives, earnings rose 18.4 percent, hitting the high end of Wall Street estimates.
Many investors agreed with the company that the derivatives losses were not a reflection of the company's performance, and Fannie Mae shares rose nearly 7 percent to close at $70.98 in trading on the New York Stock Exchange.
"The overall results were excellent," said Dreyfus Corp. senior analyst Bill Rubin. "I liked the fact that the net interest margin improved more than expected, and the credit quality looks stellar."
The mortgage financier said it expects 2002 earnings growth, excluding accounting for derivative securities such as options, to be higher than in the past.
For 2003, it said precise earnings estimates are difficult because of the rapid pace of portfolio growth and wider than normal difference between its interest rates for borrowing and lending.
AMPLE BUSINESS
Fannie Mae, which benefits from backing by the U.S. government, said third-quarter net income fell to $994.3 million, or 98 cents per share, from $1.23 billion, or $1.19 per share, a year earlier. The company's net earnings were reduced by mark-to-market write-downs of the value of its options of $1.378 billion, well above the year-earlier write-down of $413.1 million.
Analysts discounted the effect of unrealized derivatives losses on the company's performance.
"They're using derivatives to hedge their portfolio and not to speculate and grow earnings," said David Duchow of Thompson, Plumb & Associates.
Strong housing and mortgage finance markets have created ample business for the company, observers said.
Excluding items, Fannie Mae's earnings rose to $1.63 billion, or $1.62 per share, from $1.38 billion, or $1.33 per share, a year earlier.
On this basis, analysts on average expected a profit of $1.57 per share, with estimates ranging from $1.55 to $1.62, according to research firm Thomson First Call.
"Very strong volumes and stable-to-increasing business margins enabled Fannie Mae to produce another record quarter of operating earnings per share," said Chief Executive Officer Franklin Raines in a statement.
MORTGAGE BUYING UP, MARGIN STEADY
Fannie Mae, which buys home loans from lenders and repackages them as securities for investors or holds them in its own portfolio, reported record mortgage purchase commitments of $128 billion for the quarter.
Buying mortgages for its own portfolio is a big earnings generator for the company, but purchases had slowed in the second quarter as other investors competed to buy mortgage-backed securities.
Another source of profit, the margin between the company's interest rates for borrowing and lending, was unchanged from the previous quarter but higher than a year earlier.
The agency has taken steps to close its duration gap, a measure of how well it matches cash flows between its mortgage assets and its own debt. On Tuesday it said it would commit to buy $57 billion of mortgage bonds and home loans -- its largest monthly commitment to date -- for its portfolio and use those assets to help manage interest rate risk.
"The $57 billion we committed to buy in September made a big push for lowering duration," said Mary Lou Christy, vice president of investor relations at Fannie Mae. "The $57 billion in retained commitments to buy mortgage loans and bonds is a record and reflects the active mortgage market."
DURATION GAP SHRANK
Fannie Mae said its September duration gap was minus 10 months, down from minus 14 months in August. It has a goal of plus or minus six months for its duration gap, which would mean its assets and liabilities would be in better balance.
Analysts said the company's financial report eased concerns raised by widening of the duration gap.
"Investor expectations were a little grim on Fannie Mae. I think there was over concern about the duration gap issue," said Yin Kon, an analyst for State Street Global Investors.
Meanwhile, Fannie Mae's credit-related losses fell to $13.9 million in the third quarter from $17.3 million in the April-June period and from $18.7 million in third quarter 2001.