As it catches up in its financial reporting, Fannie Mae said today that 2005 profits totaled $6.3 billion — up 26 percent from 2004 — but warned net income for 2006 will be lower because of higher borrowing costs and reductions in interest income.

Fannie Mae, which filed its annual report for 2004 in December, fell behind in financial reporting after management and accounting scandals forced the company to restate results for 2002, 2003 and part of 2004. The government-sponsored mortgage repurchaser says it will release its 2006 annual report by the end of 2007.

In filing its 2005 annual report with the Securities Exchange Commission today, Fannie Mae provided some information on 2006. The company said its investment portfolio totaled $2.5 trillion as of Dec. 31, 2006, or 23 percent of U.S. residential mortgage debt. The portfolio includes loans Fannie Mae repurchases to provide liquidity to lenders, as well as mortgage-backed securities that the company issues and sells to investors, usually with guarantees.

Outstanding single-family MBS issued by Fannie Mae totaled $2 trillion at the end of 2006, up from $1.8 trillion in 2005.

Approximately 49 percent of the benchmark notes issued by Fannie Mae in 2006 were purchased by non-U.S. investors, including private institutions and non-U.S. governments and government agencies, the company said.

Fluctuations in the global debt and equity capital markets, including sudden changes in short-term or long-term interest rates, “could decrease the fair value of our mortgage assets, derivatives positions and other investments, negatively affect our ability to issue debt at attractive rates and reduce our net interest income,” the company said.

Fannie Mae expects net income to decline in 2006, “primarily due to further reductions in our net interest income and net interest yield” resulting from a decrease in interest-earning assets and the declining spread between the yield on those assets and borrowing costs.

Administrative expenses were also up “significantly” in 2006, to an estimated $3.1 billion, because of costs associated with the restatement process and related regulatory examinations, investigations and litigation defense.

Higher interest rates, however, will help strengthen the income Fannie Mae earns from its guarantees, and reduce fair value losses on its derivatives investments. Fannie Mae expects to see “moderate increases” in its provision for credit losses.

Fannie Mae believes its exposure to exposure to subprime loans that underlie some of the mortgage-related securities in its portfolio is limited because it has only purchased the highest-rated tranches of those securities.

The company estimates that at the end of 2006, 2 percent of its single-family mortgage credit book of business consisted of private-label mortgage-related securities backed by subprime mortgage loans and resecuritizations of private-label mortgage-related securities backed by subprime mortgage loans.

The company said the most notable change in the risk profile of its single-family mortgage credit book of business, which includes mortgage assets in the company’s investment portfolio, has been in product type. Interest-only ARMs and negative-amortizing ARMs together represented approximately 6 percent of Fannie Mae’s conventional single-family mortgage credit book of business in 2005 and 2006.

Interest-only ARMs, which represented approximately 5 percent of Fannie’s conventional single-family repurchase volume in 2004, increased to approximately 9 percent in 2005 and 2006.

“We have worked with our lender customers to support a broad range of mortgage products, including Alt-A and subprime products and other products with a higher level of credit risk, which have represented an increased proportion of mortgage originations in recent years,” the company said in its annual report. “We have increased our participation in these types of products where we have concluded that it would be economically advantageous or that it would contribute to our mission objectives. We have worked to enhance our credit analytics and data to better understand, assess and price for the risks associated with these products to allow us to closely monitor credit risk and pricing dynamics across the full spectrum of mortgage product types.”

In December 2006, the Office of Housing Enterprise Oversight directed Fannie to adopt risk management, underwriting and consumer disclosure principles found in guidance federal regulators have issued for nontraditional mortgages it purchases or guarantees.

“In response to the guidance, we are implementing changes to our Desktop Underwriter automated underwriting system relating to the calculation of qualifying ratios for certain nontraditional mortgage products,” Fannie Mae said. “We are also making adjustments to our underwriting and eligibility standards to ensure our guidelines conform to the interagency guidance.”

More than 1,000 lenders sold loans or delivered them to Fannie Mae for securitization in 2005, with the tip five customers accounting for 49 percent of single-family business volume (down from 53 percent in 2004). Countrywide Financial Corp. was Fannie Mae’s top customer, accounting for 25 percent of loan volume in 2005.

Fannie Mae’s reliance on a small number of lenders for such a large proportion of its business has been a concern of regulators, and the company acknowledges the consolidation in the mortgage lending industry.

Maintaining the loan volume Fannie Mae receives from its top lenders “is critical to our business,” the company acknowledged in its annual report.

“If any of our key lender customers significantly reduces the volume of mortgage loans that the lender delivers to us or that we are willing to buy from them, we could lose significant business volume that we might be unable to replace,” the report said.

Fannie Mae also relies on a small number of companies to service loans it owns, or that back its MBS issuances.

At the end of 2005, only 10 companies serviced 72 percent of Fannie Mae’s single-family loans, with Countrywide alone taking 22 percent of that business.

The impact of a default by any one of those servicers “could result in a more significant decrease in our net income than if our loans were serviced by a more diverse group of servicers,” Fannie Mae acknowledged.

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