Fannie Mae, the troubled mortgage guarantor, is continuing to shrink its massive portfolio of residential mortgage loans and bonds, in order to comply with regulatory capital standards. Yesterday, the company reported that its mortgage portfolio – which provides about two-thirds of the company’s income – shrank $13.7 billion to $890.8 billion. Annualized, the drop represents a 16.8% decline in size.

Fannie Mae has been forced to take a series of unprecedented measures to meet regulatory capital requirements resulting from what the Securities and Exchange Commission said was inappropriate accounting for hedges on its portfolio. The amount that it will have to restate is between $9 billion and $11 billion. Last year, Fannie’s regulator, the Office of Federal Housing Enterprise Oversight, or Ofheo, said that the company would have to build a surplus equal to 30% greater than its minimum capital amount.

As of its last reported filing on September 30, Fannie Mae had $28.9 billion in capital, $3 billion short of its minimum at the time. Now, with a $9.2 billion reduction to earnings, the company has to get to $41.4 billion. To meet its goals, the company has halved its common stock dividend, sold $5 billion worth of preferred stock, and has been shedding portfolio assets.

Everywhere Fannie looks, life is turning rougher for the massive Washington, D.C.-based mortgage guarantor. The shrinking portfolio means that the company will have less spread between what it pays to fund its portfolio and what it takes in as interest income. Moreover, with short-term rates rising rapidly, that spread is diminishing rapidly. In turn, the company’s stock price has been eroding steadily as investors and analysts are forced to lower their earnings estimates. Yesterday, the stock dropped to $57.80, down $1.10, its lowest price in two years.

A hedge fund manager, and longtime critic of Fannie’s financial management practices, Sonic Capital’s Mark Haefele, said things that are happening with Fannie Mae are unprecedented. “Everyone who owns this stock is doing so without audited financials or any sense of what its real liabilities are,” he said. Moreover, he doesn’t think that audited financials will be available until early 2006, which will continue to force the stock lower. Mr. Haefele has put his money where his mouth is, and has had a “sizable” short position in Fannie for over a year now.

Last week, Federal Reserve Chairman Alan Greenspan said that the sheer size of Fannie Mae and its federally chartered rival, Freddie Mac, might necessitate a mandatory portfolio contraction. The two companies hold $1.5 trillion of mortgage loans and bonds in their combined portfolios.