Interest Rate Roundup

Tuesday, November 20, 2007

Freddie Mac attack

Wow -- there's some nasty news out of the Government Sponsored Enterprise Freddie Mac this morning. But before I get to it, let's review just what kind of company Freddie Mac is.

Freddie and sister firm Fannie Mae buy mortgages from lenders for their own portfolios. They also help lenders bundle home loans into mortgage-backed securities for sale to investors. They charge lenders a "guarantee" fee and assume the credit risk during that process. If the underlying borrowers behind the mortgages in the MBS default, Fannie Mae ensures mortgage bond investors get timely payments of principal and interest anyway. Together, the two companies own or guarantee loans representing roughly 40% of the U.S. mortgage market.

That's a great business model when the housing and mortgage markets are in good shape. It's a terrible one when those markets are experiencing the worst downturn in modern U.S. history, as they are now.

Indeed, a few days ago, we learned that Fannie Mae's third-quarter loss more than doubled to $1.39 billion due to derivatives contract hits and rising credit costs. And the rabbit hole reportedly may go even deeper. A Fortune article the other day noted that Fannie Mae changed the way it calculates its credit loss ratio, a measure of bad loans as a percentage of total loans. That made its credit loss ratio look better, but some are questioning whether the change was a valid one. Fannie Mae held a conference call to try to assuage investor fears, but it failed miserably. The stock kept declining.

Now, this morning, Freddie Mac is out on the tape saying it lost a hefty $2.02 billion in the third quarter. That's a huge jump from $715 million a year earlier. It also slashed the value of net assets by roughly $8.1 billion. Moreover, its credit costs (provisions for losses related to souring loans and foreclosed property) skyrocketed to $1.2 billion from $112 million a year earlier. Freddie Mac also said it has hired Goldman Sachs and Lehman Brothers to help the firm raise capital. And by the way, the firm is warning that it could slash its Q4 dividend by 50%.

The stock has already dropped from around $60 to $37.50 at yesterday's close. It was recently trading down to $32 and change in the premarket.


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