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Freddie: Much Worse Than Expected

Bottom line, the second quarter was rough on ailing mortgage finance giant Freddie Mac (FRE); and that's not considering the drubbing the company's shares have already absorbed in equity markets during the past month. The GSE said Wednesday morning that it lost $821 million, or $1.63 per share, during the second quarter; a total that compares to net income of $729 million, or $0.96 per diluted common share, one year earlier, and a loss of $151 million, or $0.66 per share, in Q1. The huge quarterly loss nearly tripled most analysts' loss estimates, and is the company's fifth such loss in the past six quarters. The GSE was forced to slash its dividend to 5 cents (or less) from a previous 25 cents per share -- the second such dividend cut in the past year. Clearly driving the continued losses at Freddie are soaring credit costs tied to bad mortgages: credit costs rose to $2.8 billion, double first quarter's $1.4 billion, with the GSE citing deteriorating performance in the 2006 and 2007 vintages. The GSE also absorbed write-downs on available-for-sale mortgage securities totaling roughly $1 billion, mostly tied to subprime and Alt-A RMBS positions that have seen their investment-grade ratings slashed in recent months. Which meant that CEO Richard Syron could say little about his company's performance for the quarter, beyond the fact that the company he helms is doing what is was designed to do. "Freddie Mac was created to ensure the continued flow of funds to America's homebuyers," said Richard F. Syron, chairman and chief executive officer. "At a time of severe stress in the housing and credit markets, we are successfully providing critical liquidity and stability." Piling up the foreclosures Digging through mounds of data presented by Freddie on Wednesday, one thing is clear: losses are piling up for Freddie almost as much as REO properties are. The GSE held roughly 22,000 properties in REO inventory at the end of the quarter (!), and saw loss severity ratchet up from 22 to 26 percent by the end of June, as it continues to fight stiff headwinds in its approach to managing REO properties. Freddie, like sister GSE Fannie Mae (FNM), prefers to sell its REO to owner-occupants, and at a price that helps protect "neighborhood stability" -- meaning the GSE tends to try to hold the line on selling prices. In the current market, however, this approach has clearly hurt the GSE: unsold properties are piling up amid a dearth of qualified buyers, and prices continue to fall further every day in many of the most troubled markets where REO is most heavily concentrated. Freddie noted, for example, that seven states (think California, Florida and others) drove a whopping 65 percent of its REO acquisitions during the quarter. Beyond bumping up its loss provision charge to $2.5 billion, Freddie said that realized credit losses increased from $528 million to $810 million between 1Q08 and 2Q08 alone -- a jump of 54 percent in realized losses within a single quarter. Credit losses represented 17.3 basis points of the average total mortgage portfolio, up from 11.6 basis points in the first quarter. Freddie had projected credit losses of 12 basis points this year, and 14 basis points in 2009; company CFO Buddy Pinzel told analysts that the company was already "moving north of our guidance" and that it would simply stop estimating credit losses going forward. Serious borrower delinquencies -- those 90 or more days behind, or in foreclosure -- reached 104 basis points of the $2.2 trillion in mortgages Freddie owns and guarantees by the end of the second quarter, up from 88 basis points at the end of Q1. A basis point is one one-hundredth of a percent. Add in 60+ day delinquencies, that number reaches 149 basis points; add in 30+ day delinquences, and it reaches 307 basis points. "Neither we, nor anyone else, can predict when the housing market will recover and it would be folly for anyone to try to do so,'' Syron told analysts on the company's earnings call, also suggesting that more foreclosures were yet in the offing. Alt-A proving problematic Of the $810 million in credit losses realized during Q2, $437 million were tied to Alt-A mortgages; a full 32 percent of all credit losses were the result of Alt-A mortgages in California alone. A total of $190 billion of the GSE's $1.84 trillion guaranteed portfolio lies in Alt-A; another $177 billion is in interest-only and option ARM mortgages, Freddie Mac said. Serious delinquencies are centered in recent vintages and in Alt-A classes in particular; according to an investor presentation, for example, Freddie's Alt-A portfolio saw serious delinquencies reach 372 basis points by the end of Q2, up sharply from 232 basis points one quarter earlier. The GSE's $13 billion in option ARM holdings also saw serious delinquencies -- defined as borrowers in arrears by more than 90 days -- reach 492 basis points by the end of the second quarter. 29 percent of Freddie's Alt-A guaranteed portfolio holdings are in the 2007 and 2008 vintages, and it's clear at this point that the 2007 vintage is taking a huge bite out of Freddie's bottom line -- by way of comparison, consider that 2007 vintage delinquencies hit 138 basis points at the end of Q2, a whopping 100 basis points above the 38 basis points recorded for the 2006 vintage. Some of HW's sources suggested the poor performance of recent vintages underscored the folly of pushing the entire mortgage market into the GSEs' laps as the rest of the mortgage market collapsed last year. "Pile enough people into a lifeboat, and it'll sink, too," said one of HW's sources, who asked not to be named. "That's what's taking place at Freddie, and it'll show up in Fannie Mae's results Friday, too." In addition to its guaranteed portfolio, Freddie holds $21.6 billion in Alt-A ABS -- the good news here is that 67 percent of the Alt-A securities book in 2005 and earlier production. Related coverage: Wall Street Journal, Bloomberg, MarketWatch Related links: Freddie Mac earnings statement, investor presentation, core financials Disclosure: The author was long FRE, and held no positions in FNM when this story was published; indirect holdings may exist via mutual fund investments. HW reporters and writers follow a strict disclosure policy, the first in the mortgage trade.

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