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The Misery Mounts at Freddie Mac

Freddie has lots of cash, but the value of its paper assets, minus its liabilities, looks like a dreadful black hole

How much is mortgage-finance giant Freddie Mac (FRE) worth? Judging by the stock market, $4.2 billion, its market capitalization at the close of trading on Aug. 6. But the company's update on its second-quarter earnings and financial condition, released Aug. 6, seems to tell a grimmer story.

Look past the devastating $821 million loss it reported for the quarter—nearly three times what Wall Street analysts had forecast. Ignore the $1 billion writedown the government-sponsored enterprise took on subprime and other risky mortgages, only the latest in a painful series. Disregard the rising rate of foreclosures, which grew 20% in the June quarter from the preceding quarter. Drill down to its fair value—a measure of the total worth of the assets on its balance sheet, minus its total liabilities. What do you see?

It looks an awful lot like a gaping hole. Freddie's fair value as of June 30 was a negative $5.6 billion. Based on this particular measure of its financial condition, if it had to sell its assets today, Freddie Mac would be worth less than nothing.

Mark-to-Market Reckoning

Freddie says that number is wrong. And to give the GSE its due, it most likely is. Fair value is a mark-to-market number, a theoretical figure at best and as much a result of investor sentiment as the actual quality of the assets. Freddie is required to mark some assets down now, and CEO Richard Syron expects to write them back up in the future.

In fact, Freddie looks much stronger on a cash basis, sitting on $37.1 billion in capital at the end of the second quarter, $2.7 billion more than its mandatory capital surplus. Analysts disagree, however, about just how much stronger.

Freddie's capital position is not a panacea. "It doesn't make me feel much better," says Chris Whalen of Institutional Risk Analytics. He calls the negative fair-value figure "a grotesque number."

Freddie's Quandary

Of course, Freddie isn't going away anytime soon. In July, Congress approved legislation to provide emergency financing to the company and allow the U.S. Treasury to buy Freddie's stock. Syron, however, says he will do everything to avoid tapping the government's emergency kitty. To shore up its balance sheet, Freddie cut its dividend from 25¢ to 5¢ a share, a move that CreditSights analyst Richard Hofmann estimates could save the company $518 million annually. Freddie also plans to raise $5.5 billion in capital by selling common and preferred stock.

Yet investors who bought preferred shares back in November can't be happy with the way the investment has worked out, now that Freddie's common stock is trading at 6.49 instead of the 25 it fetched at the time of the sale. If market players avoid the preferred offering, Freddie may be forced to raise the entire amount with common stock, a move that would cut shareholder equity per share by more than half. Even then, a common offering might not be entirely successful. Freddie's "expected capital raise may meet market resistance," credit rating agency Fitch said in a note.

And if the housing market continues to deteriorate, $5.5 billion may not be enough. Freddie says it can withstand up to $40 billion in losses before it falls below its mandated capital levels. Yet by its estimates, home prices are only halfway through their expected decline and could drop another 10 percentage points before bottoming, a total haircut of 20%. In the face of that kind of hit, Freddie may be hard-pressed to maintain its capital limits and be forced to raise more cash, most likely by selling the government preferred shares.

"If the private sector doesn't want to provide [financing]," says Dan Seiver, a finance professor at San Diego State University, "the U.S. Treasury will."

Estimates vary on how much money Freddie will need to raise. Friedman Billings Ramsey (FBR) analyst Paul Miller puts the number at $10 billion. Bill Gross, who manages PIMCO's (AZ) Total Return bond fund, told Bloomberg Television the amount could be closer to $30 billion.

And Institutional Risk's Whalen? "If they raised $100 billion, maybe I'd take a look," he says.

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