Behind Freddie and Fannie's Free Fall
Like other companies involved in the mortgage business, Freddie Mac (FRE) and Fannie Mae (FNM) have seen their share prices suffer amid the subprime crisis. But that was nothing compared to what happened Nov. 20. Investors punished the shares of the home finance giants after Freddie posted a surprising—and disturbing—third-quarter loss of $2 billion and warned that it was having trouble meeting its regulatory capital requirements and may need to cut its dividend in half to raise capital reserves.
The news caught the market off guard, cast doubt on the reliability of Fannie's Nov. 9 earnings release, which showed a $1.4 billion loss, and shivered the shares of both companies. The two government-sponsored enterprises (GSEs) lost one-quarter of their value Nov. 20, with Fannie's shares dropping by 25% and Freddie's tumbling 29% by the end of the day.
Despite Freddie's own bleak assessment of its performance, equity and debt analysts still questioned whether executives were being overly optimistic in forecasting future losses, and investors punished the company's shares as a result. Ratings agencies also chimed in: Fitch Ratings and Standard & Poor's Ratings Services both warned that they may cut Freddie's AA- credit rating on its preferred stock. Equity analysts like Paul Miller of Friedman, Billings, Ramsey (FBR) quickly slashed price targets and downgraded the company's stock.
"These guys are supposed to be the best credit evaluators in the world. And it looks like they're getting caught a little off guard along with everyone else," says Miller, who cut Freddie's target price from $55 a share to $20 a share.
Freddie set aside $1.2 billion in reserves in the third quarter against future credit losses and took a $3.6 billion writedown on its assets to account for deteriorating market values. Freddie's third-quarter loss of $3.29 per share was about three times analysts' expectations, and nearly triple its loss of $1.17 a share for the same quarter last year.
Analysts Expect Worse
Miller doesn't think Freddie's projections on its expected charge-offs—the amount of loans that it thinks it will write off as bad debt expense—are realistic. Freddie estimated that its charge-offs will cost the company 3¢ (.03%) on every $100 it has invested in residential mortgages this year, or $500 million. Those losses were projected to climb to .08%, or $1.5 billion, next year and .11% in 2009, or $2.1 billion. Miller thinks the company's provision for credit losses should be closer to .20%. "They're going to have to continue to provision at about $1 billion to $1.5 billion for the next few quarters. So the drag on earnings is going to be meaningful," he says.
S&P Ratings (S&P, like BusinessWeek, is a unit of The McGraw-Hill Companies (MHP)) lowered its outlook on Freddie's preferred stock because of concern over the company's capital reserves and weak earnings outlook. Freddie's regulatory capital surplus fell to the lowest level in seven years during the third quarter, forcing the company to sell off $20 billion in assets in September and another $25 billion in October to stay above its regulatory requirements. Chief Executive Officer Richard Syron said Freddie was "seriously considering" halving its fourth-quarter dividend to raise cash, Freddie's first dividend cut since going public in 1989. The company also hired Goldman Sachs (GS) and Lehman Brothers (LEH) to explore other options, such as selling preferred stock.
Executives said the fourth quarter won't look much better and additional losses could further erode the company's capital position. "If nothing improves, it may not be as bad as the third quarter, but it's not going to be pretty," Chief Financial Officer Anthony Piszel told analysts in a conference call.
The gloomy forecast, however, did not factor in $1.8 billion in unrealized losses from Freddie's $105 billion portfolio of securities backed by subprime mortgage assets—about 15% of its total retained assets. Freddie executives said they didn't mark down those losses through earnings because they expect the prices will eventually recover. Most of those investments are also highly rated and insured against losses. "For us to incur an actual realized loss, more than 50% of the [subprime] loans backing those securities would have to go into trouble and the losses on those loans would have to be more than 50%," says spokesman Michael Cosgrove.
Losses May Not Be Temporary
In all, Freddie recorded $4.4 billion and $4.3 billion, respectively, in unrealized losses on its securities and derivatives during the third quarter. Those are losses the company generally considers temporary and do not flow through earnings.
Analysts worry that Freddie's default and loss assumptions might be too optimistic and that those losses may not be temporary.
"The loss severity they talked about was 26% to 30%" on all loans says Joshua Rosner, managing director of Graham Fisher & Co. "While it sounds like a very high number, relative to history, that's not the peak," he adds. Loan loss rates of "25% to 30%, given the historically unprecedented bursting of a real estate bubble, is not either conservative nor would it be unrealistic to expect. Given the deterioration in conditions, the severity could be significantly higher than that."
Given the Thanksgiving week surprise Freddie unleashed, the key for investors in GSEs in the weeks and months ahead may be to expect the unexpected.