Optimism Rings Hollow on FRE Call

There's no doubt that mortgage guarantor Freddie Mac (FRE - commentary - Cramer's Take) got dealt a lousy hand this quarter. Due to the weakness in the housing market and increased delinquency rates on the company's mainstay single-family portfolio commitments, the company posted a loss of 66 cents per diluted share, up sequentially by 83% from the fourth-quarter loss of $3.97 per diluted share. The year-over-year comparison with a loss of 67 cents per share, however, showed relative stability.

The company offered some glimmers of hope for the future due to a new $5.5 billion infusion of capital along with low delinquency rates compared to the industry, at 77 basis points compared to industry levels of 167 basis points. In addition, losses on mark-to-market items stabilized year-over-year at $1.36 billion, or $6.85 per share, and declined sequentially by 72% from a fourth-quarter loss of $5 billion. Lower interest-rate sensitivity, a steepening of the yield curve and reduced losses on certain credit guarantees were some of the drivers of this sequential improvement. The overall picture that can be retained is one of very weak optimism.

First, some important positive items from this earnings result include the following:

• A capital cushion of $38 billion was higher than the $11.4 billion minimum statutory surplus.
• A 3% sequential increase in net interest income (due to the wider spreads alluded to above) was offset by the adverse effect of spread compression on one-month resets on floating rate assets. As well, net interest income was also slightly higher from the $866 million in first quarter 2007. Overall, the company expects the widening of spreads and net interest income to grow revenue by 40% to 50% in 2008.
• A 56-basis-point sequential decline in expected default costs is on the worst quintile of new guarantees.
• There were no credit-related impairments of the asset-backed securites portfolio of $143 billion. It should be noted that 82% of this portfolio is labeled subprime and Alt-A, but the company maintains that 92% of the portfolio value is investment grade.
• Guarantees to the multifamily segment of the portfolio generated $98 million in earnings compared to the losses of $458 million in single-family guarantee earnings. It should be noted that these represent declines of 22% and 304% in the multifamily and single-family segments, respectively.

Investors should be cautious, however, due to the following glaring negative aspects of the report:

• Originations from 2006 and 2007 continued to drive the $1.4 billion credit loss provision this quarter, compared to $912 million for the fourth quarter. Freddie Mac continues to expect its total credit losses to be in the range of 16 basis points in 2008, up from the 12 basis points previously expected, and total single-family originated credit losses, in particular, to be $3.1 billion in 2008.
• Continued declines of 15% are expected in housing prices vs. the 8.2% decline nationwide year over year.

Investors can hope that the change in the quality of new originations, with California and Florida representing 26% of 2008 originations vs. to 36% in 2007 will allow Freddie Mac to gradually grow its portfolio.

For Vijayraghavan's preview heading into the Freddie Mac conference call, please click here.

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At the time of publication, Vijayraghavan had no positions in the stocks mentioned.

Vasu Vijayraghavan was an academic finance professor at the University of Paris who has now turned to a new career as a financial consultant. As an academic, she wrote on corporate governance issues, especially in the European context, and she believes in a long-run and balance sheet approach to stock picking.

Currently, Vasu is working as a consultant for lawyers, doing business valuation. She is a Level II CFA candidate and enjoys writing long/short and earnings calls pieces for TheStreet.Com.

Vasu holds a Ph.D. from the University of Michigan and a B.A. from Harvard University.