FRE Prioritizes Accounting and Reporting

Updated from 1:07 p.m. EST on Feb. 27.

Freddie Mac (FRE - commentary - Cramer's Take) reported losses of $3.97 a share for the fourth quarter and $5.37 a share for the full year 2007, much worse than Street expectations.

After a recent capital raise, the lender has $39 billion of capital, $4 billion surplus above minimum levels, just about enough to squeak through under a reasonably orderly economic scenario. More urgently, the lender has remediated three of six material weaknesses in internal controls and is fixing the others in preparation for registering with the SEC later in the year. (As a government-sponsored entity, it had not had to do so before, even though it sells stocks and bonds.) Even so, it's unlikely that the lender will do better than breakeven in 2008.

The lender notes but doesn't fret over high single-digit declines in national house prices because unemployment rates remain low. Another problem -- spread-widening -- enabled Freddie Mac to gain market share and raise fees because of the collapse of other players.

The company has not yet marked to market the associated losses, which it considers to be only temporary. Freddie Mac plans to hold its mortgages to maturity, which is to say that it will eventually realize only the underlying credit losses, not trading losses.

Underlying credit quality is improving because of cherry picking. The company has eliminated the purchase of the worst (NINA: no income, no assets) loans and now insists on credit scores of around 700 for new purchases. And Freddie Mac welcomes, although it has few immediate plans to take advantage of, the recent lifting of caps on mortgage levels that it can service.

Instead, the main priorities are accounting and reporting. In addition to the above-mentioned fixing of audit problems, Freddie Mac is moving toward accounting procedures that are more neutral in their impact than previously and, thereby, don't need as many mark-to-market adjustments that have caused the wide swings in reported earnings. There will be fewer off-balance-sheet transactions, and the remaining ones will be reported accounted for in a more transparent fashion. Some other accounting changes are planned to make the company's reporting more comparable to that of Fannie Mae (FNM - commentary - Cramer's Take).

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At the time of publication, Au had no positions in the stocks mentioned, although holdings can change at any time.

Thomas P. Au, CFA, is a principal with R. W. Wentworth, a financial services firm in New York City. Earlier he was an emerging markets portfolio manager for the investment arm of Cigna Corp. and an analyst with Unifund, S.A. of Switzerland and Value Line. He graduated cum laude with a B.A. in Economics and History from Yale University and an M.B.A. in Finance from New York University. Au is the author of A Modern Approach to Graham and Dodd Investing. Au appreciates your feedback; click here to send him an email.