Updated from 10:40 a.m. ESTShares of mortgage giants Freddie Mac ( FRE) and Fannie Mae ( FNM) are getting spanked in trading, after the former posted a $2 billion third-quarter loss Tuesday morning. Freddie shares were plummeting almost 29% after announcing before the opening bell that it may need to cut its dividend by 50% and seek out additional sources of capital. The so-called government-sponsored entities, which purchase residential mortgages and mortgage related securities, hired Goldman Sachs ( GS) and Lehman Brothers ( LEH) to help it hit the Street for fresh funds. "We do not believe it would be wise to be sanguine about the intermediate-term housing market," said CEO Richard Syron during Freddie's third-quarter earnings call. He added, however, that he still remains positive about the long-term opportunities for shareholders. The comments did little to quell investor fears, which sent Freddie shares down $10.85 to $26.65. Its bigger peer, government-sponsored entity Fannie Mae, which found itself having to defend its accounting practices after a media report suggested it had changed the way it accounted for losses last week, also was down almost 24% to $29.75. McLean, Va.-based Freddie said it would need to set aside $1.2 billion in the third quarter to account for bad home loans, prompting the nation's second-largest guarantor of home mortgages to seek additional sources of capital. The quarterly loss equated to $3.29 a share. In the same period a year earlier, Freddie Mac lost $715 million, or $1.17 a share.
Fannie and Freddie are facing increasing defaults and significant shrinking of the values of U.S. homes. As a result, the quasi-governmental agencies are beginning to be forced to ratchet down the prices of mortgage assets they hold on their books. Freddie's asset values fell by about $8.1 billion in the third quarter. Also, total mark-to-market losses amounted to $3.6 billion. Another significant issue for the big agency is that it is regulated by the Office of Federal Housing Enterprise Oversight, which limits the amount of mortgages it can purchase. Estimated regulatory core capital for the agency was $34.6 billion at the end of September, which represented about $8.5 billion more than the regulatory minimum capital requirement and is around $600 million above the target capital surplus. Freddie's capital-raising initiative is an attempt to generate more cash to purchase more loans and operate its business. Keefe, Bruyette & Woods analyst Fred Cannon estimated during the earnings call that the agency may need to raise between $2 billion and $4 billion. Freddie officials declined to provide a firm number, but did imply the funds necessary may be much larger than that analyst estimate. Freddie said it would be looking to raise sufficient funds to wade through the distress in the mortgage market, which could take the entity well into 2008.
The agency's most likely capital-raising route appears to be an offering of preferred shares. Such a move is expected to cause its existing preferred shares to suffer a downgrade. Fitch Ratings analyst Vincent Arscott says the rating agency has put Freddie on ratings watch negative. Freddie's preferred shares are currently rated double A-minus, but could be downgraded one notch, he notes. (The company itself maintains a triple-A rating, because of its implied government backing.) Freddie maintains the U.S. cash equivalent of about $8.1 billion in preferred. The firm suggested that its capital raising efforts were underway. "Painful as it may be, we want to be able to both satisfy our shareholders and address our charter responsibility to provide stability and liquidity," Syron added. "We could sort of go to fortress Freddie and shrink the business," he said, adding, "I don't think that would be in the interest of our shareholders." Freddie made an attempt to host a thorough call, which at times became intense. "We're not happy about this ... but we are trying to do this in a way that's least worse or most friendly to our common shareholders," Syron commented, referencing the prospects of cutting the agency's dividend and raising additional capital. Freddie intimated that a request to its regulator OFHEO to allow it to raise additional funds was denied. Later the agency noted that its poor history with regulators may be playing a part in OFHEO's reluctance to increase its mortgage purchasing power.
"There is a lot of market-to-market noise and disconnect between what market value is and what the perception is the underlying risk," Fitch's Arscott noted. Although an unlikely prospect, given their implicit government backing, the shaky markets have Fannie and Freddie trading as if they might falter in the face of the market dislocation -- a prospect that Syron attempted to address. "This is a very, very difficult time, this is not happy news," he said. "... We will work through this."