Freddie Mac announced on Tuesday that it has agreed to limit the size of its $722.2 billion mortgage portfolio. Under the agreement - which was voluntarily accepted by the GSE after being pressured by its regulator the Office of Federal Housing Enterprise Oversight (OFHEO) - the firm's mortgage holdings will grow no more than 2% above the level it was at last June 30. Mortgage holdings account for about two-thirds of the company's profit.

"Simply put, we would say our regulator made a request of us and we provided the response to their request," said Richard Syron, Freddie Mac chairman and CEO, in a conference call late Tuesday afternoon. "We acted because we believe a constructive relationship with our regulator is necessary and essential to our ability to generate long-term shareholder value."

The portfolio cap for the McLean, Va.-based company does not stand alone, however. A similar cap was placed on Fannie Mae earlier this year, following the OFHEO's special examination of Freddie Mac's larger rival stemming from a bunch of accounting irregularities. The errors in both the GSEs' earnings reports have also forced top executives out of these companies and they are now in the process of reworking bookkeeping and corporate governance issues.

In response to Freddie Mac's voluntary acceptance of the cap, the OFHEO Director James Lockhart issued a statement concurring with the decision. "Freddie Mac has a need to address the size and scope of its portfolio, particularly in light of current operational problems surrounding accounting and internal controls," Lockhart said. "A large retained portfolio presents both inherent risks as well as a distraction from the tasks at hand for the enterprise - implementing its various remedial plans."

FHLMC's priorities

The process of remediation is Freddie Mac's first priority, Syron said in the conference call, as he reassured listeners that a return to quarterly reporting following the release of full-year 2006 results is the company's main objective. In order to complete this admittedly challenging target, the company is looking towards a number of interim goals relating to the controls and reporting systems. Freddie Mac has also stated its plans to update the market and the OFHEO regularly on the progress made towards these objectives.

Although remediation is the chief goal, Freddie Mac insists that its basic business fundamentals of strong interest rate and credit risk management remain unchanged. Moreover, Syron stated that this cap is temporary, a factor he referred to and emphasized many times throughout the call.

Art Frank, head of mortgage research at Nomura Securities, also finds the cap's temporary nature to be of great significance while considering its impact on both the company itself and the mortgage market as a whole.

"I think the important thing to note is that this cap is temporary," Frank said. "As soon as they have their operational accounting systems running properly so that they can issue timely quarterly financial reports under the cap, this will be lifted. It's a temporary agreement while they are unable to do that. And from what I heard in the [conference] call, I think that by April or May next year, they will be in a position to do that. It does not seem likely to bind them for more than a year or so. I don't think it's devastating to them."

As for timing goals, Freddie Mac set no specific dates, but a general time line goes something as follows: the company will issue 2006 results for the entire year and a finalization of the four quarters sometime before late in the first quarter of 2007 - which would make them current - followed by the release of first quarter 2007 results, which, if all goes well, could be out sometime during the second quarter of next year.

Freddie Mac recently provided an update on the first half 2006 business performance, citing excellent interest rate and credit risk performance management, preliminary estimates of financial performance for the first quarter of 2006 and continuing progress on capital transactions. The current projected net income for the first quarter is approximately $1.3 billion and the estimate of the fair value return on net assets attributable to common stockholders, before capital transactions, is about 10% annualized.

The cap's impact

Yet, in the meantime, what impact will the voluntary cap have on Freddie Mac and the mortgage market? Analysts speculate not much. According to Frank, the company was already in "slow growth mode" as a result of the current political pressures on the GSEs and Freddie Mac's inability to put out timely quarterly reports. Meanwhile, a recent UBS Mortgage Strategist report issued in response to the news echoed Frank's position, stating last Tuesday, "We expect today's announcement to have very limited, if any, impact on the mortgage market over the next nine to 12 months."

The report noted Freddie Mac's mortgage portfolio is growing at a modest rate of 3.43% per year so far in 2006. UBS analysts also expect Freddie Mac to be back in compliance with quarterly financial reporting no later than 2Q07, possibly even the first quarter of next year.

The UBS report even goes so far as to say that Freddie Mac's announcement "might actually be a plus for the mortgage market, since it puts an end to speculation that some sort of the OFHEO-imposed limit on the Freddie Mac portfolio might be coming. In fact, Freddie Mac may very well have honored the OFHEO's request to limit its growth because its cost of doing so is quite limited, given its main goal of getting GAAP-complaint by early next year."

The cap does not impose additional limits on the types of mortgage products that Freddie Mac can buy or sell, according to the company's senior management, which is presumably good news for all. Moreover, the MBS market will not be totally devastated by the diminished demand from Freddie Mac, and Fannie Mae for that matter, as it has gotten other sponsorship from banks and foreign investors, who have been good buyers recently.

"It's been a factor to the extent that if there would be some event that would cause spreads to gap out, Fannie and Freddie can't come in and buy in the size that they once did to bring things back into line, so a little bit of a backup has been lost by the mortgage market," Frank said. "However, I think other sources have helped buoy the mortgage market."

Thus, Freddie Mac's voluntary cap, expected by current projections to only last about a year, may not be as significant as it initially appeared. Fannie Mae's agreement with the OFHEO, on the other hand, is not set to expire until the OFHEO director has determined that such expiration would be appropriate. Fannie Mae's mortgage portfolio is restricted to its size as of December 31, 2005.

(c) 2006 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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