While Freddie Mac's recent infusion of capital brought a wave of calm after its tumultuous third-quarter losses, analysts remain concerned about the overall financial health of the nation's second-largest buyer and guarantor of home loans.
The company recently sold $6 billion in preferred stock as a way to raise capital and win over investor confidence. The move came just over a week after the GSE announced that it was posting a $2 billion third-quarter loss, its largest quarterly drop ever. Approximately $1.2 billion in losses were tied to money the company set aside to cover bad home loans.
Not only did the size of the third-quarter deficit catch most analysts by surprise, it initially stoked fears about Freddie Mac's ability to meet the 30% mandatory target capital surplus stipulated by the Office of Federal Housing Enterprise Oversight (OFHEO). The company's stock sell-off, coupled with its decision to cut its quarterly dividend in half, will likely give Freddie Mac enough capital to meet its regulatory requirements for 2008, analysts said.
But despite the lender's efforts to shore up capital, it was knocked last week with downgrades from both Fitch Ratings and Credit Suisse. Fitch downgraded Freddie Mac's preferred stock rating to A+' from AA-'. It had previously placed the GSE on rating watch negative after the mortgage company announced its third-quarter loss.
"The credit market will not get significantly better in the near term," said Vince Arscott, director and lead analyst of Freddie Mac and Fannie Mae for Fitch Ratings. "I suspect [Freddie Mac] will hit a trough before it gets better."
Fitch's rating action followed the closing of the GSE's non-cumulative, perpetual stock offering. "I think my level of concern is reflected in the rating we gave Freddie," said Arscott. When it placed Freddie Mac on negative watch, the rating agency indicated that a downgrade was likely if the amount of hybrid securities relative to total capital became more significant, resulting in higher loss absorption for preferred shareholders.
The other rating agencies responded to Freddie Mac's third-quarter deficit by lowering their outlook for the GSE. Moody's Investors Service placed a negative outlook on the company's Aa2' subordinated debt, A-' bank financial strength and Aa3' preferred stock ratings. Standard & Poor's revised to negative from stable its ratings on AA-' risk to government, subordinated debt and preferred stock.
Meanwhile, Credit Suisse also downgraded shares of Freddie Mac from "neutral" to "underperform" in a research note released on Dec. 5. The downgrades reflected "the lack of internal capital generation over our forecast horizon, which should limit its operational flexibility," according to analysts Moshe Orenbuch and Kerry Hueston.
The analysts affirmed that the $6 billion preferred offering should "largely fill the capital void" from forecasted GAAP losses and dividends through 2008. But, "given its sizable preferred shareholder equity base and the roughly $800 million in annual preferred dividends, these create larger hurdles to produce above-average common shareholder returns when profitability is restored," Orenbuch and Hueston wrote.
In a Dec. 3 research note, RBS Greenwich Capital analyst Pankaj Jha noted the GSE went in an opposite direction of Fannie Mae in October. Freddie Mac's retained portfolio dropped by $10 billion, while Fannie Mae added $8 billion.
Freddie Mac owed its decline in retained portfolio to a sale of more liquid PCs and structured securities in order to maintain a regulatory surplus over the 30% mandatory target capital. "In effect, they are getting rid of the better-rated, more liquid bonds to cover for losses in their subprime book," Jha wrote.
Freddie Mac CEO Richard Syron offered a bleak assessment of the future of his firm in the near term during an earnings conference call last month. Deteriorating mortgage credit, falling home prices and continued volatility in the fixed income market would likely lead to a difficult fourth quarter for the lender, he said. Syron, however, added that the market shift toward fixed-rate originations and improved pricing would put Freddie Mac in a strong position once the credit market begins to improve.
"Freddie Mac is a housing finance company operating in what today is a troubled housing and credit market," Syron said. "It will take time for this market to turn around."
Analysts are now turning their focus onto what's in store for Freddie Mac. It is generally understood that bad news for GSEs means horrible news for the entire housing sector. As one market participant from California said, "The Freddie Mac news was a real kick in the head. I'm assuming they're going to be OK and that both the [Bush] administration and Congress realize that is the last card they have to play."
But analysts differ on when and if the portfolio caps will be lifted for Freddie Mac. Lifting the portfolio caps would allow the GSE to securitize more expensive mortgages, which is seen as benefiting the beleaguered market. Art Frank, head of agency MBS research at Deutshe Bank, expects the caps to be lifted sometime next year. Until then, the mortgage company will play a reduced role, he said. "I don't see them being big buyers right now," he said. "They're going to be on the sidelines."
Meanwhile, Fitch's Arscott noted the larger role Freddie Mac will play in a market turnaround. "Freddie Mac is an important part of the overall economy," he said. "It would likely be a part of the tool bag to be used in any sort of bailout."
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