Although the Securities and Exchange Commission (SEC) told Freddie Mac last week that it might bring civil charges against the GSE for its $5 billion earnings restatement, analysts maintain that the firm's shares remain attractive and that significant headline risk has already been priced into Freddie's securities.

"In our view, Freddie Mac shares already trade with a significant headline and regulatory risk premium built into the price, so this formal event could provide modest relief for investors that feared more severe action," said Michael Hughes, equity analyst from Merrill Lynch.

These remarks came after Freddie Mac announced last Wednesday that it received a "Wells Notice" from the SEC about its earnings restatement, meaning the recipient violated securities laws. This might mean that the SEC could file civil charges against the GSE, which might result in a permanent injunction and/or a civil penalty.

The market reaction was quite muted. On Thursday morning, Freddie's unsecured debt was trading half a basis point wider than its Fannie Mae counterpart and a basis point wider versus Treasurys. However, Gold passthroughs moved in line with Fannies, which is typical in this scenario, said Art Frank, head of mortgage research at Nomura Securities International.

Merrill's Hughes said he does not believe that the Wells Notice will have a significant impact on Freddie shares because the SEC's move "should not come as a surprise to investors considering the earnings restatement is well-publicized and it's well-known, in our opinion, that the SEC could file charges."

While most market participants believe that the SEC action is related to its recent restatement of financials - since the GSE was issuing debt during the period when incorrect financials were outstanding - UBS speculated that the SEC may consider Freddie to have violated securities laws over this period as well.

"We believe that the worst-case scenario is that the Wells Notice could refer to new activities at the company," said UBS. "This would probably result in further regulatory scrutiny and a greater push for a more restrictive regulatory regime."

In a press release from Freddie, the GSE stated that it would continue cooperating with the SEC's investigation even while evaluating its response to the receipt of the Wells Notice.

It should be noted that Freddie has, in the past, paid a $125 million civil penalty to its regulator for the actions leading to the restatement. But with the firm expected to generate an operating net income of about $5 billion in 2005, analysts said that any fine would have to be significantly large before it could have a considerable impact. They also stated that Freddie shares remain attractive with Merrill Lynch reiterating its "Buy" recommendation last Thursday.

Fannie Mae earnings

In other GSE news, Fannie Mae last week reported significantly slower, 2.1% gross mortgage portfolio annualized growth, totaling $892.7 billion. This is versus a 19% annualized growth in June. Analysts attribute the slowing portfolio growth to tight spreads in mortgages as well as considerably less triple-A floater purchases.

"Growth in the mortgage portfolio was consistent with guidance that mortgage to debt spreads continue to be tight and that growth would likely be driven more by lower liquidations during 2H04," said Prudential Equity Group, LLC.

Meanwhile, the GSE also disclosed that its outstanding MBS grew at a 2.9% annualized rate to $1.36 trillion, versus 5.3% growth in June. Net yield for newly acquired mortgage assets last month stayed flat from June at 4.44%.

Fannie also reported that portfolio prepays slowed sequentially to an annualized rate of 26.2% in July versus almost 31% in June. MBS outstanding saw a drop as well in liquidations to 27.6% in July compared with 32% annualized in June. The GSE's duration gap was zero for the month compared to (positive) two in June. Merrill Lynch said this implies the firm's interest rate volatility exposure is still controlled. Analysts added that credit risk remains fairly benign as well.

"In our opinion, Fannie Mae's uninspiring performance was generally anticipated," analysts wrote. "Portfolio growth remains elusive due to relatively tight mortgage spreads, though interest rate risk appears contained." Analysts noted that the GSE's retained commitments dipped significantly in July to $19.5 billion compared with $29 .7 billion in June. This is reflective of the backup in mortgage production seen recently in the primary mortgage market that has affected the secondary market as well, analysts added.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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