People once thought guaranteeing conventional, thoroughly underwritten mortgages with near Treasury-level funding costs was a lucrative, low-risk business. Freddie Mac's forthcoming second-quarter results could provide a reminder why.

When the government conservatee, a bastion of the mortgage market, releases the results — probably on Monday — it is expected to report hefty losses on derivatives and continued credit troubles, just as it has the last several quarters. However, Freddie will also probably show revenue growth, amid other inklings that the worst of the credit crisis is behind the government-sponsored enterprises.

One such inkling: Fannie Mae said Thursday that its net loss narrowed significantly in the second quarter and that it has enough reserves set aside to cover the "substantial majority" of further credit losses on loans from the bubble years.

Some even say it is reasonable to believe Freddie could return to profitability in the not too distant future.

"I would certainly use the word 'could,' " said Brian Harris, a senior vice president at Moody's Investors Service. "A fair amount of things need to break their way."

Fannie Mae reported a $3.1 billion loss for the second quarter after paying preferred dividends — one-fifth its net loss a year earlier — as credit-related expenses fell 74%, to $4.85 billion. Fannie also asked the government for another $1.5 billion to plug its net worth deficit. But it said it expects further draws from the Treasury "will be driven increasingly by dividend payments" on the government's preferred stock — rather than credit losses.

Freddie, and to a greater extent Fannie, still have huge problems. Another drop in home prices would hurt them, for example.

But there have been some positive signs. Delinquency rates have been falling and, by all accounts, the new loans they have guaranteed are solid as underwriting standards have tightened.

"The best loans are made during recessions," said Jeremy Diamond, managing director of Annaly Capital Management, a real estate investment trust that owns Fannie and Freddie MBS. "The quality of underwriting across the spectrum improves as banks get more selective about who and when to lend. … As losses get realized, then what's left is going to have the benefit of positive selection."

The inference can be made that, just as banks are emerging from the crisis, so, too, are the government-sponsored enterprises.

Though analyst coverage of the GSEs has become nearly nonexistent since the two became wards of the state in September 2008, most everyone has an opinion on Fannie and Freddie and what should be done with them. After all, regardless of their troubles, they are still an integral part of the housing market, backing half of all the outstanding residential mortgages in the U.S.
When talking about their future, the conversation is inevitably littered with "coulds" and "buts."

The main concerns are when losses from the firms' 2005 through 2008 books of business subside; whether the new book of business they've been writing since 2009 will be profitable; and just how much total cumulative losses, and the subsequent cost to taxpayers, will be.

In its second-quarter report on Thursday, Fannie tried to shed light on some of those questions. For one, it said single-family loans made in 2009 and 2010 have the lowest early serious delinquency rates of any loans the company has acquired in the last 10 years.

Freddie could report even better numbers. It has already shown some improvement. And Freddie is considered to have the better book of business in part because alternative-A loans from the boom years — which have produced big losses — make up a smaller percentage of its overall portfolio.

Freddie's net loss has narrowed as it has set aside fewer dollars for future credit costs. In the first quarter, the net loss after paying preferred dividends was $6.7 billion, down from $9.9 billion a year earlier. The provision for loan losses dropped to $5.40 billion from $8.92 billion in the first quarter of 2009.

Credit quality has also steadily improved. Freddie's single-family delinquency rate fell to 3.96% in June from 4.06% in May. The rate was unchanged in May but had fallen in March and April.
The first-quarter results were clouded by one-time items. But the core business looks stable. Net interest income rose 6.9% from a year earlier, to $4.13 billion. Single-family guarantee income, meanwhile, has remained fairly consistent. In the first quarter it was $848 million, down 3% from the year earlier but up slightly from the fourth quarter.

Perhaps the strongest case for a brighter future at Freddie is that the makeup of its portfolio, in terms of the percentage of loans from older vintages, is shifting.

During the first quarter of last year, loans from the years 2005 through 2008 — considered to be the worst-performing vintages — made up 61% of Freddie's total portfolio. This share fell to 46% in the first quarter of 2010.

As that portion of the portfolio becomes smaller and smaller, replaced with higher-quality loans from 2009, 2010 and beyond, financial performance should improve.

"There's no question we're going to see the initial benefits of credit trends from tightening up their credit box," said Josh Rosner, a managing director at Graham Fisher & Co., a research firm for institutional investors.

Rosner said he expects stabilization of nonperforming assets, but he asserted that such a milestone could be fleeting. "Yes, we're going to have some stabilization at this point, but is it sustainable?" he asked. "It's a little too early" to say. The biggest wild card may be what direction home prices take. Some experts worry that the GSEs are not reserving enough to prepare for another drop in home prices.

"Any type of house price depreciation would really impact them," Moody's Harris said. "They'd have to start provisioning again."

On the flip side, if home prices rise, the GSEs are in a good position. "You start playing with those provisioning numbers, and the returns really start changing," Harris said.

Even if the picture for the GSEs is rosier than a year ago, many bridges remain to be crossed.
"Absent the overhang of the legacy loans and government-directed efforts to modify post conservatorship mortgage loans, Freddie Mac is clearly a viable entity," said Michael Youngblood, principal of Five Bridges Advisors. "But given the magnitude of the legacy loan issues and the ever broadening array of loan modification efforts, that netting will undoubtedly keep their ink red. … It's like telling the grasshopper, 'apart from the elephant on your back, you could really fly high.' "


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