Friday, June 30, 2006

Freddie Mac- Continuing Progress

Freddie Mac released its annual report a couple of days ago with the title "Continuing Progress."

Though Washington seems to be abuzz with anti-Fannie (FNM) and Freddie rhetoric as Washington prepares for the summer, it occurs to me that these franchises, and especially Freddie's are discounting the worst that regulators can throw at them.

Freddie (FRE) addresses its challenges rather forthrightly in its annual. Remember, the accounting sins of FRE were related to under-reporting of earnings not over-statement of earnings. This was a case of holding reported earnings back for a rainy day rather than trumpeting success that was not there. An accounting sin, but more venial than mortal as accounting misrepresentation goes.

The company continues to address some Sarbanes-Oxley shortcomings....internal controls still need some work in financial reporting. The weaknesses are not credit or derivatives related. The internal controls weaknesses are being addressed.

Portfolio limits which have been imposed and accepted by Fannie have been asked for by OFHEO of Freddie, as the annual puts it, "Limitations on our portfolio activities for some period of time."

Derivatives exposure is down considerably at only $225 million in net exposure versus a gross notional exposure of $683 billion. The market value of derivatives which was $15 billion at the end of 2004 is down to $6.5 billion.

The 30% of capital requirement for surplus is comfortably exceeded. Freddie has core capital of about $36 billion or about $3.5 billion more than the 30% requirement entails.

The credit risk in the mortgage portfolio is low. For 2005, 87% of its business had loan to value ratios below 80% and 21% were below 60%. The credit scores for the borrowers were also more than satisfactory...only 4% had FICO's below 620 and 64% had FICO's over 700.

What happens if Fannie and Freddie are constrained in their portfolio purchases? From an investor viewpoint, at least this one's, I suspect nothing. I believe that the current valuation for FRE already suggests a zero growth assumption for mortgage growth. Even with zero growth, my guess is a valuation of $70-75.

If Congress blesses some growth in the portfolio, this provides upside to my valuation estimate.

A vindictive Congress had better be careful with an unwinding and a downsizing of the two biggest players in this marketplace. Banks are counterparties on many derivative exposures for both FNM and FRE. Significant amounts of the banking system's core capital is exposed to Fannie and Freddie paper. So pulling the plug has adverse consequences for the banking system in total.

Even though the political climate could well become more adverse as November approaches, the low valuation of FRE and its "innocence" at least relative to the mis-deeds of FNM, seems under-appreciated. In the interim, the large banks have been buying mortgages at a much faster pace than the GSE's. The constraints on FNM and FRE have been a benefit to BAC, WB, and WFC.

But in my opinion, the valuation of the portfolio even without growth favors FRE as an investment.

Disclaimer: I, my family, and most clients currently have a position in FRE. Neither I, my family, or clients have a current position in FNM, or WB. Neither I, nor my family have a position in WFC though certain clients do own a current position.


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