Richard X. Bove, Vice President Equity Research at Rafferty Capital Markets, highlights Freddie Mac’s third quarter losses.
Freddie Mac reported a loss of $0.23 per share in the third quarter. This was $0.23 per share below my estimate and second quarter results. The earnings estimate for 2015 is being lowered to a loss of $0.15 per share from a projected loss of $0.04 per share. The estimates for 2016 and 2017 remain unchanged at a loss of $0.04 per share in both years.
During the quarter, Freddie Mac suffered a pretax “hedging” loss of $4.2 billion. This is the 6th time in the past 7 quarters that the company has reported a derivatives loss. In 2014, the aggregate pretax loss on derivatives was $8.3 billion. In the first three quarters of this year the company has lost $3.4 billion on derivatives.
Don Layton, the company’s CEO explained in a press conference call, where analysts were not allowed to speak, that the derivatives business is effective in lowering the firm’s cost of funds.
Reasons behind Freddie Mac earnings loss
This is hard to accept for two reasons. The first is that this company’s debt is backed by the full faith and credit of the United States government. It is pretty hard to get a lower cost of funding than that.
Second, note this quote from the company’s earnings press release: “$1.5 billion (after-tax) approximately, was driven by the fair value losses on derivatives used to hedge the company’s interest rate risk. However, significant GAAP earnings volatility can occur as the derivative instruments are measured at fair value each period while certain hedged assets and liabilities are not.”
Stated differently, this company is not hedged. It is betting on interest rates. Plus, it has made the wrong bet believing that rates will rise not fall. As a result, the earnings of Freddie Mac show all the tendencies that cause observers to believe that it is an uncontrolled mammoth sitting there to harm the taxpayer.
In the second quarter there was the only hedge profit in about 2 years. In the first and third quarters there were losses. The swing in derivatives revenue between the second and third quarter was $7.3 billion. A move of this magnitude raises questions about both management and the Federal Housing Finance Agency (FHFA).
Freddie Mac has no common equity. Its total equity is $1.3 billion on a balance sheet that is $1.96 trillion in size. Another after tax loss like the one in the third quarter will wipe out the company’s equity. The farce that argues that this company’s debt is not taxpayer debt will be wiped away. Plus, the company will be forced to go to the Treasury and take down more money.
This will force Congress and the courts to come to some decisions about the status of the government sponsored agencies. This company is insolvent and playing financial games that are not acceptable. The Treasury is robbing its capital. Yet, it is expected to aid in the financing of the housing market.
This is simply wrong. It is a train seeking a brick wall.
