Richard X. Bove, Vice President Equity Research at Rafferty Capital Markets, highlights that Freddie Mac has no common equity and it may report a sizable first quarter loss.
It would appear that Freddie Mac is in a great deal of trouble. The company has no common equity. The actual number is negative $83.5 billion. It reports that it has $2.9 billion in total equity. In reality it has no equity. Moreover, it may report a sizable first quarter loss.
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Yet the firm, in theory, guarantees the payments and principal on $1.6 trillion in mortgages. Plus, the company may be the second largest provider of funds to the United States housing market. Repeating, a closer look at its operations suggests that this core company to U.S. housing in reality has erratic earnings and no equity.
Since the common equity is a negative $83.5 billion, the claim that the company has real equity is based upon the value of its preferred stock. There is a senior preferred that has a stated value of $72.3 billion.
Plus there are a series of junior preferreds that are valued at $14.1 billion. However, the terms of the senior preferred are such that the junior preferreds will never receive a dividend. Thus, if these preferreds were fair valued they would be worth nothing.
The reality then is that Freddie Mac has no equity and yet it has just under $2.0 trillion in debt backing the guarantees noted above. Any fair assessment of this company would note that it is totally insolvent.
The reason why it exists is because it is currently being held in a conservatorship by an agency of the United States government. For this reason it is believed that the debt and guarantees of Freddie Mac are backed by the full faith and credit of the government.
However, the government does not acknowledge this to be the case. It does not show the obligations of Freddie Mac on the U.S. balance sheet as obligations of the United States government.
Everyone is happy with the current arrangement even though no other financial company in the country (except other GSEs) is allowed to operate in this fashion. The question raised by this report is whether this arrangement built on falsehoods can continue even though the President, the courts, Congress, and the marketplace do not want it to end.
Unfortunately this arrangement “of speak no evil, see no evil, hear no evil” is close to failure despite the goodwill of all the participants, involved.
Freddie Mac – Income Statement
This view is based upon an assessment of Freddie Mac’s income statement. It appears that the entity may report a sizable loss in the first quarter resulting in market demands that it raise more money from the U.S. Treasury. If it makes this request then it is very possible that the congenial support of all parties to the current situation will fall apart.
Freddie Mac does not have many sources of revenues. They break down roughly as follows:
- The firm collects net interest income from two sources:
- Its ownership of mortgages and other investments; and
- It guarantees of mortgage principal payments on third party mortgages
- A normal balance sheet would not count guarantees as interest income but Freddie Mac does.
- The guarantee fees must be shared with the government; Freddie Mac obtains about 80% of the total.
- The firm’s revenues are also impacted by a series of other factors
- There are gains and losses on the extinguishment of debt as the firm continues to deal with its historic problems.
- The company is a very aggressive factor in the derivatives markets as it attempts to hedge its interest rate risk.
- There are net impairments on its available–for-sale securities also due to the past issues.
- There are gains and losses on investment securities — some realized, some unrealized.
- Plus, the company has an “other” income category composed of
- Litigation settlements
- Fair value adjustments of mortgage and security values
- Other fees
Revenues are also impacted by the accounting for loan losses. In recent years, Freddie Mac has been very successful in recapturing loan losses and this shows up as an addition to revenues. In reality it is not. On a core basis, the firm’s revenues are its net interest income and some fees. The other entries are mainly non-cash and not integral to the firm’s core operations.
Basic operating expenses are very low relative to the revenues generated through net interest income. However, there are multiple other variable expenses that impact the business:
- Administrative expenses are composed of normal outlays for personnel, occupancy, professional services, and basic operating costs like supplies and marketing.
- However, a meaningful cost is the Congressional demand that Freddie Mac charge a 10 basis point fee on all of the mortgages it guarantees to help rebuild the nation’s highway system.
- The FHFA, Freddie Mac’s regulator, is also requiring the company to put a certain amount of it revenues each year into trust funds to aid low income housing. This is a big number in the hundreds of thousands of dollars.
- There are also other costs associated with litigating, and shifts in accounting as loans are moved from investment to for- sale status.
Building an Operating Model
An operating model for the company might be composed of the following:
- All of the firm’s net interest income; and
- An estimation of 0.5% of net interest income to reflect ongoing fees
- A loan loss provision of 2 basis points per quarter of all loans as new commitments offset the historic problems
- Operating expenses at a flat $650 million per quarter.
- $50 million for the highway fund
- $350 million for the trust fund
- $250 million to run the company
The results of this hypothetical model are shown on the following page compared to actual reported results. What is immediately evident when comparing what one might call core income to actual income, is that the hypothetical number is profitable, and stable – i.e., it is not growing. The actual results are just the opposite. They are totally erratic.
The reason for the erratic reported earnings performance is the non-interest portions of the company’s income statement. The most important of these are shown below.
On the revenue side it can be noted that variable revenues can be as high as a positive $3.1 billion or as low as a negative $3.8 billion. Looking forward some of this volatility is likely to be eliminated as Freddie Mac is rationalizing both its liabilities and assets, and the firm is unlikely to receive any additional major litigation settlements.
On the expense side the cost of litigation is likely to dissipate and the huge loan recoveries of the past are probably gone. However, the costs of the highway and low-income home buyer trust funds are now expected to be a normal cost of operations.
Thus, in the future the key driver of volatility in Freddie Mac earnings is the company’s hedging activities which show up in mainly non-cash derivative value adjustments. The company has positioned itself for a rise in interest rates. This is apparent in the movement of derivative revenues against changes in the 10-year Treasury. When the Treasury yield declines, Freddie Mac posts a sizable derivatives loss.
To date in the first quarter, the 10-year Treasury has declined by 0.366%. This is the largest decline since the first quarter of 2014. It is impossible for an outsider to predict what this will do to Freddie Mac earnings but it is not unrealistic to assume a loss of $2.0 billion plus in derivatives (it could be as high as $4.0 billion or more). At the $2.0 billion plus level, Freddie Mac’s pretax earnings would be negative $749 million.
The Director of the FHFA, which supervises Freddie Mae, has indicated that both GSEs may have to ask Treasury for more money to rebuild their capital. The CEO of Freddie Mac in the company’s last conference call referred to the fact that the Treasury has more backstop funding which should be considered “hidden” equity for the company. The question is: “Will this President and Congress sit idly by and let Freddie Mac dip into Treasury funds without any reaction or is this game over?”