Richard X. Bove, Vice President Equity Research at Rafferty Capital Markets, highlights that the government and incredible mismanagement is driving Freddie Mac into bankruptcy.
Freddie Mac is in Deep Trouble – Government and Incredible Mismanagement is Driving It Into Bankruptcy
The numbers are frightening:
- Freddie Mac’s net interest income, which is the core source of its revenues, in the first quarter of 2016 was $3.405 billion. This is 27.3% below where it was at its peak in the Q4 2011.
- In the past four quarters net interest income has been as follows: $3.969 billion in Q2 2015; $3.743 billion in Q3 2015; $3.587 billion in Q4 2015; and $3.405 billion in Q1 2016.
- One reason for the persistent declines is that the government requires the company to shrink the size of its loan portfolio and the company is doing so.
- Despite the fact that most banking companies showed flat to up net interest margins in the first quarter due to the Federal Reserve rate hike last December, Freddie Mac posted a 4 basis point decline in its net interest margin in the first quarter. The margin is down 12 basis points in the last three quarters.
- One reason for the weakness here is that the government requires the company to pay 10 basis points of its guarantee fees to the Highway Trust Fund to fix roads and bridges.
- In the past 5 quarters the company has reduced its reserves by about $825 billion per quarter. This is equal to 68% of the company’ net income in the period.
- Most unbelievable, and the reason for the claim of mis-management, is the company’s gambling on derivatives. The posted numbers from Q1 2015 to Q1 2016 are as follows: minus $2.4 billion; plus $3.1 billion; minus $4.2 billion; plus $0.7 billion; minus $4.6 billion. If a bank did this the government would fine it for incompetence as it did JPMorgan Chase (JPM/$61.87/Buy) for a smaller trading loss that did not cause that bank to show negative earnings.
Management argues that it is doing well and that the company is providing positive results. Yet, year-over-year, its retained earnings deficit is up by $901 million. Its stated equity is now only $1.0 billion. It refuses to talk to analysts and/or explain its derivatives follies to anyone.
This equity number is a charade. The company’s net worth is positive only because the firm lists itself as having $14.1 billion in junior preferreds. Yet these preferreds have no value since the government refuses now, and forever, under its so-called “third amendment” to its PSPA agreement to pay any dividends on these preferreds.
False Guarantee
Thus, the company is in theory guaranteeing $1.6 trillion in mortgages with $1.0 billion in equity that is not really equity. Looked at differently, it is supporting $2.0 trillion in debt on effectively no equity.
Management says there is no worry here because it can borrow $140.5 billion from the U.S. government whenever it chooses to. Thus, its asset to equity ratio is actually 7.2%.
Representative Ed Royce (R.; CA) says not so fast. The taxpayer cannot be held hostage to this company. Mr. Royce was able to get Congress to cap the salaries of the GSE CEOs at $600,000 per year so he is not without power in the GSE discussion. Plus, the budget and balance sheet of the United States government do not admit that it is in any way backing the guarantees of Freddie Mac.
Why Should Anyone Care (They do Not) But Why Should They?
The latest figures released by the Financial Institutions Group at the Federal Reserve indicate that the GSEs and Federal Agencies as a group accounted for 102% of the net new funds flowing into the home mortgage markets (see chart on the following page). Additionally, this government group of agencies either own or guarantee 3 of every 5 home mortgages in the country.
In effect, the home mortgage sector has been nationalized. One key aspect of the government’s control is the 30-year fixed rate mortgage. Without government guarantees, this instrument will become a financial oddity. This has significant ramifications for housing prices and population mobility. No one who has a 30-year fixed will move if these loans disappear and the value of all housing will decline if monthly payments go up should shorter duration loans with variable rates become the norm.
Conclusion
The home mortgage market in the United States is controlled by the government even though it disputes this control. A key lynchpin in this control is Freddie Mac. Freddie Mac is clearly insolvent in that it cannot repay its debts should some reversal develop in the economy. Yet Freddie Mac guarantees $2.0 trillion in debt with $1 billion in questionable equity. This is a 2,000 to 1 ratio. Even the conservator of the company Mell Watt, head of the FHFA, admits that if rates go lower the company will need money from the U.S. Treasury.
Both the President and Congress refuse to deal with the evident financial problem here. The courts will take at least five years and possibly a decade to make some definitive rulings. The media does not care and neither does the public.
This may be the basis for another, deeper acting, financial crisis. Only then, it appears, will someone act to resolve the current issues. This is making the related banking, housing, and financial associations very nervous.
