Stock of the Day
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Freddie Mac (FRE)
Has Freddie Mac Stabilized After Recent Volatile Trading?
Shares in the Federal Home Loan Mortgage Corporation, more commonly known as Freddie Mac, took a severe beating yesterday losing about 20%. Freddie's Mac stock is down 80% over the last year as the mortgage lender has been hammered by the sub-prime credit crisis and rising default rates on home loans. Stock in the company has rebounded a bit today; it is up around 3.1% in mid-afternoon trading. For investors who like to bottom-fish, was yesterday a capitulation and now is it time to get back into Freddie and/or the other major government-sponsored enterprise in the mortgage business, Fannie Mae (FNM: Charts, News, Offers)?
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Freddie Mac plays an important role in the housing market as it buys mortgages from home lenders (presuming they meet a basic set of criterion in terms of the creditworthiness of the end borrower) and then it repackages these loans, groups them together, securitizes them and sells them to investors. Freddie also guarantees that investors will receive interest payments and principal as scheduled even if the end borrower (typically a homeowner) defaults. In exchange for this guarantee, Freddie charges these investors a fee. Freddie, as does Fannie, makes a substantial amount of its profits from this fee. Since Freddie buys mortgages from home lenders, it effectively takes these loans off their hands, freeing up the capital of these lenders. This allows lenders to make new loans, which ensures that homebuyers can get a mortgage for a reasonable rate.
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This business model works well when the default rate on mortgages is low and consumers are paying off their loans in time. Obviously, that has not been the case recently. First, the sub-prime dam burst and there was a wave of defaults from borrowers who had spotty credit records. Recently, there have also been defaults in higher quality mortgages, for e.g. the Alt+A mortgages, which are riskier than prime but safer than sub-prime, have started showing higher rates of delinquencies. Freddie, along with Fannie, is left holding the bag on a lot of these defaults. Hence, the pressure on the stock price. Also, due to higher rates of default, mortgages which have not been defaulted on yet lose some of their value. And thanks to mark-to market accounting, Freddie has to write the value of these down on its balance sheet, causing additional losses and mark-downs.
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The catalyst for yesterday's beatdown in the stock was a note put out by a Lehman Brothers analyst which basically said that if new accounting rules being considered by the Financial Accounting Standards Board (FASB) go into effect, Freddie would have to change the way it accounts for some of its off-balance investment entities. Losses from these entities would have to be accounted for on the parent's (i.e. Freddie Mac's) balance sheet. This would result in further write-downs and to meet minimum capital requirements, Freddie Mac would have to raise additional capital, further diluting shareholders. However, this morning, the main regulator that oversees Freddie and Fannie, the Office of Federal Housing Enterprise Oversight, basically implied that even if the new accounting regulations go into effect, the capital reserve requirements on Freddie and Fannie will not increase. This means that Freddie will not have to keep additional capital on its balance sheet and instead can use that money to purchase new loans, thereby maintaining the liquidity in the housing market. That is why investors are bidding up the stock higher today.
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So has Freddie reached a bottom and is it time to get in? That might be a tempting conclusion to reach but is sure a risky one. No one knows for sure whether the mortgage market has reached a bottom. Chances are that things will get worse and the pressure on homeowners will keep increasing, leading to more defaults. Freddie and Fannie have taken a lot of hits but they probably will have to take some more and their ability to survive them remains questionable. Sure, Freddie and Fannie will probably never go bankrupt, they are implicitly backed by the government, but if a government bailout is needed, shareholders won't get much. The bailout money will go to the bondholders and other debtors. The US government has no problem letting equity holders feel the pain, a la Bear Stearns.
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