To Investors, Freddie's Cushion Was Thin

By David S. Hilzenrath
Washington Post Staff Writer
Friday, August 29, 2008

Freddie Mac, which has lost more than 90 percent of its stock value since last fall, has repeatedly tried to dampen talk of a government bailout by highlighting the amount of capital it has on hand to weather problems.

A presentation by top executives this month offered a window into why those claims have so far failed to reassure investors.

The McLean mortgage finance giant released a chart illustrating its ability to withstand an array of hypothetical financial hits. But the implication that it could maintain a big enough financial cushion was based on one government standard. Freddie Mac and its rival, Fannie Mae, must comply with other standards, and Freddie acknowledged that it may have difficulty meeting them.

"We discount Freddie's presentation . . . about how it can stay above regulatory-capital minimums come hell or high water," the consulting and research firm Federal Financial Analytics said in a report to clients. "Any number of assumptions in it are questionable," the firm said, adding that it was "a near-certainty" that Freddie Mac will ultimately become undercapitalized.

Along with its competitor Fannie Mae, Freddie Mac is one of the main funding conduits for mortgage lenders, and in the current troubled environment it is widely considered essential to the nation's mortgage system.

Freddie Mac is required to maintain a financial cushion, known as capital, to absorb potential losses. As rising mortgage defaults and declining home prices take a toll on the company, one of the dangers it faces is falling below the required level of capital. That could trigger a freeze on the firm's asset growth, restricting its ability to provide funding for mortgages. Depending on the severity of the problem, it could prompt the government to replace officers and directors or put the company in federal receivership, potentially wiping out shareholders' value.

The chart meant to illustrate the company's financial staying power was part of a packet Freddie Mac issued when it announced that it lost $821 million in the second quarter.

"We've obviously provided you with an extraordinary amount of information, but I'm not going to apologize for that," chairman and chief executive Richard F. Syron said in an Aug. 6 conference call with investors and analysts. The aim, Syron said, was to provide "as much information as you could possibly need . . . to come to your own best view of what the future may hold."

As of June 30, Freddie Mac estimated it had $37.1 billion of capital, exceeding what the government then required by $2.7 billion. The surplus is small relative to the company's overall financial picture, which includes $874.3 billion of debts and $2.2 trillion of mortgage investments and guarantees.

The government's standards are not the only way of assessing Freddie Mac's financial fitness, and other measures underscore the challenges the company faces.

For example, Freddie Mac reported that if it was forced to liquidate its assets and liabilities at their values as of June 30, it would have been left with negative $5.6 billion.

Freddie Mac also reported that it ended the second quarter with $34.3 billion of unrealized losses -- declines in the value of mortgage-related investments that it still holds. The company says it has not counted those unrealized losses against its earnings or capital because it expects the investments to recover their lost value and plans to hold on to them until they do.

In addition, Freddie Mac is counting as assets about $18.4 billion in deferred tax credits. The credits are useful if Freddie Mac can apply them against profits, but the company has been reporting quarter after quarter of losses. If Freddie Mac were to conclude that the odds of its being able to use tax credits are no greater than 50 percent, it would have to write them off, taking a potentially big bite out of its capital.

"If we haven't gotten to the point where a write-off is going to be imposed by the accountants, we're no more than a quarter away," and the charge could reach $10 billion, said Robert Willens, a consultant on tax and accounting issues.

In a regulatory filing, the company said it doesn't think such a write-down is needed because it expects the downturn in the housing market to be temporary.

Merrill Lynch this week issued a report saying Freddie Mac probably would not deplete its capital for several quarters and predictions of an imminent bailout might be premature.

Freddie Mac's Aug. 6 conference call was one of the company's most pointed efforts to address concerns about its capital. The chart on page 11 of the presentation showed how much capital Freddie Mac estimated it would have, above the government's "statutory minimum requirement," in an array of hypothetical scenarios involving increasingly large write-downs of mortgage investments and other costs related to bad loans.

"While we are not expecting the most severe outcomes reflected in this analysis, what it shows is that we can withstand approximately $40 billion of credit pain for all of '08 and '09, and essentially meet our minimum statutory capital requirements," chief financial officer Anthony "Buddy" Piszel said on the conference call.

Freddie Mac spokesman Michael Cosgrove said that the company has incurred about $8.25 billion of such expenses since the housing downturn began last year.

The chart conservatively assumes that Freddie Mac will maintain its current level of mortgage investments; if it reduced them, it would need less capital.

For several reasons, however, the chart was less reassuring than it might have seemed.

First, as a footnote to the chart explained, and as Piszel noted, the numbers were based on an assumption that Freddie Mac had fulfilled its long-standing plan to raise an additional $5.5 billion of capital. Freddie Mac has yet to raise the $5.5 billion and faces difficulty doing so. The stock market currently values the company at $3.4 billion.

Second, the chart sought to illustrate Freddie Mac's ability to meet the "statutory minimum requirement," but that is not the only measure of capital adequacy the company must meet. Even if Freddie Mac remains in compliance with that requirement, falling short of another standard known as the risk-based capital requirement can trigger the same consequences.

The risked-based requirement focuses on the grades that credit-rating agencies such as Moody's and Standard & Poor's assign to mortgage securities in the company's investment portfolio. The risk-based standard becomes more stringent as the securities are downgraded.

"While we have historically met the risk-based capital standard, there is a significant possibility that continued adverse developments . . . could cause us to fail to meet this standard," Freddie Mac said in a report filed with the Securities and Exchange Commission. "If we were not to meet the risk-based capital standard, we would be classified as 'undercapitalized,' " the company reported.

Third, following an accounting scandal at Freddie Mac, a federal regulator directed Freddie Mac to maintain more capital than the statutory minimum -- currently, 20 percent more. The extra requirement, which the company said it exceeded by $2.7 billion on June 30, is not reflected in the chart.

"The chart was constructed in this way for ease of presentation," Cosgrove said by e-mail.

During the conference call, an analyst asked the Freddie Mac chief executive about other ways of looking at the company's capital needs.

"Well, there are obviously lots of different ways that people can look at capital," Syron said. "And the framework that we're working within now is the statutory framework, and that's the reason that we are focused on it."

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