Freddie Mac's Earnings

Yesterday was not a good one for Freddie Mac: its earnings were substantially more negative than nearly everyone was expecting, and the value of the stock slid by 30 percent.

I am not entirely sure yet why earnings were so poor, but press accounts suggest that the heart of the problem was the mark-downs the company took on delinquent loans that it had repurchased from loan pools. The losses on these loans have not actually been realized in a cash-flow sense (Freddie has not sold them at below market value), but in light of the fact that these are by definition problem loans and that losses conditional upon default seem to be rising, the write-down seems appropriate.

The episode brings home several points. First, it was not long ago that Fannie and Freddie were criticized for having returns on equity that were "too high" and for charging guarantee fees that were also "too high." Guarantee fees are the insurance premium the GSEs charge to sellers of loans to guarantee timely payment of principal and interest. The reason ROES were so high for years is because house prices rose everywhere, and so default losses were nearly non-existent. The companies faced an environment analogous to a casualty company with a book of business in Florida that didn't face a serious hurricane for five years. It one looks at the long term history of default in the United States, Fannie/Freddie G-fees were not excessive (fwiw, I made this point at least as far back as 2005).

Second, as Freddie is confined to conventional/conforming loans, and focuses on prime loans, the markdown at which the market is pricing its non-current loans reflects the fact that the market is building in a high risk-premium for all loans. One thing we know about prime mortgages from the past is that people actually rarely defaulted on them, unless they were facing job loss, divorce or illness, regardless of house price movements. It is possible that attitudes toward default among prime borrowers have changed--we are in the middle of an experiment that will allow us to find out.

Finally, it is an important and open question as to what the role of the companies should be going forward. If the regulatory climate (such as capital requirements) remains tight, the inability of the companies to purchase loans could make housing conditions worse. On the other hand, if house prices overshot up, they will likely overshoot down regardless of credit market conditions. Congress and regulators need to ask themselves whether they are willing to hang on tight if they allow Fannie and Freddie to increase lending in such an environment.

We went through a ride like this in the early 1980s, where because of interest rate changes, Fannie Mae was technically insolvent (and bleeding cash flow). The government decided to forbear, and once interest rates fell, Fannie was OK again.