Fannie Mae & Freddie Mac mirror the US Housing Ground Zero

Fannie Mae And Freddie Mac Second-Quarter Results Highlight Ongoing Housing Market Weakness

Results for Fannie Mae and Freddie Mac in second-quarter 2011 reflected ongoing weakness in the housing market. Credit losses remain concentrated in 2005 to 2008 vintage loans and hedging losses hurt profits. Operating losses and sizable dividends to the U.S. Treasury led these firms to request a combined $6.6 billion in additional capital from the Treasury to cover deficits. Standard & Poor's Ratings Services doesn't believe either institution has the capacity to generate sufficient earnings to cover annual dividends currently owed to the Treasury.

Net interest income at both firms was largely flat from the first quarter. Interest rates declined and helped to lower the cost of borrowing for both firms, but also kept returns on earning assets low. Both firms continue to purchase delinquent loans from sponsored trusts so as not to have to make payments to investors for nonearning assets.

Overview

• Second-quarter 2011 net interest income at both Fannie Mae and Freddie Mac was largely flat from the first quarter.
• Both institutions saw the overall seriously delinquent rate for their portfolios fall in the second quarter.
• Both firms continue actively to pursue home retention strategies and foreclosure alternatives to reduce their level of ultimate credit losses.

The Federal Reserve has announced that it intends to keep interest rates low until at least mid-2013. Historically, 30-year fixed-rate mortgages are about 150 to 200 basis points higher than the 10-year Treasury yield. Low rates on new mortgage production will continue to put pressure on the top line at both Fannie Mae and Freddie Mac.

Loan Loss Provisions Varied, And Delinquency Rates Dropped

Freddie Mac reported a higher loan loss provision in the second quarter versus the first quarter, reflecting more newly delinquent loans and a less favorable rate of transition into the seriously delinquent category versus the prior period. Conversely, Fannie Mae's loan loss provision declined sequentially to $5.8 billion in the second quarter from $10.6 billion in the first quarter. Fannie Mae stated that the decline in home prices was more severe in the first quarter, and that it was seeing better recoveries from its repurchase requests. Charge-offs at Freddie Mac were $3.1 billion in the quarter, up $0.1 billion from the first quarter, while Fannie Mae saw net charge-offs drop to $3.8 billion from $4.7 billion, which also reflects the better repurchase request recoveries.

Charge-off rates remain historically high, but have been somewhat subdued because of delays in the foreclosure process across the country. We still expect the $39 billion reserve at Freddie and $69 billion reserve at Fannie to substantially cover remaining embedded credit losses on the existing legacy portfolio vintages 2005-2008. These vintages now represent 35% of Freddie Mac's single-family portfolio and 34% of Fannie Mae's single-family portfolio, but continue to generate a majority of the total credit losses at each firm. We expect charge-off rates to rise once foreclosure delays are resolved and servicers are able to liquidate their backlogs of nonperforming loans, which could begin to happen later this year or in 2012.

Both institutions saw the overall seriously delinquent rate for their portfolios fall in the second quarter. Bad loans are being written off or restructured, and new, better-quality loans are growing as a percentage of their portfolios (nearly 50% at both). Freddie Mac ended the quarter with a seriously delinquent rate of 3.50%, down from 3.63% at the end of the first quarter. Fannie Mae's comparable rate was 4.08% versus 4.27% at March 31, 2011. We could see these trends leveling or reversing with continuing weak economic conditions. A number of states have changed their foreclosure laws or processes, and servicers have halted or significantly delayed the processing of foreclosures in those states. This has significantly lengthened the time it takes to foreclose mortgage loans in these states and could hurt single-family serious delinquency rates. Fannie Mae's single-family foreclosure rate decreased to 1.20% for the first half of 2011 from 1.45% for the first half of 2010.

Both companies continue to experience difficulties with 2005-2008 vintage loans, with the most stress in loans originated in 2006 and 2007. Loans originated since the beginning of 2009 have performed significantly better, and reflect better underwriting standards by banks and higher purchasing standards by the government-sponsored entities. We expect these loans, characterized by higher average FICO scores and lower loan-to-value ratios, also to perform somewhat better than loans originated before 2009 if the economy deteriorates significantly from here. So far, these loans have experienced historically low levels of delinquencies shortly after their acquisition. Specifically, 2009 and 2010 loans that went seriously delinquent by the end of the second quarter following their acquisition year were approximately 8x and 10x lower, respectively, than the average comparable serious delinquency rate for loans acquired in 2005-2008.

Reducing Losses

Both firms continue actively to pursue home retention strategies and foreclosure alternatives to reduce their level of ultimate credit losses. These strategies include modifications, forbearance, pursuing deeds-in-lieu, and preforeclosure sales, among others. The ultimate long-term benefit of modification and other home retention solutions is unknown, but recent data show that the early-term success rate for modifications has improved. For Freddie Mac, 85% of loans it modified in second-quarter 2010 were current or less than 30 days past due after 12 to 14 months, versus just 55% of loans modified in second-quarter 2009. Similarly, Fannie Mae says 73% of loans it modified in third-quarter 2010 were performing after nine months, versus just 45% of loans modified in third-quarter 2009. We expect these entities to continue to pursue foreclosure alternatives, which can speed up the sale process and preserve the values and prices of the homes in areas with significant home inventories. These strategies should continue to mitigate ultimate credit losses, though their reperformance and recovery rates could suffer if the economy slows significantly or home prices decline more than we anticipate. To the extent properties fall into the companies' other real estate owned through foreclosure, short sales, and the like, we believe they will judiciously dispose of assets so as to not flood any particular market. Such flooding could pressure prices, increase loss severities, and trigger further foreclosures.

Hedging losses were significant in the quarter for both firms because they typically hedge against rising interest rates to preserve the value of their largely fixed-rate portfolios, and interest rates declined. Freddie Mac posted a loss of $3.8 billion related to hedging in the second quarter, while Fannie Mae's loss from hedging totaled $1.7 billion. In many cases, the instruments being hedged are securities whose gains are not accounted for in income, but rather improve or reduce accumulated other comprehensive income (AOCI) on the balance sheet. Freddie Mac, however, saw wider spreads on its securities offset the benefit to its securities portfolio from rising rates. These losses should reverse when interest rates begin to rise.

Freddie Mac posted smaller credit impairments on its securities portfolio this quarter, down to $352 million from $1.2 billion in the first quarter. Fannie Mae's securities portfolio is smaller, and it posted a $56 million other-than-temporary impairment on its available-for-sale securities, up slightly from the first quarter. Each firm has seen its balance of AOCI drop during the past few quarters as positions are sold and prices rebound with added liquidity in the securities markets. A greater percentage of these unrealized loss positions could be realized if the economy deteriorates more than we anticipate, if market volatility causes liquidity to re-exit the market, and/or the quality of collateral underlying the securities worsens.

For the quarter, Freddie Mac posted a net loss of $2.1 billion versus net income of $676 million in the first quarter. Total other comprehensive income totaled $1 billion, reflecting the previously mentioned securities gains on its investment portfolio, so its total comprehensive loss was just $1.1 billion. Its net worth deficit was $1.5 billion at the end of the quarter, incorporating the comprehensive loss for the quarter, its $1.6 billion quarterly dividend to the U.S. Treasury, and its positive net worth entering the quarter. The Federal Housing Finance Agency (FHFA), as Freddie Mac's conservator, will submit a $1.5 billion draw request to the U.S. Treasury to cover the deficit, bringing the aggregate liquidation preference of its senior preferred stock position to $66.2 billion.

Fannie Mae posted a net and comprehensive loss of $2.9 billion in the quarter, versus a net loss of $6.5 billion in the first quarter. After preferred dividends to the Treasury of $2.3 billion, and incorporating a modest positive net worth entering the quarter, Fannie Mae had a net deficit of roughly $5.1 billion. The FHFA will also submit a request to Treasury on its behalf for funds to cover the deficit, bringing the total liquidation preference of its senior preferred stock to $104.8 billion following the draw. Freddie Mac and Fannie Mae will owe annual dividends to the Treasury of $6.6 billion and $10.5 billion, respectively.

We believe that these companies will most likely be forced to draw perpetually from the Treasury to cover losses and dividend payments absent any intervention or forbearance. Even if the companies can return to break-even core operations, we believe Treasury will continue imputing future dividends based on capital replenishment the companies have drawn from the Treasury to pay the current Treasury dividends.