Wishful thinking about Freddie Mac
Mortgage lender's shares rally as investors make a risky bet that the housing meltdown will be contained.
NEW YORK (Fortune) -- Freddie Mac is the latest beneficiary of wishful thinking about the housing market.
Shares of the government-sponsored mortgage investor surged 9% Wednesday, in a replay of last Tuesday's rally in Fannie Mae stock. Like Fannie, Freddie Mac (FRE, Fortune 500) posted a third straight quarterly loss and laid out plans to raise billions of dollars in new capital to cushion against future losses tied to the souring housing market.
Yet, while Freddie execs said they expect to see rising credit costs over the next year and a half, they also emphasized that Fannie (FNM, Fortune 500) and Freddie's near monopoly on the mortgage securities market will make for huge profits once their credit costs peak. (Fannie echoed that rosy prediction last week.)
It's a story that's grabbing Wall Street's attention these days. "We believe [Freddie Mac] has turned the corner and is now a revenue growth story," analyst Howard Shapiro of Fox-Pitt Kelton wrote in upgrading Freddie to outperform from in line. "This does not mean we have seen the worst in credit costs, but it does mean that revenue growth will be significantly stronger than the growth in credit costs."
Some observers, however, believe Freddie and others are underestimating the depth of the housing downturn - and the costs they and their investors could face. Joshua Rosner, a managing director at financial consultancy Graham-Fisher in New York, says Freddie Mac's housing-market forecasts "strike me as more than a little optimistic."
So far, defaults in Freddie's core loan portfolio have been low, and losses have largely been confined to states such as California, Nevada and Florida that saw huge house-price runups and are now suffering sharp downturns. But Rosner expects default rates across the portfolio to spike as banks tighten their lending standards and pull back on home equity lending - reducing borrowers' access to credit.
He points to data from the 2001 recession showing that, when the economy slows, more and more consumers borrow to meet everyday needs - as long as they're able. Bank of America (BAC, Fortune 500) executives reported Tuesday a sharp increase recently in credit-card spending on necessities - a trend that probably isn't sustainable for long. A recent Fed survey showed a substantial tightening of standards by lending officers.
Rosner isn't the only one expecting the housing downturn to deepen. Moody's downgraded Freddie Mac's bank financial strength rating to B-plus from A-minus, saying the lender's substantial credit losses will hurt its financial flexibility.
Desmond Lachman, a resident scholar at the American Enterprise Institute and a former Salomon Smith Barney economist, says bloated inventories of unsold houses - about 10 months' worth, according to recent government data - will keep pressure on prices for the foreseeable future. He notes that price declines have been accelerating in recent months and that there has been little government response.
Freddie knows there's more pain ahead. The company said it still expects a 15% peak-to-trough drop in U.S. house prices, and that the steep decline in house prices - they fell 4.2% in the first quarter alone, going by the Fannie Mae index - caused the company to boost its estimates of future losses. Freddie said credit-related expenses surged to $1.45 billion in the first quarter, from $262 million a year ago, as delinquency rates rose.
Freddie now expects to see 2008 credit losses equaling 16 basis points, or 0.16%, of its portfolio, and 20 to 25 basis points next year. Fannie Mae last week raised its 2008 credit loss forecast to 13 to 17 basis points from the previous 11 to 15 basis points.
Lachman believes that predictions of a real estate bottom next year are too optimistic. "The nature of a housing market bust means that it takes time to play out," he says. Lachman also worries about what he calls a "negative feedback loop" in which the housing-induced credit crunch tips the economy into recession, which then further reduces already weak demand for housing. 
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