Big loss, grim outlook at Freddie Mac

Breaking down the housing rescue

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NEW YORK (CNNMoney.com) -- Mortgage finance giant Freddie Mac on Wednesday reported a much bigger-than-expected loss, slashed its dividend and warned of more problems ahead for the battered housing and credit markets.

Company executives, in a sobering forecast about the nation's housing woes, said nationwide home prices are likely to drop another 7% to 9%. Those declines, and other problems in the economy, are likely to cause additional losses on the $1.8 trillion worth of single-family loans that Freddie guarantees or owns.

"Today's challenging economic environment suggests that the housing market is far from stabilizing," Freddie Mac CEO Richard Syron said during a conference call.

Syron and other Freddie executives sought to assure investors that the company is prepared to ride out the difficulties.

But investors were unconvinced. Shares plunged 19% in afternoon trading. The decline also dragged shares of Fannie Mae (FNM, Fortune 500), which operates in the same business as Freddie and is set to report quarterly results on Friday, down 15%.

Early Wednesday, Freddie (FRE, Fortune 500) reported that it lost $821 million, or $1.63 a share, in the second quarter. Analysts surveyed by Thomson Reuters had forecast it would trim its loss to 41 cents a share from the $151 million or 66 cents-a-share it lost in the first three months of the year.

A year ago, the company earned $729 million, or 96 cents a share.

Freddie also announced that it would cut its quarterly dividend to 5 cents a share or less, subject to a final decision by its board, from 25 cents a share in an effort to save capital. Losses have strained Freddie's capital, and the dividend cut should save the company more than $500 million a year.

Freddie's year-to-date losses of nearly $1 billion are far below the $3.7 billion it lost the second half of 2007 as it took charges for the value of its loans portfolio. The current losses are driven by the rapidly rising costs of loan defaults and rising provisions for future losses that are certain to rise.

"While we may be roughly half way through the eventual decline, we are still in the early stages of realized defaults," said Patricia Cook, the company's chief business officer. "Most of the expected losses are yet to be realized."

Since the start of 2007, Freddie's portfolio of single-family home loans suffered credit default costs of nearly $2 billion. Three months ago the company estimated that those defaults could end up costing between $15 billion and $20 billion during the life of the loans.

But with steeper home price declines now being forecast, and the increasing rate of mortgage foreclosures and delinquencies, Freddie expects those costs to go higher - to as much as $42 billion in what it says is a worst-case scenario.

Freddie officials said the company should have enough capital to deal with even those worst-case losses, once it goes ahead with plans to raise $5 billion in additional capital.

"We have the wherewithal and the earning power to manage through this period," said Buddy Piszel, its chief financial officer.

Freddie said its estimated core capital slipped to $37.1 billion at the end of the quarter from $38.3 billion at the end of March. That capital level is about $2.7 billion above the level it agreed to meet with its federal regulator.

Provisions for credit losses more than doubled to $2.5 billion from $1.2 billion in the first quarter. The reason: increases in the delinquency and foreclosure rates of the mortgages Freddie owns and guarantees, as well as the continued declines in home prices.

Those provisions for credit losses caused the company to lose $1.4 billion on the guarantees it makes on loans for single-family homes - about triple the $458 million loss on that line in the first quarter. The company made $129 million on those guarantees in the year-ago period.

The company saw losses soar even though its net interest income, the difference between interest paid and interest income soared to $1.5 billion from $793 million a year ago, due to lower interest costs for the firm in the just completed quarter.

That rise in net interest income was more than offset by the $3.3 billion hit in investment activity due to the reduced estimated value of its holdings. That's up from a loss of $540 million a year earlier.

About $1 billion of the most recent investment loss was caused by the decline in the value of Freddie's mortgage securities, which are backed by subprime mortgages or so-called Alt-A home loans made to borrowers who did not provide full or any verification of income or assets.

Freddie and Fannie Mae (FNM, Fortune 500), which were set up by the government to provide funding for the mortgage markets, have become the primary source of capital for banks and other lenders making home loans. They are seen as crucial to the recovery of the housing and credit markets.

But investor anxiety about the firms has driven shares of Freddie down by 66% between June 16 and Tuesday's close, while Fannie shares lost nearly half their value during the same period. It also prompted Congress to pass a rescue measure for the firms, allowing the Treasury Department to loan them an unlimited amount of cash and even buy their shares if necessary.

Syron was asked Wednesday if Fannie and Freddie, known as government sponsored enterprises or GSEs, can continue to operate in a way that both helps the housing market and makes the profits that shareholders demand. He said he believes they can continue to serve both missions going forward, despite these losses.

"I don't think we're at a point that the model doesn't work anymore," he said. "I think we are a point where the model is more stressed."

"I think virtually everyone, including our critics, would say that this would be an extremely ugly mortgage market if you didn't have the GSEs in it," Syron said.