Freddie Mac: Capitalize on Subprime Chaos

For those confused by the misrepresentation and often apparent contradiction in the analysis of Freddie Mac (FRE) and Fannie Mae (FNM), you are not alone. Again, we find the bears trawling for mortgage stocks susceptible to "headline" news due to the chaos in the subprime ABS market. Mark my word: if anything, well-capitalized Freddie Mac will be taking advantage of the chaos.

Forget about the "noise" coming about "derivative losses" as a result of the mark to market of positions that theoretically are hedging business risks. These allow the company to report rather stable "spread" margins on its on balance sheet mortgage spread business. That, and the guarantee of mortgages, is the essence of the business model, for which they have operated the same way for twenty years. The difference between the late nineties and the early part of this decade (besides the reasonable (and merited for the most part) contraction in valuation is the Freddie has to provide values for derivatives for which there is no secondary market (and hence no real way to assess value). Margins have shrunk in the business, and Freddie's business model is now a mid to high teens ROE business (operating), and not a mid twenties ROE business. That, in part is due to the forced retention of capital and reduced leverage (hence lower Return on Equity).

But there is a greatly increased chance that as a result of the rise in rates and reduced refinancings, the annuity stream of revenues is improving in security and stability, hence enhancing the long-term value of the underlying credit and equity. At a discount to the price/book of the peer financial group, and a more dependable revenue stream than banks, broker-dealers which would you rather own (or short)? At Freddie there were perhaps a few rogue traders (profitable) and some bad controls. For that they have to appear at senate hearings. At Goldman, they are called superstars and go to head the Treasury department.

See also: The Short Case on Freddie Mac

FRE 1-yr chart

Comments

[Daniel Jones:]

I have to heartily disagree. Labeling analysis of three quarterly losses as "misrepresentation" and "noise" is itself misrepresentation and noise. Perhaps you are one of the analysts like the Freidman Billings person who thinks "GAAP economics don't apply here". Utter nonsense. FRE is very much like the Bear Hedge funds that have now blown up. Using their delays in reporting and accounting machinations, they can mask their losses & hope for better days. Heck of an investment strategy.

FRE may soon be relegated to only providing for affordable housing loans. That enhanced business model, unchanged from the 80's as you put it, needs to radically change. This turkey is cooked. Stick a fork in it.

I'm long puts - would you care to disclose your position?

Daniel Jones
e-bluewater.com

2007 Jun 22 09:56 AM

[FIG trader_:]

Under separate cover (through your firms message system), I have sent you the long/short arbitrage dated 2004 (long FRE/short FNM), check the subsequent collapse and underperformance of FNM. You could have made a lot of money. Check the blog for reco on FRE/FNM in begiinging of year.

2007 Jun 22 11:00 AM