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Freddie also Now Faces Threat of Portfolio Limits

The Office of Federal Housing Enterprise Oversight could impose portfolio limits on Freddie Mac, the company's chairman warned investors last week, which would potentially put Freddie in the same boat as Fannie Mae.

The new acting OFHEO director, James Lockhart, recently placed a freeze on the size of Fannie Mae's portfolio until the government-sponsored enterprise fixes its internal controls and financial reporting systems.

"Director Lockhart has indicated that he intends to consider whether additional remedial action may be appropriately applied to Freddie Mac while we continue to fix our control environment. And this could include consideration of portfolio growth limitations for some period of time," Freddie chairman and chief executive Richard Syron said.

The CEO stressed during a teleconference with investors and analysts that fixing the internal controls and accounting infrastructure "is our most highest and most urgent priority."

Freddie hopes to complete the testing of its systems by year-end 2006. But it does not expect to begin timely reporting of quarterly results under the release of its 2006 annual report.

Mr. Syron made the disclosure about potential portfolio limits during a teleconference about the corporation's 2005 unaudited annual report (see related story).

Freddie Mac executives said they expect return on equity to be in the low teens - even though 2005 ROE was 3.3% in 2005. But double-digit ROE growth implies solid portfolio growth. Freddie's portfolio grew by 8.7% to $710 billion in 2005 and it has grown at a 5.8% annualized rate during the first four months of this year to $723.8 billion.

When asked about what impact portfolio limits could have on earnings, the Freddie CEO said they have not had time to consider such a "hypothetical."

"We have had very preliminary discussions with the director," Mr. Syron said. And he declined to speculate what action Mr. Lockhart might take.

Morgan Stanley analyst Kenneth Posner estimates the impact of possible portfolio limits on Freddie's stock "valuation would be modest." Even if OFHEO caps the portfolio in "perpetuity," which he called a worst-case scenario, it would only reduce his target price for Freddie's stock by $2 to $72 a share.

"Given the importance of the retained portfolio to market liquidity and the company's housing goals, and given the progress Freddie has already made in improving its financial controls, we think the worst-case scenario is unlikely, but it helps bracket a range of possible outcomes," Mr. Posner said.

Former OFHEO director Armando Falcon said he would have required Fannie Mae to shrink its portfolio as opposed to capping it at $727 billion and keeping it in a holding pattern.

If their internal controls and financial reporting systems are so bad, "why are they good enough to maintain them at their current size," he told a Citizens Against Government Waste event here last week. Mr. Falcon left OFHEO in May 2005 to become a principal at Canonbury Group's Washington office.

The former GSE regulator noted that Fannie and Freddie's portfolios could be cut in half just through simple attrition over a couple of years. Since October 2004, Fannie has reduced the size of its portfolio by 20% to $730.4 billion.

"They have already shown that they can reduce the size of their portfolio in a very orderly way," he said. (c) 2006 Mortgage Servicing News and SourceMedia, Inc. All Rights Reserved. http://www.mortgageservicingnews.com http://www.sourcemedia.com

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