Katrina, Accounting Issues Still a Challenge at Freddie

Freddie Mac's 2005 earnings fell 27% from 2004 as the costs of a recent securities settlement, accounting changes and Hurricane Katrina weighed down earnings. But declining net interest margins also factored into Freddie Mac's results.

Net income totaled $2.1 billion in 2005, down from $2.9 billion in 2004. Diluted earnings per share were $2.75, down from $3.94 a year earlier, under generally accepted accounting principles.

The market reaction was negative, with Freddie Mac's stock pricing closed at $60.04 on May 31, down more than 3% from its closing price of $61.58 on May 30.

Freddie Mac executives stressed positive trends, saying that they gained market share in the mortgage-securities business and exceeded the company's 30% surplus capital requirement by $3.5 billion at the end of 2005. They also said that interest-rate and credit risks remain near historic lows.

During a conference call to discuss 2005 results, chairman and CEO Richard Syron said Freddie Mac's share of the GSE mortgage securities market rose to 45% last year, up from 41% in 2004.

"The fundamentals of this franchise remain strong. We have a powerful capital position and balance sheet, excellent risk management and a stronger competitive position."

Eugene McQuade, president and chief operating officer, said that Freddie Mac's investments in business capabilities, infrastructure improvements and new management marked a return to competitiveness last year and early this year.

"We have substantially increased our penetration of the overall markets we serve. We have done this by increasing our business volumes in both our credit guarantee and retained portfolio investment businesses."

Freddie Mac said that an alternative measure of performance, the fair value of net assets attributable to common shareholders before capital transactions, increased by $900 million last year to $26.7 billion. That translates into a 3.3% return on equity, Mr. McQuade said.

Freddie Mac said that it's fair value benefited from its guarantee fees and the spread earned on its retained mortgage portfolio, but that a wider option-adjusted spread reduced fair value by $1.4 billion.

Patricia Cook, an executive vice president at Freddie Mac, said that wider option-adjusted spreads between mortgages and debt were bad from a mark-to-market perspective in last year's results, but she said the wider OAS has a silver lining for the long term.

"The implications for the business are generally more positive, because it means we are able to add assets at the margin at wider spreads."

Freddie Mac executives said they still believe the company can continue to achieve fair value returns "in the low to mid-teens."

Meanwhile, analysts at Friedman Billings Ramsey gave Freddie Mac's stock a "market perform" rating after the earnings release, citing a decline in net interest margin on Freddie Mac's portfolio to 76 basis points form 123 basis points a year earlier. And FBR believes the net interest margin may trend even lower to the mid-60 basis point level for 2006.

In a report, FBR analyst Paul Miller said he expects fundamentals to remain weak for the balance of this year, meaning return on equity "should remain flat to down from current levels."

Mr. Miller also questioned Freddie Mac's ability to achieve its "fair value" target for growth, saying growth may be constrained by current capital positions and market fundamentals.

FBR gave Freddie Mac's stock a $65 price target.

SNAPSHOT: Factors in Freddie's 2005 Earnings

Class-Action Settlement $220 Million

Hurricane Katrina Charges $133 Million

Accounting Changes $265 Million

SOURCE: Freddie Mac (c) 2006 Mortgage Servicing News and SourceMedia, Inc. All Rights Reserved. http://www.mortgageservicingnews.com http://www.sourcemedia.com

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