Freddie Advises that Credit Costs Could Rise

Freddie Mac's net income fell sharply from one year earlier during the second quarter as an increase in credit losses and markdowns of credit-related items pinched results.

Moreover, Freddie Mac said that it expects to see continued credit pressure in the third quarter, though Freddie Mac executives said on a conference call that they expect charge-offs to remain below the company's long-term historical average.

"We were not immune to market forces and we continue to take a cautious view toward housing conditions," said chairman and CEO Richard Syron in a conference call with investors and analysts.

"While I was an early bear on the housing markets, I was not bearish enough," he said later during the call. Freddie Mac now expects housing values nationally to be flat to negative this year and next year as well.

While Freddie Mac's quarterly results "continue to be bumpy," Mr. Syron said that the market is pricing risk more rationally, and that provides investment opportunities for the company.

Freddie Mac reported net income of $764 million, or $1.02 per share, in the second quarter. Net income was down 45% from the second quarter of last year, though it was up from the first quarter of this year when Freddie Mac reported a loss due to fluctuations in the fair value of assets.

While credit costs have begun to chip away at earnings, Freddie Mac said that net interest revenue from its portfolio was down only modestly compared to a year earlier, and guaranty fee income continued to grow.

Higher-credit-related costs drove a big increase in overall expenses for Freddie Mac, pushing total expenses to nearly double their level from the first quarter of last year.

Credit-related expenses -- the provision for credit losses plus operational costs on Freddie Mac's real estate-owned portfolio -- totaled $336 million in the second quarter, up from $63 million in the second quarter of 2006.

Freddie Mac executives said the increase primarily reflects deterioration in the early performance of loans originated in 2006 and 2007. In those books of business, the transition from delinquency to foreclosure and loss severity rates have been higher than expected due to slower home price appreciation and higher unpaid principal balances.

Freddie Mac also said that higher anticipated losses on guaranteed securities resulted in a "higher fair value of credit costs" on the certain guarantees and new business.

"Our overall exposure to higher-risk products is low relative to our competition," said CFO Buddy Piszel.

He said the credit deterioration in Freddie's portfolio has spread beyond industrial Midwest states like Michigan and Ohio to states such as California and Florida, where Freddie Mac is seeing a big increase in delinquencies.

He said the early delinquency picture on participation certificates issued in 2006 is that the serious delinquency rate is double the average from the books of business written in 2003 through 2005. He attributed the higher delinquency rate to a stall in home price appreciation and a high ratio of loans with second mortgage debt.

Freddie Mac's overall credit costs approached 2 basis points in the second quarter, up from 1.3 basis points a year earlier. Freddie Mac expects that rate to approach 3 basis points by the end of the year. But that remains below the long-term historical average of 5 basis points, the company's executives said.

Freddie Mac said that higher replacement costs on its maturing long-term debt contributed to the squeeze on net interest revenue. Guarantee fee revenue increased because of a higher balance of outstanding securities and participation certificates as well as a "moderately higher" average guarantee fee rate, the company said.

While Freddie Mac's portfolio continued to shrink modestly in the second quarter, executive vice president Patricia Cook said on the call that market conditions are creating more attractive investment opportunities for the firm. At the end of the second quarter, the retained portfolio totaled $712 billion.

Net purchase commitments increased during the month of June. Wider mortgage-to-debt option-adjusted spreads are making purchases more attractive.

And Mr. Syron suggested that lifting caps on GSE portfolio purchases would help Freddie Mac stabilize the troubled market for mortgage assets.

Freddie Mac said that its core capital exceeded its regulatory minimum by $1.8 billion. (c) 2007 Mortgage Servicing News and SourceMedia, Inc. All Rights Reserved. http://www.mortgageservicingnews.com http://www.sourcemedia.com/

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