Managed earnings were much more fun
Back in the good old days,
“Yesterday — all my troubles seemed so far away.”
Fannie Mae and Freddie Mac aggressively managed their earnings, keeping unrealized gains and losses in reserve so they could turbocharge the balance sheet and deliver earnings that matched estimates with heartwarming accuracy, and maximizing their seven- and eight-figure executive bonuses.
We must be good if we hit it every time
Those days are over. Between new reporting rules, accounting scandals, and pending strengthened oversight legislation, the two GSEs now have to report fluctuations in their earnings not just from realized gains and losses (that is, mortgages sold or foreclosed), but also unrealized (changes in inherent value resulting from market factors, chiefly payment performance), and the results are not pretty. As reported last week by CNNMoney.com:
Freddie Mac scrambles for cash
Problems, uncle Freddie?
Finance company’s shares plunge on news that it has turned to Wall Street and may cut dividends as losses cut deep into capital.
One reason why investors like dividends
The linkage is this: capital is comprised of more than just cash. Losses eat into a company’s capital base, and if the capital drops close to regulatory minimums,
The news whacked the company’s shares more than 28% in morning trade.
This hurts your stock price more than it hurts me
The firm reported a net loss of $2 billion, or $3.29 a share, in the third quarter, wider than the loss of $715 million, or $1.17 a share, a year earlier.
It isn’t just that Freddie Mac’s loss was so much greater than last year, it was also much greater than expected.
Analysts surveyed by earnings tracker Thomson First Call had forecast that Freddie would trim losses to 22 cents a share in the period.
Our forecasts were that far off???
The firm also announced an $8.1 billion, or 25% drop, in the fair value of its assets - another way it measures its financial performance - and it said it had set aside $1.2 billion to cover credit losses.
The market took roughly $10 billion immediately off its market capitalization, as revealed by this Grand-Canyon-esque trading history:
That price cliff represents $10 billion of market cap gone
But what got the most attention on Wall Street was Freddie’s announcement that its capital surplus had fallen by $1.2 billion to only $600 million above a mandatory target set under a consent decree with regulators.
Time to fill-er-up with equity!
Freddie also said it has hired Wall Street firms Goldman Sachs (Charts, Fortune 500) and Lehman Brothers (Charts, Fortune 500) to help it “consider very near term capital-raising alternatives.”
If not help, at least send money
Among the alternatives it is looking at to increase its available cash would be to slash its dividend by 50 percent.
In the capital markets, slashing your dividend is at least a two-minute minor penalty
Investors hate dividend cuts, for they fear the cuts will be many years in the reversing. Also, cutting the dividend makes the stock price higher as a multiple of dividends, so income-oriented investors tend to look elsewhere.
It also could be forced to limit the growth or reduce the size of its retained portfolio, slow purchases by its credit guarantee portfolio or issue additional preferred or common stock.
You want to issue additional stock? What’s wrong with me?
Slowing new purchases would be what a normal lender might do here.
Issuing new preferred stock is a common approach, although if the preferred stock has a higher coupon rate than the stock’s current effective yield (E/P), the result will be dilutive of current investors.
Investors fled the stock because the cut in the dividend and the likelihood of additional shares being sold would make existing shares less valuable.
I don’t like being diluted
Company officials also said they had discussions with federal regulators about possibly relaxing the capital standards agreed to by Freddie Mac due to past accounting problems.
I feel much better with my capital standards relaxed
“We have had discussions with them on the (rule),” said Freddie Chairman and CEO Richard Syron. “We expect to have discussions in the future.”
When asked by analysts if regulators had rejected that request for relief from the rules, Syron responded, “You can interpret the answer.”
Making this ironic — probably to the nation’s detriment — is that right now, what the market needs is stability and confidence, precisely the false security that the GSEs’ previous earnings management sought so diligently to foster. Yet, now that their inherent volatility has been exposed, we find that not only were the GSEs vulnerable, so too was the entire securitization pipeline.
“We’re not happy about this. We don’t expect you to be happy about this,” he said during a call with analysts and investors. “The two basic approaches we can take now either (are to) go to ‘Fortress Freddie,’ which I don’t think would be in interest to our shareholders or to our charter and the mortgage market, or we could take these steps that we think are in the best interest of the mortgage market and the shareholders.”
Had the GSEs done a better job of managing themselves, had they been less arrogant, had the OFHEO report been less damning, there would be more Congressional confidence in their motives, and Congress might well be willing to loosen the reins.
“It is likely that the fourth quarter will prove difficult as well,” said Syron. “We do not believe it would be wise to be sanguine about the near-term outlook for the housing market. The right thing for us to do now is to take steps to strengthen our capital position.”
On Nov. 9, the other government-sponsored mortgage finance firm, Fannie Mae (Charts), reported lower earnings that raised questions about its accounting. Shares of Fannie have fallen nearly 25% since that report, and Freddie had fallen nearly 15% during the same period through the close of trading Monday.
Tuesday, it was Fannie’s turn to see its shares follow Freddie lower, as it was off more than 20% in
It was all so much easier when earnings could be reliably managed.
Penrod, it was much better when we could do that stuff
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