Have you followed the saga of Freddie Mac (NYSE:FRE) over the last couple of years? If not, you have missed accounting scandals and CEO turnover. Today's news is a revision of 2003 earnings to $6.79 per share. That was above consensus estimates, but represents a 52% decline from 2002's numbers. According to CFO Martin F. Bauman, this is all part of an overhaul to its financial reporting process, and he notes that there is still more work ahead.
The problem stemmed mostly from underreporting earnings in an accounting crisis that was first exposed about a year ago. There was confusion as to how to account for derivatives gains and losses. Freddie is on its third CEO since the news first broke.
Freddie Mac is a quasi-governmental agency that buys mortgages from banks and bundles them into investment products that are then sold to investors. This allows banks to create more mortgages. That seems like a fairly simple concept.
Unfortunately, it's not that simple, though. The bigger issue from an investor's viewpoint is the complex derivatives strategy that manages interest rate risk. Bond price fluctuations could hurt the company. Remember, Freddie's primary business is to create liquidity in the mortgage market -- not play interest rates. Derivatives can reduce or extend duration (depending on market conditions) and manage convexity (which involves risk taken by bondholders of prepayment) and other more complicated risks.
Both Freddie Mac and Fannie Mae (NYSE:FNM) are controversial companies. They are known as government-sponsored entities (GSE), which means they receive preferential tax treatment. There have been calls from Congress to revoke the GSE status, which I believe would be a big negative.
Detractors also cite concerns with leverage. Freddie's retained portfolio is $645 billion. The market cap of the stock is $44 billion. I have read negative commentaries referring to Freddie as a house of cards. I haven't made up my mind on that one yet.
The stock is not having much of a reaction to today's news. That is because the issue is a year old and already priced into the stock. The question should be, do you want to own a mortgage company when rates are about to rise? This will hurt new-loan origination and refinancings. Freddie Mac may be the wrong stock in the wrong sector.
Fool contributor Roger Nusbaum is an investment manager and wildland firefighter in Prescott, Ariz. At press time, neither he nor his clients owned any of the stocks mentioned.
