The commentariat may be up in arms about it, but traders seem to like Freddie Mac’s new maths.
On the back of results reported on Wednesday, the totemic US mortgage finance company saw its share price tick a healthy 9.2 per cent up. Even with a $5.5bn rights issue on the horizon.
The proximate cause for celebration, or at least relief, was the imposition of two new accounting rules that transformed a putative $1.7bn net loss into a $151m one. Enough to make anyone suspicious, or so one might have thought. But as a Freddie spokesperson told Bloomberg:
Clearly, based on the comments and reports this morning by the real, substantive analysts who follow this company, the Street is comfortable with our accounting and reporting, and encouraged by the results we presented today.
If the market is buying it, why then the suspicion?
The big number arousing doubt seems to be the huge increase in “level 3” assets – which, under FAS 157, are priced according to the company’s own valuation due to illiquid or dysfunctional market prices. Whereas $31.9bn of FRE’s assets were level three in December, as of Wednesday, $156.7bn were, says Bloomberg.
The apparent opacity of that move, of course, is what has everyone pointing fingers and crying fire.
But a big part of that level-three increase has nothing to do with Freddie’s new net loss numbers. FRE’s entire ABS portfolio was reclassified in the first quarter as level three – thanks largely to the failing of indices like the ABX as the “observable inputs” required for level-2 modelling.
Those reclassified ABS are also part of Freddie’s trading portfolio – structured assets it holds on its books. And it’s not accounting changes to the trading portfolio which have saved Freddie money. As made clear on the Freddie conference call (HT Calculated Risk)…
Analyst: There is a headline out there that you have level 3 assets of $157 billion. I was just wondering is that true and is that related at all to the markups of the 1.2 billion gain?
Freddie Mac: No, it is not Paul. We made a determination in the first quarter that given how widely the pricing we were getting on the abs portfolio [varied] that it no longer made sense to leave that into level two. So we essentially moved the entire abs portfolio into level three. We were still using the mean pricing that we were getting from the dealers. So we’re not using a model price. That is all that is. It has nothing to do with the trading portfolio
FAS 157 and FAS 159 do come into play in assessing the value of Freddie’s guarantee obligations, however – the “insurance” the mortgage giant effectively writes on MBS it sells on. (“We guarantee the payment of principal and interest on issued PCs and Structured Securities that are backed by pools of mortgage loans, and we are obligated to purchase delinquent loans that are covered by long-term standby commitments”)
The accounting rules – long scheduled for implementation in 2008 – affect the model-derived valuation (based on projected gains/losses) on those guarantees.
Using FAS 157:
As a result, effective January 1, 2008, the company no longer records estimates of deferred gains or immediate losses recognised upon issuances of single-family Mortgage Participation Certificates (PCs) and Structured Securities in guarantor swap transactions through losses on certain credit guarantees, a component of non-interest expense. In the fourth quarter of 2007, the company incurred $1.3 billion in losses on certain credit guarantees.
And using FAS 159:
Effective January 1, 2008, the company elected the fair value option for certain available-for-sale mortgage-related securities and its foreign-currency denominated debt. Upon adoption of SFAS 159, the company recognised a $1.0 billion after-tax increase to its beginning retained earnings at January 1, 2008. See the Appendix for more detail on the adoption of SFAS 157 and SFAS 159.
You can read Freddie’s own appraisal of the new accounting standards here.
Of course, none of that gives the green signal on Freddie. Cash reserves are pitifully low for one thing. It’s worth reading the litany of problems kindly condensed into an accessible form by the Nattering Naybob.