Freddie Gets a Boost

Hearing good news from certain large financial companies these days has become as rare as finding a pearl in an oyster.

On Wednesday, Freddie Mac (NYSE: FRE), the second-largest provider of funding for U.S. residential mortgages, bucked the current trend by reporting better-than-expected results, combined with ambitious growth projections. In response, its stock soared more than 9%.

Here are the numbers
Freddie reported a first-quarter loss of $151 million, or $0.66 per share, versus a $133 million loss and $0.35 per share for the year-ago quarter. These numbers compare favorably to Reuters' estimate of a $1.57-per-share loss, not to mention the company's $2.5 billion loss last quarter. The quarter also looks good compared to fellow mortgage giant Fannie Mae (NYSE: FNM), which reported a $2.2 billion loss last week.

On the surface, a $151 million loss seems like small change these days, compared to the recent humongous first-quarter losses of subprime overindulgers including Citigroup (NYSE: C), Merrill Lynch (NYSE: MER), UBS (NYSE: UBS), or Wachovia (NYSE: WB). Heck, the overpaid senior executives at these firms probably have spent $151 million on lattes alone.

However, numbers can be misleading. The improved numbers mostly owe to an accounting change in how the company values certain derivatives, rather than any improvement in business conditions. In fact, Freddie's Chief Financial Officer Buddy Piszel said that without the accounting changes, Freddie's losses would have exceeded $2 billion.

Why'd Freddie really rally?
Anticipation of future growth was the true force behind the stock's rise. Freddie announced plans to raise $5.5 billion in additional capital through an offering of both common and preferred stock. As a result of this offering, federal regulators agreed to lower the company's required capital cushion from 20% to 15%. The cushion is expected to be lowered to 10% in September, as long as Freddie remains in good standing with the regulator. Fannie Mae is getting similar treatment from regulators.

In addition to offsetting losses, the new capital raising, combined with its lower capital requirements, should infuse Freddie with the funds it needs to boost earnings potential going forward. The market likes that notion.

In fact, the company reportedly expects to see a 40% to 50% jump in investment income, and a 15% to 20% rise in mortgage bond guaranty business, in 2008. This quarter's revenue already rose to $1.53 billion, from $694 million a year ago.

The bad news
Don't get too excited -- the news wasn't all good. Moody's downgraded Freddie's financial strength rating, forecasting that the company would endure $7.5 billion more in losses from bad mortgages over the next two years.

In addition, credit-related expenses, which include provisions for credit losses and the costs of taking back real estate, increased to $1.49 billion from just $262 million a year ago.

What does the future hold?
The government is clearly relying on Freddie Mac and Fannie Mae to remain active and be the ultimate liquidity providers for an ailing housing market. Consequently, regulators are relaxing restrictions on the mortgage companies. The new regulatory environment will enhance the companies' ability to generate business and higher revenues.

If we truly have passed the worst of the housing and credit meltdown, the stocks should do well from here. If the current crisis takes another turn for the worse, Fannie and Freddie could find themselves overexposed in a market meltdown, and in for real trouble. Stay tuned.