Higher provisions for losses on loans and write-downs on the value of derivative contracts pushed mortgage repurchaser Freddie Mac $2 billion into the red during the third quarter, company officials said today.

Freddie Mac said it was forced to set aside $1.2 billion for credit losses and real estate-owned property expenses during the third quarter, compared with $112 million a year ago. The increase was attributed to “significant deterioration of mortgage credit” as a result of continuing weakness in the housing market.

Freddie Mac’s loss, and a similar turn of events at Fannie Mae, could weaken the ability of both companies to serve as bulwarks to mortgage lenders who have become increasingly dependent on their ability to buy, guarantee and securitize loans.

Major lenders like Countrywide Financial Corp. have shifted the majority of their production into loans eligible for repurchase or guarantee by Fannie and Freddie, as Wall Street investors have become reluctant to buy securities backed by mortgage loans that lack such guarantees.

On Nov. 9, Fannie Mae reported $1.4 billion in third-quarter losses, driven by $1.2 billion in credit losses the company owns or guarantees, and $2.24 billion in write-downs on the value of derivative contracts (see Inman News story).

The losses at Fannie and Freddie could force the companies to curtail loan purchase and guarantee programs, at a time when some lawmakers have been pushing to expand them in order to counter a “credit crunch” that’s contributed to the housing downturn.

Legislation pending in Congress would lift limits on Fannie’s and Freddie’s loan portfolios, allowing them to buy more loans, and raise the $417,000 conforming loan limit to allow the government-sponsored entities (GSEs) to back bigger loans.

But mounting losses could make it challenging for Fannie and Freddie to continue buying and guaranteeing loans at the current pace, let alone expand.

Freddie expects more losses

At Freddie Mac, total credit losses — net charge-offs and REO operations expense — totaled $126 million in the third quarter, equal to 3 basis points of the average mortgage portfolio. For the year to date, the average was 2.2 basis points, with credit losses totaling $263 million.

“We have begun raising prices, tightened our credit standards and enhanced our risk management practices,” said Freddie Mac’s chief financial officer, Buddy Piszel, in a statement. “We also continue to improve our internal controls as we move closer to completing our remediation efforts and returning to timely financial reporting. These actions position us well to take advantage of opportunities when the current market dislocation ends.”

But Freddie Mac said it expects credit losses to continue to increase for the remainder of this year and next, “especially if conditions, such as home prices and the rate of home sales, continue to deteriorate.”

The McLean, Va.-based mortgage financer grew its portfolio of retained loans at an annualized rate of 1 percent, to $713 billion. The Office of Federal Housing Enterprise Oversight (OFHEO) has limited growth in Fannie’s and Freddie’s retained loan portfolios to 2 percent a year (see story).

A bill that would allow a temporary 10 percent increase in the GSEs’ loan portfolios, HR 3838, was introduced Oct. 16 by Rep. Barney Frank, D-Mass. Sen. Charles Schumer, D-N.Y., has introduced a similar bill in the Senate, S 2169. OFHEO Director James Lockhart has called the legislation “unnecessary, unsafe and unsound” (see Inman News story).

Capital scarce

The issue was moot during the third quarter, because OFHEO requires that Fannie and Freddie maintain a 30 percent capital surplus. That requirement “limited Freddie Mac’s ability to take advantages of purchase opportunities” for its retained loan portfolio, and the company was forced to sell $20 billion in loans in September and another $25 billion in October to stay within the requirements.

Freddie Mac’s regulatory core capital was estimated at $34.6 billion as of Sept. 30 — just $600 million above the 30 percent capital surplus set by OFHEO.

The company has hired Goldman Sachs and Lehman Brothers as financial advisors to help it consider ways to raise capital, and is “seriously considering” reducing its fourth-quarter common stock dividend by 50 percent.

“If these measures are not sufficient to help the company manage to the 30 percent mandatory target capital surplus, then the company may consider additional measures in the future such as limiting growth or reducing the size of our retained portfolio, slowing purchases into our credit guarantee portfolio, issuing additional preferred or convertible preferred stock and issuing common stock,” Freddie Mac said.

During the third quarter, Freddie Mac grew its guarantee portfolio — loans which the company guarantees payments on — at an annual rate of 18 percent, to $1.7 trillion. That compares to forecasted annual growth of 6 percent in total U.S. residential mortgage debt this year.

But widening credit spreads on the value of the company’s credit guarantee activities forced the company to acknowledge $1.4 billion in “mark-to-market” losses. Declining long-term interest rates required an additional $1.4 billion markdown on the value of the company’s derivatives portfolio.

Mark-to-market losses required by accounting rules totaled $3.6 billion, including $1.5 billion in interest-rate-related items and $2.3 billion in credit-related items. The interest-rate- and credit-related losses were offset by other gains.

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