NEW YORK Aug. 11, 2008--Standard & Poor's Ratings Services said today that it affirmed its 'AAA/Stable/A-1+' senior unsecured debt rating on Freddie Mac. At the same time, we lowered our subordinated debt and preferred stock ratings on Freddie Mac to 'A-' from 'AA-' and our risk-to-the government rating to 'A' from 'AA-'. These ratings are removed from CreditWatch Negative where they were placed July 25, 2008. The outlook is negative.
The affirmation of the 'AAA/A-1+' senior debt rating reflects the strong explicit and implicit U.S. government support these securities hold in the marketplace, as evidenced by the recent U.S. Treasury actions. This underscores the key public policy role and the key liquidity role the congressionally chartered government-sponsored enterprises (GSEs) have in the U.S. mortgage market.
"The lower risk-to-the-government, subordinated debt, and preferred stock ratings reflect Freddie Mac's pressured capital position in the face of higher operating losses. The risk-to-the-government rating measures Freddie Mac's "stand-alone" creditworthiness (i.e., its credit quality absent extraordinary government support). Higher credit expenses are the driver of net operating losses, as Freddie Mac is not immune to the weak housing markets," said Standard & Poor's credit analyst Victoria Wagner.
The lower subordinated debt and preferred stock ratings reflect the introduction of notching below the risk-to-the-government issuer credit rating. We are introducing this new notching to reflect heightened subordination risk. The passage of HR 3221, "Housing and Economic Recovery Act of 2008," introduces a new regulatory structure including, among other features, the application of a prompt and corrective action framework similar to the powers outlined in the 1991 FDICIA banking regulation for commercial banks and thrifts. Under a severe safety and soundness risk scenario, the regulatory authority now has receivership powers that would place the nonsenior creditors of Freddie Mac at a greater risk of nonpayment, especially the dividend payments on preferred stock.
The new legislation goes a long way in adding clarity to the regulatory framework of the GSEs, adding more depth to the regulatory authority and powers, which is positive for creditors. It also has a provision that protects the Freddie Mac charter even in receivership. Although the legislation is effective immediately with the passage of the bill, it will take time to develop and implement some of the new regulations, including new capital requirements. Embedded in HR 3221 is the U.S. Treasury's temporary backstop liquidity plan, which expires on Dec. 31, 2009. Likewise, this backstop plan brings clarity to the liquidity support that Treasury would provide if needed. If Treasury actually provides equity support to Freddie Mac as authorized under this backstop plan, we believe that all subordinated creditors of Freddie Mac could be at an even greater risk of default.
Although Freddie Mac has committed to raise $5.5 billion of new equity in the near term, its capital cushion over the 20% surplus Office of Federal Housing Enterprise Oversight-required capital level has declined to $2.7 billion. Given the earnings pressure at Freddie Mac and the uncertain receptivity of the capital markets for new capital issuance, the firm will be more challenged to maintain a regulatory capital cushion in the near term. The expected further cut to the common dividend to $0.05 per share (pending Board of director approval) and more restraint on balance-sheet growth will help the capital ratios.
Revenues were stronger in the second quarter as the net interest margin (NIM) increased significantly to 80 basis points (bps) and there was strong retained portfolio growth. Although the NIM expansion is a positive trend that we expect will continue, the increase in credit losses was greater than we had anticipated. Freddie Mac's credit losses in the second quarter totaled $810 million, 53% higher than in the first quarter, and were equivalent to a net credit loss ratio of 17.3 bps. We expect total credit losses will be slightly higher in the second half of 2008 and will surpass the credit loss level Freddie Mac experienced in the early 1980s Texas down banking cycle. The Alt-A exposure is $190 billion or approximately 10% of the total single-family mortgage portfolio, and is fueling the majority of credit losses. The Alt-A 2006 and 2007 vintage mortgage books account for 36% of its total single-family mortgage portfolio.
The outlook is negative. Freddie Mac's lower capital base and higher credit losses are pressuring the current ratings. Execution of the $5.5 billion capital raise is critical to Freddie Mac staying above regulatory capital requirements. The timing of issuance is an additional challenge given the current depressed pricing of its common stock and uncertain appetite for additional preferred stock by investors. Given the longer-term negative outlook for mortgage credit performance, we do not anticipate a return to a stable outlook until we see evidence of core earnings reverting to more normal levels and a firm easing of credit losses, as well as stabilization in the firms' capitalization. If efforts to raise capital ratios fall short of the business needs, further pressuring capital ratios, we could lower the ratings.
