UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

FORM 10-Q

 

 

 

For the quarterly period ended September 30, 2008

 

or

 

 

For the transition period from                to

 

Commission File Number: 000-53330

 

 

Federal Home Loan Mortgage Corporation

(Exact name of registrant as specified in its charter)

 

Freddie Mac

 

(703) 903-2000

 

(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the registrant:  (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.     x Yes  o No

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “accelerated filer,” “large accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  o Yes   x No

 

As of November 10, 2008, there were 647,158,633 shares of the registrant’s common stock outstanding.

 

 

TABLE OF CONTENTS

 

 

FINANCIAL STATEMENTS

 

 

 

This Quarterly Report on Form 10-Q includes forward-looking statements, which may include expectations and objectives related to our operating results, financial condition, business, capital management, remediation of significant deficiencies in internal controls, credit losses, market share and trends, the conservatorship and its effects on our business and other matters. You should not rely unduly on our forward-looking statements. Actual results might differ significantly from those described in or implied by such forward-looking statements due to various factors and uncertainties, including those described in (i) “MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS,” or MD&A, “FORWARD-LOOKING STATEMENTS” and “RISK FACTORS” in this Form 10-Q and in the comparably captioned sections of our Form 10-Q for the quarter ended June 30, 2008 and our Form 10 Registration Statement filed and declared effective by the SEC on July 18, 2008, or Registration Statement, and (ii) the “BUSINESS” section of our Registration Statement. These forward-looking statements are made as of the date of this Form 10-Q and we undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date of this Form 10-Q, or to reflect the occurrence of unanticipated events.

 

Conservatorship

 

Entry Into Conservatorship and Treasury Agreements

 

On September 7, 2008, Henry M. Paulson, Jr., Secretary of the U.S. Department of the Treasury, or Treasury, and James B. Lockhart III, Director of the Federal Housing Finance Agency, or FHFA, announced several actions taken by Treasury and FHFA regarding Freddie Mac and Fannie Mae. Director Lockhart stated that they took these actions “to help restore confidence in Fannie Mae and Freddie Mac, enhance their capacity to fulfill their mission, and mitigate the systemic risk that has contributed directly to the instability in the current market.” These actions included the following:

 

 

Entry into Conservatorship

 

On September 6, 2008, at the request of the Secretary of the Treasury, the Chairman of the Board of Governors of the Federal Reserve and the Director of FHFA, our Board of Directors adopted a resolution consenting to putting the company into conservatorship. After obtaining this consent, the Director of FHFA appointed FHFA as our Conservator on September 6, 2008, in accordance with the Federal Housing Finance Regulatory Reform Act of 2008, or Reform Act, and the Federal Housing Enterprises Financial Safety and Soundness Act of 1992.

 

Upon its appointment, the Conservator immediately succeeded to all rights, titles, powers and privileges of Freddie Mac, and of any stockholder, officer or director of Freddie Mac with respect to Freddie Mac and its assets, and succeeded to the title to all books, records and assets of Freddie Mac held by any other legal custodian or third party. The Conservator has the power to take over our assets and operate our business with all the powers of our stockholders, directors and officers, and to conduct all business of the company. The Conservator announced at that time that it would eliminate the payment of dividends on common and preferred stock during the conservatorship.

 

On September 7, 2008, the Director of FHFA issued a statement that he had determined that we could not continue to operate safely and soundly and fulfill our critical public mission without significant action to address FHFA’s concerns, which were principally: safety and soundness concerns as they existed at that time, including our capitalization; market conditions; our financial performance and condition; our inability to obtain funding according to normal practices and prices; and our critical importance in supporting the U.S. residential mortgage market. We describe the terms of the conservatorship and the powers of our Conservator in detail below under “Legislative and Regulatory Matters — Conservatorship and Treasury Agreements.”

 

Overview of Treasury Agreements

 

Senior Preferred Stock Purchase Agreement

 

The Conservator, acting on our behalf, entered into a senior preferred stock purchase agreement, or Purchase Agreement, with Treasury on September 7, 2008. Under the Purchase Agreement, Treasury provided us with its commitment to provide up to $100 billion in funding under specified conditions. The Purchase Agreement requires Treasury, upon the request of the Conservator, to provide funds to us after any quarter in which we have a negative net worth (that is, our total liabilities exceed our total assets, as reflected on our GAAP balance sheet). In addition, the Purchase Agreement requires

 

Treasury, upon the request of the Conservator, to provide funds to us if the Conservator determines, at any time, that it will be mandated by law to appoint a receiver for us unless we receive funds from Treasury under the Commitment. In exchange for Treasury’s funding commitment, we issued to Treasury, as an initial commitment fee: (1) one million shares of Variable Liquidation Preference Senior Preferred Stock (with an initial liquidation preference of $1 billion), which we refer to as the senior preferred stock; and (2) a warrant to purchase, for a nominal price, shares of our common stock equal to 79.9% of the total number of shares of our common stock outstanding on a fully diluted basis at the time the warrant is exercised, which we refer to as the warrant. We received no other consideration from Treasury as a result of issuing the senior preferred stock or the warrant.

 

Under the terms of the agreement, Treasury is entitled to a quarterly dividend of 10% per year (which increases to 12% per year if not paid timely and in cash) on the aggregate liquidation preference of the senior preferred stock. To the extent we are required to draw on Treasury’s funding commitment the liquidation preference of the senior preferred stock will be increased by the amount of any funds we receive. The amounts payable for this dividend could be substantial and have an adverse impact on our financial position and net worth. The senior preferred stock is senior in liquidation preference to our common stock and all other series of preferred stock. In addition, beginning on March 31, 2010, we are required to pay a quarterly commitment fee to Treasury, which will accrue from January 1, 2010. We are required to pay this fee each quarter for as long as the Purchase Agreement is in effect. The amount of this fee has not yet been determined.

 

The Purchase Agreement includes significant restrictions on our ability to manage our business, including limiting the amount of indebtedness we can incur to 110% of our aggregate indebtedness as of June 30, 2008 and capping the size of our retained portfolio at $850 billion as of December 31, 2009. See “CONSOLIDATED BALANCE SHEETS ANALYSIS — Retained Portfolio” and “OUR PORTFOLIOS” for a description and composition of our portfolios. In addition, beginning in 2010, we must decrease the size of our retained portfolio at the rate of 10% per year until it reaches $250 billion. Depending on the pace of future mortgage liquidations, we may need to reduce or eliminate our purchases of mortgage assets or sell mortgage assets to achieve this reduction. We currently do not have plans to sell our mortgage assets at a loss. In addition, while the senior preferred stock is outstanding, we are prohibited from paying dividends (other than on the senior preferred stock) or issuing equity securities without Treasury’s consent. The terms of the Purchase Agreement and warrant make it unlikely that we will be able to obtain equity from private sources.

 

The Purchase Agreement has an indefinite term and can terminate only in very limited circumstances, which do not include the end of the conservatorship. The agreement therefore could continue after the conservatorship ends. Treasury has the right to exercise the warrant, in whole or in part, at any time on or before September 7, 2028. We provide more detail about the provisions of the Purchase Agreement, the senior preferred stock and the warrant, the limited circumstances under which those agreements terminate, and the limitations they place on our ability to manage our business under “Legislative and Regulatory Matters — Conservatorship and Treasury Agreements” below. See “ITEM 1A. RISK FACTORS” for a discussion of how the restrictions under the Purchase Agreement may have a material adverse effect on our business.

 

Expected Draw Under the Purchase Agreement

 

At September 30, 2008, our liabilities exceeded our assets under GAAP by $(13.7) billion while our stockholders’ equity (deficit) totaled $(13.8) billion. The Director of FHFA has submitted a request under the Purchase Agreement in the amount of $13.8 billion to Treasury. We expect to receive such funds by November 29, 2008. If the Director of FHFA were to determine in writing that our assets are, and have been for a period of 60 days, less than our obligations to creditors and others, FHFA would be required to place us into receivership. As a result of this draw, the aggregate liquidation preference of the senior preferred stock will increase to $14.8 billion, and our annual aggregate dividend payment to Treasury, at the 10% dividend rate, would increase to $1.5 billion. If we are unable to pay such dividend in cash in any quarter, the unpaid amount will be added to the aggregate liquidation preference of the senior preferred stock and the dividend rate on the unpaid liquidation preference will increase to 12% per year.

 

Treasury Credit Facility

 

On September 18, 2008, we entered into a lending agreement with Treasury, or Lending Agreement, pursuant to which Treasury established a new secured lending credit facility that is available to us until December 31, 2009 as a liquidity back-stop. In order to borrow pursuant to the Lending Agreement, we are required to post collateral in the form of Freddie Mac or Fannie Mae mortgage-backed securities to secure all borrowings under the facility. The terms of any borrowings under the Lending Agreement, including the interest rate payable on the loan and the amount of collateral we will need to provide as security for the loan, will be determined by Treasury. Treasury is not obligated under the Lending Agreement to make any loan to us. Treasury does not have authority to extend the term of this credit facility beyond December 31, 2009, which is when Treasury’s temporary authority to purchase our obligations and other securities, granted by the Reform Act, expires. After December 31, 2009, Treasury may purchase up to $2.25 billion of our obligations under its permanent authority, as set forth in our charter.

 

As of November 14, 2008, we have not borrowed any amounts under the Lending Agreement. The terms of the Lending Agreement are described in more detail in “Legislative and Regulatory Matters — Conservatorship and Treasury Agreements.”

 

Changes in Company Management and our Board of Directors

 

Since our entry into conservatorship on September 6, 2008, eight members of our Board of Directors have resigned, including Richard F. Syron, our former Chairman and Chief Executive Officer. On September 16, 2008, the Conservator appointed John A. Koskinen as the new non-executive Chairman of our Board of Directors. We currently have four members of our Board of Directors and nine vacancies.

 

As noted above, as our Conservator, FHFA has assumed the powers of our Board of Directors. Accordingly, the current Board of Directors acts with neither the power nor the duty to manage, direct or oversee our business and affairs. The Conservator has indicated that it intends to appoint a full Board of Directors to which it will delegate specified roles and responsibilities.

 

On September 7, 2008, the Conservator appointed David M. Moffett as our Chief Executive Officer, effective immediately. Since September 7, 2008, we have announced the departures of our former Chief Financial Officer and our former Chief Business Officer.

 

Supervision of our Business under the Reform Act and During Conservatorship

 

During the third quarter of 2008, the company experienced a number of significant changes in our regulatory supervisory environment. First, on July 30, 2008, President Bush signed into law the Reform Act, which placed us under the regulation of a new regulator, FHFA. That legislation strengthened the existing safety and soundness oversight of the government sponsored enterprises, or GSEs, and provided FHFA with new safety and soundness authority that is comparable to, and in some respects, broader than that of the federal bank agencies. That legislation gave FHFA enhanced powers that, even if we were not placed into conservatorship, gave them the authority to raise capital levels above statutory minimum levels, regulate the size and content of our portfolio, and to approve new mortgage products. That legislation also gave FHFA the authority to place the GSEs into conservatorship or receivership under conditions set forth in the statute. Refer to “MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS — EXECUTIVE SUMMARY — Legislative and Regulatory Matters” in our Form 10-Q for the period ended June 30, 2008 for additional detail regarding the provisions of the Reform Act. See “ITEM 1A. RISK FACTORS,” for additional risks and information regarding this legislation, including the receivership provisions.

 

Second, we experienced a change in control when we were placed into conservatorship on September 6, 2008. Under conservatorship, we have additional heightened supervision and direction from our regulator, FHFA, who is also acting as our Conservator.

 

Below is a summary comparison of various features of our business before and after we were placed into conservatorship and entered into the Purchase Agreement. Following this summary, we provide additional information about a number of aspects of our business now that we are in conservatorship under “Managing Our Business During Conservatorship — Our Objectives.” In addition, we describe the impacts of the Treasury agreements on our business above under “Overview of Treasury Agreements” and below under “Legislative and Regulatory Matters — Conservatorship and Treasury Agreements.”

 

 

 

The conservatorship has no specified termination date. There can be no assurance as to when or how the conservatorship will be terminated, whether we will continue to exist following conservatorship, or what our business structure will be during or following our conservatorship. In a statement issued on September 7, 2008, the Secretary of the Treasury indicated that 2008 and 2009 should be viewed as a “time out” where we and Fannie Mae are stabilized while policymakers decide our future role and structure. He also stated that there is a consensus that we and Fannie Mae pose a systemic risk and that we cannot continue in our current form. For more information on the risks to our business relating to the conservatorship and uncertainties regarding the future of our business, see “ITEM 1A. RISK FACTORS.”

 

Managing Our Business During Conservatorship

 

Our Management

 

FHFA, in its role as Conservator, has overall management authority over our business. During the conservatorship, the Conservator has delegated authority to management to conduct day-to-day operations so that the company can continue to operate in the ordinary course of business. We can, and have continued to, enter into and enforce contracts with third parties. The Conservator retains the authority to withdraw its delegations to us at any time. The Conservator is working actively with management to address and determine the strategic direction for the enterprise, and in general has retained final decision-making authority in areas regarding: significant impacts on operational, market, reputational or credit risk; major accounting determinations, including policy changes; the creation of subsidiaries or affiliates and transacting with them; significant litigation; setting executive compensation; retention of external auditors; significant mergers and acquisitions; and any other matters the Conservator believes are strategic or critical to the enterprise in order for the Conservator to fulfill its obligations during conservatorship. See “Conservatorship and Treasury Agreements — Conservatorship — General Powers of the Conservator Under the Regulatory Reform Act” for more information.

 

Our Objectives

 

Based on the Federal Home Loan Mortgage Corporation Act, which we refer to as our charter, public statements from Treasury officials and guidance from our Conservator, we have a variety of different, and potentially conflicting, objectives, including:

 

 

These objectives create conflicts in strategic and day-to-day decision making that will likely lead to less than optimal outcomes for one or more, or possibly all, of these objectives. For example, maintaining a positive net worth could require us to constrain some of our business activities, including activities that provide liquidity, stability and affordability to the mortgage market. Conversely, to the extent we increase activities to assist the mortgage market, our financial results are likely to suffer, and we may be less able to maintain a positive net worth. We regularly consult with and get direction from our Conservator on how to balance these objectives. To the extent that we are unable to maintain a positive net worth following our expected draw of funds from Treasury after the filing of this Form 10-Q, we will be required to request additional funding from Treasury under the Purchase Agreement, which will further increase our ongoing dividend obligations and, therefore, extend the period of time until we might be able to return to profitability. These objectives also create risks that we discuss in “ITEM 1A. RISK FACTORS.”

 

Changes in Strategies to Meet New Objectives

 

Since September 6, 2008, we have made a number of changes in the strategies we use to manage our business in support of our new objectives outlined above. These include the changes we describe below.

 

Eliminating Planned Increase in Adverse Market Delivery Charge

 

As part of our efforts to increase liquidity in the mortgage market and make mortgage loans more affordable, we announced on October 3, 2008 that we were eliminating our previously announced 25 basis point increase in our adverse market delivery charge that was scheduled to take effect on November 7, 2008. The elimination of this charge will reduce our future net income.

 

Temporarily Increasing the Size of Our Mortgage Portfolio

 

Consistent with our ability under the senior preferred stock purchase agreement to increase the size of our on-balance sheet mortgage portfolio through the end of 2009, FHFA has directed us to acquire and hold increased amounts of mortgage loans and mortgage-related securities in our mortgage portfolio to provide additional liquidity to the mortgage market. Our extremely limited ability to issue callable or long-term debt at this time makes it difficult to increase the size of our mortgage portfolio. In addition, we are also subject to the covenant in the senior preferred stock purchase agreement

 

prohibiting us from issuing debt in excess of 110% of our aggregate indebtedness as of June 30, 2008. For a discussion of the limitations we are currently experiencing on our ability to issue debt securities, see “LIQUIDITY AND CAPITAL RESOURCES” and “RISK FACTORS.”

 

Current Conditions in the Housing and Mortgage Market

 

Deterioration in Market Conditions and Impact on Third Quarter Results

 

Market conditions affecting the company deteriorated dramatically during the third quarter. This had a materially adverse impact on our quarterly results of operations in the third quarter of 2008 compared to the second quarter of 2008.

 

Home prices nationwide resumed the rate of decline experienced earlier in the year after briefly leveling off during the second quarter of 2008. The percentage decline in home prices was particularly large in California, Florida, Arizona and Nevada, where Freddie Mac has significant concentrations of mortgage loans.

 

Unemployment rates also worsened significantly. California, Arizona and Nevada saw increases of between 14 and 27% in unemployment from the second quarter to the third quarter of 2008, on a seasonally-adjusted basis, while the national rate exceeded 6%. Unemployment rates increased again in October to a national rate of 6.5%. An upward spike in food and other goods prices during the third quarter of 2008 further eroded household financial conditions, and real consumer spending declined significantly. Both consumer and business credit tightened considerably during the third quarter of 2008 as financial institutions curtailed their lending activities. This contributed to significant increases in credit spreads for both mortgage and corporate loans.

 

These macro-economic conditions and other factors contributed to a substantial increase in the number of delinquent loans in our single-family mortgage portfolio during the third quarter of 2008. The rate of transition of these loans from delinquency through foreclosure also increased. We observed a significant increase in market-reported delinquency rates for mortgages serviced by financial institutions not only for subprime and Alt-A loans but also for prime loans. This delinquency data suggests that continuing home price declines and growing unemployment are now affecting behavior by a broader segment of mortgage borrowers, increasing numbers of whom are “underwater,” or owing more on their mortgage loans than their homes are currently worth. Our loan loss severities, or the average amount of recognized losses per loan, also increased in the third quarter of 2008, especially in California, Florida and Arizona, where home price declines have been more severe and where we have significant concentrations of mortgage loans with higher average loan balances than in other states.

 

We were not the only financial institution that was adversely affected by the worsening market conditions during the third quarter of 2008. IndyMac Bank, FSB and Washington Mutual Bank were placed into receivership, and Lehman Brothers Holdings, Inc., or Lehman, filed for bankruptcy. American International Group, Inc. received a substantial infusion of cash from the U.S. government, and both Merrill Lynch & Co, Inc. and Wachovia Corporation were acquired by other institutions. In an attempt to stabilize the markets and restore liquidity, the U.S. government introduced several unprecedented programs to provide various forms of financial support to market participants. One of these proposed programs involves guarantees by the Federal Deposit Insurance Corporation, or FDIC, of the debt obligations issued by banks. This proposal and other existing programs have created uncertainty in the market resulting in limited access to long-term and callable funding. Uncertainty has also contributed to increased borrowing costs relative to the U.S. Treasury market and the London Interbank Offered Rate, or LIBOR. See “LIQUIDITY AND CAPITAL RESOURCES” for further information.

 

These market developments have been the principal drivers of our substantially increased loss for the third quarter of 2008. Our provision for credit losses increased from $2.5 billion in the second quarter of 2008 to $5.7 billion in the third quarter of 2008, principally due to increased estimates of incurred losses caused by the deteriorating economic conditions and evidenced by our increased rates of delinquency and foreclosure; increased mortgage loan loss severities; and, to a much lesser extent, heightened concerns that certain of our seller/servicer counterparties may fail to perform their recourse or repurchase obligations to us.

 

Our security impairments on available for sale securities increased from $1.0 billion in the second quarter of 2008 to $9.1 billion in the third quarter of 2008. The deteriorating market conditions during the third quarter also led to a considerably more pessimistic outlook for the performance of the non-agency mortgage-related securities in our retained portfolio. The loans backing these securities exhibited much worse delinquency behavior than that mentioned above with respect to loans in our guarantee portfolio. Rising unemployment, accelerating house price declines, tight credit conditions, volatility in interest rates, and weakening consumer confidence not only contributed to poor performance during the third quarter but significantly impacted our expectations regarding future performance, both of which are critical in assessing security impairments. Furthermore, the mortgage-related securities backed by subprime and Alt-A and other loans, including Moving Treasury Average, or MTA, loans, have significantly greater concentrations in the states that are undergoing the greatest stress, including California, Florida, Arizona and Nevada. MTA adjustable-rate mortgages (also referred to as option ARMs) have adjustable interest rates and optional payment terms, including options that result in negative amortization, for an initial period of years that allow for deferral of principal repayments. MTA loans generally have a date when the

 

mortgage is recast to require principal payments under new terms, which can result in substantial increases in monthly payments to the borrower. Additionally, during the third quarter of 2008 there were significant negative ratings actions and unprecedented and sustained categorical asset price declines most notably in the mortgage-related securities backed by Alt-A loans, including MTA loans, in our portfolio. The combination of all of these factors not only had a material, negative impact on our view of expected performance in the third quarter, but also significantly reduced the likelihood of more favorable outcomes, resulting in a substantial increase in other-than-temporary impairments in the third quarter of 2008.

 

Our aggregate losses on trading securities, our guarantee asset and derivatives, net of the unrealized gains on foreign-currency denominated debt, increased from $481 million in the second quarter of 2008 to $4.2 billion in the third quarter of 2008, as the turmoil in the markets contributed to dislocations in the normal correlations between different instruments. In our capacity as securities administrator for our issued securities, we also incurred a $1.1 billion loss in the third quarter of 2008 related to investments in short-term unsecured loans as a result of Lehman’s bankruptcy.

 

We determined it was necessary to establish a partial valuation allowance against our deferred tax assets due to the rapid deterioration of market conditions discussed above, the uncertainty of future market conditions on our results of operations and the uncertainty surrounding our future business model as a result of our placement into conservatorship by FHFA on September 6, 2008. These and other factors led us to record a non-cash charge of $14.3 billion in the third quarter of 2008 in order to establish a partial valuation allowance against our deferred tax asset. As a result, at September 30, 2008, we had a net deferred tax asset of $11.9 billion representing the tax effect of unrealized losses on our available-for-sale securities portfolio.

 

Each of these drivers of our third quarter results is discussed in more detail below within “GAAP Results” and our “CONSOLIDATED RESULTS OF OPERATIONS”.

 

Credit Overview

 

The factors affecting all residential mortgage market participants during 2008 have continued to adversely impact our single-family mortgage portfolio during the third quarter of 2008. The following statistics illustrate the credit deterioration of loans in our single-family mortgage portfolio, which consists of single-family mortgage loans in our retained portfolio and those backing our guaranteed PCs and Structured Securities.

 

Table 1 — Credit Statistics, Single-Family Mortgage Portfolio⁽¹⁾

 

 

As the table above illustrates, we experienced continued deterioration in the performance of our single-family mortgage portfolio. Certain loan groups of the single-family mortgage portfolio, such as Alt-A and interest-only loans, as well as 2006 and 2007 vintage loans, are the main contributors to our worsening credit statistics. These loan groups have been affected by certain macro-economic factors, such as recent declines in home prices, which have resulted in erosion in the borrower’s equity. These loan groups are also concentrated in the West region. The West region comprised 26% of the unpaid principal balances of our single-family mortgage portfolio as of September 30, 2008, but accounted for 48% and 43% of our REO

 

acquisitions in the third and second quarters of 2008, respectively. Alt-A loans, which represented 10% of our single-family mortgage portfolio as of September 30, 2008, accounted for approximately 50% of our credit losses for the nine months ended September 30, 2008. In addition, stressed markets in the West region (especially California, Arizona and Nevada) and Florida tend to have higher average loan balances than the rest of the U.S. and were most affected by the steep home price declines. As we continue to experience home price declines in these and other regions, the severity of our single-family credit losses will continue to increase, as evidenced by our REO disposition severity ratio.

 

As of September 30, 2008, single-family mortgage loans in the state of Florida comprise 7% of our single-family mortgage portfolio; however the loans in this state make up more than 20% of the total delinquent loans in our single-family mortgage portfolio, based on unpaid principal balances. Consequently, Florida remains our leading state for serious delinquencies, although these have not yet evidenced themselves in REO acquisitions or our credit losses due to the duration of Florida’s foreclosure process. California and Arizona were the states with the highest credit losses in the third quarter of 2008 with 44% of our single-family credit losses on a combined basis. These and other factors caused us to significantly increase our estimate for loan loss reserves during the third quarter of 2008.

 

In an effort to mitigate our losses and the continued growth of non-performing assets, we continue to expand our efforts to increase our foreclosure alternatives. Due to the overall deterioration in the mortgage credit environment, our loss mitigation activity has increased, as exemplified by our increased volumes of loan modifications in 2008. We are continuing to implement and develop strategies designed to mitigate the increase in our credit losses, including a recently announced program by our Conservator to expedite the modification process for certain troubled borrowers.

 

Our non-agency securities in our retained portfolio, which are primarily backed by subprime, Alt-A and MTA mortgage loans, also continue to be affected by the deteriorating credit conditions during 2008. The table below illustrates the changes in delinquencies that are 60 days or more past due within our non-agency mortgage-related securities portfolio backed by subprime, Alt-A, and MTA loans in our retained portfolio. Increases in delinquencies that are 60 days or more past due do not fully reflect the recent poor performance of these securities as cumulative losses are also growing considerably more rapidly. Given the recent unprecedented deterioration in the economic outlook and the renewed acceleration of housing price declines, future performance of the loans backing these securities could continue to deteriorate.

 

Table 2 — Credit Statistics, Non-Agency Mortgage-Related Securities Backed by Subprime, Alt-A and MTA Loans

 

 

We held unpaid principal balances of $125.7 billion of non-agency mortgage-related securities backed by subprime and Alt-A and other loans in our retained portfolio as of September 30, 2008 compared to $152.6 billion as of December 31, 2007. We recognized impairment losses on these securities of $8.9 billion for the three months ended September 30, 2008. We had gross unrealized losses, net of tax, on these securities totaling $14.6 billion and $7.2 billion at September 30, 2008 and December 31, 2007, respectively. The increase in unrealized losses, despite the decline in unpaid principal balance, is due to the significant declines in non-agency mortgage asset prices which occurred during 2008 and which accelerated significantly for Alt-A and other loans, including MTA loans, during the third quarter of 2008. We believe the majority of the declines in the fair value of these securities are attributable to decreased liquidity and larger risk premiums in the mortgage market. See “CONSOLIDATED BALANCE SHEETS ANALYSIS — Retained Portfolio” for further information.

 

GAAP Results

 

Summary of Financial Results for the Three Months Ended September 30, 2008

 

Net loss was $25.3 billion and $1.2 billion for the three months ended September 30, 2008 and 2007, respectively. Net loss increased in the three months ended September 30, 2008 compared to the same period of 2007, principally due to the establishment of a partial valuation allowance on our deferred tax asset, increased losses on investment activities, increased derivative losses, increased losses on our guarantee asset as well as increased credit-related expenses, which consist of the provision for credit losses and REO operations expense. In the third quarter of 2008, we recorded a non-cash charge of

 

$14.3 billion related to the establishment of a partial valuation allowance against our deferred tax asset. The valuation allowance excludes the portion of the deferred tax asset representing the tax effect of unrealized losses on available-for-sale securities recorded in accumulated other comprehensive income, or AOCI, which management has the intent and ability to hold until recovery of the unrealized loss amounts. See “CONSOLIDATED BALANCE SHEETS ANALYSIS — Deferred Tax Asset” for further information. These loss and expense items for the three months ended September 30, 2008 were partially offset by: (a) higher net interest income and income on guarantee obligation; (b) unrealized gains on foreign-currency denominated debt recorded at fair value; (c) lower losses on certain credit guarantees; and (d) lower losses on loans purchased due principally to changes in our operational practice of purchasing delinquent loans out of PC securitization pools in December 2007. As a result of the net loss, at September 30, 2008, our liabilities exceeded our assets under GAAP by $(13.7) billion while our stockholders’ equity (deficit) totaled $(13.8) billion. The Director of FHFA has submitted a request under the Purchase Agreement in the amount of $13.8 billion to Treasury. We expect to receive such funds by November 29, 2008.

 

Net interest income was $1.8 billion for the three months ended September 30, 2008, compared to $761 million for the three months ended September 30, 2007. We held higher amounts of fixed-rate agency mortgage-related securities in our retained portfolio at significantly wider spreads relative to our funding costs during the three months ended September 30, 2008. The increase in net interest income and yield is also due to significantly lower short-term interest rates on our short-term borrowings and lower long-term interest rates on our long-term borrowings for the three months ended September 30, 2008. The combination of a higher proportion of short-term debt, together with a higher proportion of fixed-rate securities within our retained portfolio during a steep yield curve environment, contributed to the improvement in net interest income and net interest yield during the three months ended September 30, 2008.

 

Non-interest income (loss) was $(11.3) billion for the three months ended September 30, 2008, compared to non-interest income of $117 million for the three months ended September 30, 2007. The decrease in non-interest income in the third quarter of 2008 was primarily due to higher losses on investment activity, increased derivative losses, net of related foreign-currency gains and higher losses on our guarantee asset, partially offset by increased income on our guarantee obligation and higher management and guarantee income. Increased losses on investment activity during the third quarter of 2008 were principally attributed to $9.1 billion of security impairments primarily recognized on available-for-sale non-agency mortgage-related securities backed by subprime and Alt-A and other loans during the third quarter of 2008. See “CONSOLIDATED BALANCE SHEET ANALYSIS — Retained Portfolio” for additional information. Income on our guarantee obligation was $783 million and $473 million for the three months ended September 30, 2008 and 2007, respectively. The amortization of income on our guarantee obligation was accelerated in the third quarter of 2008 as compared to the third quarter of 2007 in order to match our economic release from risk on the pools of mortgage loans we guarantee. Management and guarantee income increased 16%, to $832 million for the three months ended September 30, 2008 from $718 million for the three months ended September 30, 2007. This reflects increases in the average balance of our PCs and Structured Securities of 11% on an annualized basis for the three months ended September 30, 2008, as compared to the average balance during the third quarter of 2007. This increase in management and guarantee income also reflects higher average fee rates for the three months ended September 30, 2008 compared to the third quarter of 2007.

 

Non-interest expense for the three months ended September 30, 2008 and 2007 totaled $7.9 billion and $3.1 billion, respectively. This includes normal credit-related expenses of $6.0 billion and $1.4 billion for the three months ended September 30, 2008 and 2007, respectively. For the three months ended September 30, 2008, our provision for credit losses significantly increased due to continued credit deterioration in our single-family credit guarantee portfolio, primarily due to further increases in delinquency rates and higher severity of losses on a per-property basis. Credit deterioration has been largely driven by declines in home prices and regional economic conditions as well as the effect of a greater composition of interest-only and Alt-A mortgage products in the mortgage origination market that we have purchased or guaranteed. REO operations expense increased primarily as a result of an increase in market-based write-downs of REO property due to the decline in home prices, coupled with higher volumes in REO inventory, particularly in the states of California, Florida, Arizona, Michigan and Nevada.

 

Non-interest expense, excluding normal credit-related expenses, for the three months ended September 30, 2008 totaled $1.9 billion compared to $1.7 billion for the three months ended September 30, 2007. The increase in non-interest expense, excluding normal credit-related expenses, was primarily due to a loss of $1.1 billion during the third quarter of 2008, related to the investments in short-term, unsecured loans we made to Lehman in our role as securities administrator for certain trust-related assets offset by decreases in losses on certain credit guarantees and losses on loans purchased. We refer to these transactions with Lehman as the Lehman short-term lending transactions. For more information on the Lehman short-term lending transactions, see “CONSOLIDATED RESULTS OF OPERATIONS — Securities Administrator Loss on Investment Activity.” Losses on certain credit guarantees decreased to $2 million for the three months ended September 30, 2008, compared to $392 million for the three months ended September 30, 2007, due to the change in our method for determining the fair value of our newly-issued guarantee obligation upon adoption of Statement of Accounting Standards, or SFAS,

 

No. 157, “Fair Value Measurements,” or SFAS 157, effective January 1, 2008. Losses on loans purchased decreased to $252 million for the three months ended September 30, 2008, compared to $649 million for the three months ended September 30, 2007, due to changes in our operational practice of purchasing delinquent loans out of PC pools. See “CONSOLIDATED RESULTS OF OPERATIONS — Non-Interest Expense — Losses on Certain Credit Guarantees and — Losses on Loans Purchased,” for additional information on this change in our operational practice. Administrative expenses totaled $308 million for the three months ended September 30, 2008, down from $428 million for the three months ended September 30, 2007 primarily due to a reduction in our short-term performance compensation during the third quarter of 2008 as well as a decrease in our use of consultants throughout 2008. As a percentage of our average total mortgage portfolio, administrative expenses declined to 5.6 basis points for the three months ended September 30, 2008, from 8.7 basis points for the three months ended September 30, 2007.

 

For the three months ended September 30, 2008 and 2007, we recognized effective tax rates of (46)% and 44%, respectively. See “NOTE 12: INCOME TAXES” to our consolidated financial statements for additional information about how our effective tax rate is determined.

 

Summary of Financial Results for the Nine Months Ended September 30, 2008

 

Effective January 1, 2008, we adopted SFAS 157 which defines fair value, establishes a framework for measuring fair value in financial statements and expands required disclosures about fair value measurements. In connection with the adoption of SFAS 157, we changed our method for determining the fair value of our newly-issued guarantee obligations. Under SFAS 157, the initial fair value of our guarantee obligation equals the fair value of compensation received, consisting of management and guarantee fees and other upfront compensation, in the related securitization transaction, which is a practical expedient for determining fair value. As a result, prospectively from January 1, 2008, we no longer record estimates of deferred gains or immediate, “day one” losses on most guarantees. Our adoption of SFAS 157 did not result in an immediate recognition of gain or loss, but the prospective change had a positive impact on our financial results for the three and nine months ended September 30, 2008.

 

Also effective January 1, 2008, we adopted SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities, Including an Amendment of FASB Statement No. 115,” or SFAS 159 or the fair value option, which permits companies to choose to measure certain eligible financial instruments at fair value that are not currently required to be measured at fair value in order to mitigate volatility in reported earnings caused by measuring assets and liabilities differently. We initially elected the fair value option for certain available-for-sale mortgage-related securities and our foreign-currency denominated debt. Upon adoption of SFAS 159, we recognized a $1.0 billion after-tax increase to our retained earnings at January 1, 2008. We may continue to elect the fair value option for certain securities to mitigate interest-rate aspects of our guarantee asset and certain non-hedge designated pay-fixed swaps.

 

Net loss was $26.3 billion and $642 million for the nine months ended September 30, 2008 and 2007, respectively. Net loss increased during the nine months ended September 30, 2008 compared to the same periods of 2007, principally due to the establishment of a partial valuation allowance against our deferred tax asset, increased losses on investment activity primarily related to impairment losses on certain non-agency mortgage-related securities, increased derivative losses, increased losses on guarantee asset as well as an increase in normal credit-related expenses, which consist of our provision for credit losses and REO operations expense. In the third quarter of 2008, we recorded a $14.3 billion non-cash charge related to the establishment of a partial valuation allowance against our deferred tax asset. The valuation allowance excludes the portion of the deferred tax asset representing the tax effect of unrealized losses on available-for-sale securities recorded in AOCI, which management has the intent and ability to hold until recovery of the unrealized loss amounts. These loss and expense items for the nine months ended September 30, 2008 were partially offset by higher net interest income and income on our guarantee obligation as well as lower losses on certain credit guarantees due to our use of the practical expedient for determining fair value under SFAS 157 and lower losses on loans purchased due to changes in our operational practice of purchasing delinquent loans out of PC securitization pools.

 

Net interest income was $4.2 billion for the nine months ended September 30, 2008, compared to $2.3 billion for the nine months ended September 30, 2007. The 2% annualized limitation on the growth of our retained portfolio established by FHFA expired during March of 2008 as we became a timely filer of our financial statements. As a result, we were able to hold higher amounts of fixed-rate agency mortgage-related securities at significantly wider spreads relative to our funding costs during the nine months ended September 30, 2008. Non-interest income (loss) was $(10.4) billion and $1.6 billion for the nine months ended September 30, 2008 and 2007, respectively. The decrease in non-interest income in the 2008 period was primarily due to higher losses on investment activity, higher derivative losses excluding foreign-currency related effects, and higher losses on our guarantee asset. These losses were partially offset by increased income on our guarantee obligation and higher management and guarantee income in the 2008 period. Non-interest expense for the nine months ended September 30, 2008 and 2007 totaled $13.5 billion and $5.8 billion, respectively, and included normal credit-related expenses of $10.3 billion and $2.1 billion, respectively. Non-interest expense, excluding normal credit-related expenses, for the nine

 

months ended September 30, 2008 and 2007 totaled $3.2 billion and $3.7 billion, respectively. The decline in non-interest expense, excluding normal credit-related expenses, was primarily due to the reductions in losses on certain credit guarantees and losses on loans purchased and was partially offset by the $1.1 billion loss on the Lehman short-term lending transactions. Administrative expenses totaled $1.1 billion for the nine months ended September 30, 2008, down from $1.3 billion for the nine months ended September 30, 2007. As a percentage of our average total mortgage portfolio, administrative expenses declined to 6.8 basis points for the nine months ended September 30, 2008, from 8.8 basis points for the nine months ended September 30, 2007.

 

For the nine months ended September 30, 2008 and 2007, we recognized effective tax rates of (33)% and 66%, respectively. See “NOTE 12: INCOME TAXES” to our consolidated financial statements for additional information about how our effective tax rate is determined.

 

Segments

 

We manage our business through three reportable segments subject to the conduct of our business under the direction of the Conservator, as discussed above under “Managing Our Business During Conservatorship — Our Objectives.”:

 

 

Certain activities that are not part of a segment are included in the All Other category. We manage and evaluate the performance of the segments and All Other using a Segment Earnings approach. Segment Earnings differs significantly from, and should not be used as a substitute for, net income (loss) as determined in accordance with GAAP. There are important limitations to using Segment Earnings as a measure of our financial performance. Among them, our regulatory capital measures are based on our GAAP results, as is the need to obtain funding under the Purchase Agreement. Segment Earnings adjusts for the effects of certain gains and losses and mark-to-fair-value items, which depending on market circumstances, can significantly affect, positively or negatively, our GAAP results and have in recent periods caused us to record significant GAAP net losses. GAAP net losses will adversely impact our GAAP stockholders’ equity (deficit), as well as our need for funding under the Purchase Agreement, regardless of results reflected in Segment Earnings. For a summary and description of our financial performance on a segment basis, see “CONSOLIDATED RESULTS OF OPERATIONS — Segment Earnings” and “NOTE 16: SEGMENT REPORTING” to our consolidated financial statements.

 

In managing our business, we present the operating performance of our segments using Segment Earnings. Segment Earnings present our results on an accrual basis as the cash flows from our segments are earned over time. The objective of Segment Earnings is to present our results in a manner more consistent with our business models. The business model for our investment activity is one where we generally buy and hold our investments in mortgage-related assets for the long term, fund our investments with debt and use derivatives to minimize interest rate risk, thus generating net interest income in line with our return on equity objectives. We believe it is meaningful to measure the performance of our investment business using long-term returns, not short-term value. The business model for our credit guarantee activity is one where we are a long-term guarantor in the conforming mortgage markets, manage credit risk and generate guarantee and credit fees, net of incurred credit losses. As a result of these business models, we believe that this accrual-based metric is a meaningful way to present our results as actual cash flows are realized, net of credit losses and impairments. We believe Segment Earnings provides us with a view of our financial results that is more consistent with our business objectives and helps us better evaluate the performance of our business, both from period-to-period and over the longer term.

 

Table 3 presents Segment Earnings (loss) by segment and the All Other category and includes a reconciliation of Segment Earnings (loss) to net income (loss) prepared in accordance with GAAP.

 

Table 3 — Reconciliation of Segment Earnings (Loss) to GAAP Net Income (Loss)

 

 

Investments Segment

 

Our Investments segment is responsible for our investment activity in mortgages and mortgage-related securities, other investments, debt financing and managing our interest-rate risk, liquidity and capital positions. We invest principally in mortgage-related securities and single-family mortgage loans through our mortgage-related investment portfolio.

 

We seek to manage our mortgage-related investments portfolio to generate positive returns while maintaining a disciplined approach to interest-rate risk and capital management. We seek to accomplish this objective through opportunistic purchases, sales and restructurings of mortgage assets and repurchases of liabilities. Although we are primarily a buy-and-hold investor in mortgage assets, we may sell assets that are no longer expected to produce desired results, to reduce risk, to respond to capital constraints, to provide liquidity or to structure certain transactions in order to improve our returns. We currently do not plan to sell assets at a loss. We estimate our expected investment returns using an option-adjusted spread, or OAS, approach. Our Investments segment activities may also include the purchase of mortgages and mortgage-related securities with less attractive investment returns and with incremental risk in order to achieve our mission. Additionally, we maintain a cash and non-mortgage-related securities investment portfolio in this segment to help manage our liquidity needs.

 

Investments segment performance highlights for the three and nine months ended September 30, 2008:

 

 

 

 

Single-family Guarantee Segment

 

In our Single-family Guarantee segment, we securitize substantially all of the newly or recently originated single-family mortgages we have purchased and issue mortgage-related securities called PCs that can be sold to investors or held by us in our Investments segment. We guarantee the payment of principal and interest on our single-family PCs, including those held in our retained portfolio, in exchange for management and guarantee fees, which are paid on a monthly basis as a percentage of the underlying unpaid principal balance of the loans, and initial upfront cash payments referred to as credit or delivery fees. Earnings for this segment consist of management and guarantee fee revenues, including amortization of upfront payments, and trust management fees, less the related credit costs (i.e., provision for credit losses) and operating expenses. Also included is the interest earned on assets held in the Investments segment related to single-family guarantee activities, net of allocated funding costs.

 

Single-family Guarantee segment performance highlights for the three and nine months ended September 30, 2008 and 2007:

 

 

 

 

Multifamily Segment

 

Our Multifamily segment activities include purchases of multifamily mortgages for our retained portfolio and guarantees of payments of principal and interest on multifamily mortgage-related securities and mortgages underlying multifamily housing revenue bonds. The assets of the Multifamily segment include mortgages that finance multifamily rental apartments. Our Multifamily segment also includes certain equity investments in various limited partnerships that sponsor low- and moderate-income multifamily rental apartments, which benefit from low-income housing tax credits, or LIHTC. These activities support our mission to supply financing for affordable rental housing. Also included is the interest earned on assets held in our Investments segment related to multifamily guarantee activities, net of allocated funding costs.

 

Multifamily segment performance highlights for the three and nine months ended September 30, 2008 and 2007:

 

 

Capital Management

 

The conservatorship resulted in changes to the assessment of our capital adequacy and our management of capital. On October 9, 2008, FHFA announced that it was suspending capital classification of us during conservatorship in light of the Purchase Agreement. Concurrent with this announcement, FHFA classified us as undercapitalized as of June 30, 2008 based on discretionary authority provided by statute. FHFA noted that although our capital calculations as of June 30, 2008 reflected that we met the statutory and FHFA-directed requirements for capital, the continued market downturn in July and August of 2008 raised significant questions about the sufficiency of our capital. Factors cited by FHFA leading to the downgrade in our capital classification and the need for conservatorship included (a) our accelerated safety and soundness weaknesses, especially with regard to our credit risk, earnings outlook and capitalization, (b) continued and substantial deterioration in equity, debt and mortgage-related securities market conditions, (c) our current and projected financial performance, (d) our inability to raise capital or issue debt according to normal practices and prices, (e) our critical importance in supporting the U.S. residential mortgage markets and (f) concerns over the proportion of intangible assets as part of our core capital.

 

FHFA will continue to closely monitor our capital levels, but the existing statutory and FHFA-directed regulatory capital requirements will not be binding during conservatorship. We will continue to provide our regular submissions to FHFA on both minimum and risk-based capital. FHFA will publish relevant capital figures (minimum capital requirement, core capital, and GAAP net worth) but does not intend to publish our critical capital, risk-based capital or subordinated debt levels during

 

conservatorship. Additionally, FHFA announced it will engage in rule-making to revise our minimum capital and risk-based capital requirements. See “NOTE 9: REGULATORY CAPITAL” to our consolidated financial statements for our minimum capital requirement, core capital and GAAP net worth results as of September 30, 2008.

 

FHFA has directed us to focus our risk and capital management on maintaining a positive balance of GAAP stockholders’ equity while returning to long-term profitability. FHFA is directing us to manage to a positive stockholders’ equity position in order to reduce the likelihood that we will need to make a draw on the Purchase Agreement with Treasury. The Purchase Agreement provides that, if FHFA determines as of quarter end that our liabilities have exceeded our assets under GAAP, Treasury will contribute funds to us in an amount equal to the difference between such liabilities and assets; a higher amount may be drawn if Treasury and Freddie Mac mutually agree that the draw should be increased beyond the level by which liabilities exceed assets under GAAP. The maximum aggregate amount that may be funded under the Purchase Agreement is $100 billion. At September 30, 2008, our liabilities exceeded our assets under GAAP by $(13.7) billion while our stockholders’ equity (deficit) totaled $(13.8) billion. The Director of FHFA has submitted a request under the Purchase Agreement in the amount of $13.8 billion to Treasury. Under the Reform Act, FHFA must place us into receivership if our assets are less than our obligations for a period of 60 days. If this were to occur, we would be required to obtain funding from Treasury pursuant to its commitment under the Purchase Agreement in order to avoid a mandatory trigger of receivership under the Reform Act.

 

The Purchase Agreement places several restrictions on our business activities, which, in turn, affect our management of capital. For instance, our retained portfolio may not exceed $850 billion as of December 31, 2009 and must then decline by 10% per year until it reaches $250 billion. We are also unable to issue capital stock of any kind without Treasury’s prior approval, other than in connection with the common stock warrant issued to Treasury under the Purchase Agreement or binding agreements in effect on the date of the Purchase Agreement. In addition, on September 7, 2008, the Director of FHFA announced the elimination of dividends on our common and preferred stock, excluding the senior preferred stock, which will accrue quarterly cumulative dividends at a rate of 10% per year or 12% in any quarter in which dividends are not paid in cash until all dividend accruals have been paid in cash. See “Legislative and Regulatory Matters” for additional information regarding covenants under the Purchase Agreement.

 

A variety of factors could materially affect the level and volatility of our GAAP stockholders’ equity (deficit) in future periods, requiring us to make additional draws under the Purchase Agreement. Key factors include continued deterioration in the housing market, which could increase credit expenses; adverse changes in interest rates, the yield curve, implied volatility or mortgage OAS, which could increase realized and unrealized mark-to-market losses recorded in earnings or AOCI; dividend obligations under the Purchase Agreement; establishment of a valuation allowance for our remaining deferred tax assets; changes in accounting practices or standards; or changes in business practices resulting from legislative and regulatory developments or mission fulfillment activities or as directed by the Conservator. At September 30, 2008, our remaining deferred tax assets, which could be subject to a valuation allowance in future periods, totaled $11.9 billion. In addition, during October 2008 mortgage spreads widened significantly, resulting in additional mark-to-market losses included in stockholders’ equity (deficit). As a result of the factors described above, it is difficult for us to manage our stockholders’ equity (deficit). Thus, it may be difficult for us to meet the objective of managing to a positive stockholders’ equity (deficit).

 

If we need additional draws under the Purchase Agreement, this would result in a considerably higher dividend obligation for us. Higher dividends combined with potentially substantial commitment fees payable to Treasury starting in 2010 and limited flexibility to pay down capital draws will have a significant adverse impact on our future financial position and net worth. For additional information concerning the potential impact of the Purchase Agreement, including taking additional large draws, see “RISK FACTORS.”

 

Liquidity

 

Since early July 2008, we have experienced significant deterioration in our access to the unsecured medium- and long-term debt markets and in the yields on our debt as compared to relevant market benchmarks. Consistent demand for our debt securities has decreased for our term debt and callable debt, and the spreads we must pay on our new issuances of short-term debt securities increased.

 

There are many factors contributing to the reduced demand for our debt securities, including continued severe market disruptions, market concerns about our capital position and the future of our business (including its future profitability, future structure, regulatory actions and agency status) and the extent of U.S. government support for our debt securities. In addition, the various U.S. government programs are still being digested by market participants creating uncertainty as to whether competing obligations of other companies are more attractive investments than our debt securities.

 

As noted above, due to our limited ability to issue long-term debt, we have relied increasingly on short-term debt to fund our purchases of mortgage assets and to refinance maturing debt. As a result, we are required to refinance our debt on a more frequent basis, exposing us to an increased risk of insufficient demand, increasing interest rates and adverse credit market conditions. It is unclear when these market conditions will reverse allowing us access to the longer term debt

 

markets. See “LIQUIDITY AND CAPITAL RESOURCES — Liquidity” for more information on our debt funding activities and risks posed by our current market challenges and “Part II — Item 1A — Risk Factors” for a discussion of the risks to our business posed by our reliance on the issuance of debt to fund our operations.

 

Fair Value Results

 

Our consolidated fair value measurements are a component of our risk management processes, as we use daily estimates of the changes in fair value to calculate our Portfolio Market Value Sensitivity, or PMVS, and duration gap measures.

 

During the three months ended September 30, 2008, the fair value of net assets, before capital transactions, decreased by $36.7 billion compared to a $8.4 billion decrease during the three months ended September 30, 2007. Included in the reduction of the fair value of net assets is $19.4 billion related to our partial valuation allowance for our deferred tax asset for the three months ended September 30, 2008.

 

Our attribution of changes in the fair value of net assets relies on models, assumptions and other measurement techniques that evolve over time. The following attribution of changes in fair value reflects our current estimate of the items presented (on a pre-tax basis) and excludes the effect of returns on capital and administrative expenses.

 

During the three months ended September 30, 2008, our investment activities decreased fair value by approximately $12.2 billion. This estimate includes declines in fair value of approximately $5.3 billion attributable to the net widening of mortgage-to-debt OAS. Of this amount, approximately $7.9 billion was related to the impact of the net mortgage-to-debt OAS widening on our portfolio of non-agency mortgage-related securities with a limited, but increasing amount attributable to the risk of future losses, as well as an $11.1 billion decrease in negative fair value from our preferred stock. The reduction in fair value was partially offset by our higher core spread income. Core spread income on our retained portfolio is a fair value estimate of the net current period accrual of income from the spread between mortgage-related investments and debt, calculated on an option-adjusted basis.

 

During the three months ended September 30, 2007, our investment activities decreased fair value by approximately $6.2 billion. This estimate includes declines in fair value of approximately $8.0 billion attributable to the net widening of mortgage-to-debt OAS. Of this amount, approximately $3.5 billion was related to the impact of the net mortgage-to-debt OAS widening on our portfolio of non-agency mortgage-related securities.

 

The impact of mortgage-to-debt OAS widening during the three months ended September 30, 2008 decreased the current fair value of our investment activities. Due to the relatively wide OAS levels for purchases during the period, there is a likelihood that, in future periods, we will be able to recognize core-spread income from our investment activities at a higher spread level than historically. We estimate that for the three months ended September 30, 2008, we will recognize core spread income at a net mortgage-to-debt OAS level of approximately 190 to 210 basis points in the long run, as compared to approximately 60 to 70 basis points estimated for the three months ended September 30, 2007. As market conditions change, our estimate of expected fair value gains from OAS may also change, leading to significantly different fair value results.

 

During the three months ended September 30, 2008, our credit guarantee activities, including our single-family whole loan credit exposure, decreased fair value by an estimated $8.1 billion. This estimate includes an increase in the single-family guarantee obligation of approximately $6.3 billion, primarily attributable to an increase in expected default costs.

 

During the three months ended September 30, 2007, our credit guarantee activities decreased fair value by an estimated $6.4 billion. This estimate includes an increase in the single-family guarantee obligation of approximately $7.6 billion, primarily attributable to the market’s pricing of mortgage credit. This increase in the single-family guarantee obligation was partially offset by a fair value increase in the single-family guarantee asset of approximately $0.5 billion and cash receipts primarily related to management and guarantee fees and other up-front fees related to new business.

 

See “CONSOLIDATED FAIR VALUE BALANCE SHEETS ANALYSIS” for additional information regarding attribution of changes in the fair value of net assets for the nine months ended September 30, 2008.

 

Legislative and Regulatory Matters

 

Conservatorship and Treasury Agreements

 

Conservatorship

 

On September 6, 2008, FHFA, our safety, soundness and mission regulator, was appointed as our Conservator when the Director of FHFA placed us into conservatorship. The conservatorship is a statutory process designed to preserve and conserve our assets and property, and put the company in a sound and solvent condition. As Conservator, FHFA has assumed the powers of our Board of Directors and management, as well as the powers of our stockholders. The powers of the Conservator under the Reform Act are summarized below.

 

The conservatorship has no specified termination date. In a Fact Sheet issued by FHFA on September 7, 2008, FHFA indicated that the Director of FHFA will issue an order terminating the conservatorship upon the Director’s determination that the Conservator’s plan to restore the company to a safe and solvent condition has been completed successfully. The FHFA’s

 

September 7, 2008 Fact Sheet also indicated that, at present, there is no time frame that can be given as to when the conservatorship may end.

 

General Powers of the Conservator Pursuant to the Reform Act

 

Upon its appointment, the Conservator immediately succeeded to all rights, titles, powers and privileges of Freddie Mac, and of any stockholder, officer or director of Freddie Mac with respect to Freddie Mac and its assets, and succeeded to the title to all books, records and assets of Freddie Mac held by any other legal custodian or third party. The Conservator has the power to take over our assets and operate our business with all the powers of our stockholders, directors and officers, and to conduct all business of the company.

 

The Conservator may take any actions it determines are necessary and appropriate to carry on our business and preserve and conserve our assets and property. The Conservator’s powers include the ability to transfer or sell any of our assets or liabilities (subject to limitations and post-transfer notice provisions for transfers of qualified financial contracts, as defined below under “Special Powers of the Conservator — Security Interests Protected; Exercise of Rights Under Qualified Financial Contracts”) without any approval, assignment of rights or consent. The Reform Act, however, provides that mortgage loans and mortgage-related assets that have been transferred to a Freddie Mac securitization trust must be held for the beneficial owners of the trust and cannot be used to satisfy our general creditors.

 

In connection with any sale or disposition of our assets, the Conservator must conduct its operations to maximize the net present value return from the sale or disposition, to minimize the amount of any loss realized, and to ensure adequate competition and fair and consistent treatment of offerors. The Conservator is required to pay all of our valid obligations that were due and payable on September 6, 2008 (the date we were placed into conservatorship), but only to the extent that the proceeds realized from the performance of contracts or sale of our assets are sufficient to satisfy those obligations. In addition, the Conservator is required to maintain a full accounting of the conservatorship and make its reports available upon request to stockholders and members of the public.

 

We remain liable for all of our obligations relating to our outstanding debt and mortgage-related securities. In a Fact Sheet dated September 7, 2008, FHFA indicated that our obligations will be paid in the normal course of business during the conservatorship.

 

Special Powers of the Conservator Under the Reform Act

 

     Disaffirmance and Repudiation of Contracts

 

The Conservator may disaffirm or repudiate contracts (subject to certain limitations for qualified financial contracts) that we entered into prior to its appointment as Conservator if it determines, in its sole discretion, that performance of the contract is burdensome and that disaffirmation or repudiation of the contract promotes the orderly administration of our affairs. The Reform Act requires FHFA to exercise its right to disaffirm or repudiate most contracts within a reasonable period of time after its appointment as Conservator. As of November 14, 2008, the Conservator had not determined whether or not such reasonable period of time had passed for purposes of the applicable provisions of the Reform Act.

 

As of November 14, 2008, the Conservator has advised us that it has not disaffirmed or repudiated any contracts we entered into prior to its appointment as Conservator. We can, and have continued to, enter into and enforce contracts with third parties.

 

The Conservator has advised us that it has no intention of repudiating any guarantee obligation relating to Freddie Mac’s mortgage-related securities because it views repudiation as incompatible with the goals of the conservatorship. In addition, as noted above, the Conservator cannot use mortgage loans or mortgage-related assets that have been transferred to a securitization trust to satisfy the general creditors of the company. The Conservator must hold these assets for the beneficial owners of the related Freddie Mac mortgage-related securities.

 

In general, the liability of the Conservator for the disaffirmance or repudiation of any contract is limited to actual direct compensatory damages determined as of September 6, 2008, which is the date we were placed into conservatorship. The liability of the Conservator for the disaffirmance or repudiation of a qualified financial contract is limited to actual direct compensatory damages determined as of the date of the disaffirmance or repudiation. If the Conservator disaffirms or repudiates any lease to or from us, or any contract for the sale of real property, the Reform Act specifies the liability of the Conservator.

 

     Limitations on Enforcement of Contractual Rights by Counterparties

 

The Reform Act provides that the Conservator may enforce most contracts entered into by us, notwithstanding any provision of the contract that provides for termination, default, acceleration, or exercise of rights upon the appointment of, or the exercise of rights or powers by, a conservator.

 

     Security Interests Protected; Exercise of Rights Under Qualified Financial Contracts

 

Notwithstanding the Conservator’s powers described above, the Conservator must recognize legally enforceable or perfected security interests, except where such an interest is taken in contemplation of our insolvency or with the intent to hinder, delay or defraud us or our creditors. In addition, the Reform Act provides that no person will be stayed or prohibited from exercising specified rights in connection with qualified financial contracts, including termination or acceleration (other than solely by reason of, or incidental to, the appointment of the Conservator), rights of offset, and rights under any security agreement or arrangement or other credit enhancement relating to such contract. The term qualified financial contract means any securities contract, commodity contract, forward contract, repurchase agreement, swap agreement and any similar agreement, as determined by FHFA.

 

     Avoidance of Fraudulent Transfers

 

The Conservator may avoid, or refuse to recognize, a transfer of any property interest of Freddie Mac or of any of our debtors, and also may avoid any obligation incurred by Freddie Mac or by any debtor of Freddie Mac, if the transfer or obligation was made: (1) within five years of September 6, 2008; and (2) with the intent to hinder, delay, or defraud Freddie Mac, FHFA, the Conservator or, in the case of a transfer in connection with a qualified financial contract, our creditors. To the extent a transfer is avoided, the Conservator may recover, for our benefit, the property or, by court order, the value of that property from the initial or subsequent transferee, unless the transfer was made for value and in good faith. These rights are superior to any rights of a trust or any other party, other than a federal agency, under the U.S. bankruptcy code.

 

     Modification of Statutes of Limitations

 

Under the Reform Act, notwithstanding any provision of any contract, the statute of limitations with regard to any action brought by the Conservator is: (1) for claims relating to a contract, the longer of six years or the applicable period under state law; and (2) for tort claims, the longer of three years or the applicable period under state law, in each case, from the later of September 6, 2008 or the date on which the cause of action accrues. In addition, notwithstanding the state law statute of limitation for tort claims, the Conservator may bring an action for any tort claim that arises from fraud, intentional misconduct resulting in unjust enrichment, or intentional misconduct resulting in substantial loss to us, if the state’s statute of limitations expired not more than five years before September 6, 2008.

 

     Suspension of Legal Actions

 

In any judicial action or proceeding to which we are or become a party, the Conservator may request, and the applicable court must grant, a stay for a period not to exceed 45 days.

 

     Treatment of Breach of Contract Claims

 

Any final and unappealable judgment for monetary damages against the Conservator for breach of an agreement executed or approved in writing by the Conservator will be paid as an administrative expense of the Conservator.

 

     Attachment of Assets and Other Injunctive Relief

 

The Conservator may seek to attach assets or obtain other injunctive relief without being required to show that any injury, loss or damage is irreparable and immediate.

 

     Subpoena Power

 

The Reform Act provides the Conservator, with the approval of the Director of FHFA, with subpoena power for purposes of carrying out any power, authority or duty with respect to Freddie Mac.

 

     Current Management of the Company Under Conservatorship

 

As noted above, as our Conservator, FHFA has assumed the powers of our Board of Directors. Accordingly, the current Board of Directors acts with neither the power nor the duty to manage, direct or oversee our business and affairs. The Conservator has indicated that it intends to appoint a full Board of Directors to which it will delegate specified roles and responsibilities. Until FHFA has made these delegations, our Board of Directors has no power to determine the general policies that govern our operations, to create committees and elect the members of those committees, to select our officers, to manage, direct or oversee our business and affairs, or to exercise any of the other powers of the Board of Directors that are set forth in our charter and bylaws.

 

FHFA, in its role as Conservator, has overall management authority over our business. During the conservatorship, the Conservator has delegated authority to management to conduct day-to-day operations so that the company can continue to operate in the ordinary course of business. The Conservator retains the authority to withdraw its delegations to management at any time. The Conservator is working actively with management to address and determine the strategic direction for the enterprise, and in general has retained final decision-making authority in areas regarding: significant impacts on operational, market, reputational or credit risk; major accounting determinations, including policy changes; the creation of subsidiaries or affiliates and transacting with them; significant litigation; setting executive compensation; retention of external auditors;

 

significant mergers and acquisitions; and any other matters the Conservator believes are strategic or critical to the enterprise in order for the Conservator to fulfill its obligations during conservatorship.

 

Treasury Agreements

 

The Reform Act granted Treasury temporary authority (through December 31, 2009) to purchase any obligations and other securities issued by Freddie Mac on such terms and conditions and in such amounts as Treasury may determine, upon mutual agreement between Treasury and Freddie Mac. As of November 14, 2008, Treasury had used this authority as follows:

 

Agreement and Related Issuance of Senior Preferred Stock and Common Stock Warrant

 

     Purchase Agreement

 

On September 7, 2008, we, through FHFA, in its capacity as Conservator, and Treasury entered into the Purchase Agreement. The Purchase Agreement was subsequently amended and restated on September 26, 2008. Pursuant to the Purchase Agreement, we agreed to issue to Treasury one million shares of senior preferred stock with an initial liquidation preference equal to $1,000 per share (for an aggregate liquidation preference of $1 billion), and a warrant for the purchase of our common stock. The terms of the senior preferred stock and warrant are summarized in separate sections below. We did not receive any cash proceeds from Treasury as a result of issuing the senior preferred stock or the warrant.

 

The senior preferred stock and warrant were sold and issued to Treasury as an initial commitment fee in consideration of the commitment from Treasury to provide up to $100 billion in funds to us under the terms and conditions set forth in the Purchase Agreement. In addition to the issuance of the senior preferred stock and warrant, beginning on March 31, 2010, we are required to pay a quarterly commitment fee to Treasury. This quarterly commitment fee will accrue from January 1, 2010. The fee, in an amount to be mutually agreed upon by us and Treasury and to be determined with reference to the market value of Treasury’s funding commitment as then in effect, will be determined on or before December 31, 2009, and will be reset every five years. Treasury may waive the quarterly commitment fee for up to one year at a time, in its sole discretion, based on adverse conditions in the U.S. mortgage market. We may elect to pay the quarterly commitment fee in cash or add the amount of the fee to the liquidation preference of the senior preferred stock.

 

The Purchase Agreement provides that, on a quarterly basis, we generally may draw funds up to the amount, if any, by which our total liabilities exceed our total assets, as reflected on our GAAP balance sheet for the applicable fiscal quarter (referred to as the deficiency amount), provided that the aggregate amount funded under the Purchase Agreement may not exceed $100 billion. The Purchase Agreement provides that the deficiency amount will be calculated differently if we become subject to receivership or other liquidation process. The deficiency amount may be increased above the otherwise applicable amount upon our mutual written agreement with Treasury. In addition, if the Director of FHFA determines that the Director will be mandated by law to appoint a receiver for us unless our capital is increased by receiving funds under the commitment in an amount up to the deficiency amount (subject to the $100 billion maximum amount that may be funded under the agreement), then FHFA, in its capacity as our Conservator, may request that Treasury provide funds to us in such amount. The Purchase Agreement also provides that, if we have a deficiency amount as of the date of completion of the liquidation of our assets, we may request funds from Treasury in an amount up to the deficiency amount (subject to the $100 billion maximum amount that may be funded under the agreement). Any amounts that we draw under the Purchase Agreement will be added to the liquidation preference of the senior preferred stock. No additional shares of senior preferred stock are required to be issued under the Purchase Agreement.

 

The Purchase Agreement provides that the Treasury’s funding commitment will terminate under any the following circumstances: (1) the completion of our liquidation and fulfillment of Treasury’s obligations under its funding commitment at that time; (2) the payment in full of, or reasonable provision for, all of our liabilities (whether or not contingent, including mortgage guarantee obligations); and (3) the funding by Treasury of $100 billion under the Purchase Agreement. In addition, Treasury may terminate its funding commitment and declare the Purchase Agreement null and void if a court vacates, modifies, amends, conditions, enjoins, stays or otherwise affects the appointment of the Conservator or otherwise curtails the Conservator’s powers. Treasury may not terminate its funding commitment under the agreement solely by reason of our being in conservatorship, receivership or other insolvency proceeding, or due to our financial condition or any adverse change in our financial condition.

 

The Purchase Agreement provides that most provisions of the agreement may be waived or amended by mutual written agreement of the parties; however, no waiver or amendment of the agreement is permitted that would decrease Treasury’s aggregate funding commitment or add conditions to Treasury’s funding commitment if the waiver or amendment would adversely affect in any material respect the holders of our debt securities or Freddie Mac mortgage guarantee obligations.

 

In the event of our default on payments with respect to our debt securities or Freddie Mac mortgage guarantee obligations, if Treasury fails to perform its obligations under its funding commitment and if we and/or the Conservator are not diligently pursuing remedies in respect of that failure, the holders of these debt securities or Freddie Mac mortgage

 

guarantee obligations may file a claim in the United States Court of Federal Claims for relief requiring Treasury to fund to us the lesser of: (1) the amount necessary to cure the payment defaults on our debt and Freddie Mac mortgage guarantee obligations; and (2) the lesser of: (a) the deficiency amount; and (b) $100 billion less the aggregate amount of funding previously provided under the commitment. Any payment that Treasury makes under those circumstances will be treated for all purposes as a draw under the Purchase Agreement that will increase the liquidation preference of the senior preferred stock.

 

The Purchase Agreement includes several covenants that significantly restrict our business activities, which are described below under “Covenants Under Treasury Agreements — Purchase Agreement Covenants.”

 

The Purchase Agreement is filed as an exhibit to this Form 10-Q.

 

     Issuance of Senior Preferred Stock

 

Pursuant to the Purchase Agreement described above, we issued one million shares of senior preferred stock to Treasury on September 8, 2008. The senior preferred stock was issued to Treasury in partial consideration of Treasury’s commitment to provide up to $100 billion in funds to us under the terms set forth in the Purchase Agreement.

 

Shares of the senior preferred stock have no par value, and have a stated value and initial liquidation preference equal to $1,000 per share. The liquidation preference of the senior preferred stock is subject to adjustment. Dividends that are not paid in cash for any dividend period will accrue and be added to the liquidation preference of the senior preferred stock. In addition, any amounts Treasury pays to us pursuant to its funding commitment under the Purchase Agreement and any quarterly commitment fees that are not paid in cash to Treasury or waived by Treasury will be added to the liquidation preference of the senior preferred stock. As described below, we may make payments to reduce the liquidation preference of the senior preferred stock.

 

Holders of the senior preferred stock are entitled to receive, when, as and if declared by our Board of Directors, cumulative quarterly cash dividends at the annual rate of 10% per year on the then-current liquidation preference of the senior preferred stock. The initial dividend, if declared, will be payable on December 31, 2008 and will be for the period from but not including September 8, 2008 through and including December 31, 2008. If at any time we fail to pay cash dividends in a timely manner, then immediately following such failure and for all dividend periods thereafter until the dividend period following the date on which we have paid in cash full cumulative dividends (including any unpaid dividends added to the liquidation preference), the dividend rate will be 12% per year.

 

The senior preferred stock ranks ahead of our common stock and all other outstanding series of our preferred stock, as well as any capital stock we issue in the future, as to both dividends and rights upon liquidation. The senior preferred stock provides that we may not, at any time, declare or pay dividends on, make distributions with respect to, or redeem, purchase or acquire, or make a liquidation payment with respect to, any common stock or other securities ranking junior to the senior preferred stock unless: (1) full cumulative dividends on the outstanding senior preferred stock (including any unpaid dividends added to the liquidation preference) have been declared and paid in cash; and (2) all amounts required to be paid with the net proceeds of any issuance of capital stock for cash (as described in the following paragraph) have been paid in cash. Shares of the senior preferred stock are not convertible. Shares of the senior preferred stock have no general or special voting rights, other than those set forth in the certificate of designation for the senior preferred stock or otherwise required by law. The consent of holders of at least two-thirds of all outstanding shares of senior preferred stock is generally required to amend the terms of the senior preferred stock or to create any class or series of stock that ranks prior to or on parity with the senior preferred stock.

 

We are not permitted to redeem the senior preferred stock prior to the termination of Treasury’s funding commitment set forth in the Purchase Agreement; however, we are permitted to pay down the liquidation preference of the outstanding shares of senior preferred stock to the extent of (1) accrued and unpaid dividends previously added to the liquidation preference and not previously paid down; and (2) quarterly commitment fees previously added to the liquidation preference and not previously paid down. In addition, if we issue any shares of capital stock for cash while the senior preferred stock is outstanding, the net proceeds of the issuance must be used to pay down the liquidation preference of the senior preferred stock; however, the liquidation preference of each share of senior preferred stock may not be paid down below $1,000 per share prior to the termination of Treasury’s funding commitment. Following the termination of Treasury’s funding commitment, we may pay down the liquidation preference of all outstanding shares of senior preferred stock at any time, in whole or in part. If, after termination of Treasury’s funding commitment, we pay down the liquidation preference of each outstanding share of senior preferred stock in full, the shares will be deemed to have been redeemed as of the payment date.

 

The certificate of designation for the senior preferred stock is incorporated by reference as an exhibit to this Form 10-Q.

 

     Issuance of Common Stock Warrant

 

Pursuant to the Purchase Agreement described above, on September 7, 2008, we, through FHFA, in its capacity as Conservator, issued a warrant to purchase common stock to Treasury. The warrant was issued to Treasury in partial

 

consideration of Treasury’s commitment to provide up to $100 billion in funds to us under the terms set forth in the Purchase Agreement.

 

The warrant gives Treasury the right to purchase shares of our common stock equal to 79.9% of the total number of shares of our common stock outstanding on a fully diluted basis on the date of exercise. The warrant may be exercised in whole or in part at any time on or before September 7, 2028, by delivery to us of: (a) a notice of exercise; (b) payment of the exercise price of $0.00001 per share; and (c) the warrant. If the market price of one share of our common stock is greater than the exercise price, then, instead of paying the exercise price, Treasury may elect to receive shares equal to the value of the warrant (or portion thereof being canceled) pursuant to the formula specified in the warrant. Upon exercise of the warrant, Treasury may assign the right to receive the shares of common stock issuable upon exercise to any other person. The warrant contains several covenants, which are described under “Covenants Under Treasury Agreements — Treasury Warrant Covenants.”

 

As of November 14, 2008, Treasury has not exercised the warrant. The warrant is incorporated by reference as an exhibit to this Form 10-Q.

 

Lending Agreement

 

On September 18, 2008, we entered into the Lending Agreement with Treasury under which we may request loans until December 31, 2009. Loans under the Lending Agreement require approval from Treasury at the time of request. Treasury is not obligated under the Lending Agreement to make, increase, renew or extend any loan to us. The Lending Agreement does not specify a maximum amount that may be borrowed thereunder, but any loans made to us by Treasury pursuant to the Lending Agreement must be collateralized by Freddie Mac or Fannie Mae mortgage-backed securities. Further, unless amended or waived by Treasury, the amount we may borrow under the Lending Agreement is limited by the restriction under the Purchase Agreement on incurring debt in excess of 110% of our aggregate indebtedness as of June 30, 2008.

 

The Lending Agreement does not specify the maturities or interest rate of loans that may be made by Treasury under the credit facility. In a Fact Sheet regarding the credit facility published by Treasury on September 7, 2008, Treasury indicated that loans made pursuant to the credit facility will be for short-term durations and would in general be expected to be for less than one month but no shorter than one week. The Fact Sheet further indicated that the interest rate on loans made pursuant to the credit facility ordinarily will be based on daily LIBOR, fixed for a similar term of the loan plus 50 basis points. Given that the interest rate we are likely to be charged under the credit facility will be significantly higher than the rates we have historically achieved through the sale of unsecured debt, use of the facility in significant amounts could have a material adverse impact on our financial results.

 

As of November 14, 2008, we have not requested any loans or borrowed any amounts under the Lending Agreement.

 

For a description of the covenants contained in the Lending Agreement, refer to “Covenants under Treasury Agreements — Lending Agreement Covenants” below. For additional information on the terms of the Lending Agreement, refer to our Current Report on Form 8-K filed with the SEC on September 23, 2008 and a copy of the Lending Agreement is incorporated by reference as an exhibit to this Form 10-Q.

 

Covenants under Treasury Agreements

 

The Purchase Agreement, warrant and Lending Agreement contain covenants that significantly restrict our business activities. These covenants, which are summarized below, include a prohibition on our issuance of additional equity securities (except in limited instances), a prohibition on the payment of dividends or other distributions on our equity securities (other than the senior preferred stock or warrant), a prohibition on our issuance of subordinated debt and a limitation on the total amount of debt securities we may issue. As a result, we can no longer obtain additional equity financing (other than pursuant to the Purchase Agreement ) and we are limited in the amount and type of debt financing we may obtain.

 

Purchase Agreement Covenants

 

The Purchase Agreement provides that, until the senior preferred stock is repaid or redeemed in full, we may not, without the prior written consent of Treasury:

 

 

 

 

The Purchase Agreement also provides that we may not own mortgage assets in excess of: (a) $850 billion on December 31, 2009; or (b) on December 31 of each year thereafter, 90% of the aggregate amount of our mortgage assets as of December 31 of the immediately preceding calendar year, provided that we are not required to own less than $250 billion in mortgage assets.

 

In addition, the Purchase Agreement provides that we may not enter into any new compensation arrangements or increase amounts or benefits payable under existing compensation arrangements of any named executive officer (as defined by SEC rules) without the consent of the Director of FHFA, in consultation with the Secretary of the Treasury.

 

We are required under the Purchase Agreement to provide annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K to Treasury in accordance with the time periods specified in the SEC’s rules. In addition, our designated representative (which, during the conservatorship, is the Conservator) is required to provide quarterly certifications to Treasury certifying compliance with the covenants contained in the Purchase Agreement and the accuracy of the representations made pursuant to the agreement. We also are obligated to provide prompt notice to Treasury of the occurrence of specified events, such as the filing of a lawsuit that would reasonably be expected to have a material adverse effect. As of November 13, 2008, we believe we were in compliance with the covenants under the Purchase Agreement.

 

For a summary of the terms of the Purchase Agreement, see “Purchase Agreement and Related Issuance of Senior Preferred Stock and Common Stock Warrant — Purchase Agreement” above. For the complete terms of the covenants, see the copy of the Purchase Agreement filed as an exhibit to this Form 10-Q.

 

Warrant Covenants

 

The warrant we issued to Treasury includes, among others, the following covenants: our SEC filings under the Exchange Act will comply in all material respects as to form with the Exchange Act and the rules and regulations thereunder; we may not permit any of our significant subsidiaries to issue capital stock or equity securities, or securities convertible into or exchangeable for such securities, or any stock appreciation rights or other profit participation rights; we may not take any action that will result in an increase in the par value of our common stock; we may not take any action to avoid the observance or performance of the terms of the warrant and we must take all actions necessary or appropriate to protect Treasury’s rights against impairment or dilution; and we must provide Treasury with prior notice of specified actions relating to our common stock, such as setting a record date for a dividend payment, granting subscription or purchase rights, authorizing a recapitalization, reclassification, merger or similar transaction, commencing a liquidation of the company or any other action that would trigger an adjustment in the exercise price or number or amount of shares subject to the warrant.

 

The warrant remains outstanding through September 7, 2028.

 

As of November 13, 2008, we believe we were in compliance with the covenants under the warrant. For a summary of the terms of the warrant, see “Purchase Agreement and Related Issuance of Senior Preferred Stock and Common Stock Warrant — Issuance of Common Stock Warrant” above. For the complete terms of the covenants contained in the warrant, a copy of the warrant is incorporated by reference as an exhibit to this Form 10-Q.

 

Lending Agreement Covenants

 

The Lending Agreement includes covenants requiring us, among other things:

 

 

 

 

The Lending Agreement expires on December 31, 2009.

 

As of November 13, 2008, we believe we were in compliance with the covenants under the Lending Agreement. For a summary of the terms of the Lending Agreement, see “Lending Agreement” above. For the complete terms of the covenants contained in the Lending Agreement, a copy of the agreement is incorporated by reference as an exhibit to this Form 10-Q.

 

Effect of Conservatorship and Treasury Agreements on Existing Stockholders

 

The conservatorship and Purchase Agreement have materially limited the rights of our common and preferred stockholders (other than Treasury as holder of the senior preferred stock). The conservatorship has had the following adverse effects on our common and preferred stockholders:

 

 

The Purchase Agreement and the senior preferred stock and warrant issued to Treasury pursuant to the agreement have had the following adverse effects on our common and preferred stockholders:

 

 

As described above, the conservatorship and Treasury agreements also impact our business in ways that indirectly affect our common and preferred stockholders. By their terms, the Purchase Agreement, senior preferred stock and warrant will continue to exist even if we are released from the conservatorship. For a description of the risks to our business relating to the conservatorship and Treasury agreements, see “ITEM 1A. RISK FACTORS.”

 

Treasury Mortgage-Backed Securities Purchase Program

 

Pursuant to its authority under our charter, as amended by the Reform Act, on September 7, 2008, Treasury announced a program under which Treasury will purchase GSE mortgage-backed securities in the open market. The size and timing of Treasury’s investments in GSE mortgage-backed securities will be subject to the discretion of the Secretary of the Treasury. The scale of the program will be based on developments in the capital markets and housing markets. Treasury’s authority to purchase GSE mortgage-backed securities expires on December 31, 2009.

 

New York Stock Exchange Matters

 

As of November 14, 2008, our common stock continues to trade on the New York Stock Exchange, or NYSE. We have been in discussions with the staff of the NYSE regarding the effect of the conservatorship on our ongoing compliance with the rules of the NYSE and the continued listing of our stock on the NYSE in light of the unique circumstances of the conservatorship. To date, we have not been informed of any non-compliance by the NYSE.

 

Other Regulatory Matters

 

FHFA is responsible for implementing the various provisions of the Reform Act. In a statement published on September 7, 2008, the Director of FHFA indicated that FHFA will continue to work expeditiously on the many regulations needed to implement the new legislation, and that some of the key regulations will address minimum capital standards, prudential safety and soundness standards and portfolio limits. In general, we remain subject to existing regulations, orders and determinations until new ones are issued or made.

 

Since we entered into conservatorship on September 6, 2008, FHFA has taken the following actions relating to the implementation of provisions of the Reform Act.

 

Adoption by FHFA of Regulation Relating to Golden Parachute Payments

 

FHFA issued interim final regulations pursuant to the Reform Act relating to “golden parachute payments” in September 2008. Under these regulations, FHFA may limit golden parachute payments as defined. On September 14, 2008, the Director of FHFA notified us that severance and other payments contemplated in the employment contract of Richard F. Syron, our former Chairman and Chief Executive Officer, are golden parachute payments within the meaning of the Reform Act and that these payments should not be paid, effective immediately. On September 22, 2008, the Director of FHFA notified us that severance payments contemplated in the employment agreement of Anthony S. Piszel, our former Chief Financial Officer, are golden parachute payments within the meaning of the Reform Act and should not be paid. Patricia L. Cook, our former Chief Business Officer, also will not receive severance payments contemplated under her employment agreement.

 

Suspension of Regulatory Capital Requirements During Conservatorship

 

As described in “Capital Management,” FHFA announced in October 2008 that our existing statutory and FHFA-directed regulatory capital requirements will not be binding during the conservatorship.

 

Subordinated Debt

 

FHFA has directed us to continue to make interest and principal payments on our subordinated debt, even if we fail to maintain required capital levels. As a result, the terms of any of our subordinated debt that provide for us to defer payments of interest under certain circumstances, including our failure to maintain specified capital levels, are no longer applicable. In addition, the requirements in the agreement we entered into with FHFA in September 2005 with respect to issuance, maintenance, and reporting and disclosure of Freddie Mac subordinated debt have been suspended during the term of conservatorship and thereafter until directed otherwise.

 

Emergency Economic Stabilization Act of 2008, or EESA

 

On October 3, 2008, the President signed into law the EESA which among other actions, gave further authority to Treasury to purchase or guarantee financial assets from financial institutions in the public market. The EESA also requires FHFA, as Conservator, to implement a plan for delinquent single family and multifamily mortgage loans (including mortgage-backed securities and asset-backed securities) to maximize assistance for homeowners and encourage servicers to take advantage of the HOPE for Homeowners Program implemented by the U.S. Department of Housing and Urban Development, or HUD, or other available programs to minimize foreclosure. FHFA must develop and begin implementing a plan 60 days after the date of enactment. We cannot predict the content of the plan FHFA may implement or its effect on our business.

 

Mission and Affordable Housing Goals

 

As was the case in 2007, market conditions are making it harder to meet certain affordable housing targets. Nevertheless, we estimate that our affordable mortgage purchases will substantially mirror the levels of goal-qualifying loans being originated in the market today.

 

On September 12, 2008, FHFA issued a statement indicating that support for multifamily housing finance is central to our public purpose and that the conservatorship does not affect existing contracts, our authority to enter into new contracts, or their enforceability. The statement indicated that FHFA, as Conservator, expects us to continue underwriting and financing sound multifamily business.

 

On October 27, 2008, FHFA issued a letter finding that we had officially met or exceeded the affordable housing goals for 2007, except for the two subgoals which HUD had previously determined to be infeasible.

 

Conforming Loan Limits

 

On November 7, 2008, FHFA announced that the conforming loan limit will remain $417,000 for 2009, with higher limits in certain cities and counties.

 

Pursuant to the Reform Act, FHFA has set loan limits for certain “high-cost” areas in 2009. These limits are set equal to 115% of area median house prices and cannot exceed 150% of the base limit, or $625,500 for a one-unit property. The new limits affect loans purchased in 2009.

 

 

 

 

The following discussion of our consolidated results of operations should be read in conjunction with our consolidated financial statements including the accompanying notes. Also see “CRITICAL ACCOUNTING POLICIES AND ESTIMATES” for more information concerning our more significant accounting policies and estimates applied in determining our reported financial position and results of operations.

 

Table 4 — Summary Consolidated Statements of Income — GAAP Results

 

 

Net Interest Income

 

Table 5 presents an analysis of net interest income, including average balances and related yields earned on assets and incurred on liabilities.

 

Table 5 — Net Interest Income/Yield and Average Balance Analysis

 

 

 

 

Net interest income and net interest yield on a fully taxable-equivalent basis increased during the three and nine months ended September 30, 2008 compared to the three and nine months ended September 30, 2007. During the latter half of the first quarter of 2008 and continuing into the second quarter of 2008, liquidity concerns in the market resulted in more favorable investment opportunities for agency mortgage-related securities at wider spreads. In response, we increased our purchase activities resulting in an increase in the average balance of our interest-earning assets. The increases in net interest income and net interest yield on a fully taxable-equivalent basis are primarily attributable to both the purchases of fixed-rate assets at wider spreads relative to our funding costs and the replacement of higher cost short- and long-term debt with lower cost debt issuances. Interest income for the third quarter of 2008 includes $80 million of income related to the accretion of other-than-temporary impairments of investments in available-for-sale securities recorded in the second quarter of 2008. Net interest income and net interest yield for the three and nine months ended September 30, 2008 also benefited from funding fixed-rate assets with a higher proportion of short-term debt in a steep yield curve environment as well as replacing higher cost long-term debt with lower cost issuances. However, our use of short-term debt funding has also been driven by the unprecedented levels of volatility in the worldwide financial markets, which has limited our ability to obtain long-term and callable debt funding. During the first nine months of 2008, our short-term funding balances increased significantly when compared to the first nine months of 2007. We seek to manage interest rate risk by attempting to substantially match the duration characteristics of our assets and liabilities. To accomplish this, we use a strategy that involves asset and liability portfolio management, including the use of derivatives for purposes of rebalancing the portfolio and maintaining low PMVS and duration gap. While we use interest rate derivatives to economically hedge a significant portion of our interest rate exposure, due to the market turmoil we are exposed to risks relating to both our ability to issue new debt when our outstanding debt matures and to the variability in interest costs on our new issuances of debt which directly impacts our net interest income and net interest yield. The increases in net interest income and net interest yield on a fully tax-equivalent basis during the nine months ended September 30, 2008 were partially offset by the impact of declining interest rates because our floating rate assets reset faster than our short-term debt during the first quarter of 2008. As a result of the creation of the securitization trusts in December of 2007, interest due to PC investors is now recorded in trust management fees within other income on our consolidated statements of income. See “Non-Interest Income — Other Income” for additional information about due to PC investors interest expense.

 

Non-Interest Income

 

Management and Guarantee Income

 

Table 6 provides summary information about management and guarantee income. Management and guarantee income consists of contractual amounts due to us (reflecting buy-ups and buy-downs to base management and guarantee fees) as well as amortization of certain pre-2003 deferred credit and buy-down fees received by us that were recorded as deferred income as a component of other liabilities. Post-2002 credit and buy-down fees are reflected as increased income on guarantee obligation as the guarantee obligation is amortized.

 

Table 6 — Management and Guarantee Income⁽¹⁾

 

 

The primary drivers affecting management and guarantee income are the average balance of our PCs and Structured Securities and changes in management and guarantee fee rates. Contractual management and guarantee fees include adjustments to the contractual rates for buy-ups and buy-downs, whereby the contractual management and guarantee fee rate is adjusted for up-front cash payments we make (buy-up) or receive (buy-down) at guarantee issuance. Our average rates of management and guarantee income are also affected by the mix of products we issue, competition in market pricing and customer preference for buy-up and buy-down fees. The majority of our guarantees are issued under customer “flow” channel contracts, which have pricing schedules for our management and guarantee fees that are fixed for periods of up to one year. The remainder of our purchase and guarantee securitization of mortgage loans occurs through “bulk” purchasing with management and guarantee fees negotiated on an individual transaction basis. The appointment of FHFA as Conservator and the Conservator’s subsequent directive that we provide increased support to the mortgage market will likely affect our future guarantee pricing decisions.

 

Management and guarantee income increased for the three and nine months ended September 30, 2008 compared to the three and nine months ended September 30, 2007, primarily reflecting an increase in the average PCs and Structured Securities balances of 11% and 14%, respectively, on an annualized basis. The average contractual management and guarantee fee rate for the three and nine months ended September 30, 2008 was higher than the three and nine months ended September 30, 2007, primarily due to an increase in buy-up activity. To a lesser extent, increased purchases of 30-year fixed-rate product during 2008, which has higher guarantee fee rates relative to adjustable-rate mortgages, or ARMs, and 15-year fixed-rate product, have also contributed to the increase in guarantee fee rates.

 

Gains (Losses) on Guarantee Asset

 

Upon issuance of a guarantee of securitized assets, we record a guarantee asset on our consolidated balance sheets representing the fair value of the management and guarantee fees we expect to receive over the life of our PCs or Structured Securities. Guarantee assets are recognized in connection with transfers of PCs and Structured Securities that are accounted for as sales under SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities, a replacement of Financial Accounting Standards Board, or FASB, Statement No. 125.” Additionally, we recognize guarantee assets for PCs issued through our guarantor swap program and for certain Structured Transactions that we issue to third parties in exchange for non-agency mortgage-related securities. Subsequent changes in the fair value of the future cash flows of our guarantee asset are reported in the current period income as gains (losses) on guarantee asset.

 

The change in fair value of our guarantee asset reflects:

 

 

The fair value of future management and guarantee fees is driven primarily by expected changes in interest rates that affect the estimated life of mortgages underlying our PCs and Structured Securities and related discount rates used to determine the net present value of the cash flows. For example, an increase in interest rates generally slows the rate of