UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

FORM 10-Q

 

 

 

For the quarterly period ended March 31, 2009

 

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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).     o 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 “large accelerated filer,” “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 May 4, 2009, there were 648,220,792 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 statements pertaining to the conservatorship and our current expectations and objectives for internal control remediation efforts, future business plans, capital management, economic and market conditions and trends, market share, credit losses, and results of operations and financial condition on a GAAP, Segment Earnings and fair value basis. 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, or MD&A, “MD&A — FORWARD-LOOKING STATEMENTS” and “RISK FACTORS” in this Form 10-Q and in the comparably captioned sections of our Annual Report on Form 10-K for the year ended December 31, 2008, or 2008 Annual Report, and (ii) the “BUSINESS” section of our 2008 Annual Report. 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.

 

Throughout PART I of this Form 10-Q, including the Financial Statements and MD&A, we use certain acronyms and terms and refer to certain accounting pronouncements which are defined in the Glossary.

 

You should read this MD&A in conjunction with our consolidated financial statements and related notes for the three months ended March 31, 2009 and our 2008 Annual Report.

 

Freddie Mac was chartered by Congress in 1970 to stabilize the nation’s residential mortgage market and expand opportunities for home ownership and affordable rental housing. Our statutory mission is to provide liquidity, stability and affordability to the U.S. housing market. Our participation in the secondary mortgage market includes providing our credit guarantee for residential mortgages originated by mortgage lenders and investing in mortgage loans and mortgage-related securities. We refer to our investments in mortgage loans and mortgage-related securities as our mortgage-related investments portfolio. Through our credit guarantee activities, we securitize mortgage loans by issuing PCs to third-party investors. We also resecuritize mortgage-related securities that are issued by us or Ginnie Mae as well as private, or non-agency, entities. We also guarantee multifamily mortgage loans that support housing revenue bonds issued by third parties and we guarantee other mortgage loans held by third parties. Securitized mortgage-related assets that back PCs and Structured Securities that are held by third parties are not reflected as our assets. Our Structured Securities represent beneficial interests in pools of PCs and certain other types of mortgage-related assets. We earn management and guarantee fees for providing our guarantee and performing management activities (such as ongoing trustee services, administration of pass-through amounts, paying agent services, tax reporting and other required services) with respect to issued PCs and Structured Securities. Our management activities are essential to and inseparable from our guarantee activities. We do not provide or charge for the activities separately. The management and guarantee fee is paid to us over the life of the related PCs and Structured Securities and reflected in earnings, as management and guarantee income, as it is accrued.

 

We had a net loss attributable to Freddie Mac of $9.9 billion for the first quarter of 2009 and a deficit in total equity of $6.0 billion as of March 31, 2009. Our financial results for the first quarter of 2009 reflect the adverse conditions in the U.S. mortgage markets. Deterioration of market conditions, including declining home prices, higher mortgage delinquency rates and higher loss severities, contributed to large credit-related expenses and other-than-temporary impairments for the first quarter of 2009.

 

We continue to operate under the conservatorship that commenced on September 6, 2008, conducting our business under the direction of FHFA as our Conservator. During the conservatorship, the Conservator has delegated certain authority to the Board of Directors to oversee, and management to conduct, day-to-day operations so that the company can continue to operate in the ordinary course of business.

 

We are working with our Conservator to, among other things, help distressed homeowners through adverse times. Currently, we are primarily focusing on initiatives that support the Making Home Affordable Program announced by the Obama Administration in February 2009 (previously known as the Homeowner Affordability and Stability Plan). The MHA Program includes (i) Home Affordable Refinance, which gives eligible homeowners with loans owned or guaranteed by Freddie Mac or Fannie Mae an opportunity to refinance into more affordable monthly payments, and (ii) the Home Affordable Modification program, which commits U.S. government, Freddie Mac and Fannie Mae funds to keep eligible homeowners in their homes by preventing avoidable foreclosures. We will play an additional role under the Home Affordable Modification program as the compliance agent for foreclosure prevention activities. As the

 

program compliance agent, we will conduct examinations and review servicer compliance with the published rules for the program with respect to mortgages owned or guaranteed by us, Fannie Mae and banks and by trusts backing non-agency mortgage-related securities and report results to Treasury. We will also advise and consult with Treasury about the design, results and future improvement of the MHA Program. At present, it is difficult for us to predict the full impact of these initiatives on us. However, we are devoting significant internal resources to their implementation and, to the extent our servicers and borrowers participate in these programs in large numbers, it is likely that the costs we incur will be substantial.

 

There is significant uncertainty as to whether or when we will emerge from conservatorship, as it has no specified termination date, and as to what changes may occur to our business structure during or following our conservatorship, including whether we will continue to exist. However, we are not aware of any current plans of our Conservator to significantly change our business structure in the near-term.

 

Significant recent developments with respect to the conservatorship, our business and the MHA Program include the following:

 

 

 

 

To address our deficit in net worth as of March 31, 2009, FHFA has submitted a draw request, on our behalf, to Treasury under the Purchase Agreement in the amount of $6.1 billion. We expect to receive these funds by June 30, 2009. Upon funding of the $6.1 billion draw request:

 

 

Our implementation of the MHA Program requires us, in some cases, to modify loans when default is imminent even though the borrower’s mortgage payments are current. In our 2008 Annual Report, we disclosed the possibility that, if current loans were modified and were purchased from PC pools under this program, our guarantee might not be eligible for an exception from derivative accounting under SFAS 133, thereby requiring us to account for our guarantee as a derivative instrument. In April, we obtained confirmation from regulatory authorities of an interpretation that modifications of currently performing loans where default is reasonably foreseeable will not alter our ability to apply the exception from derivative accounting under SFAS 133. As a result, we will not recognize any pre-tax charge relating to the initial impact of accounting for our guarantee as a derivative. For a further discussion of this issue, see “BUSINESS — Our Business and Statutory Mission — Recent Developments Impacting Our Business” in our 2008 Annual Report.

 

We are dependent upon the continued support of Treasury and FHFA in order to continue operating our business. We also receive substantial support from the Federal Reserve. Our ability to access funds from Treasury under the Purchase Agreement is critical to keeping us solvent and avoiding the appointment of a receiver by FHFA under statutory mandatory receivership provisions.

 

Under conservatorship, we have changed certain business practices to provide support for the mortgage market in a manner that serves public policy and other non-financial objectives but that may not contribute to profitability. Some of these changes increased our expenses or required us to forego revenue opportunities in the near term. It is not possible at present to estimate the extent to which these costs may be offset, if at all, by the prevention or reduction of potential future costs of loan defaults and foreclosures due to these changes in business practices.

 

For more information on the terms of the conservatorship, the powers of our Conservator and certain of the initiatives, programs and agreements described above, see “BUSINESS — Conservatorship and Related Developments” in our 2008 Annual Report.

 

Housing and Economic Conditions and Impact on First Quarter 2009 Results

 

Our financial results for the first quarter of 2009 reflect the continuing adverse conditions in the U.S. mortgage markets, which deteriorated dramatically during the last half of 2008 and have continued to deteriorate in 2009. As a result, we experienced significantly higher credit-related expenses for the first quarter of 2009 as compared to the first quarter of 2008. Our provision for credit losses was $8.8 billion in the first quarter of 2009 compared to $1.2 billion in the first quarter of 2008, principally due to increased estimates of incurred losses caused by the deteriorating economic conditions, evidenced by our increased rates of delinquency and foreclosure; increased mortgage loan loss severities;

 

and, to a much lesser extent, concerns about the failure or potential failure of certain of our seller/servicer counterparties to perform under their recourse or repurchase obligations to us.

 

Home prices nationwide declined an estimated 1.4% in the first quarter of 2009 based on our own internal index, which is based on properties underlying our single-family mortgage portfolio. The percentage decline in home prices in the last twelve months has been particularly large in the states of California, Florida, Arizona and Nevada, where we have significant concentrations of mortgage loans. Unemployment rates also worsened significantly, and the national unemployment rate increased to 8.5% at March 31, 2009 as compared to 7.2% at December 31, 2008. However, certain states have experienced much higher unemployment rates, such as California, Florida, Nevada and Michigan, where the unemployment rate reached 11.2%, 9.7%, 10.4% and 12.6%, respectively, at March 31, 2009. Both consumer and business credit tightened considerably during the fourth quarter of 2008 and the first quarter of 2009, as financial institutions have been more cautious in their lending activities. Although there was improvement in credit and liquidity conditions toward the end of the quarter, there is a continuation of higher, or wide, credit spreads for both mortgage and corporate loans.

 

These macroeconomic conditions and other factors, such as our temporary suspensions of foreclosure transfers of occupied homes, contributed to a substantial increase in the number and aging of delinquent loans in our single-family mortgage portfolio during the first quarter of 2009. While temporary suspensions of foreclosure transfers reduced our charge-offs and REO activity during the first quarter of 2009, our provision for credit losses includes expected losses on those foreclosures currently suspended. We also observed a continued 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, and we experienced an increase in delinquency rates for all product types during the first quarter of 2009. This delinquency data suggests that continuing home price declines and growing unemployment are significantly affecting behavior by a broader segment of mortgage borrowers. Additionally, as the slump in the U.S. housing market has persisted for more than a year, increasing numbers of borrowers that began with significant equity are now “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 continued to increase in the first quarter of 2009, especially in the states of California, Florida, Nevada 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.

 

The continued deterioration in economic and housing market conditions during the first quarter of 2009 also led to a further decline in the performance of the non-agency mortgage-related securities in our mortgage-related investments portfolio. Furthermore, the mortgage-related securities backed by subprime, MTA, Alt-A and other loans, have significantly greater concentrations in the states that are undergoing the greatest stress, including California, Florida, Arizona and Nevada. As a result of these and other factors, we recognized $7.1 billion of other-than-temporary security impairments primarily on available-for-sale non-agency securities in the first quarter of 2009.

 

Consolidated Results of Operations

 

Net loss attributable to Freddie Mac was $9.9 billion and $151 million for the first quarters of 2009 and 2008, respectively. Net loss increased in the first quarter of 2009 compared to the first quarter of 2008, principally due to losses on investment activities, increased credit-related expenses, which consist of the provision for credit losses and REO operations expense, and increased losses on loans purchased. These loss and expense items for the three months ended March 31, 2009 were partially offset by higher net interest income and lower losses on our guarantee asset in the first quarter of 2009, compared to the first quarter of 2008. As a result of the net loss, at March 31, 2009, our liabilities exceeded our assets under GAAP and the Director of FHFA has submitted a draw request under the Purchase Agreement in the amount of $6.1 billion to Treasury. We expect to receive such funds by June 30, 2009.

 

Net interest income was $3.9 billion for the first quarter of 2009, compared to $798 million for the first quarter of 2008. As compared to the first quarter of 2008, we held higher amounts of fixed-rate agency mortgage-related securities in our mortgage-related investments portfolio and had significantly lower interest rates on our short- and long- term borrowings for the three months ended March 31, 2009.

 

Non-interest income (loss) was $(3.1) billion for the three months ended March 31, 2009, compared to non-interest income (loss) of $614 million for the three months ended March 31, 2008. The increase in non-interest loss in the first quarter of 2009 was primarily due to higher losses on investment activity, which were partially offset by lower losses on our guarantee asset. Increased losses on investment activity during the first quarter of 2009 were principally attributed to $7.1 billion of security impairments primarily recognized on available-for-sale non-agency mortgage-related securities backed by subprime, MTA and Alt-A and other loans during the quarter.

 

Non-interest expense for the three months ended March 31, 2009 and 2008 totaled $11.6 billion and $2.0 billion, respectively. This includes credit-related expenses of $9.1 billion and $1.4 billion for the three months ended March 31,

 

2009 and 2008, respectively. The significant increase in our provision for credit losses was due to continued credit deterioration in our single-family credit guarantee portfolio, primarily from further increases in delinquency rates and higher loss severities on a per-property basis. Credit deterioration has been largely driven by declines in home prices and regional economic conditions. REO operations expense increased primarily as a result of higher foreclosure acquisition volume and higher losses on REO dispositions, partially offset by a decrease in market-based writedowns of existing REO inventory.

 

Non-interest expense, excluding credit-related expenses discussed above, for the three months ended March 31, 2009 totaled $2.5 billion compared to $535 million for the three months ended March 31, 2008. Losses on loans purchased increased to $2.0 billion for the three months ended March 31, 2009, compared to $51 million for the three months ended March 31, 2008, due to higher volumes of loan modifications of loans in our PCs in the first quarter of 2009, which will cause our purchases of these loans out of the PCs to increase. Administrative expenses totaled $372 million for the three months ended March 31, 2009, down from $397 million for the three months ended March 31, 2008, primarily due to a reduction in the use of consultants and other cost reduction measures during the first quarter of 2009 compared to the first quarter of 2008.

 

Segment Earnings

 

Our operations consist of three reportable segments, which are based on the type of business activities each performs — Investments, Single-family Guarantee and Multifamily. Certain activities that are not part of a segment are included in the All Other category. We manage and evaluate performance of the segments and All Other using a Segment Earnings approach, subject to the conduct of our business under the direction of the Conservator.

 

In managing our business, we present the operating performance of our segments using Segment Earnings. Segment Earnings differs significantly from, and should not be used as a substitute for, net loss as determined in accordance with GAAP.

 

The objectives set forth for us under our charter and by our Conservator, as well as the restrictions on our business under the Purchase Agreement with Treasury, may negatively impact our Segment Earnings and the performance of individual segments. See “MD&A — EXECUTIVE SUMMARY — Segment Earnings” in our 2008 Annual Report.

 

Segment Earnings is calculated for the segments by adjusting GAAP net loss for certain investment-related activities and credit guarantee-related activities. Segment Earnings includes certain reclassifications among income and expense categories that have no impact on net loss but provide us with a meaningful metric to assess the performance of each segment and our company as a whole. Segment Earnings does not include the effect of the establishment of the valuation allowance against our deferred tax assets, net. For more information on Segment Earnings, including the adjustments made to GAAP net loss to calculate Segment Earnings and the limitations of Segment Earnings as a measure of our financial performance, see “CONSOLIDATED RESULTS OF OPERATIONS — Segment Earnings” and “NOTE 16: SEGMENT REPORTING” to our consolidated financial statements.

 

Table 1 presents Segment Earnings by segment and the All Other category and includes a reconciliation of Segment Earnings to net loss prepared in accordance with GAAP.

 

Table 1 — Reconciliation of Segment Earnings to GAAP Net Loss

 

 

Consolidated Balance Sheets Analysis

 

During the first quarter of 2009, total assets increased by $96 billion to $947 billion while total liabilities increased by $71.4 billion to $953 billion. Total equity (deficit) was $(6.0) billion at March 31, 2009 compared to $(30.6) billion at December 31, 2008.

 

Our cash and other investments portfolio increased by $35.1 billion during the first quarter of 2009 to $99.4 billion, with a $23.9 billion increase in securities purchased under agreements to resell and a $8.4 billion increase in highly liquid shorter-term cash and cash equivalent assets. On March 31, 2009, we received $30.8 billion from Treasury under the Purchase Agreement pursuant to a draw request that FHFA submitted to Treasury on our behalf. The unpaid principal balance of our mortgage-related investments portfolio increased 8%, or $62.3 billion, during the first quarter of 2009 to $867.1 billion. The increase in our mortgage-related investments portfolio resulted from our acquiring and holding increased amounts of mortgage loans and mortgage-related securities to provide additional liquidity to the mortgage market, and, to a lesser degree, more favorable investment opportunities for agency securities as a result of a broad market decline driven by a lack of liquidity in the market. Deferred tax assets, net decreased $2.1 billion during the first quarter of 2009 to $13.3 billion, primarily attributable to the decline in the net loss in AOCI, net of taxes, as discussed below.

 

Short-term debt increased by $18.2 billion during the first quarter of 2009 to $453.3 billion, and long-term debt increased by $48.3 billion to $456.2 billion. The increase in our long-term debt reflects the improvement during the first quarter of spreads on our debt and our increased access to the debt markets as a result of decreased interest rates and the Federal Reserve’s purchases in the secondary market of our long-term debt under its purchase program. Additionally, our reserve for guarantee losses on PCs increased during the quarter by $6.9 billion to $21.8 billion as a result of probable incurred losses, primarily attributable to the overall macroeconomic environment with declining home values, higher mortgage delinquency rates, and increasing unemployment.

 

Total equity (deficit) of $(6.0) billion at March 31, 2009 reflects the $30.8 billion in funding from Treasury we received on that date pursuant to a draw under the Purchase Agreement, and a $10.2 billion net loss attributable to common stockholders for the first quarter of 2009. In addition, the net loss in AOCI, net of taxes, declined by $4.1 billion, resulting largely from unrealized gains on our agency mortgage-related securities and the recognition of certain unrealized losses as other-than-temporary impairments on our non-agency mortgage-related securities.

 

Consolidated Fair Value Balance Sheets Analysis

 

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 PMVS and duration gap measures. Included in our fair value results for the three months ended March 31, 2009 are the funds received from Treasury of $30.8 billion under the Purchase Agreement.

 

During the three months ended March 31, 2009, the fair value of net assets, before capital transactions, decreased by $15.7 billion compared to a $17.4 billion decrease during the three months ended March 31, 2008. The fair value of net assets as of March 31, 2009 was $(80.9) billion, compared to $(95.6) billion as of December 31, 2008. The decline in the fair value of our net assets, before capital transactions, during the first quarter of 2009 principally related to an increase in the fair value of our single-family guarantee obligation primarily due to the declining credit environment. Included in the reduction of the fair value of net assets is $6.5 billion related to our partial valuation allowance for our deferred tax assets, net for the three months ended March 31, 2009.

 

Liquidity and Capital Resources

 

Liquidity

 

During the first quarter of 2009, the Federal Reserve was an active purchaser in the secondary market of our long-term debt under its purchase program as discussed below and, as a result, spreads on our debt and access to the debt markets improved toward the end of the quarter. Prior to that time and commencing in the second half of 2008, we had experienced less demand for our debt securities, as reflected in wider spreads on our term and callable debt. This resulted in overall deterioration in our access to unsecured medium and long term debt markets to fund our purchases of mortgage assets and to refinance maturing debt. Therefore, we have been required to refinance our debt on a more frequent basis, exposing us to an increased risk of insufficient demand and adverse credit market conditions. We have also had to expand our use of derivatives. However, the use of these derivatives may expose us to additional counterparty credit risk. Because we use a mix of pay-fixed interest rate swaps and short-term debt to synthetically create the substantive economic equivalent of various longer-term fixed rate debt funding structures, our business results would be adversely affected if our access to the derivative markets were disrupted. See “MD&A — LIQUIDITY AND CAPITAL RESOURCES — Liquidity” in our 2008 Annual Report for more information on our debt funding

 

activities and risks posed by current market challenges and “RISK FACTORS” in our 2008 Annual Report for a discussion of the risks to our business posed by our reliance on the issuance of debt to fund our operations.

 

Treasury and the Federal Reserve have taken a number of actions affecting our access to debt financing, including the following:

 

 

The Lending Agreement is scheduled to expire on December 31, 2009. Upon expiration, we will not have a liquidity backstop available to us (other than Treasury’s ability to purchase up to $2.25 billion of our obligations under its permanent authority) if we are unable to obtain funding from issuances of debt or other conventional sources. Under such circumstances, our long-term liquidity contingency strategy is currently dependent on extension of the Lending Agreement beyond December 31, 2009 which will require amendment of existing law.

 

Our annual dividend obligation on the senior preferred stock exceeds our annual historical earnings in most periods, and will contribute to increasingly negative cash flows in future periods, if we continue to pay the dividends in cash. In addition, the continuing deterioration in the financial and housing markets and further net losses in accordance with GAAP will make it more likely that we will continue to have additional draws under the Purchase Agreement in future periods, which will make it more difficult to pay senior preferred dividends in cash in the future.

 

Capital Adequacy

 

On October 9, 2008, FHFA announced that it was suspending capital classification of us during conservatorship in light of the Purchase Agreement.

 

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, up to the maximum aggregate amount that may be funded under the Purchase Agreement. At March 31, 2009, our liabilities exceeded our assets by $6.01 billion and FHFA has submitted a draw request, on our behalf, to Treasury under the Purchase Agreement in the amount of $6.1 billion. Our draw request is rounded up to the nearest $100 million. Following receipt of this pending draw, the aggregate liquidation preference of the senior preferred stock will increase to $51.7 billion and the amount remaining under the Treasury’s funding agreement will be $149.3 billion.

 

Treasury will be entitled to annual cash dividends of $5.2 billion based on this aggregate liquidation preference. This dividend obligation, combined with potentially substantial commitment fees payable to Treasury starting in 2010 (the amounts of which have not yet been determined) and limited flexibility to pay down draws under the Purchase Agreement, will have an adverse impact on our future financial position and net worth. In addition, we expect to make additional draws under the Purchase Agreement in future periods, due to a variety of factors that could materially affect the level and volatility of our net worth. For instance, if financial and housing markets conditions continue to deteriorate, resulting in further GAAP net losses, we will likely need to take additional draws, which would increase our senior preferred dividend obligation. For additional information concerning the potential impact of the Purchase Agreement, including taking additional draws, see “RISK FACTORS” in our 2008 Annual Report. For additional information on our capital management during conservatorship and factors that could affect the level and volatility of our net worth, see “LIQUIDITY AND CAPITAL RESOURCES — Capital Adequacy” and “NOTE 9: REGULATORY CAPITAL” to our consolidated financial statements.

 

Risk Management

 

Credit Risks

 

Our total mortgage portfolio is subject primarily to two types of credit risk: mortgage credit risk and institutional credit risk. Mortgage credit risk is the risk that a borrower will fail to make timely payments on a mortgage we own or guarantee. We are exposed to mortgage credit risk on our total mortgage portfolio because we either hold the mortgage assets or have guaranteed mortgages in connection with the issuance of a PC, Structured Security or other mortgage-related guarantee. Institutional credit risk is the risk that a counterparty that has entered into a business contract or arrangement with us will fail to meet its obligations.

 

Mortgage and credit market conditions deteriorated during 2008 and continued to deteriorate in the first quarter of 2009. These conditions were brought about by a number of factors, which have increased our exposure to both

 

mortgage credit and institutional credit risks. Factors that have negatively affected the mortgage and credit markets included:

 

 

The deteriorating economic conditions discussed above and the effect of any current or future government actions to remedy them have increased the uncertainty of future economic conditions, including unemployment rates and home price changes. While our forecast using our own home price index is for a national decline of 5% to 10% in 2009, there continues to be divergence among economists about the amount and timeframe of decline that may occur. The following statistics illustrate the credit deterioration of loans in our single-family mortgage portfolio, which consists of single-family mortgage loans in our mortgage-related investments portfolio and those backing our PCs, Structured Securities and other mortgage-related guarantees.

 

Table 2 — Credit Statistics, Single-Family Mortgage Portfolio⁽¹⁾

 

 

As the table above illustrates, we have experienced continued deterioration in the performance of our single-family mortgage portfolio due to several factors, including the following:

 

 

 

 

We have taken several steps during 2008 and continuing in 2009 designed to support homeowners and mitigate the growth of our non-performing assets, some of which were undertaken at the direction of FHFA. We continue to expand our efforts to increase our use of foreclosure alternatives, and have expanded our staff to assist our seller/servicers in completing loan modifications and other outreach programs with the objective of keeping more borrowers in their homes. We expect that many of these efforts will have a negative impact on our financial results. See “MD&A — EXECUTIVE SUMMARY — Credit Overview” in the 2008 Annual Report for more information. Some recent developments and initiatives include:

 

 

These activities and those discussed in our 2008 Annual Report will create fluctuations in our credit statistics. For example, beginning in November 2008, we implemented a temporary suspension of foreclosure transfers of occupied homes. This has reduced the rate of growth of our REO inventory and of charge-offs, a component of our credit losses, since November 2008 but caused our reserve for guarantee losses to rise. This also has created an increase in the number of delinquent loans that remain in our single-family mortgage portfolio, which results in higher reported delinquency rates than without the suspension of foreclosure transfers. In addition, the implementation of the MHA Program in the second quarter of 2009 may cause the number of our forbearance agreements, modifications and related losses, such as losses on loans purchased, to rise. It is not possible at present to estimate the extent to which these costs may be offset, if at all, by the prevention or reduction of potential future costs of loan defaults and foreclosures due to these changes in business practices.

 

Our investments in non-agency mortgage-related securities, which are primarily backed by subprime, MTA and Alt-A loans, also were affected by the deteriorating credit conditions in the last half of 2008 and continuing into the first three months of 2009. The table below illustrates the increases in delinquency rates for subprime first lien, MTA and Alt-A loans that back the non-agency mortgage-related securities we own. Given the recent deterioration in the economic outlook and the forecast for continued home price declines in 2009, the performance of the loans backing these securities could continue to deteriorate.

 

Table 3 — Credit Statistics, Non-Agency Mortgage-Related Securities Backed by Subprime, MTA and Alt-A Loans

 

 

We held unpaid principal balances of $114.4 billion of non-agency mortgage-related securities backed by subprime, MTA, Alt-A and other loans, in our mortgage-related investments portfolio as of March 31, 2009, compared to $119.5 billion as of December 31, 2008. We received monthly remittances of principal repayments on these securities of $5.1 billion during the first quarter of 2009, representing a partial return of our investment in these securities. We recognized impairment losses on non-agency mortgage-related securities backed by subprime, MTA, Alt-A and other loans of approximately $6.9 billion for the first quarter of 2009. As of March 31, 2009, we recognized an aggregate of $23.4 billion of impairment losses on these non-agency mortgage-related securities since the second quarter of 2008, of which $13.8 billion is expected to be recovered. See “NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES — Recently Issued Accounting Standards, Not Yet Adopted — Additional Guidance and Disclosures for Fair Value Measurements and Change in the Impairment Model for Debt Securities — Change in the Impairment Model for Debt Securities” to our consolidated financial statements for information on how other-than-temporary impairments will be recorded on our financial statements commencing in the second quarter of 2009. Gross unrealized losses, pre-tax, on securities backed by subprime, MTA, Alt-A and other loans reflected in AOCI, decreased by $3.2 billion to $27.5 billion at March 31, 2009. This decrease includes the impact of $6.9 billion of impairment losses recorded on non-agency mortgage-related securities during the first quarter of 2009, which more than offset the declines in non-agency mortgage asset prices that occurred during the first quarter of 2009. We believe the declines in the fair value of the non-agency mortgage-related securities are attributable to poor underlying collateral performance and decreased liquidity and larger risk premiums in the mortgage market.

 

Interest Rate and Other Market Risks

 

Our mortgage-related investments portfolio activities expose us to interest-rate risk and other market risks arising primarily from the uncertainty as to when borrowers will pay the outstanding principal balance of mortgage loans that are held or underlie securities in our mortgage-related investments portfolio, known as prepayment risk, and the resulting potential mismatch in the timing of our receipt of cash flows related to our assets versus the timing of payment of cash flows related to our liabilities. As interest rates fluctuate, we use derivatives to adjust the interest-rate characteristics of our debt funding in order to more closely match those of our assets.

 

The recent market environment has been increasingly volatile. Throughout 2008 and into 2009, we adjusted our interest rate risk models to reflect rapidly changing market conditions. In particular, prepayment models were dynamically adjusted to more accurately reflect the current environment. Due to extreme spread volatility, we adjusted interest-rate risk hedging methodologies to more accurately attribute OAS spread volatility and interest rate risk.

 

Operational Risks

 

Operational risks are inherent in all of our business activities and can become apparent in various ways, including accounting or operational errors, business interruptions, fraud, failures of the technology used to support our business activities, difficulty in filling executive officer vacancies and other operational challenges from failed or inadequate internal controls. These operational risks may expose us to financial loss, interfere with our ability to sustain timely

 

financial reporting, or result in other adverse consequences. Management of our operational risks takes place through the enterprise risk management framework, with the business areas retaining primary responsibility for identifying, assessing and reporting their operational risks.

 

As a result of management’s evaluation of our disclosure controls and procedures, our Interim Chief Executive Officer, who is also performing the functions of principal financial officer on an interim basis, has concluded that our disclosure controls and procedures were not effective as of March 31, 2009, at a reasonable level of assurance. We are continuing to work to improve our financial reporting governance process and remediate material weaknesses and other deficiencies in our internal controls. Although we continue to make progress on our remediation plans, our material weaknesses have not been fully remediated at this time. In view of our mitigating activities, including our remediation efforts through March 31, 2009, we believe that our interim consolidated financial statements for the quarter ended March 31, 2009, have been prepared in conformity with GAAP.

 

Off-Balance Sheet Arrangements

 

We enter into certain business arrangements that are not recorded on our consolidated balance sheets or may be recorded in amounts that differ from the full contract or notional amount of the transaction. Most of these arrangements relate to our financial guarantee and securitization activity for which we record guarantee assets and obligations, but the related securitized assets are owned by third parties. These off-balance sheet arrangements may expose us to potential losses in excess of the amounts recorded on our consolidated balance sheets.

 

Our maximum potential off-balance sheet exposure to credit losses relating to our PCs, Structured Securities and other mortgage-related guarantees is primarily represented by the unpaid principal balance of the related loans and securities held by third parties, which was $1,379 billion and $1,403 billion at March 31, 2009 and December 31, 2008, respectively. Based on our historical credit losses, which in 2008 averaged approximately 20.1 basis points of the aggregate unpaid principal balance of our PCs and Structured Securities, we do not believe that the maximum exposure is representative of our actual exposure on these guarantees.

 

Legislative and Regulatory Matters

 

Pending Legislation

 

On May 7, 2009, the House of Representatives passed a bill that, among other things, would require originators to retain a level of credit risk for certain mortgages that they sell, enhance consumer disclosures, impose new servicing standards and allow for assignee liability. If enacted, the legislation would impact Freddie Mac and the overall mortgage market. However, it is unclear when, or if, the Senate will consider comparable legislation.

 

The House of Representatives has passed several bills that would impact executive and employee compensation paid by companies receiving federal financial assistance, including Freddie Mac. One bill would impose a 90% tax on the aggregate bonuses received by certain executives and employees of such companies. Another bill would prohibit “unreasonable and excessive” compensation by certain companies that have received federal financial assistance and prohibit these companies from paying non-performance based bonuses. Under this bill, Treasury would be required to establish certain standards regarding compensation payments. It is unclear when, or if, the Senate will consider comparable legislation. The adoption of any legislation that results in a significant tax on compensation or that imposes significant compensation restrictions would likely have an adverse impact on Freddie Mac’s ability to recruit and retain executives and employees whose compensation would be limited or reduced as a result of such legislation.

 

In March 2009, the House of Representatives passed a housing-related bill that, among other items, includes provisions intended to stem the rate of foreclosures by allowing bankruptcy judges to modify the terms of mortgages on principal residences for borrowers in Chapter 13 bankruptcy. Specifically, the House bill would allow judges to adjust interest rates, extend repayment terms and lower the outstanding principal amount to the current estimated fair value of the underlying property. On May 6, 2009, the Senate passed a similar housing-related bill that did not include bankruptcy cramdown provisions. It is unclear when, or if, the Senate will reconsider other alternative bankruptcy-related legislation.

 

Affordable Housing Goals

 

In March 2009, we reported to FHFA that we did not meet the 2008 housing goals or home purchase subgoals, but that we did meet the multifamily special affordable target. We believe that achievement of the goals and subgoals was infeasible in 2008 under the terms of the Federal Housing Enterprises Financial Safety and Soundness Act of 1992, and accordingly submitted an infeasibility analysis to FHFA. In March 2009, FHFA notified us that it had determined that achievement of the housing goals and home purchase subgoals was infeasible, with the exception of the underserved areas goal. Based on our financial condition in 2008, FHFA concluded that achievement by us of the

 

underserved areas goal was feasible, but challenging. Accordingly, FHFA decided not to require us to submit a housing plan.

 

Under the Reform Act, the annual housing goals for Freddie Mac and Fannie Mae in place for 2008 remain in effect for 2009, except that within 270 days from July 30, 2008, FHFA must review the 2009 housing goals to determine the feasibility of such goals in light of current market conditions and, after seeking public comment for up to 30 days, FHFA may make adjustments to the 2009 goals consistent with market conditions.

 

On April 28, 2009, FHFA announced that it has analyzed current market conditions and is issuing and seeking comments on a proposed rule that would adjust the affordable housing goal and home purchase subgoal levels for 2009. As proposed, Freddie Mac’s goals and subgoals for 2009 would be as follows:

 

Table 4 — Housing Goals and Home Purchase Subgoals for 2009⁽¹⁾

 

 

The proposed rule would permit loans we own or guarantee that are modified in accordance with the MHA Program to be treated as mortgage purchases and count toward the housing goals. In addition, the proposed rule would exclude from the 2009 housing goals loans with original principal balances that exceed the base nationwide conforming loan limits (e.g., $417,000 for a one-unit single-family property) in certain high-cost areas and exceed 150% of the nationwide conforming loan limits in Alaska, Guam, Hawaii and the Virgin Islands.

 

Effective beginning calendar year 2010, the Reform Act requires that FHFA establish single-family and multifamily annual affordable housing goals by regulation.

 

 

 

 

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 5 — Summary Consolidated Statements of Operations — GAAP Results

 

 

Net Interest Income

 

Table 6 presents an analysis of net interest income, including average balances and related yields earned on assets and incurred on liabilities.

 

Table 6 — Net Interest Income/Yield and Average Balance Analysis

 

 

Net interest income and net interest yield on a fully taxable-equivalent basis increased during the first quarter of 2009 compared to the first quarter of 2008 primarily due to: (a) a decrease in funding costs as a result of the replacement of higher cost short- and long-term debt with lower cost debt issuances; (b) a significant increase in the average size of our mortgage-related investments portfolio including the purchases of fixed-rate assets; and (c) $715 million of income related to the accretion of other-than-temporary impairments of investments in available-for-sale securities recorded primarily during the second half of 2008.

 

During the first quarter of 2009, our short-term funding balances increased significantly when compared to the first quarter of 2008. Our use of short-term debt funding has been driven by varying levels of demand for our long-term and callable debt in the worldwide financial markets in 2008 and the first quarter of 2009. Recently, the Federal Reserve has been an active purchaser in the secondary market of our long-term debt under its purchase program and, as a result, spreads on our debt and access to the debt markets improved toward the end of the first quarter of 2009. Due to our limited ability to issue long-term and callable debt during the second half of 2008 and part of the first quarter of 2009, we increased our use of a mix of derivatives and short-term debt to synthetically create the substantive economic equivalent of various longer-term fixed rate debt funding structures. However, since these derivatives are not in hedge accounting relationships the accrual of periodic settlements related to these derivatives is not recognized in net interest income but rather is recognized in gains (losses) on derivatives. The use of these derivatives may expose us to additional counterparty credit risk. See “Non-Interest Income (Loss) — Derivative Overview” for additional information.

 

The increase in our mortgage-related investments portfolio resulted from our acquiring and holding increased amounts of mortgage loans and mortgage-related securities to provide additional liquidity to the mortgage market. Also, during the first quarter of 2009, continued 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 during the first quarter of 2009 were partially offset by the impact of declining interest rates on floating rate assets held in our mortgage-related investments portfolio. We also increased our cash and other investments portfolio during the first quarter of 2009 compared to the first quarter of 2008, and shifted from higher-yielding, longer-term non-mortgage-related securities to lower-yielding, shorter-term cash and cash equivalents and securities purchased under agreements to resell. This shift, in combination with lower short-term rates, also partially offset the increase in net interest income and net interest yield.

 

Non-Interest Income (Loss)

 

Management and Guarantee Income

 

Table 7 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 fees received by us that were recorded as deferred income as a component of other liabilities. Beginning in 2003, delivery and buy-down fees are reflected within income on guarantee obligation as the guarantee obligation is amortized.

 

Table 7 — Management and Guarantee Income

 

 

Management and guarantee income decreased slightly for the three months ended March 31, 2009 compared to the three months ended March 31, 2008 primarily due to a decrease in amortization of pre-2003 deferred fees. This decrease was partially offset by a higher amount of contractual management and guarantee fee income resulting from higher average balances of our PCs and Structured Securities in the first quarter of 2009. The ending balance of our issued PCs and Structured Securities increased by 2% and 10%, during the first quarters of 2009 and 2008, respectively, on an annualized basis.

 

Gains (Losses) on Guarantee Asset

 

Upon issuance of a financial guarantee, 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 and Structured 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:

 

 

Contractual management and guarantee fees shown in Table 8 represent cash received in each period for those financial guarantees with an established guarantee asset. A portion of these contractual management and guarantee fees is attributed to imputed interest income on the guarantee asset.

 

Table 8 — Attribution of Change — Gains (Losses) on Guarantee Asset

 

 

Contractual management and guarantee fees increased in the first quarter of 2009 as compared to the first quarter of 2008, primarily due to increases in the average balance of our PCs and Structured Securities issued.

 

As shown in the table above, the change in fair value of management and guarantee fees was $328 million in the first quarter of 2009 compared to $(920) million in the first quarter of 2008. This increase in the gain on our guarantee asset in the first quarter of 2009 was principally attributed to an improvement in the fair values of excess-servicing, interest-only mortgage securities, compared to a decline in fair values of such securities during the first quarter of 2008. Our valuation methodology for the guarantee asset uses market-based information, including market values of excess-servicing, interest-only mortgage securities, to determine the fair value of future cash flows associated with the guarantee asset.

 

Income on Guarantee Obligation

 

Upon issuance of our guarantee, we record a guarantee obligation on our consolidated balance sheets representing the estimated fair value of our obligation to perform under the terms of the guarantee. Our guarantee obligation is amortized into income using a static effective yield determined at inception of the guarantee based on forecasted repayments of the principal balances on loans underlying the guarantee. See “CRITICAL ACCOUNTING POLICIES AND ESTIMATES — Application of the Static Effective Yield Method to Amortize the Guarantee Obligation” in our 2008 Annual Report for additional information on application of the static effective yield method. The static effective yield is periodically evaluated and amortization is adjusted when significant changes in economic events cause a shift in the pattern of our economic release from risk. When this type of change is required, a cumulative catch-up adjustment, which could be significant in a given period, will be recognized. In the first quarter of 2009, we enhanced our methodology for evaluating significant changes in economic events to be more in line with the current economic environment and to monitor the rate of amortization on our guarantee obligation so that it remains reflective of our expected duration of losses.

 

Table 9 provides information about the components of income on guarantee obligation.

 

Table 9 — Income on Guarantee Obligation

 

 

Amortization income decreased primarily due to less significant cumulative catch-up adjustments partially offset by higher static effective yield rates during the first quarter of 2009 as compared to the first quarter of 2008. The cumulative catch-up adjustments recognized during the first quarter of 2008 were principally due to more significant declines in home prices during that period. We estimate that the national decline in home prices, based on our own index of our single-family mortgage portfolio was 1.4% and 2.9% during the first quarters of 2009 and 2008, respectively.

 

Derivative Overview

 

During 2008, we elected cash flow hedge accounting relationships for certain commitments to sell mortgage-related securities; however, we discontinued hedge accounting for these derivative instruments in December 2008. In addition, during 2008, we designated certain derivative positions as cash flow hedges of changes in cash flows associated with our forecasted issuances of debt, consistent with our risk management goals, in an effort to reduce interest rate risk related volatility in our consolidated statements of operations. In conjunction with our entry into conservatorship on September 6, 2008, we determined that we could no longer assert that the associated forecasted issuances of debt were probable of occurring and, as a result, we ceased designating derivative positions as cash flow

 

hedges associated with forecasted issuances of debt. The previous deferred amount related to these hedges remains in our AOCI balance and will be recognized into earnings over the expected time period for which the forecasted issuances of debt impact earnings. Any subsequent changes in fair value of those derivative instruments are included in derivative gains (losses) on our consolidated statements of operations. As a result of our discontinuance of this hedge accounting strategy, we transferred $27.6 billion in notional amount and $(488) million in fair value from open cash flow hedges to closed cash flow hedges on September 6, 2008. For a discussion of the impact of derivatives on our consolidated financial statements and our discontinuation of derivatives designated as cash flow hedges see “NOTE 10: DERIVATIVES” to our consolidated financial statements.

 

Table 10 presents the gains and losses related to derivatives that were not accounted for in hedge accounting relationships. Derivative gains (losses) represents the change in fair value of derivatives not accounted for in hedge accounting relationships because the derivatives did not qualify for, or we did not elect to pursue, hedge accounting, resulting in fair value changes being recorded to earnings. Derivative gains (losses) also includes the accrual of periodic settlements for derivatives that are not in hedge accounting relationships. Although derivatives are an important aspect of our management of interest-rate risk, they generally increase the volatility of reported net loss, particularly when they are not accounted for in hedge accounting relationships.

 

Table 10 — Derivative Gains (Losses)

 

 

 

We use receive- and pay-fixed interest rate swaps to adjust the interest-rate characteristics of our debt funding in order to more closely match changes in the interest-rate characteristics of our mortgage-related assets. We also use derivatives to synthetically create the substantive economic equivalent of various debt funding structures. For example, the combination of a series of short-term debt issuances over a defined period and a pay-fixed interest rate swap with the same maturity as the last debt issuance is the substantive economic equivalent of a long-term fixed-rate debt instrument of comparable maturity. Due to limits on our ability to issue long-term and callable debt beginning in the second half of 2008 and part of the first quarter of 2009, we increased our use of pay-fixed interest rate swaps. However, the use of these derivatives may expose us to additional counterparty credit risk. For a discussion regarding our ability to issue debt see “LIQUIDITY AND CAPITAL RESOURCES — Liquidity — Debt Securities.” During the first quarter of 2009, fair value gains on our pay-fixed interest rate swaps of $6.7 billion were partially offset by losses on our receive-fixed interest rate swaps of $1.6 billion as longer-term swap interest rates increased, resulting in an overall gain recorded for derivatives.

 

Additionally, we use swaptions and other option-based derivatives to adjust the characteristics of our debt in response to changes in the expected lives of mortgage-related assets in our mortgage-related investments portfolio. We recorded losses of $3.4 billion on our purchased call swaptions during the three months ended March 31, 2009, compared to gains of $3.2 billion during the three months ended March 31, 2008. The losses during the three months ended March 31, 2009 were attributable to increasing swap interest rates and a decrease in implied volatility, compared to the gains during the three months ended March 31, 2008, which were attributable to decreasing swap interest rates and an increase in implied volatility.

 

As a result of our election of the fair value option for our foreign-currency denominated debt, foreign-currency translation gains and losses and fair value adjustments related to our foreign-currency denominated debt are recognized on our consolidated statements of operations as gains (losses) on debt recorded at fair value. We use a combination of foreign-currency swaps and foreign-currency denominated receive-fixed interest rate swaps to hedge the changes in fair value of our foreign-currency denominated debt related to fluctuations in exchange rates and interest rates, respectively.

 

For the three months ended March 31, 2009, we recognized fair value gains of $467 million on our foreign-currency denominated debt, consisting of $580 million in translation gains and $(113) million related to interest-rate and instrument-specific credit risk adjustments. Derivative gains (losses) on foreign-currency swaps of $(573) million largely offset fair value translation gains of $580 million on our foreign-currency denominated debt. In addition, derivative gains (losses) of $187 million on foreign-currency denominated receive-fixed interest rate swaps largely offset the interest-rate and instrument-specific credit risk adjustments included in gains (losses) on debt recorded at fair value for the three months ended March 31, 2009.

 

For the three months ended March 31, 2008, we recognized fair value losses of $1.4 billion on our foreign-currency denominated debt, consisting of $1.2 billion in translation losses and $(171) million related to interest-rate and instrument-specific credit risk adjustments. Derivative gains (losses) on foreign-currency swaps of $1.2 billion offset fair value translation losses of $1.2 billion on our foreign-currency denominated debt. In addition, derivative gains (losses) of $193 million on foreign-currency denominated receive-fixed interest rate swaps largely offset the interest-rate and instrument-specific credit risk adjustments included in gains (losses) on debt recorded at fair value for the three months ended March 31, 2008.

 

For a discussion of the instrument-specific credit risk and our election to adopt the fair value option on our foreign-currency denominated debt see “NOTE 17: FAIR VALUE DISCLOSURES— Fair Value Election — Foreign-Currency Denominated Debt with the Fair Value Option Elected” in our 2008 Annual Report.

 

Gains (Losses) on Investment Activity

 

Gains (losses) on investment activity includes gains and losses on certain assets where changes in fair value are recognized through earnings, gains and losses related to sales, impairments and other valuation adjustments. Table 11 summarizes the components of gains (losses) on investment activity.

 

Table 11 — Gains (Losses) on Investment Activity

 

 

Gains (Losses) on Trading Securities

 

We recognized net gains on trading securities of $2.1 billion for the first quarter of 2009, as compared to net gains of $971 million for the first quarter of 2008. The unpaid principal balance of our securities classified as trading was approximately $253 billion at March 31, 2009 compared to approximately $103 billion at March 31, 2008 primarily due to our increased purchases of agency mortgage-related securities. The increased balance in our trading portfolio combined with tightening OAS levels, contributed $1.0 billion to the gains on these trading securities for the first quarter of 2009. In addition, during the first quarter of 2009, we sold agency securities classified as trading with unpaid principal balances of approximately $36 billion, which generated realized gains of $1.1 billion.

 

Impairments on Available-For-Sale Securities

 

During the first quarter of 2009, we recorded other-than-temporary impairments related to investments in available-for-sale securities of $7.1 billion, of which approximately $6.9 billion related to non-agency mortgage-related securities backed by subprime, MTA, Alt-A and other loans. The remaining $0.2 billion related to other-than-temporary impairments of available-for-sale non-mortgage-related asset-backed securities in our cash and other investments portfolio where we did not have the intent to hold to a forecasted recovery of the unrealized losses. The decision to impair these securities is consistent with our consideration of these securities as a contingent source of liquidity. See “NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES — Recently Issued Accounting Standards, Not Yet Adopted — Additional Guidance and Disclosures for Fair Value Measurements and Change in the Impairment Model for Debt Securities — Change in the Impairment Model for Debt Securities” to our consolidated financial statements for information on how other-than-temporary impairments will be recorded on our financial statements commencing in the second quarter of 2009.

 

During the first quarter of 2008, we recognized $71 million of other-than-temporary impairments related to investments in available-for-sale securities, including $68 million attributed to $1.3 billion of obligations of states and political subdivisions in an unrealized loss position that we did not have the intent to hold to a forecasted recovery.

 

See “CONSOLIDATED BALANCE SHEETS ANALYSIS — Mortgage-Related Investments Portfolio — Other-Than-Temporary Impairments on Available-for-Sale Mortgage-Related Securities” for additional information.

 

Gains (Losses) on Debt Recorded at Fair Value

 

We elected the fair value option for our foreign-currency denominated debt effective January 1, 2008. Accordingly, foreign-currency exposure is a component of gains (losses) on debt recorded at fair value. We manage the foreign-currency exposure associated with our foreign-currency denominated debt through the use of derivatives. For the three months ended March 31, 2009, we recognized fair value gains of $467 million on our foreign-currency denominated debt primarily due to the U.S. dollar strengthening relative to the Euro. However, the U.S. dollar weakened for the three months ended March 31, 2008, contributing to our recognition of fair value losses of $1.4 billion on our foreign-currency denominated debt. See “Derivative Overview” for additional information about how we mitigate changes in the fair value of our foreign-currency denominated debt by using derivatives.

 

Gains (Losses) on Debt Retirement

 

Gains (losses) on debt retirement were $(104) million and $305 million during the three months ended March 31, 2009 and 2008, respectively. This change was due to a decreased level of call activity involving our debt with coupon levels that increase at pre-determined intervals.

 

Recoveries on Loans Impaired Upon Purchase

 

Recoveries on loans impaired upon purchase represent the recapture into income of previously recognized losses on loans purchased and provision for credit losses associated with purchases of delinquent loans under our financial guarantee. Recoveries occur when a non-performing loan is repaid in full or when at the time of foreclosure the estimated fair value of the acquired property, less costs to sell, exceeds the carrying value of the loan. For impaired loans where the borrower has made required payments that return the loan to less than 90 days delinquent, the recovery amounts are instead accreted into interest income over time as periodic payments are received.

 

During the three months ended March 31, 2009 and 2008, we recognized recoveries on loans impaired upon purchase of $50 million and $226 million, respectively. Our recoveries on impaired loans decreased due to a lower rate of loan payoffs and a higher proportion of modified loans among those purchased during the first quarter of 2009, as compared to the first quarter of 2008. In addition, our temporary suspensions of foreclosure transfers on occupied homes during the first quarter of 2009 reduced our recognition of recoveries.

 

Trust Management Income (Expense)

 

Trust management income (expense) represents the amounts we earn as administrator, issuer and trustee, net of related expenses, related to the management of remittances of principal and interest on loans underlying our PCs and Structured Securities. Trust management income (expense) was $(207) million and $3 million in the first quarter of 2009 and first quarter of 2008, respectively. We experienced trust management expenses associated with shortfalls in interest payments on PCs, known as compensating interest, which significantly exceeded our trust management income during the first quarter of 2009. The increase in expense for these shortfalls was attributable to significantly higher refinancing activity and lower interest income on trust assets, which we receive as fee income, in the first quarter of 2009, as compared to the first quarter of 2008. If mortgage interest rates remain low, we expect refinancing activity to remain elevated in the near term and our trust management expenses will likely exceed our related income. See “MD&A — CONSOLIDATED RESULTS OF OPERATIONS — Segment Earnings-Results — Single-Family Guarantee” in our 2008 Annual Report for further information on compensating interest.

 

Other Income (Losses)

 

Other income (losses) primarily consists of resecuritization fees, net hedging gains and losses, fees associated with servicing and technology-related programs, fees related to multifamily loans (including application and other fees) and various other fees received from mortgage originators and servicers. Other income (losses) declined to $41 million in the first quarter of 2009 compared to $44 million in the first quarter of 2008.

 

Non-Interest Expense

 

Table 12 summarizes the components of non-interest expense.

 

Table 12 — Non-Interest Expense

 

 

Administrative Expenses

 

Administrative expenses decreased for the three months ended March 31, 2009, compared to the three months ended March 31, 2008, in part due to a decrease in the number of consultants and full-time employees as well as other cost reduction measures.

 

Provision for Credit Losses

 

Our reserves for mortgage loan and guarantee losses reflects our best projection of defaults we believe are likely as a result of loss events that have occurred through March 31, 2009. The substantial deterioration in the national housing market, the uncertainty in other macroeconomic factors and the uncertainty of the effect of any current or future government actions to address the economic and housing crisis makes forecasting of default rates increasingly imprecise. Our reserves also include the impact of our projections of the results of strategic loss mitigation initiatives, including our temporary suspensions of certain foreclosure transfers, a higher volume of loan modifications, and projections of recoveries through repurchases by seller/servicers of defaulted loans due to failure to follow contractual underwriting requirements at the time of the loan origination. An inability to realize the benefits of our loss mitigation plans, a lower realized rate of seller/servicer repurchases or default rates that exceed our current projections will cause our losses to be significantly higher than those currently estimated.

 

The provision for credit losses was $8.8 billion in the first quarter of 2009 compared to $1.2 billion in the first quarter of 2008, as continued weakening in the housing market and a rapid rise in unemployment affected our single-family mortgage portfolio. See “Table 2 — Credit Statistics, Single-Family Mortgage Portfolio” for a presentation of the quarterly trend in the deterioration of our credit statistics. For more information regarding how we derive our estimate for the provision for credit losses, see “MD&A — CRITICAL ACCOUNTING POLICIES AND ESTIMATES” in our 2008 Annual Report. We recorded a $7.1 billion increase in our loan loss reserve, which is a reserve for credit losses on loans within our mortgage-related investments portfolio and mortgages underlying our PCs, Structured Securities and other mortgage-related guarantees, at March 31, 2009 as a result of:

 

 

We expect our provisions for credit losses will likely remain high during 2009. The likelihood that our provision for credit losses will remain high in future periods will depend on a number of factors, including the impact of the MHA Program on our loss mitigation efforts, changes in property values, regional economic conditions, third-party mortgage insurance coverage and recoveries and the realized rate of seller/servicer repurchases.

 

REO Operations Expense

 

The increase in REO operations expense for the three months ended March 31, 2009, as compared to the three months ended March 31, 2008, was primarily due to increases in the volume of our single-family property foreclosure transfers. The decline in home prices, which has been more dramatic in certain geographical areas, combined with our higher volume of REO acquisitions, resulted in higher disposition losses during the first quarter of 2009 compared to

 

the first quarter of 2008. Market-based writedowns of REO inventory totaled $32 million and $114 million for the three months ended March 31, 2009 and 2008, respectively. We expect REO operations expense to continue to increase in the remainder of 2009, as single-family REO acquisition volume increases and home prices remain under pressure.

 

Losses on Loans Purchased

 

Losses on delinquent and modified loans purchased from the mortgage pools underlying PCs and Structured Securities occur when the acquisition basis of the purchased loan exceeds the estimated fair value of the loan on the date of purchase. As a result of increases in delinquency rates of loans underlying our PCs and Structured Securities and our increasing efforts to reduce foreclosures, the number of loan modifications increased significantly during the first quarter of 2009, as compared to the first quarter of 2008. When a loan underlying our PCs and Structured Securities is modified, we generally exercise our repurchase option and hold the modified loan in our mortgage-related investments portfolio. See “Recoveries on Loans Impaired upon Purchase” and “RISK MANAGEMENT — Credit Risks — Table 44 — Changes in Loans Purchased Under Financial Guarantees” for additional information about the impacts from these loans on our financial results.

 

During the three months ended March 31, 2009, the market-based valuation of non-performing loans continued to be adversely affected by the expectation of higher default costs and reduced liquidity in the single-family mortgage market. Our losses on loans purchased were $2.0 billion during the three months ended March 31, 2009 compared to $51 million during the three months ended March 31, 2008. The increase in losses on loans purchased is attributed both to the increase in volume of our optional repurchases of delinquent and modified loans underlying our guarantees as well as a decline in market valuations for these loans as compared to the first quarter of 2008. We expect these losses to continue to increase in 2009.

 

Income Tax Benefit

 

For the three months ended March 31, 2009 and 2008, we reported an income tax benefit of $937 million and $422 million, respectively. See “NOTE 12: INCOME TAXES” to our consolidated financial statements for additional information.

 

Segment Earnings

 

Our operations consist of three reportable segments, which are based on the type of business activities each performs — Investments, Single-family Guarantee and Multifamily. Certain activities that are not part of a segment are included in the All Other category; this category consists of certain unallocated corporate items, such as costs associated with remediating our internal controls and near-term restructuring costs, costs related to the resolution of certain legal matters and certain income tax items. We manage and evaluate performance of the segments and All Other using a Segment Earnings approach, subject to the conduct of our business under the direction of the Conservator. The objectives set forth for us under our charter and by our Conservator, as well as the restrictions on our business under the Purchase Agreement with Treasury, may negatively impact our Segment Earnings and the performance of individual segments.

 

Segment Earnings is calculated for the segments by adjusting GAAP net loss for certain investment-related activities and credit guarantee-related activities. Segment Earnings also includes certain reclassifications among income and expense categories that have no impact on net loss but provide us with a meaningful metric to assess the performance of each segment and our company as a whole. We continue to assess the methodologies used for segment reporting and refinements may be made in future periods. Segment Earnings does not include the effect of the establishment of the valuation allowance against our deferred tax assets, net. See “NOTE 16: SEGMENT REPORTING” to our consolidated financial statements for further information regarding our segments and the adjustments and reclassifications used to calculate Segment Earnings, as well as the management reporting and allocation process used to generate our segment results.

 

Segment Earnings — Results

 

Investments

 

Our Investments segment is responsible for 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 mortgages through our mortgage-related investments portfolio.

 

Table 13 presents the Segment Earnings of our Investments segment.

 

Table 13 — Segment Earnings and Key Metrics — Investments

 

 

Segment Earnings for our Investments Segment decreased $1.7 billion for the first quarter of 2009 compared to the first quarter of 2008. Security impairments increased during the first quarter of 2009 to $4.4 billion due to an increase in expected credit-related losses on our non-agency mortgage-related securities, compared to $2 million of security impairments recognized during the first quarter of 2008. Security impairments that reflect expected or realized credit-related losses are realized immediately pursuant to GAAP and in Segment Earnings. In contrast, non-credit-related security impairments are included in our GAAP results but are not included in Segment Earnings. Segment Earnings net interest income increased $1.7 billion and Segment Earnings net interest yield increased 77 basis points to 96 basis points for the first quarter of 2009 compared to the first quarter of 2008. The primary drivers underlying the increases in Segment Earnings net interest income and Segment Earnings net interest yield were (a) a decrease in funding costs as a result of the replacement of higher cost short- and long-term debt with lower cost debt issuances and (b) a significant increase in the average size of our mortgage-related investments portfolio including the purchases of fixed-rate assets. Partially offsetting these increases was an increase in derivative interest carry expense on net pay-fixed interest rate swaps, which is recognized within net interest income in Segment Earnings, as a result of decreased interest rates.

 

During the first quarter of 2009, the mortgage-related investments portfolio of our Investments Segment grew at an annualized rate of 32.4% compared to (7.0)% for the first quarter of 2008. The unpaid principal balance of the mortgage-related investments portfolio of our Investments Segment increased from $732 billion at December 31, 2008 to $791 billion at March 31, 2009. The portfolio grew because we acquired and held increased amounts of mortgage loans and mortgage-related securities in our mortgage related investments portfolio to provide additional liquidity to the mortgage market and, to a lesser degree, due to more favorable investment opportunities for agency securities, due to liquidity concerns in the market.

 

We held $92.6 billion of non-Freddie Mac agency mortgage-related securities and $192.1 billion of non-agency mortgage-related securities as of March 31, 2009 compared to $70.9 billion of non-Freddie Mac agency mortgage-related securities and $197.9 billion of non-agency mortgage-related securities as of December 31, 2008. The decline in the unpaid principal balance of non-agency mortgage-related securities is due to the receipt of monthly principal repayments on these securities. Agency securities comprised approximately 69% of the unpaid principal balance of the Investments Segment mortgage-related investments portfolio at March 31, 2009 compared with 68% at December 31, 2008. See “CONSOLIDATED BALANCE SHEETS ANALYSIS — Mortgage-Related Investments Portfolio” for additional information regarding our mortgage-related securities.

 

The objectives set forth for us under our charter and conservatorship and restrictions set forth in the Purchase Agreement may negatively impact our Investments segment results over the long term. For example, the planned reduction in our mortgage-related investments portfolio balance to $250 billion, through successive annual 10% declines commencing in 2010, will cause a corresponding reduction in our net interest income. This may negatively affect our Investments segment results.

 

Single-Family Guarantee Segment

 

In our Single-family Guarantee segment, we guarantee the payment of principal and interest on single-family mortgage-related securities, including those held in our mortgage-related investments portfolio, in exchange for monthly management and guarantee fees and other up-front compensation. Earnings for this segment consist primarily of management and guarantee fee revenues less the related credit costs (i.e., provision for credit losses) and operating expenses. Earnings for this segment also include the interest earned on assets held in the Investments segment related to single-family guarantee activities, net of allocated funding costs and amounts related to expected net float benefits.

 

Table 14 presents the Segment Earnings of our Single-family Guarantee segment.

 

Table 14 — Segment Earnings and Key Metrics — Single-Family Guarantee

 

 

Segment Earnings (loss) for our Single-family Guarantee segment declined to a loss of $(5.5) billion for the three months ended March 31, 2009, compared to a loss of $(458) million for the three months ended March 31, 2008. This decline reflects an increase in credit-related expenses due to higher delinquency rates, higher volumes of non-performing loans and foreclosure transfers, higher severity of losses on a per-property basis and a decline in home prices and other regional economic conditions. The increase in Segment Earnings management and guarantee income for the first quarter of 2009 is primarily due to higher average balances of the single-family credit guarantee portfolio partially offset by lower average contractual management and guarantee rates as compared to the first quarter of 2008.

 

Table 15 below provides summary information about Segment Earnings management and guarantee income for this segment. Segment Earnings management and guarantee income consists of contractual amounts due to us related to our management and guarantee fees as well as amortization of credit fees.

 

Table 15 — Segment Earnings Management and Guarantee Income — Single-Family Guarantee

 

 

For the three months ended March 31, 2009 and 2008, the annualized growth rates of our single-family credit guarantee portfolio were 1.7% and 9.9%, respectively. Our mortgage purchase volumes are impacted by several factors, including origination volumes, mortgage product and underwriting trends, competition, customer-specific behavior, contract terms, and governmental initiatives concerning our business activities. Origination volumes can be affected by government programs, such as the MHA Program. Single-family mortgage purchase volumes from individual customers can fluctuate significantly. Despite these fluctuations, our share of the overall single-family mortgage origination market was higher in the first quarter of 2009 as compared to the first quarter of 2008, as mortgage originators have generally tightened their credit standards, causing conforming mortgages to be the predominant product in the market during this period. We have also tightened our own guidelines for mortgages we purchase and we have seen improvements in the credit quality of mortgages delivered to us in 2009. We expect an increase in our volume in the second quarter of 2009 due to significant refinancing activity caused by recent declines in mortgage interest rates as well as our support of Home Affordable Refinance under the MHA Program.

 

Our Segment Earnings provision for credit losses for the Single-family Guarantee segment increased to $8.9 billion for the three months ended March 31, 2009, compared to $1.3 billion for the three months ended March 31, 2008, due to continued credit deterioration in our single-family credit guarantee portfolio. Mortgages in our single-family credit guarantee portfolio experienced significantly higher delinquency rates, higher transition rates to foreclosure, as well as higher loss severities on a per-property basis compared to the first quarter of 2008. Our provision for credit losses is based on our estimate of incurred losses inherent in both our credit guarantee portfolio and the mortgage loans in our mortgage-related investments portfolio using recent historical performance, such as trends in delinquency rates, recent charge-off experience, recoveries from credit enhancements and other loss mitigation activities.

 

The delinquency rate on our single-family credit guarantee portfolio increased to 2.29% as of March 31, 2009 from 1.72% as of December 31, 2008. Increases in delinquency rates occurred in all product types for the three months ended March 31, 2009. We expect our delinquency rates will continue to rise in the remainder of 2009.

 

Charge-offs, gross, for this segment increased to $1.4 billion in the first quarter of 2009 compared to $0.5 billion in the first quarter of 2008, primarily due to a considerable increase in the volume of REO properties we acquired through foreclosure transfers. Declining home prices resulted in higher charge-offs, on a per property basis, during the first quarter of 2009, and we expect growth in charge-offs to continue in 2009. See “RISK MANAGEMENT — Credit Risks — Table 48 — Single-Family Credit Loss Concentration Analysis” for additional delinquency and credit loss information.

 

Single-family Guarantee REO operations expense increased during the first quarter of 2009, compared to the first quarter of 2008. During 2008 and the first quarter of 2009, we experienced significant increases in delinquency rates and REO activity in all regions of the U.S., particularly in the states of California, Florida, Nevada and Arizona. The West region represented approximately 35% and 22% of our REO property acquisitions during the first quarter of 2009

 

and first quarter of 2008, respectively, based on the number of units. The highest concentration in the West region is in the state of California. At March 31, 2009, our REO inventory in California comprised 16% of total REO property inventory, based on units, and approximately 25% of our total REO property inventory, based on loan amount prior to acquisition. California has accounted for a significant amount of our credit losses and losses on our loans in this state comprised approximately 29% and 21% of our total credit losses in the first quarter of 2009 and the first quarter of 2008, respectively. We temporarily suspended all foreclosure transfers on occupied homes from November 26, 2008 through January 31, 2009 and from February 14, 2009 through March 6, 2009. On March 7, 2009, we suspended foreclosure transfers on owner-occupied homes where the borrower may be eligible to receive a loan modification under the MHA Program; however, we have continued with initiation and other preclosing steps in the foreclosure process. In addition, we temporarily suspended evictions for occupants of foreclosed homes from November 26, 2008 through April 1, 2009 and announced an initiative to provide for month-to-month rentals to qualified former borrowers and tenants that occupy our newly-foreclosed single-family properties. In part, this was done to allow us to implement our previously-announced Streamlined Modification Program and loan modifications under the MHA Program. These programs are designed to assist delinquent borrowers meeting certain criteria by offering loan modifications and potentially avoiding foreclosure. As a result of our suspension of foreclosure transfers, we experienced an increase in single-family delinquency rates and slower growth in charge-offs, a component of our credit losses, REO acquisitions and REO inventory during the first quarter of 2009, as compared to what we would have experienced without these actions. See “RISK MANAGEMENT — Credit Risks — Loss Mitigation Activities” for further information on these programs.

 

Declines in home prices contributed to the increase in the weighted average estimated current LTV ratio for loans underlying our single-family credit guarantee portfolio to 76% at March 31, 2009 compared to 72% at December 31, 2008 and 67% at March 31, 2008. Approximately 28% of loans in our single-family credit guarantee portfolio had estimated current LTV ratios above 90%, excluding second liens by third parties, at March 31, 2009, compared to 14% at March 31, 2008. In general, higher total LTV ratios indicate that the borrower has less equity in the home and would thus be more likely to default in the event of a financial hardship. We expect that home prices will continue to decline during 2009, and will result in increased current estimated LTV ratios on loans in our single-family credit guarantee portfolio. We expect that declines in home prices combined with the deterioration in rates of unemployment and other factors will result in higher credit losses for our Single-family Guarantee segment during 2009. Our suspension or delay of foreclosure transfers and any imposed delay in foreclosures by regulatory or governmental agencies causes a delay in our recognition of credit losses, and our loan loss reserves to increase. The implementation of any governmental actions or programs that expand the ability of delinquent borrowers to obtain modifications with concessions of past due principal or interest amounts, including proposed changes to bankruptcy laws, could lead to higher charge-offs.

 

Multifamily Segment

 

Through our Multifamily segment, we purchase multifamily mortgages for investment and guarantee the payment of principal and interest on multifamily mortgage-related securities and mortgages underlying multifamily housing revenue bonds. The mortgage loans of the Multifamily segment consist of mortgages that are secured by properties with five or more residential rental units. We typically hold multifamily loans for investment purposes. In 2008, we began holding multifamily mortgages designated held-for-sale as part of our initiative to offer securitization capabilities to the market and our customers. We plan to increase our securitization activity of multifamily loans we hold in our portfolio during 2009, as market conditions permit.

 

Table 16 presents the Segment Earnings of our Multifamily segment.

 

Table 16 — Segment Earnings and Key Metrics — Multifamily