UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

FORM 10-Q

 

 

 

For the quarterly period ended June 30, 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 July 31, 2009, there were 648,305,154 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, liquidity, capital management, economic and market conditions and trends, market share, legislative and regulatory developments, implementation of new accounting standards, 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 our Form 10-Q for the first quarter of 2009 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 and six months ended June 30, 2009 and our 2008 Annual Report.

 

Overview

 

Freddie Mac was chartered by Congress in 1970 with a public mission 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. 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. 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.

 

We had net income attributable to Freddie Mac of $0.8 billion for the second quarter of 2009 and total equity of $8.2 billion as of June 30, 2009. Net loss attributable to common stockholders was $374 million for the second quarter of 2009, reflecting the payment of $1.1 billion of dividends in cash on the senior preferred stock. As discussed below, total equity benefited from the cumulative effect of a change in accounting principle, which increased total equity by $5.1 billion. Our financial results for the second quarter of 2009 reflect the favorable impact on the fair value of our derivatives and on our investment activities of the steepening of the yield curve, as short-term rates decreased and long-term rates increased, as well as spread tightening. This favorable impact was partially offset by large credit-related expenses and losses on loans purchased due to loan modification. Second quarter net income also reflects a decrease in our provision for credit losses that we estimate to be approximately $1.4 billion related to an enhancement to our methodology for estimating loan loss reserves.

 

We expect a variety of factors will place downward pressure on our financial results in future periods, and could cause us to incur GAAP net losses. Key factors include the potential for continued deterioration in the housing market, which could increase credit-related expenses and security impairments, adverse changes in interest rates and spreads, which could result in mark-to-market losses, and our efforts under the MHA Program and other government initiatives, some of which are expected to have an adverse impact on our financial results. We believe that the recent modest home price improvements were largely seasonal, and expect home price declines in future periods. Consequently, our provisions for credit losses will likely remain high during the remainder of 2009 and increase above the level recognized in the second quarter. To the extent we incur GAAP net losses in future periods, we will likely need to take additional draws under the Purchase Agreement. In addition, due to the substantial dividend obligation on the senior

 

preferred stock, we expect to continue to record net losses attributable to common stockholders in future periods. For a discussion of factors that could result in additional draws, see “LIQUIDITY AND CAPITAL RESOURCES — Capital Adequacy”.

 

On July 21, 2009, we announced that our Board of Directors named Charles E. Haldeman, Jr. as our Chief Executive Officer. We expect that Mr. Haldeman’s employment will begin on August 10, 2009. We also announced that Mr. Haldeman was elected as a member of the Board, effective the date his employment commences. Mr. Haldeman will succeed John A. Koskinen, who has been serving as our Interim Chief Executive Officer and performing the function of principal financial officer and who will return to the position of Non-Executive Chairman of the Board.

 

Business Objectives

 

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 to management to conduct, day-to-day operations so that the company can continue to operate in the ordinary course of business.

 

We have changed certain business practices and other non-financial objectives to provide support for the mortgage market in a manner that serves public policy, but that may not contribute to profitability. Some of these changes increase our expenses, while others require us to forego revenue opportunities in the near term. In addition, 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 adversely impact our results, including our segment results.

 

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. As discussed below in “Legislative and Regulatory Matters — Pending and Proposed Legislation and Related Matters,” Treasury and HUD, in consultation with other government agencies, are expected to develop legislative recommendations for the future of the GSEs.

 

Our current focus and purpose is to meet the urgent liquidity needs of the U.S. mortgage market, lower costs for borrowers and support the recovery of the housing market and U.S. economy. Through our role in the Obama Administration’s initiatives, including the MHA Program, we are working to meet the needs of the mortgage market, in line with our mission, by making homeownership and rental housing more affordable, minimizing foreclosures and helping families keep their homes.

 

MHA Program and Other Efforts to Assist the Housing Market

 

We are working with our Conservator to help distressed homeowners through initiatives that support the MHA Program (previously known as the Homeowner Affordability and Stability Plan), which was announced by the Obama Administration in February 2009. We have also implemented a number of other initiatives to assist the U.S. residential mortgage market and help families keep their homes, some of which were undertaken at the direction of FHFA. The more significant initiatives are discussed below.

 

The MHA Program includes:

 

 

 

 

At present, it is difficult for us to predict the full impact of the MHA Program on us. However, to the extent our borrowers participate in HAMP in large numbers, it is likely that the costs we incur, including the servicer and borrower incentive fees, will be substantial. In addition, we continue to devote significant internal resources to the implementation of the various initiatives under the MHA Program. It is not possible at present to estimate the extent to which costs, incurred in the near term, may be offset, if at all, by the prevention or reduction of potential future costs of loan defaults and foreclosures due to these initiatives.

 

Our other efforts to assist the U.S. housing market include:

 

Increase in our Mortgage Portfolio Activity.  Since we entered into conservatorship in September 2008, we have been providing additional liquidity to the mortgage market, including by acquiring and holding increased amounts of mortgage loans and mortgage-related securities in our mortgage-related investments portfolio, subject to the limitation on the size of such portfolio as set forth in the Purchase Agreement. However, our mortgage-related investments portfolio decreased during the second quarter of 2009, due to a relative lack of favorable investment opportunities.

 

Temporary Foreclosure and Eviction Suspensions.  In order to allow our mortgage servicers time to implement our more recent modification programs and provide additional relief to troubled borrowers, we temporarily suspended all foreclosure transfers of occupied homes for certain periods. On March 7, 2009, we suspended foreclosure transfers on owner-occupied homes where the borrower may be eligible to receive a loan modification under HAMP. In addition, we temporarily suspended the eviction process for occupants of foreclosed homes from November 26, 2008 through April 1, 2009.

 

Increased Foreclosure Alternatives.  In the second quarter of 2009, we completed approximately 29,400 foreclosure alternative agreements, excluding loans in trial-period payment plans under HAMP, with borrowers out of the estimated 415,000 single-family loans in our single-family mortgage portfolio that were or became delinquent (90 days or more past due or in foreclosure) during the second quarter of 2009.

 

Government Support for our Business

 

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.

 

Significant recent developments with respect to the support we receive from the government include the following:

 

 

 

 

At June 30, 2009, our assets exceeded our liabilities by $8.2 billion. Because we had a positive net worth as of June 30, 2009, FHFA has not submitted a draw request on our behalf to Treasury for additional funding under the Purchase Agreement. The aggregate liquidation preference of the senior preferred stock is $51.7 billion and the amount remaining under the Treasury’s funding agreement is $149.3 billion as of June 30, 2009. The corresponding annual cash dividends payable to Treasury are $5.2 billion, which exceeds our annual historical earnings in most periods. We expect to make additional draws under the Purchase Agreement in future periods due to a variety of factors that could affect our net worth.

 

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 Second Quarter 2009 Results

 

Our financial results for the second quarter of 2009 reflect the continuing adverse economic conditions in the U.S., which deteriorated dramatically during the last half of 2008 and have continued to deteriorate in 2009. During the first half of 2009, there have been some positive housing market developments, including higher volumes of home sales and modest improvements in national home prices, which we believe to be largely seasonal. However, the U.S. recession has deepened, and there were significant increases in unemployment rates which, coupled with declines in household wealth, have contributed to increases in residential mortgage delinquency rates. Much of the increase in home sales reflects distressed home sales, including higher short sales and sales of foreclosed properties in the market. As a result, we continue to experience significant credit-related expenses, and our provision for credit losses was $5.2 billion in the second quarter of 2009, principally due to increased estimates of incurred losses caused by the deteriorating economic conditions, which were evidenced by our increased rates of delinquency, the significant volume of REO acquisitions and an increase in our single-family non-performing assets.

 

Although home prices nationwide increased an estimated 3.2% in the second quarter of 2009 (and an estimated 1.4% during the first half of 2009) based on our own internal index, which is based on properties underlying our single-family mortgage portfolio, home prices have suffered significant declines in nearly all regions and states in the last 12 months. The percentage decline in home prices in the last 12 months has been particularly large in the states of California, Florida, Arizona and Nevada, where we have significant concentrations of mortgage loans. The second quarter of the year is historically a strong period for home sales. This seasonal strength, combined with the fact that many financial institutions have maintained foreclosure suspensions during the first half of 2009, may have contributed to the increase in home prices during the period. We expect that when these temporary foreclosure suspensions are lifted and the seasonal peak in home sales has passed, there will likely be further downward pressure on home prices over the remainder of the year, which would likely result in increased credit related expenses. Unemployment rates have worsened significantly in the second quarter of 2009, and the national unemployment rate increased to 9.5% at June 30, 2009 as compared to 8.5% at March 31, 2009. Certain states have experienced much higher unemployment rates, such as California, Florida, Michigan and Nevada, where the unemployment rate reached 11.6%, 10.6%, 15.2% and 12.0%, respectively, at June 30, 2009. These states comprise approximately 25% of loans in our single-family mortgage portfolio as of June 30, 2009. Many financial institutions have continued to remain cautious in their lending activities during the second quarter of 2009. Although there was overall improvement in credit and liquidity conditions during the second quarter, credit spreads for both mortgage and corporate loans remained higher than before the start of the recession.

 

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 second quarter of 2009. While temporary suspensions of foreclosure transfers and recent loan modification efforts reduced the rate of growth in our charge-offs and REO acquisitions during the second 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 significant increases in delinquency rates for all product types during the second quarter of 2009. Additionally, as the slump in the U.S. housing market has

 

persisted for approximately two years, increasing numbers of borrowers that previously had significant equity are now “underwater,” or owing more on their mortgage loans than their homes are currently worth.

 

Multifamily housing fundamentals have also further deteriorated during the second quarter of 2009, reflecting the increasing unemployment rate and tightened credit of consumers and institutional borrowers. Home ownership is also becoming more affordable, due to home price declines that have occurred over the past several years. Consequently, multifamily properties have experienced declining rent levels and vacancy rates have recently risen to multi-year highs, which has negatively impacted multifamily property cash flows. As a result, our multifamily delinquency rate increased from 9 basis points as of March 31, 2009 to 11 basis points as of June 30, 2009. Despite challenging conditions, in June 2009 we completed a structured securitization transaction with multifamily mortgage loans totaling approximately $1 billion, which was one of the first large commercial mortgage bond issuances in the CMBS market this year.

 

The continued weakness in housing market conditions during the second 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. Mortgage-related securities backed by subprime, MTA Option ARM, 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 recorded $2.2 billion of net impairments of available-for-sale securities recognized in earnings during the second quarter of 2009.

 

There were some other positive signs of economic recovery in the U.S. during the second quarter of 2009, including a significant wave of single-family loan refinancing as mortgage interest rates dipped to near record lows in March and April. Approximately 87% of our single-family mortgage purchases were refinance loans during the second quarter of 2009 as compared to 66% during the second quarter of 2008.

 

Consolidated Results of Operations — Second Quarter 2009

 

We adopted FSP FAS 115-2 and FAS 124-2 effective April 1, 2009. FSP FAS 115-2 and FAS 124-2 amends the recognition, measurement and presentation of other-than-temporary impairments of debt securities, and is intended to bring greater consistency to the timing of impairment recognition and provide greater clarity to investors about the credit and non-credit components of impaired debt securities that are not expected to be sold. This guidance changes (a) the method of determining whether an other-than-temporary impairment exists, and (b) the amount of an impairment charge to be recorded in earnings. See “NOTE 4: INVESTMENTS IN SECURITIES” to our consolidated financial statements for further disclosures regarding our investments in securities and other-than-temporary impairments.

 

Net income (loss) was $767 million and $(819) million for the second quarters of 2009 and 2008, respectively. Net income increased in the second quarter of 2009 compared to the second quarter of 2008, principally due to higher net interest income, derivative gains and fair value gains on trading securities, compared to these items during the second quarter of 2008. These income and gains for the second quarter of 2009 were partially offset by increased credit-related expenses, which consist of the provision for credit losses and REO operations expense, and increased losses on loans purchased, compared to the second quarter of 2008. Although we reported net income in the second quarter of 2009, the dividends on the senior preferred stock resulted in net loss attributable to common stockholders for the period.

 

Net interest income was $4.3 billion for the second quarter of 2009, compared to $1.5 billion for the second quarter of 2008. As compared to the second quarter of 2008, we held higher amounts of fixed-rate agency mortgage-related securities in our mortgage-related investments portfolio and had lower funding costs, due to significantly lower interest rates on our short- and long-term borrowings during the three months ended June 30, 2009.

 

Non-interest income was $3.2 billion for the three months ended June 30, 2009, compared to non-interest income of $56 million for the three months ended June 30, 2008. The increase in non-interest income in the second quarter of 2009 was primarily due to a decrease in losses on investment activity of $1.9 billion as well as increased gains on our guarantee asset of $0.7 billion and derivatives portfolio, excluding foreign-currency related effects, of $1.2 billion. The decrease in losses on investment activity during the second quarter of 2009 was principally attributed to fair value gains on mortgage-related securities classified as trading of $0.6 billion compared to fair value losses on trading securities of $2.3 billion during the second quarter of 2008. This was partially offset by higher impairment-related losses primarily recognized on available-for-sale non-agency mortgage-related securities backed by subprime, MTA Option ARM, Alt-A and other loans during the quarter, which increased to $2.2 billion in the second quarter of 2009, compared to $1.0 billion in the second quarter of 2008.

 

Non-interest expenses increased to $6.9 billion in the second quarter of 2009 from $3.4 billion in the second quarter of 2008 due to higher credit-related expenses and losses on loans purchased. Credit-related expenses totaled $5.2 billion and $2.8 billion for the second quarters of 2009 and 2008, respectively, and included our provision for

 

credit losses of $5.2 billion and $2.5 billion, respectively. The increase in provision for credit losses was due to continued credit deterioration in our single-family mortgage portfolio, primarily from further increases in delinquency rates and higher loss severities on a per-property basis. During the second quarter of 2009, we enhanced our model for estimating credit losses on single-family loans. We estimate this change reduced our estimate of loan loss reserves, and consequently our provision for credit losses, by approximately $1.4 billion in the second quarter of 2009. See “CONSOLIDATED RESULTS OF OPERATIONS — Provision for Credit Losses” for additional information on these changes to our loan loss reserve model. Losses on loans purchased increased to $1.2 billion for the second quarter of 2009, compared to $120 million for the second quarter of 2008, due to a higher volume of purchases of modified loans out of PCs during the second quarter of 2009. Administrative expenses totaled $383 million for the second quarter of 2009, down from $404 million for the second quarter of 2008, primarily due to a reduction in short-term compensation expenses and other cost reduction measures.

 

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. Segment Earnings differ significantly from, and should not be used as a substitute for, net income (loss) as determined in accordance with GAAP.

 

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

 

Table 1 — Reconciliation of Segment Earnings to GAAP Net Income (Loss)

 

 

Segment Earnings is calculated for the segments by adjusting GAAP net income (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 income (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 income (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.

 

Consolidated Balance Sheets Analysis

 

During the six months ended June 30, 2009, total assets increased by $41.3 billion to $892.3 billion while total liabilities increased by $2.5 billion to $884.1 billion. Total equity (deficit) was $8.2 billion at June 30, 2009 compared to $(30.6) billion at December 31, 2008. See below for the key drivers of these changes in our consolidated balance sheet as of June 30, 2009.

 

Our cash and other investments portfolio increased by $9.1 billion during the six months ended June 30, 2009 to $73.3 billion, primarily due to an $11.9 billion increase in non-mortgage-related trading securities. On June 30, 2009,

 

we received $6.1 billion from Treasury under the Purchase Agreement pursuant to a draw request that FHFA submitted to Treasury on our behalf to address the deficit in our net worth as of March 31, 2009. The unpaid principal balance of our mortgage-related investments portfolio increased 3%, or $25.1 billion, during the six months ended June 30, 2009 to $829.8 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, favorable investment opportunities for agency securities, primarily in the first quarter of 2009, as a result of continued lack of liquidity in the market. Deferred tax assets, net increased $1.5 billion during the six months ended June 30, 2009 to $16.9 billion, primarily attributable to the increase in the net loss in AOCI, net of taxes, as discussed below.

 

Short-term debt decreased by $91.0 billion during the six months ended June 30, 2009 to $344.1 billion, and long-term debt increased by $84.9 billion to $492.8 billion. As a result, our outstanding short-term debt, including the current portion of long-term debt, has decreased as a percentage of our total debt outstanding to 41% at June 30, 2009 from 52% at December 31, 2008. The increase in our long-term debt reflects the improvement during the first half of 2009 of spreads on our debt and our increased access to the debt markets primarily as a result of 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 by $9.4 billion to $24.4 billion during the six months ended June 30, 2009 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) increased from $(30.6) billion at December 31, 2008 to $8.2 billion at June 30, 2009, reflecting the $36.9 billion we received from Treasury under the Purchase Agreement during the first six months of 2009 and a net increase in retained earnings (accumulated deficit) as a result of the adoption of FSP FAS 115-2 and FAS 124-2. Upon our adoption of this accounting guidance, we recognized a cumulative-effect adjustment of $15.0 billion to our opening balance of retained earnings (accumulated deficit) on April 1, 2009, and a corresponding adjustment of $(9.9) billion, net of tax, to AOCI. The cumulative effect adjustment reclassified the non-credit component of other-than-temporary impairments on our non-agency mortgage-related securities from retained earnings (accumulated deficit) (i.e., previously expensed) to AOCI. The difference between these adjustments of $5.1 billion represents an increase in total equity primarily resulting from the release of the valuation allowance previously recorded against the deferred tax asset that is no longer required related to the cumulative-effect adjustment. These increases in total equity (deficit) were partially offset by a $9.1 billion net loss and $1.5 billion of senior preferred stock dividends for the six months ended June 30, 2009. In addition, the net loss in AOCI, net of taxes, increased by $2.5 billion, resulting largely from the cumulative-effect adjustment of the adoption of FSP FAS 115-2 and FAS 124-2, partially offset by the unrealized gains on our agency mortgage-related securities and the recognition of other-than-temporary impairments in earnings related to our non-agency mortgage-related securities.

 

Consolidated Fair Value Results

 

During the three months ended June 30, 2009, the fair value of net assets, before capital transactions, increased by $5.4 billion compared to no change during the three months ended June 30, 2008. The fair value of net assets as of June 30, 2009 was $(70.5) billion, compared to $(80.9) billion as of March 31, 2009. Included in our fair value results for the three months ended June 30, 2009 are the $6.1 billion of funds received from Treasury on June 30, 2009 under the Purchase Agreement, partially offset by the $1.1 billion of dividends paid in cash to Treasury on our senior preferred stock. The increase in the fair value of our net assets, before capital transactions, during the second quarter of 2009 was principally related to an increase in the fair value of our mortgage-related investments portfolio, resulting from higher core spread income and net tightening of mortgage-to-debt OAS.

 

Liquidity and Capital Resources

 

Liquidity

 

Our access to the debt markets has improved since the height of the credit crisis in the fall of 2008. We attribute this improvement to the continued support of Treasury and the Federal Reserve. During the second quarter of 2009, the Federal Reserve continued to be 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 remained favorable. Debt spreads generally refer to the difference between the yields on our debt securities and the yields on a benchmark index or security, such as LIBOR or Treasury bonds of similar maturity. During the second quarter of 2009, we were able to increase our use of long-term and callable debt to fund our operations, and reduce our use of short-term debt. 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:

 

 

Our improved access to the unsecured debt markets may not continue upon completion or termination of the government actions noted above. Any reduction in government support for our debt funding program could adversely affect our ability to issue long-term debt. The Lending Agreement is scheduled to expire on December 31, 2009. Upon expiration of the Lending Agreement, 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. Absent an extension of the Lending Agreement, if backstop liquidity is needed after December 31, 2009, we will need to seek alternative sources for it. At present, we are not able to predict the likelihood that a liquidity backstop will be needed, or to identify the alternative sources that might then be available to us, other than draws from Treasury under the Purchase Agreement or its ability to purchase up to $2.25 billion of our obligations under its permanent authority.

 

Our annual dividend obligation on the senior preferred stock exceeds our annual historical earnings in most periods, and will result in increasingly negative cash flows in future periods, if we continue to pay the dividends in cash. In addition, the potential for continued deterioration in the housing market and future net losses in accordance with GAAP make it more likely that we will 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, as Conservator, determines as of quarter end that our liabilities have exceeded our assets under GAAP, upon FHFA’s request on our behalf, 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 June 30, 2009, our assets exceeded our liabilities by $8.2 billion. Because we had a positive net worth as of June 30, 2009, FHFA has not submitted a draw request on our behalf to Treasury for any additional funding under the Purchase Agreement. We received $6.1 billion on June 30, 2009 under the Purchase Agreement in accordance with the draw request submitted by FHFA on May 12, 2009 to address the deficit in our net worth as of March 31, 2009. The aggregate liquidation preference of the senior preferred stock is $51.7 billion and the amount remaining under the Treasury’s funding agreement is $149.3 billion as of June 30, 2009.

 

Treasury is entitled to annual cash dividends of $5.2 billion based on the current amount of the aggregate liquidation preference of the senior preferred stock. To date, we have paid $1.7 billion in cash in senior preferred stock dividends under the Purchase Agreement. This dividend obligation, combined with potentially substantial commitment fees payable to Treasury starting in 2010 (the amounts of which must be determined by December 31, 2009) 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 the housing market conditions continue to deteriorate, increasing the possibility of our incurring GAAP net losses in the future, 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

 

Overview

 

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 significantly during 2008 and remained challenging in the first half 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 uncertainty concerning the effect of current or any future government actions to remedy them have increased the uncertainty of future economic conditions, including unemployment rates and home price changes. While our assumption for home prices, based on our own index, continues to be for a decline during the second half of 2009, there continues to be divergence among economists about the future outlook and whether a sustained recovery in home prices may occur.

 

Single-Family Mortgage Portfolio

 

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:

 

 

Loss Mitigation

 

As discussed above, we have taken several steps during 2008 and continuing in 2009 designed to support homeowners and mitigate the growth of our non-performing assets. 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.

 

Currently, we are primarily focusing on initiatives that support the MHA Program. We also serve as the compliance agent under the MHA Program for certain foreclosure prevention activities, and we advise and consult with Treasury about the design, results and future improvement of the MHA Program.

 

Our more recent loss mitigation activities have created fluctuations in our credit statistics. For example, our temporary suspensions of foreclosure transfers of occupied homes temporarily reduced the rate of growth of our REO inventory and of charge-offs, a component of our credit losses, in certain periods 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 HAMP in the second quarter of 2009 contributed to a temporary decrease in the number of loan modifications since there is a three month trial-period before these modifications become effective. It is not possible at present to estimate the extent to which the costs of this program, incurred in the near term, 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.

 

Investments in Non-Agency Mortgage-Related Securities

 

Our investments in non-agency mortgage-related securities also were affected by the deteriorating credit conditions in 2008 and continuing into the first half of 2009. The table below illustrates the increases in delinquency rates for subprime first lien, MTA Option ARM and Alt-A loans that back $105.1 billion of the $186.2 billion of non-agency mortgage-related securities in our mortgage-related investments portfolio as of June 30, 2009. Given the forecast for home price declines in the remainder of 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 Option ARM and Alt-A Loans

 

 

We held unpaid principal balances of $109.5 billion of non-agency mortgage-related securities backed by subprime, MTA Option ARM, Alt-A and other loans in our mortgage-related investments portfolio as of June 30, 2009, compared to $119.5 billion as of December 31, 2008. This decrease is due to the monthly remittances of principal repayments we received on these securities of $4.9 billion and $10.0 billion during the three and six months ended June 30, 2009, respectively, representing a partial return of our investment in these securities. We have recorded net impairment of available-for-sale securities recognized in earnings on non-agency mortgage-related securities backed by subprime, MTA Option ARM, Alt-A and other loans of approximately $2.2 billion and $9.1 billion for the three and six months ended June 30, 2009, respectively. See “NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES — Change in Accounting Principles — 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 are recorded on our financial statements commencing in the second quarter of 2009. Gross unrealized losses, pre-tax, on securities backed by subprime, MTA Option ARM, Alt-A and other loans reflected in AOCI increased during the first half of 2009 by $10.4 billion to $41.2 billion at June 30, 2009. This increase in unrealized losses includes $15.3 billion, pre-tax,

 

($9.9 billion, net of tax) of other-than-temporary impairment losses reversed as a result of the second quarter 2009 adoption of FSP FAS 115-2 and FAS 124-2. These losses more than offset the unrealized gains in our non-agency mortgage-related securities that occurred during the first half of 2009.

 

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 we hold 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 adjusted during the first half of 2009 to more accurately reflect prepayment expectations under our implementation of the MHA Program as well as refinancing expectations in the current interest rate environment. During the second quarter of 2009, we purchased put swaptions to replace maturing positions in order to partially hedge our exposure to increasing negative convexity.

 

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 and key business unit 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 June 30, 2009, at a reasonable level of assurance. We continue to work to improve our financial reporting governance process and remediate material weaknesses and other deficiencies in our internal controls. While we are making 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 June 30, 2009, we believe that our interim consolidated financial statements for the quarter ended June 30, 2009, have been prepared in conformity with GAAP.

 

We face significant operational risks related to the process and systems changes we will be required to implement as a result of the FASB’s issuance of SFAS 166 and SFAS 167 (which will be effective as of January 1, 2010), including that it may be difficult for us to complete the changes in time to ensure we prepare timely financial reports in a controlled manner. These new accounting standards require us to consolidate our PC trusts in our financial statements, which could have a significant impact on our net worth.

 

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 $1,411 billion and $1,403 billion at June 30, 2009 and December 31, 2008, respectively. Based on our historical credit losses, which in the first half of 2009 averaged approximately 34 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

 

Legislation

 

On May 20, 2009, President Obama signed into law the Helping Families Save Their Homes Act of 2009, which, among other things, provides a safe harbor from liability for servicers engaging in certain loss mitigation activities,

 

requires borrowers to be notified when their mortgage loans are sold or transferred. The Protecting Tenants at Foreclosure Act, enacted as part of the Helping Families Save Their Homes Act, provides certain foreclosure protections for tenants by also requiring immediate successors in interest of foreclosed properties to give bona fide, non-owners at least 90 days advance notice before they are evicted from the premises. Freddie Mac is prohibited from evicting a bona fide tenant who was occupying the foreclosure property at the time of the sale before the expiration of a written lease agreement. We currently do not expect the impact of these provisions of the Act on us to be significant, because they are similar to our existing leasing policy.

 

On May 20, 2009, President Obama also signed into law the Fraud Enforcement and Recovery Act of 2009, which establishes a commission designated to examine the causes of the current financial crises, including the role of Freddie Mac and Fannie Mae. The commission is composed of ten members appointed by the House and Senate majority and minority leaders.

 

Pending and Proposed Legislation and Related Matters

 

On March 5, 2009, the House of Representatives passed a bill that, among other items, includes a provision allowing bankruptcy judges to modify the terms of mortgages on principal residences for borrowers in Chapter 13 bankruptcy. Specifically, the House bill would allow bankruptcy 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 provisions allowing bankruptcy judges to modify the terms of mortgages. It is unclear when, or if, the Senate will reconsider other alternative bankruptcy-related legislation. If enacted, this legislation could cause the volume of bankruptcy filings to rise, potentially increasing charge-offs for mortgages in our single-family mortgage portfolio and increasing our losses on loans purchased, which are recognized on our consolidated statements of operations.

 

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, allow for assignee liability and require lenders to determine that a borrower has a reasonable ability to repay home loans. If enacted, the legislation would impact Freddie Mac and the overall residential mortgage market. However, it is unclear when, or if, the Senate will consider comparable legislation.

 

On June 17, 2009, the Obama Administration announced a plan to overhaul the regulatory structure of the financial services industry. While the plan does not contain specific recommendations regarding the GSEs, many recommendations in the plan will, if implemented, cause significant changes in the regulation of the financial services industry. We cannot predict the impact of these potential changes on our business and operations. In addition, under the plan, Treasury and HUD are expected to develop recommendations for the future of the GSEs, in consultation with other government agencies, and will report to Congress on such recommendations at the time of the President’s 2011 budget, which is currently targeted for February 2010.

 

On June 26, 2009, the House of Representatives passed comprehensive energy legislation that would, among other things, require FHFA to provide Freddie Mac and Fannie Mae with extra affordable housing goals credit for purchases of certain energy-efficient and location-efficient mortgages. The legislation would also create a new duty to serve underserved markets for energy-efficient and location-efficient mortgages. It is currently unclear when, or if, the Senate will consider comparable legislation.

 

On July 16, 2009, the House of Representatives passed the appropriations bill for financial services and general government for fiscal year 2010. The House Committee on Appropriations report accompanying the bill directs Treasury to report to Congress on its plans to ensure that taxpayers receive repayment of their investment in Freddie Mac and Fannie Mae, as well as companies that received funds from the Troubled Asset Relief Program and other companies receiving taxpayer funds.

 

On July 23, 2009, the House of Representatives passed the appropriations bill for HUD for fiscal year 2010. The bill includes a provision that would extend the temporary high-cost conforming loan limits through September 2010.

 

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 would 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.

 

On July 31, 2009, the House of Representatives passed a bill that would require certain publicly traded companies to hold non-binding shareholder votes on executive compensation; would require certain publicly traded companies to take steps to ensure that their compensation committees are independent; would require specified financial institutions, including Freddie Mac, to disclose certain compensation structures to regulators; and would permit federal regulators to prohibit specified financial institutions, including Freddie Mac, from using certain types of compensation structures that the regulators determine encourage inappropriate risks.

 

Proposed and Interim Final Regulations

 

On June 5, 2009, FHFA published proposed executive compensation rules. The proposed rules, which would replace FHFA’s current executive compensation regulations, would establish procedural requirements and processes related to the compensation of executive officers at Freddie Mac, Fannie Mae, the FHLBs and the Office of Finance of the FHLBs and would implement certain compensation oversight authorities established by the Reform Act.

 

On June 17, 2009, FHFA published a proposed rule that would require Freddie Mac, Fannie Mae and the FHLBs to report to FHFA any fraud or possible fraud relating to any loans or other financial instruments that the entity has purchased or sold. The proposed rule would implement the Reform Act’s fraud reporting provisions and would replace the existing mortgage fraud regulation.

 

On June 29, 2009, FHFA published proposed rules that would set forth standards for permissible and prohibited golden parachute payments and indemnification payments to entity-affiliated parties by Freddie Mac, Fannie Mae, the FHLBs and the Office of Finance of the FHLBs. The proposed rules would implement FHFA’s statutory authority to regulate or prohibit golden parachute and indemnification payments, and would specify requirements that are closely related to the limitations that already exist for insured depository institutions under comparable banking regulations.

 

On July 2, 2009, FHFA published an interim final rule on prior approval of new products, implementing the new product provisions for Freddie Mac and Fannie Mae in the Reform Act. The rule establishes a process for Freddie Mac and Fannie Mae to provide prior notice to the Director of FHFA of a new activity and, if applicable, to obtain prior approval from the Director if the new activity is determined to be a new product. Under the rule, if the Director determines that a new activity of Freddie Mac is a “new product,” a description of the new product must be published for public comment, after which the Director will approve the new product if the Director determines that the new product is: (a) authorized by our charter; (b) in the public interest; and (c) consistent with the safety and soundness of Freddie Mac and the mortgage finance and financial system. We cannot currently predict the impact that the interim final rule will have on our business, financial position or results of operations.

 

Regulation Z

 

In July 2008, the Federal Reserve published a final rule amending Regulation Z (which implements the Truth in Lending Act). According to the Federal Reserve, one of the goals of the amendments is to protect consumers in the mortgage market from unfair, abusive, or deceptive lending and servicing practices while preserving responsible lending and sustainable homeownership. Most of the provisions of the final rule are effective on October 1, 2009. On July 23, 2009, the Federal Reserve proposed amendments to Regulation Z intended to improve the disclosures consumers receive in connection with certain mortgages and home-equity lines of credit. For more information, see “RISK MANAGEMENT — Credit Risks — Mortgage Credit Risk — Underwriting Standards and Quality Control Process.

 

State Actions

 

Several states have enacted laws that permit localities to impose new assessments to allow homeowners to finance energy efficient home improvements. The assessments are generally treated like property tax assessments and may result in the creation of a new lien that is senior to Freddie Mac’s lien. The ultimate impact of these new laws is currently unclear.

 

Various state and local governments have been taking actions that could delay or otherwise change their foreclosure processes. These actions could increase our expenses, including by potentially delaying the final resolution of delinquent mortgage loans and the disposition of non-performing assets. For example:

 

 

 

 

Affordable Housing Goals

 

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 July 28, 2009, FHFA issued a final rule that adjusts the affordable housing goals and home purchase subgoals for 2009 to the levels set forth in Table 4 below. Except for the multifamily special affordable volume target, FHFA decreased all of the goals and subgoals, as compared to those in effect for 2008.

 

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

 

 

The rule permits 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 rule excludes 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, which we refer to as “super-conforming” mortgages.

 

We expect that market conditions and the tightened credit and underwriting environment will make achieving our affordable housing goals and subgoals for 2009 challenging.

 

Effective beginning calendar year 2010, the Reform Act requires that FHFA establish, by regulation, four single-family housing goals and one multifamily special affordable housing goal. In addition, the Reform Act establishes a duty for Freddie Mac and Fannie Mae to serve three underserved markets, manufactured housing, affordable housing preservation and rural areas, by developing loan products and flexible underwriting guidelines to facilitate a secondary market for mortgages for very low-, low-and moderate-income families in those markets. Effective for 2010, FHFA is required to establish a manner for annually: (1) evaluating whether and to what extent Freddie Mac and Fannie Mae have complied with the duty to serve underserved markets; and (2) rating the extent of compliance.

 

New York Stock Exchange Matters

 

On November 17, 2008, we received a notice from the NYSE that we had failed to satisfy one of the NYSE’s standards for continued listing of our common stock. Specifically, the NYSE advised us that we were “below criteria” for the NYSE’s price criteria for common stock because the average closing price of our common stock over a consecutive 30 trading-day period was less than $1 per share. On December 2, 2008, we advised the NYSE of our intent to cure this deficiency, and that we may undertake a reverse stock split in order to do so.

 

On February 26, 2009, the NYSE suspended the application of its minimum price listing standard until June 30, 2009 (subsequently extended until July 31, 2009). The suspension period expired on July 31, 2009, and we have not regained compliance with the minimum price standard. Under applicable NYSE rules, we now have until October 20, 2009 to bring our share price and our average share price for the 30 consecutive trading days preceding October 20, 2009, above $1. If we fail to do so, NYSE rules provide that the NYSE will initiate suspension and delisting procedures.

 

The delisting of our common stock would likely also result in the delisting of our NYSE-listed preferred stock. The delisting of our common stock or NYSE-listed preferred stock would require any trading in these securities to occur in the over-the-counter market and could adversely affect the market prices, trading volume and liquidity of the markets for these securities. As a result, it could be more difficult for our shareholders to sell their shares, especially at prices comparable to those in effect prior to delisting. We will work with our Conservator to determine the specific action or actions that may be taken to cure the deficiency, but there is no assurance that any such actions will be taken or that any actions taken will be successful. The average share price of our common stock for the 30 consecutive trading days ended as of the filing of this Form 10-Q was less than $1 per share.

 

 

 

 

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 three and six months ended June 30, 2009 compared to the three and six months ended June 30, 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 new lower cost debt; (b) a significant increase in the average size of our mortgage-related investments portfolio, including an increase in our holdings of fixed-rate assets; and (c) $968 million of income, primarily recognized in the three months ended March 31, 2009, related to the accretion of other-than temporary impairments of investments in available-for-sale securities recorded primarily during the second half of 2008. Upon our adoption of FSP FAS 115-2 and FAS 124-2 on April 1, 2009, previously recognized non-credit related other-than-temporary impairments were reclassified from retained earnings to AOCI and these amounts are no longer accreted into net interest income. See “NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES” to our consolidated financial statements for a discussion of the impact of these accounting changes.

 

During the three and six months ended June 30, 2009, both our floating-rate long-term and our short-term debt funding average balances increased significantly when compared to the three and six months ended June 30, 2008. Our use of floating-rate long-term debt funding and short-term debt funding has been driven by varying levels of demand for our long-term and callable debt in the worldwide financial markets commencing in the second half of 2008. During the first half of 2009, the Federal Reserve was 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. Due to our limited ability to issue long-term and callable debt during the second half of 2008 and the first few months of 2009, we increased our use of the strategy of combining derivatives and floating-rate long-term debt or short-term debt to synthetically create the substantive economic equivalent of various longer-term fixed rate debt funding structures. See “Non-Interest Income (Loss) — Derivative Overview” for additional information. As discussed in “LIQUIDITY AND CAPITAL RESOURCES — Liquidity — Debt Securities,” our access to the debt markets has improved.

 

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, primarily 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, our net purchase activities resulted 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 three and six months ended June 30, 2009 were partially offset by the impact of declining short-term interest rates on floating rate assets held in our mortgage-related investments portfolio. We also increased our cash and other investments portfolio during the three and six months ended June 30, 2009 compared to the three and six months ended June 30, 2008, as we replaced higher-yielding, longer-term non-mortgage-related securities with 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 pre-2003 delivery and buy-down 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 for the three and six months ended June 30, 2009 compared to the three and six months ended June 30, 2008 primarily due to the reversal of amortization of pre-2003 deferred fees in the

 

2009 periods. Amortization of deferred fees declined due to our expectations of increasing interest rates and slowing prepayments in the future, which resulted in our recognizing a catch-up, or, in this case, reversal of previous amortization. The unpaid principal balance of our issued PCs and Structured Securities was $1.85 trillion at June 30, 2009 compared to $1.82 trillion at June 30, 2008, an increase of 1.5%. Although there were higher average balances of our issued guarantees during the three and six months ended June 30, 2009, compared to the same periods in 2008, the effect of this increase was offset by declines in the average rate of contractual management and guarantee fees. Our average management and guarantee fee rates have declined slightly in the second quarter and first half of 2009, compared to the same periods in 2008, due primarily to portfolio turnover in these periods, since newly issued PCs generally had lower average contractual guarantee fee rates than the previously outstanding PCs that were liquidated. This rate decline was primarily caused by the impact of our market-pricing on new business purchases and a decrease in higher-risk mortgage composition in our purchases that was partially offset by an increase in the preference for buy-ups in rates by our customers.

 

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.

 

Gains (losses) on guarantee asset reflect:

 

 

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 and imputed interest income increased slightly in the three and six months ended June 30, 2009 as compared to the three and six months ended June 30, 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 $2.3 billion in the second quarter of 2009 compared to $1.6 billion in the second quarter of 2008. The increase in the gain on our guarantee asset in the second quarter and first half of 2009 was principally attributed to a greater increase in interest rates during the 2009 periods, compared to the increase in interest rates that occurred during the same periods of 2008.

 

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

 

 

Basic amortization under the static effective yield method increased in both the three and six months ended June 30, 2009, compared to the same periods in 2008 primarily due to upward adjustments to the basic rates at the end of 2008, which were due to significant declines in home prices late in the year. Higher liquidation, or prepayment, rates on the related loans, which was attributed to higher refinance activity during the 2009 periods, also resulted in increased static effective yield amortization in the 2009 periods, compared to the 2008 periods.

 

Cumulative catch-up amortization was higher for the second quarter of 2009 compared to the second quarter of 2008 principally due to higher prepayment rates. We recognized much higher cumulative catch-up adjustments in the first half of 2008 than in the first half of 2009 due to home price declines during the first half of 2008 compared to an increase in national home prices during the first half of 2009, which resulted in catch-up adjustments in the 2008 period. We estimate a slight increase of 1.4% during the first half of 2009 in national home prices, based on our own index of our single family mortgage portfolio, compared to an estimated decrease of 2.9% during the first half of 2008.

 

Derivative Overview

 

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. During 2008, we also 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. 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 income (loss), particularly when they are not accounted for in hedge accounting relationships.

 

Table 10 — Derivative Gains (Losses)