UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

 

FORM 10-Q

 

 

For the quarterly period ended June 30, 2008

 

or

 

 

For the transition period from                to

 

Commission File Number: 000-53330

 

Federal Home Loan Mortgage Corporation

(Exact name of registrant as specified in its charter)

 

Freddie Mac

 

(703) 903-2000

 

(Registrant’s telephone number, including area code)

 

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

 

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

 

 

 

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

 

As of July 28, 2008, there were 647,015,161 shares of the registrant’s common stock outstanding.

 

 

TABLE OF CONTENTS

 

 

FINANCIAL STATEMENTS

 

 

 

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

 

Freddie Mac is a stockholder-owned company chartered by Congress in 1970 to stabilize the nation’s residential mortgage markets and expand opportunities for homeownership and affordable rental housing. Our mission is to provide liquidity, stability and affordability to the U.S. housing market. We fulfill our mission by purchasing residential mortgage loans and mortgage-related securities in the secondary mortgage market. We are one of the largest purchasers of mortgage loans in the U.S. We purchase mortgage loans and bundle them into mortgage-related securities that can be sold to investors. We can use the proceeds to purchase additional mortgage loans from primary market mortgage lenders, providing these lenders with a continuous flow of funds. We also purchase mortgage loans and mortgage-related securities for our retained portfolio. We finance our purchases for our retained portfolio and manage associated interest-rate and other market risks primarily by issuing a variety of debt instruments and entering into derivative contracts in the capital markets. See “CONSOLIDATED BALANCE SHEETS ANALYSIS — Retained Portfolio” and “OUR PORTFOLIOS” for a description and composition of our portfolios.

 

Though we are chartered by Congress, our business is funded completely with private capital. We alone are responsible for making payments on our securities. Neither the U.S. government nor any other agency or instrumentality of the U.S. government is obligated to fund our mortgage purchase or financing activities or to guarantee our securities or other obligations. Although the U.S. government’s ability to provide financial support to us has recently increased, this has not changed our responsibility to fund our obligations or resulted in any guarantee of our securities or other obligations. See “Legislative and Regulatory Matters.”

 

Recent Events

 

Since mid-June 2008, there has been a substantial decline in the market price of our common stock. The market conditions that have contributed to this price decline are likely to affect our approach to raising new core capital including the timing, amount, type and mix of securities we may issue. We have committed to the Office of Federal Housing Enterprise Oversight, or OFHEO, to raise $5.5 billion of new capital. We remain committed to raising this capital given appropriate market conditions and will evaluate raising capital beyond this amount depending on our needs and as market conditions mandate.

 

Our financial performance for the second quarter, while reflecting the challenges that face the industry, leaves us capitalized at a level greater than the 20% mandatory target capital surplus established by OFHEO and with a greater surplus above the statutory minimum capital requirement. Given the challenges facing the industry, we expect to take actions to maintain our capital position above the mandatory target capital surplus. Accordingly, subject to approval by our board of directors, we currently expect to reduce the dividend on our common stock in the third quarter of 2008 from $0.25 to $0.05 or less per share and to pay the full dividends at contractual rates on our preferred stock. In addition, we continue to review and consider other alternatives for managing our capital including issuing equity in amounts that could be substantial and materially dilutive to our existing shareholders, reducing or rebalancing risk, slowing purchases into our credit guarantee portfolio and limiting the growth or reducing the size of our retained portfolio by allowing the portfolio to run off and/or by selling securities classified as trading or carried at fair value under Statement of Financial Accounting Standards, or SFAS, No. 159 “The Fair Value Option for Financial Assets and Financial Liabilities, Including an Amendment of FASB Statement No. 115,” or SFAS 159, or available-for-sale securities that are accretive to capital (i.e., fair value exceeds amortized cost). We have retained and are working with financial advisors and we continue to engage in discussions with OFHEO and the U.S. Department of the Treasury, or Treasury, on these matters.

 

Our liquidity position remains strong as a result of: (a) our continued access to the debt markets at attractive spreads, (b) our cash and investments portfolio of approximately $70 billion and (c) an unencumbered agency mortgage-related securities portfolio of approximately $470 billion, which could serve as collateral for additional borrowings. Under stressful market conditions, counterparties willing to provide funding based on our unencumbered portfolio may be unavailable or may offer terms that are not attractive to the company. On July 13, 2008, the Board of Governors of the Federal Reserve System, or the Federal Reserve, granted the Federal Reserve Bank of New York the authority to lend to Freddie Mac if necessary. Any such lending would be at the discount rate charged for primary credit, or the primary credit rate, and collateralized by U.S. government and federal agency securities. This authorization was intended to supplement the Treasury’s existing authority to purchase obligations of Freddie Mac.

 

The Housing and Economic Recovery Act of 2008 was signed into law on July 30, 2008. Division A of this legislation, the Federal Housing Finance Regulatory Reform Act of 2008, or the Regulatory Reform Act, establishes a new regulator for us, the Federal Housing Finance Agency, or FHFA, with enhanced regulatory authorities relating, among other things, to our minimum and risk-based capital levels and our business activities, including portfolio investments, new products, management and operations standards, affordable housing goals, and executive compensation. The Regulatory Reform Act expands the circumstances under which we could be placed into conservatorship and also authorizes the FHFA to place us into receivership under specified circumstances. The Regulatory Reform Act also requires us to allocate or transfer certain amounts to: (a) the Secretary of the U.S. Department of Housing and Urban Development, or HUD, to fund a Housing Trust Fund and (b) a Capital Magnet Fund administered by the Secretary of the Treasury. In addition, the Regulatory Reform Act provides the Secretary of the Treasury with temporary authority, until December 31, 2009, to purchase any obligations and other securities we issue under certain circumstances. See “Legislative and Regulatory Matters” for additional information concerning the provisions of the Regulatory Reform Act and their potential impact on us.

 

Market Overview

 

In the first six months of 2008, the single-family residential mortgage market has continued to experience deterioration that began during 2007. The various factors contributing to this deterioration have adversely affected our financial condition and results of operations. Specifically, our estimates of nationwide home price changes, which measure home values primarily based on repeat home sales indicated home price declines of approximately 1% and 5%, in the three and six months ended June 30, 2008, respectively, with significant variation across regions and metropolitan areas. Home price changes are an important market indicator for us because they represent the general trend in value associated with the single-family mortgage loans underlying our Mortgage Participation Certificates, or PCs, and other mortgage-related securities. As home prices decline, the risk of borrower defaults generally increases and the severity of credit losses also increases. Forecasts of nationwide home prices indicate a continued overall decline in 2008.

 

Other trends in the single-family residential mortgage market also reflect the weakening in the housing market. Since early 2006, the volume of new and existing home sales has declined and increased inventories of unsold homes have undermined property values. Demand for investor properties and second homes has also declined dramatically. Annual total single-family conventional mortgage originations are expected to continue to decline during 2008.

 

Credit concerns and resulting liquidity issues have also affected the financial markets. Since mid-2007, the market for non-agency mortgage-related securities has been characterized by high levels of uncertainty, reduced demand, illiquidity and significantly wider credit spreads. Non-agency mortgage-related securities, particularly those backed by subprime and Alt-A mortgage products, have been subject to rating agency downgrades and significant price declines in the market. The reduced liquidity in U.S. financial markets prompted the Federal Reserve to take several significant actions during the first half of 2008, including a series of reductions in the discount rate totaling 2.50%. In early March 2008, the Federal Reserve expanded its securities lending program to allow primary dealers to borrow U.S. Treasury securities for 28 day terms (rather than only overnight) with a pledge of other securities by the borrower, including AAA-rated, private-issuer, residential mortgage securities. The Federal Reserve has left key lending rates unchanged since May 2008; however, credit and liquidity concerns have continued to affect the market.

 

The rate reductions by the Federal Reserve have had an impact on other key market rates affecting our assets and liabilities, including generally reducing the return on our cash and investments portfolio and lowering our cost of short-term debt financing. In addition, the reduction in rates by the Federal Reserve caused mortgage interest rates to temporarily decline early in 2008 and drove a surge in refinancing activity during the first four months of 2008. However, as residential mortgage rates rose during the remainder of the second quarter, the pace of refinancing activity slowed, and this is expected to also slow the growth of new issuances for our guaranteed PCs and Structured Securities portfolio during the second half of 2008.

 

The credit performance of mortgage products deteriorated during 2007 and 2008, most severely for subprime and Alt-A mortgage products. The decline in credit performance of mortgages during 2008, particularly subprime mortgages, has also impacted the ratings of certain monoline bond insurance providers, or monolines, which has negatively affected the pricing

 

of non-agency mortgage and asset-backed securities in the market. We have direct and indirect exposure to monolines and recognized other-than-temporary impairment losses related to some of these exposures during the second quarter of 2008. See “CONSOLIDATED BALANCE SHEETS ANALYSIS — Retained Portfolio” for additional information regarding our exposure to monolines as well as mortgage-related securities backed by subprime and Alt-A loans. Concerns about the potential for higher delinquency rates and more severe credit losses have resulted in greater increases in mortgage rates in the non-conforming and subprime portions of the market. Many lenders have tightened credit standards or elected to stop originating certain types of mortgages and several mortgage originators have exited the origination business. Decreases in home prices have also eroded the equity of many homeowners seeking to refinance. These factors have adversely affected many borrowers seeking alternative financing to refinance out of non-traditional and adjustable-rate mortgages, or ARMs.

 

The multifamily mortgage market differs from the residential single-family market in several respects. The likelihood that a multifamily borrower will make scheduled payments on its mortgage is a function of the ability of the property to generate income sufficient to make those payments, which is affected by rent levels and the percentage of available units that are occupied. Strength in the multifamily market therefore is affected by the balance between the supply of and demand for rental housing (both multifamily and single-family), which in turn is affected by employment, the number of new units added to the rental housing supply, rates of household formation and the relative cost of owner-occupied housing alternatives. Although multifamily market fundamentals have been strong in much of the nation, liquidity concerns and wider credit spreads have spilled over from the single-family mortgage market into the multifamily segment during 2008. However, we have continued to support the multifamily housing market during 2008 by making investments that we believe have attractive expected returns.

 

Summary of Financial Results for the Three and Six Months Ended June 30, 2008

 

Generally Accepted Accounting Principles, or GAAP, Results

 

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

 

Also effective January 1, 2008, we adopted SFAS 159 or the fair value option, which permits companies to choose to measure certain eligible financial instruments at fair value that are not currently required to be measured at fair value in order to mitigate volatility in reported earnings caused by measuring assets and liabilities differently. We initially elected the fair value option for certain available-for-sale mortgage-related securities and our foreign-currency denominated debt. Upon adoption of SFAS 159, we recognized a $1.0 billion after-tax increase to our retained earnings at January 1, 2008. We may continue to elect the fair value option for certain securities to mitigate interest-rate aspects of our guarantee asset and certain non-hedge designated pay-fixed swaps.

 

Net income (loss) was $(821) million and $729 million for the three months ended June 30, 2008 and 2007, respectively. Net income (loss) was $(972) million and $596 million for the six months ended June 30, 2008 and 2007, respectively. Net income decreased in the three and six months ended June 30, 2008 compared to the same periods of 2007, principally due to increased losses on investment activity as well as increased credit-related expenses, which consist of the provision for credit losses and real estate owned, or REO, operations expense. These loss and expense items for the three and six months ended June 30, 2008 were partially offset by higher net interest income and income on our guarantee obligation as well as lower losses on certain credit guarantees and lower losses on loans purchased due to our use of the practical expedient for determining fair value under SFAS 157 and changes in our operational practice of purchasing delinquent loans out of PC securitization pools.

 

Net interest income was $1.5 billion for the three months ended June 30, 2008, compared to $793 million for the three months ended June 30, 2007. Net interest income was $2.3 billion for the six months ended June 30, 2008, compared to $1.6 billion for the six months ended June 30, 2007. After the limitation on the growth of our retained portfolio expired, we were able to purchase significant amounts of fixed-rate agency mortgage-related securities at significantly wider spreads relative to our funding costs during the three and six months ended June 30, 2008. This action not only helped to serve our mission, but benefited our customers and the secondary mortgage market. The increase in net interest income and yield is also due to significantly lower short-term interest rates on our short-term borrowings and lower long-term interest rates on our long-term borrowings for the three and six months ended June 30, 2008. In addition, a higher proportion of short-term

 

debt, together with a lower proportion of floating rate securities within our retained portfolio contributed to the improvement in net interest income and net interest yield during the three and six months ended June 30, 2008.

 

Non-interest income was $164 million and $895 million for the three and six months ended June 30, 2008, respectively, compared to non-interest income of $1.5 billion for both the three and six months ended June 30, 2007. The decrease in non-interest income in the second quarter of 2008 was primarily due to higher losses on investment activity, excluding foreign-currency related effects, which was partially offset by gains on our guarantee asset, increased income on our guarantee obligation and higher management and guarantee income. Increased losses on investment activity during the second quarter of 2008 were primarily due to the impact of the increase in interest rates on our investments classified as trading and security impairments recognized on available-for-sale non-agency mortgage-related securities backed by subprime and Alt-A and other loans. Our investments classified as trading securities included those securities for which we elected fair value accounting under SFAS 159. The election of SFAS 159 for these securities provides income statement recognition of the economic hedge they provide against changes in the fair value of our guarantee asset and our derivative portfolio resulting from movements in interest rates. Losses related to trading securities were partially offset by gains on our guarantee asset and our derivative portfolio during the second quarter of 2008. Income on our guarantee obligation was $769 million and $474 million for the three months ended June 30, 2008 and 2007, respectively and $1.9 billion and $904 million for the six months ended June 30, 2008 and 2007, respectively. Our amortization of income on our guarantee obligation has accelerated in the three and six months ended June 30, 2008 as compared to the same 2007 periods in order to match our economic release from risk on the pools of mortgage loans we guarantee. Management and guarantee income increased 28%, to $757 million for the three months ended June 30, 2008 from $591 million for the three months ended June 30, 2007. Management and guarantee income increased to $1.5 billion, for the six months ended June 30, 2008 from $1.2 billion for the six months ended June 30, 2007. This reflects increases in the average balance of our PCs and Structured Securities of 14% and 15% on an annualized basis for the three and six months ended June 30, 2008, respectively. The increase also reflects higher average total management and guarantee fee rates for the three and six months ended June 30, 2008 compared to the same 2007 periods. See “CONSOLIDATED RESULTS OF OPERATIONS — Non-Interest Income” for further discussion of our non-interest income.

 

Our non-interest expenses for the three months ended June 30, 2008 and 2007 totaled $3.5 billion and $1.5 billion, respectively. Our non-interest expenses for the six months ended June 30, 2008 and 2007 totaled $5.6 billion and $2.7 billion, respectively. Credit-related expenses were $2.8 billion and $0.5 billion for the three months ended June 30, 2008 and 2007, respectively. Credit-related expenses were $4.3 billion and $0.7 billion for the six months ended June 30, 2008 and 2007, respectively. For the three and six months ended June 30, 2008, our provision for credit losses increased due to credit deterioration in our single-family credit guarantee portfolio, primarily due to increases in delinquency rates and higher severity of losses on a per-property basis. Credit deterioration has been largely driven by declines in home prices and regional economic conditions as well as the effect of a higher composition of nontraditional products in the mortgage origination market purchased prior to 2008. Nontraditional mortgage products, such as interest-only and Alt-A loans, made up 20% to 30% of our mortgage purchase volume during 2006 and 2007. Due to changes in underwriting practice and reduced originations in the market, these products made up approximately 7% to 10% of our mortgage purchase volume during the six months ended June 30, 2008. REO operations expense increased as a result of an increase in market-based write-downs of REO property due to the decline in home prices, coupled with higher volumes in REO inventory, particularly in the states of California, Florida, Arizona, Virginia and Nevada.

 

Non-interest expense, excluding credit-related expenses, for the three and six months ended June 30, 2008 totaled $743 million and $1.4 billion, compared to $1.1 billion and $2.0 billion for the three and six months ended June 30, 2007, respectively. The decline in non-interest expense, excluding credit-related expenses, was primarily due to the reductions in losses on certain credit guarantees and losses on loans purchased. Losses on certain credit guarantees decreased to $— and $15 million for the three and six months ended June 30, 2008, compared to $150 million and $327 million for the three and six months ended June 30, 2007, due to the change in our method for determining the fair value of our newly-issued guarantee obligation upon adoption of SFAS 157 that we adopted effective January 1, 2008. Losses on loans purchased decreased to $120 million and $171 million for the three and six months ended June 30, 2008, compared to $264 million and $480 million for the three and six months ended June 30, 2007, respectively, due to changes in our operational practice of purchasing delinquent loans out of PC pools. See “CONSOLIDATED RESULTS OF OPERATIONS — Non-Interest Expense — Losses on Certain Credit Guarantees and — Losses on Loans Purchased,” for additional information on the change in our operational practice. Administrative expenses totaled $404 million for the three months ended June 30, 2008, down from $442 million for the three months ended June 30, 2007. As a percentage of our average total mortgage portfolio, administrative expenses declined to 7.4 basis points for the three months ended June 30, 2008, from 9.2 basis points for the three months ended June 30, 2007. Administrative expenses totaled $801 million for the six months ended June 30, 2008, down from $845 million for the six months ended June 30, 2007. As a percentage of our average total mortgage portfolio,

 

administrative expenses declined to 7.5 basis points for the six months ended June 30, 2008, from 8.9 basis points for the six months ended June 30, 2007.

 

For the three months ended June 30, 2008 and 2007, we recognized effective tax rates of 56% and 11%, respectively. For the six months ended June 30, 2008 and 2007, we recognized effective tax rates of 60% and (103)%, respectively. See “NOTE 12: INCOME TAXES” to our consolidated financial statements for additional information about how our effective tax rate is determined.

 

Segments

 

We manage our business through three reportable segments:

 

 

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

 

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

 

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

 

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

 

 

Investments Segment

 

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

 

We seek to generate attractive returns on our portfolio of mortgage-related investments while maintaining a disciplined approach to interest-rate risk and capital management. We seek to accomplish this objective through opportunistic purchases, sales and restructurings of mortgage assets and repurchases of liabilities. Although we are primarily a buy-and-hold investor in mortgage assets, we may sell assets to reduce risk, to respond to capital constraints, to provide liquidity or to structure certain transactions in order to improve our returns. We estimate our expected investment returns using an option-adjusted spread, or OAS, approach. Our Investments segment activities may also include the purchase of mortgages and mortgage-related securities with less attractive investment returns and with incremental risk in order to achieve our affordable housing goals and subgoals. Additionally, we maintain a cash and non-mortgage-related securities investment portfolio in this segment to help manage our liquidity needs.

 

Investments segment performance highlights for the three and six months ended June 30, 2008:

 

 

Single-family Guarantee Segment

 

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

 

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

 

 

 

 

Multifamily Segment

 

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

 

Multifamily segment performance highlights for the three and six months ended June 30, 2008 and 2007:

 

 

Capital Management

 

Our primary objective in managing capital is preserving our safety and soundness and having sufficient capital to support our business and mission. We make investment decisions while considering our capital levels. OFHEO monitors our capital adequacy using several capital standards. Beginning in January 2004, OFHEO directed us to maintain a 30% mandatory target capital surplus above our statutory minimum capital requirement. On March 19, 2008, OFHEO reduced our mandatory target capital surplus to 20% above our statutory minimum capital requirement, and in return we announced that

 

we would begin the process to raise capital and maintain overall capital levels well in excess of requirements while the mortgage markets recover. At June 30, 2008, our estimated regulatory core capital was $37.1 billion, which is an estimated $8.4 billion in excess of our statutory minimum capital requirement and $2.7 billion in excess of the 20% mandatory target capital surplus.

 

On May 14, 2008, we announced our commitment to raise $5.5 billion of new core capital through one or more offerings, which will likely include both common or common equivalent and preferred securities. The timing, amount and mix of securities to be offered will depend on a variety of factors, including prevailing market conditions and approval by our board of directors. OFHEO has informed us that, upon completion of these offerings, our mandatory target capital surplus will be reduced from 20% to 15%. OFHEO has also informed us that it intends a further reduction of our mandatory target capital surplus from 15% to 10% upon the combination of completion of our SEC registration process, which was completed on July 18, 2008, our completion of the remaining Consent Order requirement (i.e., the separation of the positions of Chairman and Chief Executive Officer), our continued commitment to maintain capital well above OFHEO’s regulatory requirement and no material adverse changes to ongoing regulatory compliance.

 

The sharp decline in the housing market and volatility in financial markets continue to adversely affect our capital, including our ability to manage to our regulatory capital requirements and the 20% mandatory target capital surplus. Factors that could adversely affect the adequacy of our capital in future periods include our ability to execute capital raising transactions; GAAP net losses; continued declines in home prices; increases in our credit and interest-rate risk profiles; adverse changes in interest-rates, the yield curve or implied volatility; adverse OAS changes; impairments of non-agency mortgage-related securities; downgrades of non-agency mortgage-related securities (with respect to regulatory risk-based capital); counterparty downgrades; legislative or regulatory actions that increase capital requirements or changes in accounting practices or standards.

 

Under current OFHEO regulations, the regulatory risk based capital standard in particular is highly sensitive to underlying drivers, including house price changes (based on OFHEO’s all transaction index); downgrades of non-agency mortgage-related securities; counterparty downgrades; retained portfolio growth; the duration, term and optionality of our funding and hedging instruments; and other factors. While we have historically met the risk-based capital standard, there is a significant possibility that continued adverse developments in relation to one or more of these underlying drivers could cause us to fail to meet this standard. If we were not to meet the risk-based capital standard, we would be classified as “undercapitalized” by OFHEO. See “ITEM 1. BUSINESS — REGULATION AND SUPERVISION — Office of Federal Housing Enterprise Oversight — Capital Standards and Dividend Restrictions” and “ITEM 13. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA — AUDITED CONSOLIDATED FINANCIAL STATEMENTS AND ACCOMPANYING NOTES — NOTE 9: REGULATORY CAPITAL — Classification” in our Registration Statement for information regarding potential actions OFHEO may seek to take in that event. Under the Regulatory Reform Act, FHFA is charged with developing risk-based capital requirements by regulation. The nature of the requirements FHFA may eventually adopt pursuant to this authority is currently uncertain.

 

Also affecting our capital position was our adoption of SFAS 159 on January 1, 2008. Our election of the fair value option allows us to better reflect, in the financial statements, the economic offsets that exist related to items that were not previously recognized at fair value with changes in fair value reflected in our consolidated statements of income. We expect our adoption of the fair value option will reduce the impact of interest-rate changes on our net income (loss) and capital levels. However, since changes in OAS affect the gains (losses) on both our mortgage-related trading portfolio and guarantee asset, our adoption of SFAS 159 will increase the impact of OAS changes on net income (loss) and capital. For a further discussion of our adoption of SFAS 159 see “NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES — Change in Accounting Principles” to our consolidated financial statements. Beginning in the first quarter of 2008, we initiated our use of cash flow hedge accounting relationships to include hedging the changes in cash flows associated with our forecasted issuances of debt. We expect this accounting strategy will reduce the effect of interest-rate changes on our capital. We also employed this accounting strategy while maintaining our disciplined approach to interest-rate risk management. See “NOTE 10: DERIVATIVES” to our consolidated financial statements for additional information about our derivatives designated as cash flow hedges.

 

We expect to take actions to maintain our capital position above the OFHEO-directed mandatory target surplus. Accordingly, subject to approval by our Board of Directors, we currently expect to reduce the dividend on our common stock in the third quarter of 2008 from $0.25 to $0.05 or less per share and to pay the full dividends at contractual rates on our preferred stock. In addition, we continue to review and consider other alternatives for managing our capital including issuing equity in amounts that could be substantial and materially dilutive to our existing shareholders, reducing or rebalancing risk, slowing purchases into our credit guarantee portfolio and limiting the growth or reducing the size of our retained portfolio by allowing the portfolio to run off and/or by selling securities classified as trading or carried at fair value under SFAS 159 or available-for-sale securities that are accretive to capital (i.e., fair value exceeds amortized cost). We have retained and are working with financial advisors and we continue to engage in discussions with OFHEO and the Treasury on these matters.

 

Our ability to execute any of these actions or their effectiveness may be limited and we might not be able to manage to our regulatory capital requirements and the mandatory target capital surplus. If we are not able to manage to the mandatory target capital surplus, OFHEO may, among other things, seek to require us to (a) submit a plan for remediation or (b) take other remedial steps. In addition, OFHEO has discretion to reduce our capital classification by one level if OFHEO determines that we are engaging in conduct that could result in a rapid depletion of core capital or determines that the value of property subject to mortgage loans we hold or guarantee has decreased significantly. See “PART II — ITEM 1A. RISK FACTORS” in this Form 10-Q and “ITEM 1. BUSINESS — REGULATION AND SUPERVISION — Office of Federal Housing Enterprise Oversight — Capital Standards and Dividend Restrictions” and “ITEM 13. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA — AUDITED CONSOLIDATED FINANCIAL STATEMENTS AND ACCOMPANYING NOTES — NOTE 9: REGULATORY CAPITAL — Classification” in our Registration Statement for information regarding additional potential actions OFHEO may seek to take against us. See “Legislative and Regulatory Matters — Government Sponsored Enterprise, or GSE, Oversight Legislation” in this Form 10-Q for information regarding the enhanced regulatory authorities FHFA now possesses.

 

Fair Value Results

 

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

 

During the three months ended June 30, 2008, the fair value of net assets, before capital transactions, remained unchanged compared to a $0.7 billion increase during the three months ended June 30, 2007.

 

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

 

During the three months ended June 30, 2008, our investment activities increased fair value by approximately $6.7 billion, resulting from a higher core spread income and an increase in fair value of approximately $1.9 billion attributable to net mortgage-to-debt OAS tightening. Core spread income on our retained portfolio is a fair value estimate of the net current period accrual of income from the spread between mortgage-related investments and debt, calculated on an option-adjusted basis.

 

During the three months ended June 30, 2007, our investment activities decreased fair value by approximately $0.8 billion. This estimate includes declines in fair value of approximately $1.4 billion attributable to the net widening of mortgage-to-debt OAS.

 

The impact of mortgage-to-debt OAS tightening during the three months ended June 30, 2008 increased the current fair value of our investment activities. Due to the still relatively wide OAS levels for purchases during the period, there is a likelihood that, in future periods, we will be able to recognize core spread income from our investment activities at a higher spread level than historically. We estimate that for the three months ended June 30, 2008, we will recognize core spread income at a net mortgage-to-debt OAS level of approximately 140 to 160 basis points in the long run, as compared to approximately 25 to 35 basis points estimated for the three months ended June 30, 2007. As market conditions change, our estimate of expected fair value gains from OAS may also change, leading to significantly different fair value results.

 

During the three months ended June 30, 2008, our credit guarantee activities, including our single-family whole loan credit exposure, decreased fair value by an estimated $6.2 billion. This estimate includes an increase in the single-family guarantee obligation of approximately $7.2 billion, primarily attributable to a declining credit environment.

 

Our credit guarantee activities increased fair value by an estimated $1.8 billion during the three months ended June 30, 2007. This increase includes the receipt of cash primarily related to management, guarantee and other up-front fees. This increase also includes a fair value increase related to our single-family guarantee asset of approximately $1.8 billion, primarily attributable to an increase in interest rates during the three months ended June 30, 2007. These increases were partially offset by an increase in the fair value of our single-family guarantee obligation of approximately $0.6 billion.

 

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

 

Legislative and Regulatory Matters

 

Government Sponsored Enterprise, or GSE, Oversight Legislation

 

The Regulatory Reform Act was signed into law on July 30, 2008. This Act consolidates regulation of Freddie Mac and Federal National Mortgage Association, or Fannie Mae, or the enterprises, and the Federal Home Loan Banks, or FHLBs, into a single new regulator, FHFA. FHFA is an independent agency of the federal government responsible for oversight of the operations of the enterprises and the FHLBs. OFHEO will remain in existence for a transition period of up to one year.

 

FHFA has a Director appointed by the President and confirmed by the Senate for a five-year term, removable only for cause. The Regulatory Reform Act authorizes the Director of OFHEO on the date of enactment to act for all purposes and with the full powers of the Director of FHFA until such Director is appointed and confirmed.

 

The Regulatory Reform Act also establishes the Federal Housing Finance Oversight Board, or the Oversight Board which is responsible for advising the Director of FHFA with respect to overall strategies and policies. The Oversight Board consists of the Director of FHFA as Chairperson, the Secretary of the Treasury, the Chairman of the SEC and the Secretary of HUD.

 

The Regulatory Reform Act gives our regulator substantial authority to assess our safety and soundness and to regulate our portfolio investments, including requiring reductions in those investments, consistent with our mission and safe and sound operations. The Act also includes provisions that increase the regulator’s authority to change our minimum and risk-based capital levels and to regulate our business activities. In addition, the Act requires us to make certain contributions to affordable housing funds administered by the Secretary of HUD and the Secretary of the Treasury.

 

Given the recent enactment of this Act and the fact that FHFA has considerable discretion in implementing its provisions, including through rulemaking proceedings and the issuance of orders, we cannot predict the impacts that the Act and FHFA’s exercise of its authority under the Act will have on our business, financial position or results of operations. However, to the extent the Act or regulations or orders issued by FHFA pursuant to the Act may, for example, increase our capital requirements, limit our portfolio and new product activities, increase our affordable housing goals, or limit our ability to attract and retain senior executives, we anticipate that the impact could be materially adverse. Certain of the more significant provisions of the Act are summarized below.

 

Capital

 

FHFA may increase minimum capital levels from the existing statutory percentages either by regulation or on a temporary basis by order. FHFA may also, by regulation or order, establish capital or reserve requirements with respect to any product or activity of an enterprise, as FHFA considers appropriate. In addition, FHFA must, by regulation, establish risk-based capital requirements to ensure the enterprises operate in a safe and sound manner, maintaining sufficient capital and reserves to support the risks that arise in their operations and management. The Act provides FHFA with greater authority to take additional remedial actions as an enterprise’s capital levels decline.

 

Portfolio Activities

 

The Regulatory Reform Act requires FHFA to establish, by regulation, criteria governing retained portfolio holdings to ensure the holdings are backed by sufficient capital and consistent with the enterprises’ mission and safe and sound operations. In establishing these criteria, FHFA must consider the ability of the enterprises to provide a liquid secondary market through securitization activities, the portfolio holdings in relation to the mortgage market and the enterprises’ compliance with the prudential management and operations standards prescribed by FHFA.

 

FHFA may make temporary adjustments to the established portfolio standards by issuing an order to a particular enterprise, such as during times of economic distress or market disruption. In addition, FHFA must monitor the portfolio of each enterprise and may, by order, require an enterprise on such terms and conditions as FHFA determines appropriate to dispose of, or to acquire, any asset if FHFA determines such action is consistent with certain statutory purposes and the enterprises’ authorizing statutes.

 

New Products

 

The Regulatory Reform Act requires the enterprises to obtain the approval of FHFA before initially offering any new product. Excluded from the product review process are automated loan underwriting systems of the enterprises in existence on July 30, 2008, including upgrades; any modification to mortgage terms and conditions or underwriting criteria relating to mortgages purchased or guaranteed, as long as the modifications do not change the underlying transaction to include services or financing other than residential mortgage financing; and any other activities that are substantially similar to the activities described above or that have previously been approved by FHFA. The Act provides for a public comment process on requests for approval of new products. FHFA may temporarily approve a product without soliciting public comment if delay would be contrary to the public interest. FHFA may condition approval of a product on specific terms, conditions and limitations. The standards for FHFA’s approval of a new product are that the product is authorized by the enterprise’s charter, is in the public interest and is consistent with the safety and soundness of the enterprise or the mortgage finance system.

 

Prudential Management and Operations Standards

 

The Regulatory Reform Act requires FHFA to establish prudential standards, by regulation or by guideline, for a broad range of operations of the enterprises. These standards must address internal controls, information systems, independence and adequacy of internal audit systems, management of interest rate risk, management of market risk, liquidity and reserves, management of asset and investment portfolio growth, overall risk management processes, investments and asset acquisitions,

 

management of credit and counterparty risk, and recordkeeping. FHFA may also establish any additional operational and management standards the Director of FHFA determines appropriate.

 

If an enterprise or a FHLB fails to comply with the standards, FHFA could require submission of a plan to correct the deficiency. If the enterprise fails to submit an acceptable plan, or fails in any material respect to carry out an accepted plan, FHFA must order correction of the deficiency and may impose certain growth restrictions, require an increase in the ratio of core capital to assets and require other actions. FHFA must take one or more of these actions if FHFA determines that an enterprise has failed to meet a standard, the deficiency has not been corrected, and the enterprise underwent extraordinary growth, as defined by the Director of FHFA, during the 18-month period before the date of failure to meet a standard.

 

Affordable Housing Goals

 

Under the Regulatory Reform Act, the annual affordable housing goals previously established by HUD and 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 appropriate adjustments to the 2009 goals consistent with market conditions.

 

Effective beginning calendar year 2010, the Regulatory Reform Act replaces the existing annual affordable housing goals with the requirement that FHFA establish the following annual affordable housing goals by regulation:

 

  Single-family Housing Goals

 

 

  Multifamily Special Affordable Housing Goal

 

 

The Regulatory Reform Act allows an enterprise to petition FHFA for a reduction in any goal or subgoal at any time, and authorizes FHFA to reduce the level of the goal or subgoal only if market and economic conditions or the financial condition of the enterprise require such a reduction, or if efforts to meet the goal would result in the constraint of liquidity, over-investment in certain market segments or other consequences contrary to the intent of the goals or the public purposes of the enterprises.

 

The Regulatory Reform Act requires FHFA to establish annual goals targets, by regulation, for each goal described above. In establishing the single-family targets, FHFA must take into consideration national housing needs; economic, housing and demographic conditions, including expected market developments; the performance and effort of the enterprises toward achieving the housing goals in previous years; the size of the purchase money conventional or refinance conventional mortgage market, as applicable; the ability of the enterprise to lead the industry in making mortgage credit available; the need to maintain the sound financial condition of the enterprises; and the prior three years of information under the Home Mortgage Disclosure Act of 1975 for conventional, conforming, single-family, owner-occupied purchase money and refinance mortgages, as applicable.

 

In establishing the multifamily target, FHFA must take into consideration national multifamily credit needs and the ability of the enterprises to provide additional liquidity and stability for the multifamily market, the performance and effort of the enterprises towards achieving the housing goals in previous years, the size of the multifamily market, the ability of the enterprises to lead the industry in making multifamily mortgage credit available, the availability of public subsidies, and the need to maintain the sound financial condition of the enterprises.

 

FHFA may change annual targets, by regulation, to reflect market conditions and subsequent available data. The targets cannot consider segments of the market that are inconsistent with safety and soundness, unauthorized for purchase by the enterprises pursuant to regulation or, for single-family targets, contrary to good lending practices.

 

In addition, the Regulatory Reform Act creates a duty to serve underserved markets requiring the enterprises to provide leadership to the market in developing loan products and flexible underwriting guidelines to facilitate a secondary market for

 

mortgages on manufactured homes, for affordable housing preservation, and for housing in rural areas. FHFA must establish, by regulation effective beginning 2010, a manner for evaluating compliance with the duty to serve underserved markets and for rating the extent of compliance, and include the evaluation and rating in FHFA’s annual report to Congress.

 

Affordable Housing Allocations

 

The Regulatory Reform Act requires each enterprise to set aside, in each fiscal year, an amount equal to 4.2 basis points of the unpaid principal balance of total new business purchases, and to allocate or transfer (1) 65% of such amounts to the Secretary of HUD to fund the Housing Trust Fund program to be established and managed by the Secretary of HUD, and (2) 35% of such amounts to the Capital Magnet Fund to be established and managed by the Secretary of the Treasury. FHFA must suspend the allocation of an enterprise upon finding that the payment is contributing, or would contribute, to the financial instability of the enterprise; is causing, or would cause, the enterprise’s capital to be classified as undercapitalized; or is preventing, or would prevent, the enterprise from successfully completing a capital restoration plan. FHFA must promulgate regulations prohibiting the enterprises from passing on the cost of contributions through increased charges or fees or decreased premiums, or in any other manner, to the originators of mortgages purchased or securitized by the enterprise.

 

Loan Limits

 

The Regulatory Reform Act allows increases in single-family conforming loan limits based on changes in the new housing price index established by FHFA, beginning January 1, 2009. Consistent with existing OFHEO Examination Guidance, “Conforming Loan Limit Calculations,” decreases would be accumulated and would offset any future increases in the housing price index so that loan limits do not decrease from year-to-year. In high-cost areas — where 115% of the median home price exceeds the otherwise applicable conforming loan limit — the Regulatory Reform Act increases the loan limits to the lesser of (i) 115% of the median house price or (ii) 150% of the conforming loan limit, currently $625,500. The high-cost provisions on loan limits become effective January 1, 2009 when the temporary authority for purchases of high-cost loans granted by the Economic Stimulus Act of 2008 expires.

 

Executive Compensation

 

The Regulatory Reform Act provides FHFA with executive compensation authority that extends beyond the authority OFHEO possessed.

 

In determining whether executive compensation for an enterprise executive officer is prohibited under the “reasonable and comparable” standard contained in existing law, FHFA is authorized to take into account any factors it considers relevant, including any wrongdoing on the part of the executive officer, such as any fraudulent act or omission, breach of trust or fiduciary duty, any violation of law, rule, regulation, order, or written agreement, and insider abuse with respect to the enterprise. A determination by FHFA that termination compensation is prohibited would override any contrary contractual provisions, even if such provisions had been previously approved.

 

FHFA is also authorized to require an enterprise to withhold, or place in escrow, a payment, transfer or disbursement of compensation pending review of the reasonableness and comparability of such compensation. The Regulatory Reform Act amends the enterprises’ charters expressly to prohibit the transfer, disbursement or payment of compensation to any executive officer or entry into an agreement with an executive officer for matters being reviewed by FHFA under its authority to prohibit compensation that is not reasonable and comparable.

 

In addition, FHFA is authorized to prohibit or limit, by regulation or order, certain golden parachute and indemnification payments to an affiliated party of the enterprises. The Director is to prescribe, by regulation, the factors to be considered in limiting golden parachute and indemnification payments.

 

FHFA Enforcement Authority

 

The Regulatory Reform Act expands the grounds for issuing both permanent and temporary cease-and-desist orders against the enterprises and affiliated parties to include grounds such as unsafe or unsound practices. The amounts of civil money penalties FHFA may impose are increased substantially. In addition, FHFA has new authority to remove certain affiliated parties of the enterprises and to prohibit them from further participation in the industry. The Regulatory Reform Act also provides expanded authority to enforce the affordable housing goals.

 

Conservatorship and Receivership

 

The Regulatory Reform Act replaces the conservatorship provisions previously applicable to the enterprise with conservatorship and receivership provisions based generally on federal banking law. The Regulatory Reform Act expands the grounds for which an enterprise may be placed into conservatorship, establishes the grounds for which an enterprise may be placed into receivership, and provides for appointment of FHFA as conservator or receiver. FHFA has broad powers when acting as conservator or receiver of an enterprise. As conservator, FHFA may take such actions as may be necessary for restoring the enterprise to a sound and solvent condition, and appropriate to carry on the business of the enterprise and to conserve the assets and property of the enterprise. As receiver, FHFA must liquidate and proceed to realize upon the assets of

 

an enterprise in such manner as FHFA deems appropriate, including through the sale of assets, through the transfer of assets to a limited-life regulated entity which succeeds to the charter of the enterprise and operates in accordance with the charter and other applicable laws, or through the exercise of other rights and privileges granted FHFA.

 

As either conservator or receiver, FHFA has the power to take over the assets of an enterprise and operate with all the powers of the shareholders, directors and officers of the enterprise. In addition, among other powers as conservator or receiver, FHFA may replace management, transfer or sell any asset or liability of an enterprise in default without any approval, assignment or consent with respect to such transfer or sale, and repudiate contracts entered into prior to appointment if, in the sole discretion of FHFA, FHFA determines such contracts to be burdensome and determines repudiation will promote the orderly administration of affairs. The Regulatory Reform Act contains special provisions applicable to service contracts, leases, contracts for the purchase of real property and qualified financial contracts such as forward contracts, repurchase agreements and swap agreements.

 

Temporary Treasury Authority to Purchase GSE Obligations and Securities

 

The Regulatory Reform Act grants the Secretary of the Treasury authority to purchase any obligations and securities issued by the enterprises until December 31, 2009 on such terms and conditions and in such amounts as the Secretary may determine, provided that the Secretary determines the purchases are necessary to provide stability to the financial markets, prevent disruptions in the availability of mortgage finance, and protect taxpayers. The Secretary may not engage in open market purchases of the common stock of an enterprise in the absence of an agreement with the enterprise, and the enterprises are not required to issue obligations or securities to the Secretary without mutual agreement.

 

In connection with exercising this temporary purchase authority, the Secretary of the Treasury must consider the need for preferences regarding payments to the government; limits on maturity or disposal of the enterprise obligations and securities purchased; the enterprise’s plan for orderly resumption of private market funding or capital market access; the probability of the enterprise fulfilling the terms of the obligations and securities, including repayment; the need to maintain the status of the enterprise as a private shareholder-owned company; and restrictions on the use of enterprise resources, including limits on dividend payments and executive compensation. The Regulatory Reform Act also grants FHFA temporary authority to approve, disapprove or modify executive compensation for top executive officers for which compensation must be disclosed publicly pursuant to the SEC’s Regulation S-K. These authorities of both FHFA and Treasury expire on December 31, 2009.

 

Temporary Consultative Requirement Between the Director of FHFA and the Chairman of the Federal Reserve

 

The Regulatory Reform Act requires FHFA to consult with, and consider the views of, the Chairman of the Federal Reserve regarding the risks posed by the enterprises to the financial system prior to issuing any proposed or final regulations, orders, or guidelines with respect to prudential management and operations standards, safe and sound operations, capital requirements and portfolio standards. In addition, the Regulatory Reform Act requires consultation regarding any decision to place an enterprise into conservatorship or receivership. To facilitate the consultative process, the Regulatory Reform Act requires periodic sharing of information between FHFA and the Federal Reserve regarding the capital, assets and liabilities, financial condition and risk management practices of the enterprises and any information related to financial market stability. This consultative requirement expires December 31, 2009.

 

Composition of Board of Directors

 

The Regulatory Reform Act eliminates the five Presidential appointees from the boards of directors of the enterprises, leaving 13 shareholder-elected members, and allows FHFA to determine that a different number of board members is appropriate. The Regulatory Reform Act leaves in place the requirements for having board members from the home building, mortgage lending, and real estate industries and from an organization representing consumer or community interests.

 

Temporary Increase in Conforming Loan Limits

 

On February 13, 2008, the President signed into law the Economic Stimulus Act of 2008, which includes a temporary increase in conventional conforming loan limits that apply to the GSEs as well as the Federal Housing Administration, or FHA. The law raises the conforming loan limits for mortgages originated in certain high-cost areas from July 1, 2007 through December 31, 2008 to the higher of the applicable 2008 conforming loan limits, set at $417,000 for a mortgage secured by a one-unit, single-family residence, or 125% of the median house price for a geographic area, not to exceed $729,750 for a one-unit, single-family residence. We began accepting these “conforming-jumbo” mortgages for securitization as PCs and purchases into our retained portfolio in April 2008. Our purchases of these loans into our total mortgage portfolio for the three months ended June 30, 2008 totaled $471 million in unpaid principal balance. We have experienced increased competition in the mortgage finance market during the first half of 2008 with respect to this product. Given market conditions and competition especially from FHA, we do not anticipate purchasing material amounts of conforming jumbo product in 2008.

 

Voluntary, Temporary Growth Limit

 

In response to a request by OFHEO on August 1, 2006, we announced that we would voluntarily and temporarily limit the growth of our retained portfolio to 2% annually. Consistent with OFHEO’s February 27, 2008 announcement of the removal of the growth limit on March 1, 2008, the growth limit has expired.

 

Risk-based Capital

 

On June 10, 2008, OFHEO announced two rule changes for loss severity calculations under OFHEO’s risk-based capital regulation. These changes became effective on June 25, 2008 for our third quarter 2008 risk-based capital submission. According to OFHEO, these rule changes correct certain deficiencies in the formulas used to calculate risk-based capital. The first change was implemented because certain loss severity equations resulted in the GSEs recording profits instead of losses on foreclosed mortgages during the calculation of the risk-based capital requirement. Unaltered, the loss severity equations overestimated GSE recoveries for defaulted government-guaranteed and low LTV ratio mortgages. Those results were not consistent with the risk-based capital regulation and resulted in significant reductions to the risk-based capital requirements of the GSEs. The second change was implemented because the prior treatment of FHA insurance associated with single-family mortgages with an LTV below 78% is inconsistent with current law. According to OFHEO, implementation of these rule changes would have increased our risk-based capital requirement by $5.4 billion at December 31, 2006 had they been in effect at that time.

 

Mission and Affordable Housing Goals

 

In March 2008, we reported to HUD that we did not achieve two home purchase subgoals (the low- and moderate-income subgoal and the special affordable housing subgoal) for 2007. We believe that achievement of these two home purchase subgoals was infeasible in 2007 under the terms of the Federal Housing Enterprises Financial Safety and Soundness Act of 1992, or the GSE Act, and accordingly submitted an infeasibility analysis to HUD. In April 2008, HUD notified us that it had determined that, given the declining affordability of the primary market since 2005, the scope of market turmoil in 2007, and the collapse of the non-agency, or private label, secondary mortgage market, the availability of subgoal-qualifying home purchase loans was reduced significantly and therefore achievement of these subgoals was infeasible. Consequently, we will not submit a housing plan to HUD.

 

In 2008, we expect that the market conditions discussed above and the tightened credit and underwriting environment will continue to make achieving our affordable housing goals and subgoals challenging.

 

 

 

 

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 2 — Summary Consolidated Statements of Income — GAAP Results

 

 

Net Interest Income

 

Table 3 presents an analysis of net interest income, including average balances and related yields earned on assets and incurred on liabilities.

 

Table 3 — 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, 2008 compared to the three and six months ended June 30, 2007. During the latter half of the first quarter of 2008 and continuing into the second quarter of 2008, liquidity concerns in the market resulted in more favorable investment opportunities for agency mortgage-related securities at wider spreads. In response, we increased our purchase activities resulting in an increase in the average balance of our interest-earning assets. The increases in net interest income and net interest yield on a fully taxable-equivalent basis are primarily attributable to purchases of fixed-rate assets at significantly wider spreads relative to our funding costs. Net interest income and net interest yield for the three and six months ended June 30, 2008 also benefited from funding fixed-rate assets with a higher proportion of short-term debt in a steep yield curve environment as well as replacing higher cost long-term debt with lower cost issuances. Altering the mix of our debt funding between longer- and shorter-term debt is consistent with our overall investment management framework. As market conditions change, we can change the mix of debt we use to fund our retained portfolio, both floating- and fixed-rate assets. During the first and second quarters of 2008, our short-term funding balances increased significantly. We seek to manage interest rate risk by attempting to substantially match the duration characteristics of our assets and liabilities. To accomplish this, we use an integrated strategy that involves asset and liability portfolio management, including the use of derivatives for purposes of rebalancing the portfolio and maintaining low PMVS and duration gap. The increases in net interest income and net interest yield on a fully tax-equivalent basis during the six months ended June 30, 2008 were partially offset by the impact of declining interest rates because our floating rate assets reset faster than our short-term debt during the first quarter of 2008. As a result of the creation of the securitization trusts in December of 2007, due to PC investors interest expense is now recorded in trust management fees within other income on our consolidated statements of income. See “Non-Interest Income — Other Income” for additional information about due to PC investors interest expense.

 

Non-Interest Income

 

Management and Guarantee Income

 

Table 4 provides summary information about management and guarantee income. Management and guarantee income consists of contractual amounts due to us (reflecting buy-ups and buy-downs to base management and guarantee fees) as well as amortization of certain pre-2003 deferred credit and buy-down fees received by us that were recorded as deferred income as a component of other liabilities. Post-2002 credit and buy-down fees are reflected as increased income on guarantee obligation as the guarantee obligation is amortized.

 

Table 4 — Management and Guarantee Income⁽¹⁾

 

 

The primary drivers affecting management and guarantee income are the average balance of our PCs and Structured Securities and changes in management and guarantee fee rates. Contractual management and guarantee fees include adjustments to the contractual rates for buy-ups and buy-downs, whereby the contractual management and guarantee fee rate is adjusted for up-front cash payments we make (buy-up) or receive (buy-down) at guarantee issuance. Our average rates of management and guarantee income are also affected by the mix of products we issue, competition in market pricing and customer preference for buy-up and buy-down fees. The majority of our guarantees are issued under customer “flow” channel contracts, which have fixed pricing schedules for our management and guarantee fees for periods of up to one year. The remainder of our purchase and guarantee securitization of mortgage loans occurs through “bulk” purchasing with management and guarantee fees negotiated on an individual transaction basis. Given the volatility in the credit market during the three and six months ended June 30, 2008, we will continue to closely monitor the pricing of our management and guarantee fees as well as our delivery fee rates and make adjustments when appropriate.

 

Management and guarantee income increased for the three and six months ended June 30, 2008 compared to the three and six months ended June 30, 2007, primarily reflecting an increase in the average PCs and Structured Securities balances of 14% and 15%, respectively, on an annualized basis. The average contractual management and guarantee fee rate for the three and six months ended June 30, 2008 was higher than the three and six months ended June 30, 2007, primarily due to an increase in buy-up activity as well as the impact of higher management and guarantee fees on purchases of mortgage loans, including interest-only loans, guaranteed in the last half of 2007 that remain in the portfolio. Our management and guarantee fee rates are generally higher on nontraditional loans, such as interest-only mortgages, than our fee rates for fixed-rate mortgages. We experienced a significant decrease in purchase volume through bulk channels as well as declines in the composition of non-traditional loans underlying our newly-issued guarantees during the six months ended June 30, 2008.

 

Gains (Losses) on Guarantee Asset

 

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

 

The change in fair value of our guarantee asset reflects:

 

 

The fair value of future management and guarantee fees is driven primarily by expected changes in interest rates that affect the estimated life of mortgages underlying our PCs and Structured Securities and related discount rates used to determine the net present value of the cash flows. For example, an increase in interest rates generally slows the rate of prepayments and extends the life of our guarantee asset and increases the fair value of future management and guarantee fees. Our valuation methodology for our guarantee asset uses market-based information, including market values of interest-only securities, to determine the fair value of future cash flows associated with our guarantee asset.

 

Table 5 — Attribution of Change — Gains (Losses) on Guarantee Asset

 

 

Contractual management and guarantee fees represent cash received in the current period related to our PCs and Structured Securities with an established guarantee asset. A portion of these cash receipts is attributed to imputed interest income on our guarantee asset. Contractual management and guarantee fees increased for the three and six months ended June 30, 2008 compared to the three and six months ended June 30, 2007, respectively, primarily due to increases in the average balance of our PCs and Structured Securities issued.

 

The increases in the fair values of management and guarantee fees for the three and six months ended June 30, 2008 and 2007 were primarily driven by higher market valuations for interest-only mortgage securities, used to value our guarantee asset resulting from increases in interest rates during these periods. The fair value change during the second quarter of 2008, as compared to the second quarter of 2007, was higher due to a larger increase in interest rates combined with higher average balances during the second quarter of 2008. The increases in the fair values of management and guarantee fees were less significant during the six months ended June 30, 2008, compared to the six months ended June 30, 2007 due to a larger increase in interest rates during the 2007 period than during the 2008 period.

 

Income on Guarantee Obligation

 

Upon issuance of our guarantee, we record a guarantee obligation on our consolidated balance sheets representing the fair value of our obligation to perform under the terms of the guarantee. Our guarantee obligation primarily represents our performance and other related costs, which consist of estimated credit costs, including estimated unrecoverable principal and interest that will be incurred over the expected life of the underlying mortgages backing PCs, estimated foreclosure-related costs, and estimated administrative and other costs related to our 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. The static effective yield is periodically evaluated and adjusted when significant changes in economic events cause a shift in the pattern of our economic release from risk. For example, certain market environments may lead to sharp and sustained changes in home prices or prepayment rates of mortgages, leading to the need for an adjustment in the static effective yield for specific mortgage pools underlying the guarantee. When a change is required, a cumulative catch-up adjustment, which could be significant in a given period, will be recognized and a new static effective yield will be used to determine our guarantee obligation amortization.

 

Effective January 1, 2008, we began estimating the fair value of our newly-issued guarantee obligations at their inception using the practical expedient provided by FIN 45, as amended by SFAS 157. Using this approach, the initial guarantee obligation is recorded at an amount equal to the fair value of the compensation received in the related guarantee transactions, including upfront delivery and other fees. As a result, we no longer record estimates of deferred gains or immediate “day one” losses on most guarantees. All unamortized amounts recorded prior to January 1, 2008 will continue to be deferred and amortized using existing amortization methods. This change had a significant positive impact on our financial results for the three and six months ended June 30, 2008.

 

Table 6 provides information about the components of income on guarantee obligation.

 

Table 6 — Income on Guarantee Obligation

 

 

Amortization income increased for the three and six months ended June 30, 2008, compared to the three and six months ended June 30, 2007. This increase is due to (1) higher guarantee obligation balances recognized in 2007 as a result of significant market risk premiums, including those that resulted in significant day one losses (i.e., where the fair value of the guarantee obligation at issuance exceeded the fair value of the guarantee and credit enhancement-related assets), (2) higher cumulative catch-up adjustments for the three and six months ended June 30, 2008 and (3) higher average balances of our

 

PCs and Structured Securities. The cumulative catch-up adjustments recognized during the six months ended June 30, 2008 were principally due to significant declines in home prices and, to a lesser extent, increases in mortgage prepayment speeds related to pools of mortgage loans issued during 2006 and 2007. These cumulative catch-up adjustments are recorded to provide a pattern of revenue recognition that is consistent with our economic release from risk and better aligns with the timing of the recognition of losses on the pools of mortgage loans we guarantee.

 

Derivative Overview

 

Table 7 presents the effect of derivatives on our consolidated financial statements, including notional or contractual amounts of our derivatives and our hedge accounting classifications.

 

Table 7 — Summary of the Effect of Derivatives on Selected Consolidated Financial Statement Captions

 

 

 

Beginning in the first quarter of 2008, we began designating 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 the periods presented prior to 2008, we only elected cash flow hedge accounting relationships for certain commitments to sell mortgage-related securities. We expect this expanded hedge accounting strategy will reduce volatility in our consolidated statements of income going forward. For a derivative accounted for as a cash flow hedge, changes in fair value are reported in AOCI, net of taxes, on our consolidated balance sheets to the extent the hedge is effective. The ineffective portion of changes in fair value is reported as other income on our consolidated statements of income. We record changes in the fair value, including periodic settlements, of derivatives not in hedge accounting relationships as derivative gains (losses) on our consolidated statements of income. See “NOTE 10: DERIVATIVES” to our consolidated financial statements for additional information about our derivatives designated as cash flow hedges.

 

Derivative Gains (Losses)

 

Table 8 provides a summary of the notional or contractual amounts and 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 will generally increase the volatility of reported net income (loss), particularly when they are not accounted for in hedge accounting relationships.

 

Table 8 — Derivatives Not in Hedge Accounting Relationships