UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

FORM 10-Q

 

 

 

For the quarterly period ended September 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 October 30, 2009, there were 648,337,003 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 the MHA Program and other efforts to assist the U.S. residential mortgage markets, as well as our 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, internal control remediation efforts, 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 Quarterly Reports on Form 10-Q for the first and second quarters 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 nine months ended September 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 by issuing Structured Securities to third-party investors. 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 assets on our balance sheets. 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 are focused on meeting the urgent liquidity needs of the U.S. residential mortgage market, lowering costs for borrowers and supporting the recovery of the housing market and U.S. economy. By continuing to provide access to funding for mortgage originators and, indirectly, for mortgage borrowers and through our role in the Obama Administration’s initiatives, including the MHA Program, we are working to meet the needs of the mortgage market by making homeownership and rental housing more affordable, reducing the number of foreclosures and helping families keep their homes.

 

We had net loss attributable to Freddie Mac of $5.0 billion for the third quarter of 2009 and total equity of $10.4 billion as of September 30, 2009. Net loss attributable to common stockholders was $6.3 billion for the third quarter of 2009, which includes the payment of $1.3 billion of dividends in cash on the senior preferred stock. Our financial results for the third quarter of 2009, compared to the second quarter of 2009, reflect the unfavorable impact of decreased interest rates on the fair value of our derivatives and our guarantee asset, as well as increased credit-related expenses. These unfavorable impacts were partially offset by gains on trading securities due to tightening OAS and lower interest rates, gains on sales of available-for-sale securities and reduced net impairments on available-for-sale securities recognized in earnings. Total equity increased $2.2 billion during the quarter from $8.2 billion as of June 30, 2009. The increase included $8.3 billion of fair value improvement on available-for-sale securities within AOCI, due primarily to declines in interest rates and tightening of mortgage-to-debt OAS, offset by the third quarter 2009 net loss attributable to Freddie Mac of $5.0 billion and senior preferred stock dividends of $1.3 billion.

 

We expect a variety of factors will continue to place downward pressure on our financial results in future periods, and could cause us to incur further GAAP net losses and request additional draws from Treasury under the Purchase Agreement. Key factors include the potential for continued deterioration in the housing market and rising unemployment, which could result in additional credit-related expenses and security impairments, adverse changes in interest rates and spreads, which could result in mark-to-market losses, additional impairment of our investments in LIHTC partnerships, 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. While the housing market has experienced recent modest home price improvements beginning in the second quarter of 2009, we expect home price declines in future periods. Consequently, our provisions for credit losses will likely remain high during the remainder of 2009. Further, our senior preferred stock dividend obligation, combined with potentially substantial quarterly commitment fees payable to Treasury beginning in 2010 (the amounts of which have not yet been determined), and our inability to pay down draws under the Purchase Agreement will have a significant adverse impact on our future net worth. To the extent that these factors result in a negative net worth, we would be required to take additional draws from Treasury under the Purchase Agreement. For a discussion of factors that could result in additional draws, see “LIQUIDITY AND CAPITAL RESOURCES — Capital Adequacy”.

 

Recent Management Changes

 

Several significant management changes occurred recently:

 

 

Business Objectives

 

We continue to operate under the direction of FHFA as our Conservator. During the conservatorship, the Conservator 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 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 financial 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 — Federal 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.

 

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. We 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. If our efforts under the MHA Program and other initiatives to support the U.S. residential mortgage market do not achieve their desired results, or are otherwise perceived to have failed to achieve their objectives, we may experience damage to our reputation, which may impact the extent of future government support for our business.

 

During the third quarter of 2009, we continued to enhance our infrastructure and capacity to support the MHA Program by devoting significant internal resources to support the increased activity under both of its key initiatives: the Home Affordable Refinance Program and the Home Affordable Modification Program.

 

Home Affordable Refinance Program

 

The Home Affordable Refinance Program gives eligible homeowners with loans owned or guaranteed by Freddie Mac or Fannie Mae an opportunity to refinance into loans with more affordable monthly payments. The Freddie Mac Relief Refinance Mortgage^sm is our implementation of the Home Affordable Refinance Program for our loans. As of

 

September 30, 2009, we purchased approximately 98,000 loans totaling approximately $20.0 billion in unpaid principal balance under this program, including approximately 54,000 loans with current LTVs above 80%.

 

We expect to continue to experience strong demand for the Freddie Mac Relief Refinance Mortgage due to low interest rates and recent enhancements to the program. These enhancements were designed to help more borrowers take advantage of the program, and include:

 

 

Home Affordable Modification Program, or HAMP

 

HAMP commits U.S. government, Freddie Mac and Fannie Mae funds to help eligible homeowners avoid foreclosure and keep their homes through mortgage modifications. We have focused our loan modification efforts on HAMP since it was introduced in the second quarter of 2009, and have completed 471 modifications under HAMP as of September 30, 2009. Under HAMP, borrowers must complete a trial period of three or more months before the loan is modified. Our overall loan modification volume declined in the third quarter of 2009 as compared to the second quarter of 2009 because borrowers did not begin entering into trial periods under HAMP in significant numbers until early in the third quarter and, in many cases, trial periods were extended beyond the initial three month period as HAMP guidelines were modified. Based on information reported by our servicers to the MHA program administrator, more than 88,000 loans that we own or guarantee were in the trial period portion of the HAMP process as of September 30, 2009. Trial period loans under HAMP are those where the borrower has made the first payment under the terms of a trial period offer.

 

Through September 30, 2009, our loss mitigation activity under HAMP has been primarily focused with our larger seller/servicers, which service the majority of our loans, and variations in their approaches may cause fluctuations in HAMP processing volumes. There is uncertainty regarding the sustainability of our current volume levels once our larger seller/servicers complete the bulk of their initial efforts. The completion rate for HAMP loans, which is the percentage of loans that successfully exit the trial period due to the borrower fulfilling the requirements for the modification, remains uncertain due to the number of new requirements of this program. We have undertaken several initiatives designed to increase the number of loans modified under HAMP, including:

 

 

We also serve as compliance agent for certain foreclosure prevention activities under HAMP. Among other duties, as the program compliance agent, we will conduct examinations and review servicer compliance with the published requirements for the program. We will report the results of our examination findings to Treasury. Based on the examinations, we may also provide Treasury with advice, guidance and lessons learned to improve operation of the program.

 

The MHA Program is intended to provide borrowers the opportunity to obtain more affordable monthly payments and to reduce the number of delinquent mortgages that proceed to foreclosure and, ultimately, mitigate our total credit losses by reducing or eliminating a portion of the costs related to foreclosed properties and avoiding the credit loss in REO. 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, the costs we incur, including the servicer and borrower incentive fees, could be substantial. Under HAMP, Freddie Mac will bear the full cost of the monthly payment reductions related to modifications of loans we own or guarantee, and all servicer and borrower incentive fees, and we will not receive a reimbursement of these costs from Treasury. 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 whether, and the extent to which, costs, incurred in the near term, will be offset by the prevention or reduction of potential future costs of loan defaults and foreclosures due to these initiatives.

 

Our Other Recent Efforts to Assist the U.S. Housing Market

 

 

 

 

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.

 

We had a positive net worth at September 30, 2009 as our assets exceeded our liabilities by $10.4 billion. Therefore, we did not require additional funding from Treasury under the Purchase Agreement. However, we expect to make additional draws under the Purchase Agreement in future periods due to a variety of factors that could adversely affect our net worth.

 

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

 

 

It is difficult at this time to predict the impact that the completion of the Federal Reserve’s and Treasury’s mortgage-related securities purchase programs will have on our business and the U.S. mortgage market. It is possible

 

that interest rate spreads on mortgage-related securities could widen, resulting in more favorable investment opportunities for us following the completion of these programs. However, we may be limited in our ability to take full advantage of any potential investment opportunities because, beginning in 2010, we must reduce our mortgage-related investments portfolio, pursuant to the Purchase Agreement, by 10% per year, until it reaches $250 billion.

 

For information on the potential impacts of the completion of the Federal Reserve’s purchase program and the expiration of the Lending Agreement with Treasury on our access to the debt markets and our liquidity backstop plan, see “Liquidity and Capital Resources — Liquidity”.

 

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 Third Quarter 2009 Results

 

Our financial results for the third quarter of 2009 reflect the continuing adverse economic conditions in the U.S. During 2009, there have been some positive housing market developments, including higher volumes of home sales and modest improvements in home prices in certain regions and states. However, there have been significant increases in unemployment rates which, coupled with declines in household wealth, have contributed to increases in residential mortgage delinquency rates. We believe that 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. Our provision for credit losses was $7.6 billion in the third 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.

 

Home prices nationwide increased an estimated 0.3% in the third quarter of 2009 (and an estimated 0.9% during the nine months ended September 30, 2009) based on our own internal index. However, many regions and states suffered significant home price declines in the last two years. The percentage decline in home prices in the last two years has been particularly large in the states of California, Florida, Arizona and Nevada, which comprised approximately 25% of the loans in our single-family mortgage portfolio as of September 30, 2009. The second and third quarters of the year are historically strong periods for home sales. Seasonal strength along with the impact of state and federal government actions, including incentives for first time homebuyers and foreclosure suspensions, may have contributed to the increase in home prices during the third quarter of 2009. We expect that when temporary government actions expire and the seasonal peak in home sales has passed, home prices are likely to decline over the near term. Unemployment rates worsened in the third quarter of 2009, and the national unemployment rate increased to 9.8% at September 30, 2009 as compared to 9.5% at June 30, 2009. Certain states experienced much higher unemployment rates, such as California, Florida, Michigan and Nevada, where the unemployment rate reached 12.2%, 11.0%, 15.3% and 13.3%, respectively, at September 30, 2009. Loans originated in these states comprised approximately 26% of the loans in our single-family mortgage portfolio as of September 30, 2009. Many financial institutions continued to remain cautious in their lending activities during the third quarter of 2009. Although there was overall improvement in credit and liquidity conditions during the third 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 an increase in the number and aging of delinquent loans in our single-family mortgage portfolio during the third quarter of 2009. Beginning in November 2008, we temporarily suspended all foreclosure transfers of occupied homes for certain periods ending March 6, 2009. Beginning March 7, 2009, we began suspension of foreclosure transfers on owner-occupied homes where the borrower may be eligible to receive a loan modification under HAMP. 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 third quarter of 2009. Additionally, as the slump in the U.S. housing market has lasted over two years, increasing numbers of borrowers that previously had significant equity in their homes are now “underwater,” or owing more on their mortgage loans than their homes are currently worth.

 

The continued weakness in housing market conditions during the third 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, 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 recognized impairments of available-for-sale securities in earnings during the third quarter of 2009.

 

Multifamily housing fundamentals deteriorated during the third quarter of 2009, reflecting an increasing unemployment rate and reduced access to credit for individual and institutional borrowers. Partially as a result of home ownership becoming more affordable over the past several years, multifamily properties experienced declining rent levels and vacancy rates rose to multi-year highs. This trend negatively impacted multifamily property cash flows in the third quarter of 2009. Our multifamily delinquency rate was unchanged at September 30, 2009 from 11 basis points as of June 30, 2009, though we expect it to increase during the remainder of 2009. During 2009, we have also seen significant deterioration in the financial strength of certain multifamily borrowers in measures such as the debt coverage ratio and estimated current LTV ratios for the properties.

 

Consolidated Results of Operations — Third Quarter 2009

 

Net income (loss) was $(5.0) billion and $(25.3) billion for the third quarters of 2009 and 2008, respectively. Net loss decreased in the third quarter of 2009 compared to the third quarter of 2008, principally due to lower impairment-related losses on mortgage-related securities, higher net interest income, and fair value gains on our guarantee asset and other investment activities, compared to losses on these items during the third quarter of 2008. These income and gains for the third quarter of 2009 were partially offset by increased provision for credit losses, losses on debt recorded at fair value and losses on loans purchased, compared to the third quarter of 2008.

 

Net interest income was $4.5 billion for the third quarter of 2009, compared to $1.8 billion for the third quarter of 2008. As compared to the third quarter of 2008, we held higher amounts of fixed-rate mortgage loans and 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 September 30, 2009. Net interest income during the three months ended September 30, 2009 also benefited from the funds we received from Treasury under the Purchase Agreement. These funds generate net interest income, because the costs of such funds are not reflected in interest expense, but instead as dividends paid on senior preferred stock.

 

Non-interest income (loss) was $(1.1) billion for the three months ended September 30, 2009, compared to $(11.4) billion for the three months ended September 30, 2008. The decrease in non-interest loss in the third quarter of 2009 was primarily due to improvements in investment activity, which was a gain of $1.4 billion in the third quarter of 2009 as compared to a loss of $9.8 billion in the third quarter of 2008, and our guarantee asset, which was a gain of $0.6 billion in the third quarter of 2009 as compared to a loss of $1.7 billion in the third quarter of 2008. These improvements were partially offset by a $2.3 billion increase in derivatives losses, net of foreign-currency related effects. The decrease in losses on investment activity during the third quarter of 2009 was due principally to lower impairment-related losses primarily recognized on available-for-sale non-agency mortgage-related securities backed by subprime, option ARM, Alt-A and other loans during the quarter, which decreased to $1.2 billion in the third quarter of 2009, compared to $9.1 billion in the third quarter of 2008.

 

Non-interest expenses increased to $8.5 billion in the third quarter of 2009 from $7.8 billion in the third quarter of 2008 due primarily to higher provision for credit losses. Our results for the third quarter of 2008 included a non-recurring securities administrator loss on investment activity of $1.1 billion related to the September 2008 bankruptcy of Lehman Brothers Holdings, Inc. Credit-related expenses totaled $7.5 billion and $6.0 billion for the third quarters of 2009 and 2008, respectively, and included our provision for credit losses of $7.6 billion and $5.7 billion, respectively. The increase in provision for credit losses was primarily due to the continued credit deterioration in our single-family mortgage portfolio, reflected in further increases in delinquency rates. Losses on loans purchased increased to $531 million for the third quarter of 2009, compared to $252 million for the third quarter of 2008, due to lower market valuations for delinquent and modified loans in the third quarter of 2009, as compared to the third quarter of 2008. We expect to incur losses on loans purchased in the fourth quarter of 2009. Administrative expenses totaled $433 million for the third quarter of 2009, up from $308 million for the third quarter of 2008, primarily due to a partial reversal of short-term compensation expenses recorded in the third quarter of 2008.

 

Segment Earnings

 

Our operations consist of three reportable segments, which are based on the type of business activities each performs — Investments, Single-family Guarantee and Multifamily. Certain activities that are not part of a segment are included in the All Other category. We manage and evaluate performance of the segments and All Other using a Segment Earnings approach, subject to the conduct of our business under the direction of the Conservator. 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)⁽¹⁾

 

 

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 nine months ended September 30, 2009, total assets increased by $15.6 billion to $866.6 billion while total liabilities decreased by $25.4 billion to $856.2 billion. Total equity (deficit) was $10.4 billion at September 30, 2009 compared to $(30.6) billion at December 31, 2008.

 

Our cash and other investments portfolio increased by $19.4 billion during the nine months ended September 30, 2009 to $83.7 billion, primarily due to a $10.3 billion increase in cash and cash equivalents and a $9.7 billion increase in non-mortgage-related securities. We received $6.1 billion and $30.8 billion in June 2009 and March 2009, respectively, pursuant to draw requests that FHFA submitted to Treasury on our behalf to address the deficits in our net worth as of March 31, 2009 and December 31, 2008, respectively. Based upon our positive net worth at June 30, 2009, we did not receive any additional funding from Treasury during the three months ended September 30, 2009.

 

The unpaid principal balance of our mortgage-related investments portfolio decreased 2.6%, or $20.6 billion, during the nine months ended September 30, 2009 to $784.2 billion. The decrease in our mortgage-related investments portfolio is attributable to a relative lack of favorable investment opportunities, as evidenced by tighter spreads on agency mortgage-related securities. We believe these tighter spread levels are driven by the Federal Reserve’s and Treasury’s agency mortgage-related securities purchase programs. We expect investment opportunities for agency mortgage-related securities will remain limited while these purchase programs remain in effect. Once these programs are completed, it is possible that spreads could widen again, which might create favorable investment opportunities. We may be limited in our ability to take full advantage of any such opportunities in future periods because, beginning in 2010, we must reduce our mortgage-related investments portfolio pursuant to the Purchase Agreement by 10% per year, until it reaches $250 billion. We may be required to sell mortgage-related assets in 2010 to meet the required 10% reduction, particularly given the potential in coming periods for significant increases in loan modifications and purchases of delinquent loans, both of which result in the purchase of mortgage loans from our PCs for our mortgage-related investments portfolio. In addition, further widening of spreads could result in additional unrealized losses on our available-for-sale securities.

 

Short-term debt decreased by $69.7 billion during the nine months ended September 30, 2009 to $365.4 billion, and long-term debt increased by $30.5 billion to $438.4 billion. As a result, our outstanding short-term debt, including the current portion of long-term debt, decreased as a percentage of our total debt outstanding to 45% at September 30, 2009 from 52% at December 31, 2008. The increase in our long-term debt reflects the improvement during 2009 of spreads on our debt and our continued favorable 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. In July 2009 we made a tender offer to purchase $4.4 billion of our outstanding Freddie SUBS^® securities. We accepted $3.9 billion of the tendered securities. This tender offer was consistent with our effort to reduce our funding costs by retiring higher cost debt. Our reserve for guarantee losses on PCs increased by $13.7 billion to $28.6 billion during the nine months ended September 30, 2009 as a result of an increase in probable incurred losses, primarily attributable to the overall macroeconomic environment, including continued weakness in the housing market and increasing unemployment.

 

Total equity (deficit) increased from $(30.6) billion at December 31, 2008 to $10.4 billion at September 30, 2009, reflecting increases due to (i) $36.9 billion we received from Treasury under the Purchase Agreement during the first nine months of 2009, (ii) a $15.3 billion decrease in our unrealized losses in AOCI, net of taxes, on our available-for-sale securities and (iii) an increase in retained earnings (accumulated deficit) of $15.0 billion, and a corresponding adjustment of $(9.9) billion net of taxes, to AOCI, as a result of the April 1, 2009 adoption of an amendment to the accounting standards for investments in debt and equity securities (FASB ASC 320-10-65-1). These increases in total equity (deficit) were partially offset by (i) a $14.1 billion net loss and (ii) $2.8 billion of senior preferred stock dividends for the nine months ended September 30, 2009. The $15.3 billion decrease in the unrealized losses in AOCI, net of taxes, on our available-for-sale securities during the nine months ended September 30, 2009 was largely due to (i) fair value improvement on our available-for-sale mortgage-related securities, particularly during the third quarter of 2009, primarily as a result of tighter mortgage-to-debt OAS and lower interest rates, and (ii) the recognition in earnings of other-than-temporary impairments on our non-agency mortgage-related securities.

 

Consolidated Fair Value Results

 

During the three months ended September 30, 2009, the fair value of net assets, before capital transactions, increased by $4.1 billion compared to a decrease of $36.7 billion during the three months ended September 30, 2008. The fair value of net assets as of September 30, 2009 was $(67.7) billion, compared to $(70.5) billion as of June 30, 2009. Included in our fair value results for the three months ended September 30, 2009 are the $1.3 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 three months ended September 30, 2009 principally relates 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. The support of Treasury and the Federal Reserve in recent periods has contributed to this improvement. During the third 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 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 third quarter of 2009, we were able to continue to reduce our use of short-term debt by issuing long-term and callable 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:

 

 

The scheduled expiration of the Lending Agreement and completion of the Federal Reserve’s debt purchase program could adversely affect our ability to access the unsecured debt markets, making it more difficult or costly to fund our business. The completion of these programs could negatively affect the spreads on our debt and limit our ability to issue long-term and callable debt. This may also adversely affect our ability to replace our short-term funding with longer-term debt.

 

Upon expiration of the Lending Agreement, we will not have a liquidity backstop (other than Treasury’s ability to purchase up to $2.25 billion of our obligations under its permanent statutory authority) if we are unable to obtain funding from issuances of debt or other conventional sources. At present, we are not able to predict the likelihood that a liquidity backstop will be needed, or to identify the alternative sources of liquidity that might then be available to us, other than draws from Treasury under the Purchase Agreement or Treasury’s ability to purchase up to $2.25 billion of our obligations under its permanent statutory authority. In addition, market conditions could limit the availability of the assets in our mortgage-related investments portfolio as a significant source of funding. If we were unable to obtain funding from issuances of debt or other conventional sources at suitable terms or in sufficient amounts, it is likely that the funds potentially available from Treasury would not be adequate to operate our business.

 

Based on the current aggregate liquidation preference of the senior preferred stock, Treasury is entitled to annual cash dividends of $5.2 billion, which exceeds our annual historical earnings in most periods. To date, we have paid $3.0 billion in cash dividends on the senior preferred stock. Continued cash payment of senior preferred dividends combined with potentially substantial quarterly commitment fees payable to Treasury beginning in 2010 (the amounts of which must be determined by December 31, 2009), will have an adverse impact on our future financial condition and net worth. Further draws from Treasury under the Purchase Agreement would increase the liquidation preference of and the dividends we owe on, the senior preferred stock and, therefore, payment of our dividend obligations in cash could contribute to the need for additional draws from Treasury.

 

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 September 30, 2009, our assets exceeded our liabilities by $10.4 billion. Because we had a positive net worth as of September 30, 2009, FHFA has not submitted a draw request on our behalf to Treasury for any additional funding under the Purchase Agreement. We also did not require additional funding under the Purchase Agreement based on our positive net worth at the end of the second quarter of 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 September 30, 2009.

 

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 additional information concerning the potential impact of the Purchase Agreement, including making 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

 

During the current economic crisis, the mortgage markets have relied on Freddie Mac to provide a reliable source of liquidity, stability and affordability through our investment and credit guarantee activities. However, our business activities, including the additional activities we have undertaken during the current economic crisis, expose us to credit risk, primarily 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 remain challenging in 2009 due to a number of factors, including the following:

 

 

The deterioration in the mortgage and credit markets increased our exposure to both mortgage and institutional credit risks. A number of factors make it difficult to predict when the mortgage and credit markets will recover, including, among others, uncertainty concerning the effect of current or any future government actions in these markets. While our assumption for home prices, based on our own index, continues to be for a further decline in national home prices over the near term, there continues to be divergence among economists about the future economic outlook and when 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

 

We are focused on initiatives that support the MHA Program. We have taken several steps 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 and engaged certain vendors to assist our seller/servicers in completing loan modifications and other outreach programs with the objective of keeping more borrowers in their homes.

 

Our more recent loss mitigation activities create fluctuations in our credit statistics. For example, our temporary suspensions of foreclosure transfers of occupied homes temporarily slowed 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 completed loan modifications in both the second and third quarters of 2009 since there is a trial period before these modifications become effective. Trial periods are required to last for at least three months. Borrowers did not begin entering into trial periods under HAMP in significant numbers until early in the third quarter and, in many cases, trial periods were extended beyond the initial three month period as HAMP guidelines were modified.

 

Our servicers have a key role in the success of our loss mitigation activities. The significant increases in delinquent loan volume and the deteriorating conditions of the mortgage market during 2008 and 2009 placed a strain on the loss mitigation resources of many of our mortgage servicers. To the extent servicers do not complete loan modifications with eligible borrowers our credit losses could increase.

 

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 2009. The table below illustrates the increases in delinquency rates for loans that back our subprime first lien, option ARM and Alt-A securities and associated gross unrealized losses, pre-tax. We believe that unrealized losses on non-agency mortgage-related securities at September 30, 2009 were attributable to poor underlying collateral performance, decreased liquidity and larger risk premiums in the non-agency mortgage market. These securities comprise $100.7 billion of the $180.8 billion of non-agency mortgage-related securities in our mortgage-related investments portfolio as of September 30, 2009. Given our forecast that national home prices are likely to decline over the near term, the performance of the loans backing these securities could continue to deteriorate.

 

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

 

 

We held unpaid principal balances of $104.9 billion of non-agency mortgage-related securities backed by subprime, option ARM, Alt-A and other loans in our mortgage-related investments portfolio as of September 30, 2009, compared to $119.5 billion as of December 31, 2008. This decrease is due to the receipt of monthly remittances of principal repayments from both the recoveries of liquidated loans and, to a lesser extent, voluntary prepayments on the underlying collateral of $4.6 billion and $14.6 billion during the three and nine months ended September 30, 2009, respectively, representing a partial return of our investment in these securities. We recorded net impairment of available-for-sale securities recognized in earnings on non-agency mortgage-related securities backed by subprime, option ARM, Alt-A and other loans of approximately $1.1 billion and $10.2 billion for the three and nine months ended September 30, 2009, respectively. See “NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES — Change in Accounting Principles — 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. Pre-tax unrealized losses on securities backed by subprime, option ARM, Alt-A and other loans reflected in AOCI were $38.0 billion at September 30, 2009. These unrealized losses include $15.3 billion, pre-tax ($9.9 billion, net of tax), of other-than-temporary impairment losses reclassified from retained earnings to AOCI as a result of the second quarter 2009 adoption of an amendment to the accounting standards for investments in debt and equity securities and increases in fair value during the first nine months of 2009 of $7.9 billion primarily due to (i) tighter mortgage-to-debt OAS and (ii) the recognition in earnings of other-than-temporary impairments related to these securities.

 

Interest Rate and Other Market Risks

 

Our mortgage-related investments portfolio is a source of liquidity and stability for the home mortgage finance system, but also exposes us to interest rate risk and other market risks. Prepayment risk arises from the uncertainty as to when borrowers will pay the outstanding principal balance of mortgage loans that we hold or that represent underlying collateral for securities in our mortgage-related investments portfolio. Unexpected mortgage prepayments result in a potential mismatch in the timing of our receipt of cash flows related to such 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 remained volatile. Throughout 2008 and into 2009, we adjusted our interest rate risk models to reflect rapidly changing market conditions. In particular, these models were adjusted during 2009 to reflect changes in prepayment expectations resulting from the MHA Programs, including mortgage refinancing expectations.

 

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 and failures of the technology used to support our business activities. Our risk of operational failure may be increased by vacancies in officer and key business unit positions and 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.

 

As a result of management’s evaluation of our disclosure controls and procedures, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were not effective as of September 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. After consideration of our mitigating activities, including our remediation efforts through September 30, 2009, we believe that our interim consolidated financial statements for the quarter ended September 30, 2009, have been prepared in conformity with GAAP.

 

Adoption of SFAS 166 and SFAS 167

 

Effective January 1, 2010, we will adopt: (i) the amendment to the accounting standards for transfers of financial assets (SFAS 166), which changes the accounting standards on transfer and servicing of financial assets (FASB ASC 860); and (ii) the amendment to the accounting standards on consolidations (SFAS 167), which changes the consolidation guidance related to variable interest entities. We expect that the adoption of these two amendments will have a significant impact on our consolidated financial statements.

 

Upon adoption of these standards, we will be required to consolidate our single-family PC trusts and some of our Structured Transactions in our financial statements, which could have a significant negative impact on our net worth and could result in additional draws under the Purchase Agreement.

 

The adoption of these two amendments would significantly increase our required level of capital under existing regulatory capital rules, which are not binding during conservatorship as our Conservator has suspended regulatory capital classification of us.

 

Implementation of these changes will require significant operational and systems changes. It may be difficult for us to make all such changes in a controlled manner by the effective date.

 

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 $1,459 billion and $1,403 billion at September 30, 2009 and December 31, 2008, respectively. Based on our historical credit losses, which in the third quarter of 2009 averaged approximately 44.3 basis points of the aggregate unpaid principal balance of our single-family mortgage portfolio, we do not believe that the maximum exposure is representative of our actual exposure on these guarantees.

 

Legislative and Regulatory Matters

 

The following section discusses certain significant recent developments with respect to legislative and regulatory matters.

 

Federal Legislation and Related Matters

 

On June 17, 2009, the Obama Administration announced a legislative proposal to overhaul the regulatory structure of the financial services industry. The proposal includes draft bills addressing resolution authority for systemically significant institutions, consumer financial protection, securitization and derivatives, among other subjects. If enacted, this proposal would result in significant changes in the regulation of the financial services industry, and would affect

 

the business and operations of Freddie Mac. However, we cannot predict the impact of the proposal on our business and operations, because Congress has not yet fully considered the legislation.

 

The Obama Administration’s proposal does not address the regulatory oversight or structure of Freddie Mac. Under the proposal, Treasury and HUD are expected to consult with other government agencies and develop recommendations for the future of Freddie Mac, Fannie Mae and the Federal Home Loan Bank System. According to the proposal, Treasury and HUD will report their recommendations to Congress and the general public at the time of the President’s 2011 budget release, which is currently planned for February 2010.

 

Congress may consider separate legislation that could affect Freddie Mac’s business and operations, such as legislation allowing bankruptcy judges to modify the terms of mortgages on principal residences for borrowers who file for bankruptcy under Chapter 13 of the bankruptcy code.

 

Congress is considering legislative proposals regarding the oversight of the derivatives market. These proposals would generally extend Commodity Futures Trading Commission or SEC regulatory oversight to certain financial derivatives, including derivatives used by Freddie Mac to manage risk exposures. The proposals would also impose new clearing and reporting requirements, as well as new capital requirements for derivatives dealers and counterparties. The Obama Administration has proposed similar derivatives oversight legislation as part of its proposed overhaul of the financial services regulatory structure. If enacted, such legislation could significantly impact Freddie Mac.

 

On June 26, 2009, the House of Representatives passed a comprehensive energy bill that would, among other things, require FHFA to provide Freddie Mac and Fannie Mae with additional affordable housing goals credit for qualifying purchases of certain energy-efficient and location-efficient mortgages. The bill would also create a new duty to serve underserved markets for energy-efficient and location-efficient mortgages. In addition, the bill would create a new federal energy loan guarantee program that would help homeowners finance energy-efficient home improvements. The latter provision could adversely impact Freddie Mac by potentially subordinating our security interest in properties of borrowers who obtain such loans. It is currently unclear when, or if, the Senate will consider comparable legislation.

 

On July 16, 2009, the House of Representatives passed the Financial Services and General Government appropriations bill for fiscal year 2010. The House Committee on Appropriations report accompanying the bill directs Treasury to report to the Committee 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 investments of taxpayer funds aimed at ensuring economic and financial stability.

 

As part of the Economic Stimulus Act of 2008, the conforming loan limits were temporarily increased 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.

 

The American Recovery and Reinvestment Act of 2009, or Recovery Act, ensures that the loan limits for mortgages originated in 2009 in the high-cost areas determined under the Economic Stimulus Act do not fall below their 2008 levels. On October 30, 2009, President Obama signed a Continuing Resolution extending funding for federal agencies through December 18, 2009. The Continuing Resolution also includes language extending the temporary high-cost conforming limits set by the Recovery Act through December 2010.

 

On July 31, 2009, the House of Representatives passed a bill that would require public companies to hold non-binding shareholder votes on executive compensation and to take steps to ensure that members of their compensation committees are independent. The bill would also require specified financial institutions, including Freddie Mac, to disclose incentive-based compensation arrangements 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. It is currently unclear when, or if, the Senate will consider comparable legislation.

 

On October 22, 2009, the House Financial Services Committee approved the Consumer Financial Protection Act which would create a new Consumer Financial Protection Agency responsible for regulating covered institutions, including Freddie Mac. The agency would have regulatory, examination and enforcement authority over financial products and offerings that in many instances would overlap with FHFA’s authority. The bill could impact the regulation of our business and impose additional costs. On October 29, 2009, the House Energy and Commerce Committee also marked up and voted to approve the bill.

 

Congress is also considering systemic risk and resolution authority legislation. The proposal would address the regulation and resolution authority for certain systemically significant institutions. The bill could significantly change the regulation of Freddie Mac.

 

State Legislation

 

Approximately fourteen states have enacted laws allowing localities to create energy loan assessment programs for the purpose of financing energy efficient home improvements. While the specific terms may vary, these laws generally treat the new energy assessments like property tax assessments and allow for the creation of a new lien to secure the assessment that is senior to any existing Freddie Mac mortgage lien. The Obama Administration has expressed support for these laws. If numerous localities adopt such programs and borrowers obtain this type of financing, these laws could have a negative impact on Freddie Mac’s credit losses.

 

Various states, cities, and counties implemented mediation programs that could delay or otherwise change their foreclosure processes. The processes, requirements, and duration of mediation programs may vary for each state but are designed to bring servicers and borrowers together to negotiate foreclosure alternatives. These actions could increase our expenses, including by potentially delaying the final resolution of delinquent mortgage loans and the disposition of non-performing assets.

 

Proposed and Interim Final Regulations

 

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 OFHEO’s mortgage fraud regulation.

 

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. On August 31, 2009, Freddie Mac and Fannie Mae filed joint public comments on the interim final rule with FHFA. We cannot currently predict what changes, if any, FHFA may make to the interim final rule in response to our comments and consequently we are not able to predict the impact of the interim final rule on our business or operations. Depending on the manner in which the interim final rule is implemented, this rule could have an adverse impact on our ability to develop and introduce new products and activities to the marketplace.

 

Affordable Housing Goals

 

On July 30, 2009, FHFA issued a final rule that adjusts our 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 2008 and 2009⁽¹⁾

 

 

The final 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 conforming loan limits in certain high-cost areas as allowed by the Recovery Act.

 

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. On August 4, 2009, FHFA released an advance notice of proposed rulemaking regarding the duty of Freddie Mac and Fannie Mae to serve the underserved markets. We provided comments on the proposed rulemaking to FHFA, but we cannot predict the contents of any proposed final rule that FHFA may release, or the impact that the final rulemaking will have on our business or operations.

 

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 might undertake a reverse stock split in order to do so. We did not undertake a reverse stock split or any other action to cure this deficiency.

 

On September 3, 2009, the NYSE notified us that we had returned to compliance with the NYSE’s minimum share price listing requirement, based on a review as of August 31, 2009 showing that our average share price over the preceding 30 trading days and our closing share price on that date were both more than $1.

 

 

 

 

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 significantly during the three and nine months ended September 30, 2009 compared to the three and nine months ended September 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) accretion of other-than-temporary impairments of investments in available-for-sale securities; partially offset by (d) the impact of declining short-term interest rates on floating rate assets held in our mortgage-related investments portfolio and cash and other investments portfolio. Net interest income and net interest yield during the three and nine months ended September 30, 2009 also benefited from the funds we received from Treasury under the Purchase Agreement. These funds generate net interest income, because the costs of such funds are not reflected in interest expense, but instead as dividends paid on senior preferred stock.

 

During the nine months ended September 30, 2009, spreads on our debt improved and our access to the debt markets increased, primarily due to the Federal Reserve’s purchases in the secondary market of our long-term debt under its purchase program. As a result, we were able to replace some higher cost short- and long-term debt with new lower cost floating-rate long-term debt and short-term debt, resulting in a decrease in our funding costs. Consequently, our concentrations of floating rate debt returned to more historical levels as of September 30, 2009. 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.

 

The increase in the average balance of our mortgage-related investments portfolio during the 2009 periods 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 caused spreads to widen resulting in more favorable investment opportunities for agency mortgage-related securities. In response, our purchase activities increased, resulting in an increase in the average balance of our interest-earning assets. However, during the third quarter of 2009, the unpaid principal balance of our mortgage-related investments portfolio declined due to tightened spreads which we believe resulted from the Federal Reserve and Treasury actively purchasing agency mortgage-related securities in the secondary market which made investment opportunities less favorable. For information on the potential impact of (i) the termination of these purchase programs and (ii) the requirement to reduce the mortgage-related investments portfolio by 10% annually, beginning in 2010, see “CONSOLIDATED BALANCE SHEETS ANALYSIS — Mortgage-Related Investments Portfolio” and “LIQUIDITY AND CAPITAL RESOURCES — Liquidity.”

 

Net interest income also included $1.1 billion of income during the nine months ended September 30, 2009, primarily recognized in the first quarter of 2009, compared to $81 million of income during the nine months ended September 30, 2008, recognized in the third quarter of 2008, related to the accretion of other-than-temporary impairments of investments in available-for-sale securities. Upon our adoption of an amendment to the accounting standards for investments in debt and equity securities (FASB ASC 320-10-65-1) 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.

 

The increases in net interest income and net interest yield on a fully taxable-equivalent basis during the three and nine months ended September 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 nine months ended September 30, 2009 compared to the three and nine months ended September 30, 2008, as we replaced higher-yielding, longer-term non-mortgage-related securities with lower-yielding, shorter-term cash and cash equivalents, Treasury bills 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.

 

We expect net interest income may be negatively impacted in future periods by: (a) the required decreases in our mortgage-related investments portfolio balance, through successive annual 10% reductions commencing in 2010 until it reaches $250 billion, which will cause a reduction in our interest-earning assets; and (b) the termination of the Federal Reserve’s program to purchase our debt securities, which may increase our funding costs.

 

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 slightly for the three and nine months ended September 30, 2009 compared to the three and nine months ended September 30, 2008. For the nine months ended September 30, 2009, the decrease in management and guarantee income compared to the nine months ended September 30, 2008 is primarily due to the reversal of amortization of pre-2003 deferred fees in the first and second quarter of 2009. 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 reversal, of previous amortization in the nine months ended September 30, 2009. The unpaid principal balance of our issued PCs and Structured Securities was $1.86 trillion at September 30, 2009 compared to $1.83 trillion at September 30, 2008, an increase of 2%. Although there were higher average balances of our issued guarantees during the three and nine months ended September 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 declined in the three and nine months ended September 30, 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 also caused by the impact of market-adjusted pricing on new business purchases and an increase in the composition of 30-year fixed-rate amortizing mortgages within our new PC issuances during 2009 (for which we receive a lower fee).

 

We implemented additional delivery fee increases effective September 1, 2009 and October 1, 2009, for mortgages with certain combinations of LTV ratios and other higher-risk loan characteristics. Although we increased delivery fees during 2009, we have been experiencing competitive pressure on our contractual management and guarantee rates, which limited our ability to increase our rates as customers renew their contracts. Due to these competitive pressures, we do not have the ability to raise our contractual guarantee and management rates to offset the increased provision for credit losses on existing business.

 

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 increased slightly in the nine months ended September 30, 2009 as compared to the nine months ended September 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 future management and guarantee fees was $1.1 billion in the third quarter of 2009 compared to $(1.3) billion in the third quarter of 2008 and was $3.7 billion and $(0.6) billion for the nine months ended September 30, 2009 and 2008, respectively. The increases in the fair value gain on our guarantee asset in the 2009 periods were principally attributed to a greater increase in the valuations of excess-servicing, interest-only mortgage securities (which we use to estimate the value of our guarantee asset) during these periods, as compared to the decrease in the valuations during the corresponding 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 nine months ended September 30, 2009, compared to the same periods in 2008, due to growth in the balance of our issued PCs and Structured Securities. Higher prepayment rates on the related loans, which was attributed to higher refinance activity during the 2009 periods, also resulted in increased basic amortization in the 2009 periods, compared to the 2008 periods.

 

Cumulative catch-up amortization was higher for the third quarter of 2009 than in the third quarter of 2008 principally due to higher prepayment rates experienced in the third quarter of 2009, resulting from higher refinance activity. We recognized higher cumulative catch-up adjustments in the nine months ended September 30, 2008 than in the nine months ended September 30, 2009 due to the significant declines in home prices that occurred during the nine months ended September 30, 2008. We estimate that home prices increased by approximately 0.9% during the nine

 

months ended September 30, 2009, based on our own index of our single-family mortgage portfolio, compared to an estimated decrease of 5.5% during the nine months ended September 30, 2008.

 

Derivative Overview

 

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. At September 30, 2009, we did not have any derivatives in hedge accounting relationships. 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. Our use of derivatives also exposes us to counterparty credit risk. For a discussion of the impact of derivatives on our consolidated financial statements and our discontinuation in 2008 of hedge accounting for derivatives previously designated as cash flow hedges, see “NOTE 10: DERIVATIVES” to our consolidated financial statements.

 

Table 10 — Derivative Gains (Losses)