UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

FORM 10-Q

 

 

 

For the quarterly period ended March 31, 2010

 

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 April 21, 2010, there were 649,106,877 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 our efforts under the MHA Program and other programs to assist the U.S. residential mortgage market, 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: (a) 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, 2009, or 2009 Annual Report; and (b) the “BUSINESS” section of our 2009 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, we use certain acronyms and terms which are defined in the Glossary.

 

You should read this MD&A in conjunction with our consolidated financial statements and related notes for the three months ended March 31, 2010 and our 2009 Annual Report.

 

Overview

 

Freddie Mac was chartered by Congress in 1970 with a public mission to stabilize the nation’s residential mortgage markets 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 guarantee multifamily mortgage loans that support housing revenue bonds issued by third parties and we guarantee other multifamily mortgage loans held by third parties.

 

Our financial results for the first quarter of 2010 and net worth as of March 31, 2010 were significantly adversely affected by changes in accounting principles, which resulted in a net decrease to total equity (deficit) as of January 1, 2010 of $11.7 billion. See “Changes in Accounting Standards Related to Accounting for Transfers of Financial Assets and Consolidation of VIEs” for additional information. We had a net loss attributable to Freddie Mac of $6.7 billion for the three months ended March 31, 2010. Total equity (deficit) was $(10.5) billion at March 31, 2010. The $10.5 billion deficit was primarily driven by: (a) a net decrease in total equity (deficit) of $11.7 billion due to the cumulative effect of the change in accounting principles; (b) our first quarter 2010 net loss of $6.7 billion reflecting the ongoing adverse conditions in the U.S. mortgage markets; and (c) the dividend payment of $1.3 billion to Treasury on the senior preferred stock, partially offset by a $4.8 billion decrease in unrealized losses recorded in AOCI primarily driven by improved values on the company’s available-for-sale securities. To address the deficit in our net worth, FHFA, as Conservator, will submit a draw request, on our behalf, to Treasury for $10.6 billion in funding under our Purchase Agreement with Treasury. Following receipt of the draw, we will have received an aggregate of $61.3 billion from Treasury under the Purchase Agreement.

 

Business Objectives

 

We continue to operate under the conservatorship that commenced on September 6, 2008, conducting our business under the direction of FHFA as our Conservator. 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.

 

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 conservatorship, including whether we will continue to exist. On March 23, 2010, the Secretary of the Treasury stated in congressional testimony that, after reform, the GSEs will not exist in the same form. On April 22, 2010, Treasury and HUD published seven questions soliciting public comment on the future of the housing finance system, including Freddie Mac and Fannie Mae, and the overall role of the federal government in housing policy. Comments on the questions must be submitted by July 21, 2010. While we are not aware of any current plans of our Conservator to significantly change our business structure in the near-term, Treasury and HUD, in consultation with other government agencies, are expected to develop legislative recommendations for the future of the GSEs.

 

Our business objectives and strategies have in some cases been altered since we entered conservatorship, and may continue to change. Certain changes to our business objectives and strategies are designed to provide support for the mortgage market in a manner that serves our public mission and other non-financial objectives, but may not contribute to profitability. Our efforts to help struggling homeowners and the mortgage market, in line with our mission, may help to mitigate our credit losses, but in some cases may increase our expenses or require us to forego revenue opportunities in the near term. There is significant uncertainty as to the ultimate impact that our efforts to aid the housing and mortgage markets, including our efforts in connection with the MHA Program, will have on our future capital or liquidity needs. We cannot estimate whether, or the extent to which, the costs we incur in the near term as a result of these efforts, which for the most part we are not reimbursed for, will be offset by the prevention or reduction of potential future costs. It is likely that the costs we incur related to loan modifications and other activities under HAMP, the MHA Program’s loan modification initiative, may be significant, to the extent that borrowers participate in this program in large numbers. For information on the MHA Program and our other efforts to assist the housing market, see “MHA PROGRAM AND OTHER EFFORTS TO ASSIST THE U.S. HOUSING MARKET.”

 

In a letter to the Chairmen and Ranking Members of the Congressional Banking and Financial Services Committees dated February 2, 2010, the Acting Director of FHFA stated that minimizing our credit losses is our central goal and that we will be limited to continuing our existing core business activities and taking actions necessary to advance the goals of the conservatorship. The Acting Director stated that permitting us to engage in new products is inconsistent with the goals of the conservatorship. In addition, the Acting Director stated that FHFA does not expect we will be a substantial buyer or seller of mortgages for our mortgage-related investments portfolio, except for purchases of delinquent mortgages out of PC pools. These restrictions could limit our ability to return to profitability in future periods.

 

While the conservatorship has benefited us through, for example, improved access to the debt markets because of the support we have received from Treasury and the Federal Reserve, we are also subject to certain constraints on our business activities by Treasury due to the terms of, and Treasury’s rights under, the Purchase Agreement.

 

Government Support for our Business

 

We are dependent upon the continued support of Treasury and FHFA in order to continue operating our business. In recent periods, we also received 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. To date, we have received an aggregate of $50.7 billion in funding under the Purchase Agreement. To address our deficit in net worth of $10.5 billion as of March 31, 2010, FHFA, as Conservator, will submit a draw request, on our behalf, to Treasury under the Purchase Agreement in the amount of $10.6 billion. We expect to receive these funds by June 30, 2010. Upon funding of the draw request: (a) the aggregate liquidation preference on the senior preferred stock owned by Treasury will increase from $51.7 billion to $62.3 billion; and (b) the corresponding annual cash dividends payable to Treasury will increase to $6.2 billion, which exceeds our annual historical earnings in most periods. We expect to make additional draws under the Purchase Agreement in future periods due to a variety of factors that could adversely affect our net worth.

 

To date, we have paid $5.6 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 2011 (the amounts of which must be determined by December 31, 2010), will have an adverse impact on our future financial condition and net worth. The payment of dividends on our senior preferred stock in cash reduces our net worth. For periods in which our earnings and other changes in equity do not result in positive net worth, such as the first quarter of 2010, draws under the Purchase Agreement effectively fund the cash payment of senior preferred dividends to Treasury.

 

In November 2008, the Federal Reserve established programs to purchase: (a) our direct obligations and those of Fannie Mae and the FHLBs; and (b) mortgage-related securities issued by us, Fannie Mae and Ginnie Mae. According to information provided by the Federal Reserve, it held $66.4 billion of our direct obligations and had net purchases of $432.3 billion of our mortgage-related securities under these programs as of April 21, 2010. The Federal Reserve completed its purchases under these programs in March 2010. We have not experienced any immediate adverse effects on our business from the completion of these programs. However, it is difficult at this time to predict the impact that the completion of these programs will have on our business and mortgage market generally over time. For more information, see “LIQUIDITY AND CAPITAL RESOURCES — Liquidity” and “RISK FACTORS” in our 2009 Annual Report.

 

For more information on the terms of the conservatorship, the powers of our Conservator and the terms of the Purchase Agreement, see “BUSINESS — Conservatorship and Related Developments” in our 2009 Annual Report.

 

Changes in Accounting Standards Related to Accounting for Transfers of Financial Assets and Consolidation of VIEs

 

In June 2009, the FASB issued two new accounting standards that amended guidance applicable to the accounting for transfers of financial assets and the consolidation of VIEs. The guidance in these standards was effective for fiscal years beginning after November 15, 2009. The accounting standard for transfers of financial assets was applicable on a prospective basis to new transfers, while the accounting standard relating to consolidation of VIEs was applied prospectively to all entities within its scope as of the date of adoption. We adopted these new accounting standards prospectively for all existing VIEs effective January 1, 2010. The adoption of these two standards had a significant impact on our consolidated financial statements and other financial disclosures beginning in the first quarter of 2010.

 

We use securitization trusts in our securities issuance process. Prior to January 1, 2010, these trusts met the definition of QSPEs and were not subject to consolidation. Effective January 1, 2010, the concept of a QSPE was removed from GAAP and entities previously considered QSPEs were required to be evaluated for consolidation. Based on our consolidation evaluation, we determined that we are the primary beneficiary of trusts that issue our single-family PCs and certain Structured Transactions. As a result, a large portion of our off-balance sheet assets and liabilities will now be consolidated. Effective January 1, 2010, we consolidated these trusts and recognized their assets and liabilities at their unpaid principal balances using the practical expedient permitted upon adoption.

 

Upon consolidation, we recognized the mortgage loans as assets on our consolidated balance sheets and the debt securities issued by the securitization trusts as debt on our consolidated balance sheets. We also eliminated our investments in the debt securities issued by these trusts and the related guarantee accounting (e.g., guarantee asset, guarantee obligation, credit enhancements, etc.) associated with these trusts. After adoption of these new accounting standards, purchases of debt securities issued by these consolidated trusts are accounted for as extinguishments of debt, rather than investment securities. Further, separate management and guarantee fee income will not be recognized from these securitization trusts, and instead will be recognized as a portion of the interest income on the consolidated mortgage loans.

 

The adoption of these accounting principles resulted in an increase to our assets and liabilities of $1.5 trillion and a net decrease to total equity (deficit) as of January 1, 2010 of $11.7 billion, which includes changes to the opening balances of retained earnings (accumulated deficit) and AOCI, net of taxes. This net decrease was driven principally by: (a) the elimination of unrealized gains resulting from the extinguishment of PCs held as investment securities upon consolidation of the PC trusts, representing the difference between the unpaid principal balance of the loans underlying the PC trusts and the fair value of the PCs, including premiums, discounts and other basis adjustments; (b) the elimination of the guarantee asset and guarantee obligation established for guarantees issued to securitization trusts we consolidated; and (c) the application of our nonaccrual policy to delinquent mortgage loans consolidated as of January 1, 2010.

 

Because our results of operations for the first quarter of 2010 (on both a GAAP and segment basis) include the activities of the consolidated VIEs, they are not directly comparable with the results of operations for the first quarter of 2009, which reflect the accounting policies in effect during that time (i.e., securitization entities were accounted for off-balance sheet).

 

See “NOTE 2: CHANGE IN ACCOUNTING PRINCIPLES” to our consolidated financial statements for additional information regarding these changes and a related change to the amortization method for certain related deferred items.

 

Results for the First Quarter of 2010

 

Financial Results

 

Net loss attributable to Freddie Mac was $6.7 billion and $10.0 billion for the first quarters of 2010 and 2009, respectively. Key highlights of our financial results for the first quarter of 2010 include:

 

 

We expect a variety of factors will place downward pressure on our financial results in future periods, and could cause us to incur additional GAAP net losses. Key factors include the potential for: (a) continued weak conditions in the housing market, which could increase credit-related expenses and security impairments; and (b) adverse changes in interest rates and spreads, which could result in mark-to-market losses. Our continued efforts under the MHA Program and other government initiatives to support struggling homeowners may also have an adverse impact on our financial results. To the extent we incur GAAP net losses in future periods, we will likely need to take additional draws under the Purchase Agreement. In addition, due to the substantial dividend obligation on the senior preferred stock, we expect to continue to record net losses attributable to common stockholders in future periods. For a discussion of factors that could result in additional draws, see “LIQUIDITY AND CAPITAL RESOURCES — Capital Resources.”

 

Investment Activity Pursuant to the Purchase Agreement

 

Our mortgage-related investments portfolio under the Purchase Agreement is determined without giving effect to any change in accounting standards related to the transfer of financial assets and consolidation of VIEs or any similar accounting standard. Accordingly, for purposes of the portfolio limit, the single-family PCs and certain Structured Transactions purchased into the mortgage-related investments portfolio are considered assets rather than debt reductions. We disclose our mortgage assets on this basis monthly under the caption “Mortgage-Related Investments Portfolio — Ending Balance” in our Monthly Volume Summary reports, which are available on our website and in current reports on Form 8-K we file with the SEC.

 

The unpaid principal balance of our mortgage-related investments portfolio, for purposes of the limit imposed by the Purchase Agreement and FHFA regulation, was $753.3 billion at March 31, 2010, compared to $755.3 billion at December 31, 2009. The unpaid principal balance of our mortgage-related investments portfolio remained relatively flat primarily due to liquidations, offset by the purchase of $56.6 billion of delinquent loans from PC trusts, which resulted from our February 10, 2010 announcement that we would purchase substantially all of the single-family mortgage loans that are 120 days or more delinquent from our related fixed-rate and adjustable-rate PCs.

 

Under the terms of the Purchase Agreement, the unpaid principal balance of our mortgage-related investments portfolio calculated as discussed above may not exceed $810 billion as of December 31, 2010 and this limit will be reduced by 10% each year until it reaches $250 billion.

 

Liquidity

 

We believe that the increased support provided by Treasury pursuant to the December 2009 amendment to the Purchase Agreement will be sufficient to enable us to maintain our access to the debt markets and ensure that we have adequate liquidity to conduct our normal business activities through December 31, 2012, although the costs of our debt funding could vary. Under the December 2009 amendment, the $200 billion cap on Treasury’s funding commitment will increase as necessary to accommodate any cumulative reduction in our net worth during 2010, 2011 and 2012. During the first quarter of 2010, the Federal Reserve continued to be an active purchaser in the secondary market of our long-term debt under its purchase program and spreads on our debt remained favorable relative to historical averages. The Federal Reserve completed its purchases under this program in March 2010. We have not experienced any immediate adverse effects on our business from the completion of this program. However, the completion of this program could, over time, negatively affect the availability of longer-term funding as well as the spreads on our debt, and thus increase our debt funding costs.

 

Single-Family and Multifamily Portfolio

 

The unpaid principal balance of our single-family credit guarantee portfolio decreased 1%, from $1.90 trillion at December 31, 2009 to $1.88 trillion at March 31, 2010. The unpaid principal balance of our multifamily mortgage portfolio decreased 1%, from $98.2 billion at December 31, 2009 to $97.2 billion at March 31, 2010. Our total non-performing assets were approximately 5.8% and 5.2% of our total mortgage portfolio, excluding non-Freddie Mac securities, at March 31, 2010 and December 31, 2009, respectively, and our loan loss reserves totaled 33.3% and 34.1% of our non-performing loans, respectively, as of such dates.

 

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 evaluate segment performance and allocate resources based on a Segment Earnings approach, subject to the conduct of our business under the direction of the Conservator. Beginning January 1, 2010, we revised our method for presenting Segment Earnings to reflect changes in how management measures and assesses the financial performance of each segment and the company as a whole. Under the revised method, the financial performance of our segments is measured based on each segment’s contribution to GAAP net income (loss). This change in method, in conjunction with our implementation of changes in accounting standards relating to transfers of financial assets and the consolidation of VIEs, resulted in significant changes to our presentation of Segment Earnings. In particular, under the revised method, Segment Earnings includes fair value adjustments, gains and losses on investment sales, loans purchased from PC pools and debt retirements that are included in our GAAP-basis earnings, but that had previously been excluded from or deferred in Segment Earnings. The accounting principles we apply to present certain line items in Segment Earnings for our reportable segments, in particular Segment Earnings net interest income and management and guarantee income, differ significantly from those applied in preparing the comparable line items in our consolidated financial statements in accordance with GAAP. Accordingly, the results of such line items differ significantly from, and should not be used as a substitute for, the comparable line items as determined in accordance with GAAP.

 

Under the revised method of presenting Segment Earnings, the All Other category consists of material corporate level expenses that are: (a) non-recurring in nature; and (b) based on management decisions outside the control of the management of our reportable segments. By recording these types of activities to the All Other category, we believe the financial results of our three reportable segments are more representative of the decisions and strategies that are executed within the reportable segments and provide greater comparability across time periods. Items included in the All Other category consist of: (a) the write-down of our LIHTC investments; and (b) the deferred tax asset valuation allowance associated with previously recognized income tax credits carried forward due to our tax net operating loss carryback. Other items previously recorded in the All Other category prior to the revision to our method for presenting Segment Earnings have been allocated to our three reportable segments.

 

Table 1 presents Segment Earnings by segment and the All Other category and includes a reconciliation of Segment Earnings to net (loss) attributable to Freddie Mac prepared in accordance with GAAP for the first quarter of 2009. While we restated Segment Earnings for the first quarter of 2009 to reflect the revisions to our method of evaluating the performance of our reportable segments, we did not restate Segment Earnings to include adjustments related to our adoption of the amendments to the accounting standards for transfers of financial assets and consolidation of VIEs. This change was applied prospectively, consistent with our GAAP financial results. As a result,

 

our Segment Earnings results for the first quarter of 2010 are not directly comparable to the results for the first quarter of 2009.

 

Table 1 — Summary of Segment Earnings⁽¹⁾

 

 

For more information on Segment Earnings, including the revised method we use to present Segment Earnings, see “CONSOLIDATED RESULTS OF OPERATIONS — Segment Earnings” and “NOTE 16: SEGMENT REPORTING” to our consolidated financial statements.

 

Mortgage Credit Risk

 

Mortgage and credit market conditions remained challenging in the first quarter of 2010. A number of factors make it difficult to predict when a sustained recovery in the mortgage and credit markets will occur, including, among others, uncertainty concerning the effect of current or any future government actions in these markets. We estimate that home prices decreased nationwide by approximately 0.9% during the first quarter of 2010 based on our own index of our single-family credit guarantee portfolio. Our assumption for home prices, based on our own index, continues to be for a further decline in national average home prices over the near term before any sustained turnaround in housing begins, due to, among other factors:

 

 

Regardless of whether home prices are stabilizing or increasing, our credit losses will likely remain significantly above historical levels for the foreseeable future due to the substantial number of borrowers in our single-family credit guarantee portfolio that currently owe more on their mortgage than their home is worth in today’s market.

 

Single-Family Credit Guarantee Portfolio

 

The following table provides certain credit statistics for our single-family credit guarantee portfolio, which consists of unsecuritized single-family mortgage loans held for investment and those underlying our issued single-family PCs and Structured Securities and other mortgage-related guarantees.

 

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

 

 

As shown in the table above, although the number of delinquent loan additions (those borrowers who became 90 days or more past due or in foreclosure) declined in the first quarter of 2010, the credit statistics of our single-family credit guarantee portfolio reflect a high level of defaults. The credit losses of our single-family credit guarantee portfolio continued to increase in the first quarter of 2010 due to several factors, including the following:

 

 

We believe the credit quality of the single-family loans we acquired in the first quarter of 2010 (excluding those refinance mortgages in the Home Affordable Refinance Program) is strong as compared to loans acquired from 2006 through 2008 as measured by original LTV ratios and FICO scores. We believe this improvement was, in part, the result of: (a) changes in our underwriting guidelines implemented during 2009; (b) increases in the relative amount of refinance mortgages we acquired in the first quarter of 2010; (c) less purchase volume in the first quarter of 2010 comprised of loans with higher risk characteristics as more of those loans were insured by FHA and securitized through Ginnie Mae; and (d) changes in mortgage insurers’ and lenders’ underwriting practices. Our purchase of interest-only loans during the first quarter of 2010 was not significant. In February 2010, we announced that as of September 1, 2010 we will no longer purchase interest-only loans.

 

Multifamily Mortgage Portfolio

 

The following table provides certain credit statistics for our multifamily mortgage portfolio, which consists of loans held by us on our consolidated balance sheets as well as those underlying non-consolidated PCs, Structured Securities and other mortgage-related financial guarantees, but excluding those underlying Structured Transactions and our guarantees of HFA bonds.

 

Table 3 — Credit Statistics, Multifamily Mortgage Portfolio

 

 

Our multifamily delinquency rates and non-performing loans continued to increase in the first quarter of 2010. In the first quarter of 2010, there was some stabilization in the national unemployment rate, albeit, at very high levels. Certain other multifamily market indicators, such as occupancy rates and effective rents, were essentially unchanged after experiencing deterioration for several quarters. Our delinquency rates remain low relative to other participants in the market. However, delinquency rates are historically a lagging indicator and, as a result, we may continue to experience increased delinquencies even if the market stabilizes, which could cause us to incur additional credit losses. Market fundamentals for multifamily properties that we monitor continued to be challenging during the first quarter of 2010, particularly in certain states in the Southeast and West regions, with a continued increase in borrowers seeking assistance and loan modifications. As of March 31, 2010, approximately half of our multifamily loans 60 days or more delinquent (measured both in terms of number of loans and on a UPB basis) have credit enhancements that we believe will mitigate our expected losses on those loans.

 

Loss Mitigation

 

We continue to increase our use of foreclosure alternatives, including those under the MHA Program, and have expanded our staff to assist our seller/servicers in completing loan modifications and other outreach programs with the objective of keeping more borrowers in their homes. Our loss mitigation activity included the following:

 

 

Some of our loss mitigation activities have created fluctuations in our credit statistics. For example, our temporary suspensions of foreclosure transfers of occupied homes reduced the rate of growth of our REO inventory and of charge-offs, a component of our credit losses, in certain periods since November 2008, but caused our loan loss reserves to rise. This also created an increase in the number of delinquent loans that remain in our single-family credit guarantee portfolio, which results in higher reported delinquency rates than without the suspension of foreclosure transfers. In addition, since we include loans in the HAMP trial period as delinquent in our statistical reporting, this results in a

 

temporary rise in our delinquency rate until the modifications become effective and are removed from delinquent status. Insufficient empirical information exists to estimate the extent to which costs associated with HAMP may be offset, if at all, by the prevention or reduction of potential future costs of loan defaults and foreclosures due to these changes in business practices.

 

Investments in Non-Agency Mortgage-Related Securities

 

Our investments in non-agency mortgage-related securities continue to be adversely affected by the ongoing weak housing and credit conditions, as reflected in poor underlying collateral performance, limited liquidity and large risk premiums in the non-agency mortgage market.

 

In the table below, we provide delinquency rates for the loans that back our subprime first lien, option ARM and Alt-A securities. The information in the table on gross unrealized losses and net impairment of available-for-sale securities recognized in earnings also includes securities backed by “other loans,” which are primarily comprised of securities backed by home equity lines of credit.

 

Table 4 — Credit Statistics, Non-Agency Mortgage-Related Securities Backed by Subprime, Option ARM and Alt-A Loans

 

 

We held unpaid principal balances of $97.4 billion of non-agency mortgage-related securities backed by subprime, option ARM, Alt-A and other loans as of March 31, 2010, compared to $100.7 billion as of December 31, 2009. 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 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 $453 million during the first quarter of 2010.

 

Pre-tax unrealized losses on securities backed by subprime, option ARM, Alt-A and other loans reflected in AOCI decreased to $29.6 billion at March 31, 2010. These unrealized losses declined during the first quarter of 2010 reflecting increases in fair value of $3.5 billion. Although mortgage OAS levels were relatively unchanged for these securities, we recognized fair value gains as these securities moved closer to maturity.

 

FHFA, as conservator, has directed us to work to mitigate our losses as an investor in non-agency mortgage-related securities. The documents governing the securities trusts in which we have invested do not provide us with any direct right of enforcement. Furthermore, other investors involved in these securities trusts may have competing financial interests to our own. As a result, the effectiveness of our loss mitigation efforts is uncertain and any potential recoveries may take significant time to realize.

 

For additional information on our investments in non-agency mortgage-related securities backed by subprime first lien, option ARM and Alt-A loans, including the credit enhancements on such securities, see “CONSOLIDATED

 

BALANCE SHEETS ANALYSIS — Non-Agency Mortgage-Related Securities Backed by Subprime, Option ARM and Alt-A Loans.”

 

Legislative and Regulatory Matters

 

Proposed Legislation

 

Congress continues to consider legislation that would, if enacted, significantly change the regulation of the financial services industry, and affect the business and operations of Freddie Mac by potentially subjecting us to new and additional regulatory oversight and standards, including with respect to our activities, products and capital adequacy. For example, a substantial portion of our derivatives transactions could become subject to centralized clearing and increased capital and margin requirements. Among recent developments, on March 22, 2010 the Senate Committee on Banking, Housing and Urban Affairs passed a financial services regulatory reform bill that addresses many topics that are covered by the bill passed by the House of Representatives on December 11, 2009. For more information, see “BUSINESS — Regulation and Supervision — Legislative Developments” and “RISK FACTORS — Legal and Regulatory Risks” in our 2009 Annual Report.

 

State Actions

 

A number of 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 first mortgage lien. 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 have 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.

 

Affordable Housing Goals for 2009

 

In March 2010, we reported to FHFA that we did not meet the 2009 underserved areas housing goal, special affordable housing goal, underserved areas home purchase subgoal and multifamily special affordable target. We believe that achievement of such goals was infeasible under the terms of the GSE Act, due to market and economic conditions and our financial condition. Accordingly, in January 2010 we submitted an infeasibility analysis to FHFA, which is reviewing our submission.

 

Proposed Affordable Housing Goals for 2010 and 2011

 

Effective beginning calendar year 2010, the Reform Act requires that FHFA establish, by regulation, three single-family owner-occupied housing goals, a single-family refinancing mortgage goal, one multifamily special affordable housing goal and requirements relating to multifamily housing for very low-income families.

 

On February 26, 2010, FHFA published in the Federal Register a proposed rule for public comment that would establish new affordable housing goals for 2010 and 2011 for Freddie Mac and Fannie Mae. The proposed goals and the proposed rules governing our performance under such goals differ substantially from those in effect prior to 2010.

 

For 2010 and 2011, FHFA is proposing levels for four goals for single-family owner-occupied housing, one multifamily special affordable housing goal and one multifamily special affordable housing subgoal. The single-family housing goals target purchase money mortgages for low-income families, very low-income families, and families that reside in low-income areas; and refinancing mortgages for low-income families. The multifamily special affordable housing goal targets multifamily rental housing affordable to low-income families, and the multifamily special affordable housing subgoal targets multifamily rental housing affordable to very low-income families. The proposed single-family goals are expressed as a percentage of the total number of eligible dwelling units underlying our total mortgage purchases, as was the case with the housing goals in effect prior to 2010. The multifamily goals are expressed in terms of minimum numbers of units financed.

 

With respect to the single-family goals, the proposed rule includes: (a) an assessment of performance as compared to the actual share of the market that meets the criteria for each goal; and (b) a benchmark level to measure performance. The benchmark levels for the single-family goals are set forth in Table 5 below. Where our performance on a single-family goal falls short of the benchmark for a goal, we still could achieve the goal if our performance meets or exceeds the actual share of the market that meets the criteria for the goal for that year. For example, if the actual market share of purchase money mortgages to low-income families relative to all purchase money mortgages

 

originated to finance owner-occupied single-family properties is lower than the 27% benchmark rate, we would still satisfy this goal if we achieve that actual market percentage.

 

FHFA’s proposed affordable housing goals for Freddie Mac for 2010 and 2011 are set forth below.

 

Table 5 — Proposed Affordable Housing Goals for 2010 and 2011

 

 

The proposed rule would exclude private-label mortgage-related securities and REMICs from counting toward meeting our housing goals, broaden our ability to count mortgage revenue bonds toward meeting our housing goals, and permit jumbo conforming loans to count toward meeting our housing goals. As was the case with respect to our housing goals for 2009, the proposed rule would permit loans we own or guarantee that are modified in accordance with the MHA Program to be treated as mortgage purchases and counted toward the housing goals.

 

FHFA stated that it does not intend for Freddie Mac and Fannie Mae to undertake uneconomic or high-risk activities in support of the goals, nor does it intend for the enterprises’ state of conservatorship to be a justification for withdrawing support from these market segments.

 

 

 

 

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.

 

Change in Accounting Principles

 

In June 2009, the FASB issued two new accounting standards that amended guidance applicable to the accounting for transfers of financial assets and the consolidation of VIEs. The guidance in these standards was effective for fiscal years beginning after November 15, 2009. The accounting standard for transfers of financial assets was applicable on a prospective basis to new transfers, while the accounting standard relating to consolidation of VIEs was applied prospectively to all entities within its scope as of the date of adoption. We adopted these new accounting standards prospectively for all existing VIEs effective January 1, 2010. The adoption of these two standards had a significant impact on our consolidated financial statements and other financial disclosures beginning in the first quarter of 2010.

 

We use securitization trusts in our securities issuance process. Prior to January 1, 2010, these trusts met the definition of QSPEs and were not subject to consolidation. Effective January 1, 2010, the concept of a QSPE was removed from GAAP and entities previously considered QSPEs were required to be evaluated for consolidation. We must now consolidate VIEs when we hold a controlling financial interest. An enterprise has a controlling interest in, and thus is the primary beneficiary of, a VIE if it has both: (a) the power to direct the activities of the VIE that most significantly impact its economic performance; and (b) exposure to losses or benefits of the VIE that could potentially be significant to the VIE.

 

PCs are designed so that we bear the credit risk inherent in the loans underlying the PCs through our guarantee of principal and interest payments on the PCs. The PC holders bear the interest rate or prepayment risk on the mortgage loans and the risk that we will not perform on our obligation as guarantor. For purposes of our consolidation assessments, our evaluation of power and economic exposure with regard to PC trusts focuses on credit risk because the credit performance of the underlying mortgage loans was identified as the activity that most significantly impacts the economic performance of these entities. We have the power to impact the activities related to this risk in our role as guarantor and master servicer.

 

Specifically, in our role as master servicer, we establish requirements for how mortgage loans are serviced and what steps are to be taken to avoid credit losses (e.g., modification, foreclosure). Additionally, in our capacity as guarantor, we have the ability to purchase defaulted mortgage loans out of the PC trust to help manage credit losses. See “NOTE 5: MORTGAGE LOANS — Loans Acquired under Financial Guarantees” to our consolidated financial statements for further information regarding our purchase of mortgage loans out of PC trusts. These powers allow us to direct the activities of the VIE (i.e., the PC trust) that most significantly impact its economic performance. In addition, we determined that our guarantee to each PC trust to provide principal and interest payments exposes us to losses that could potentially be significant to the PC trusts.

 

Based on our consolidation evaluation, we determined that we are the primary beneficiary of trusts that issue our single-family PCs and certain Structured Transactions, and thus needed to consolidate the assets and liabilities of these trusts. Therefore, effective January 1, 2010, we consolidated on our balance sheet the assets and liabilities of these trusts at their unpaid principal balances, with accrued interest, allowance for credit losses or other-than-temporary impairments recognized as appropriate, using the practical expedient permitted upon adoption since we determined that calculation of historical carrying values was not practical. Other newly consolidated assets and liabilities that either do not have an unpaid principal balance or are required to be carried at fair value were measured at fair value. As a result of this consolidation, we recognized on our consolidated balance sheets the mortgage loans underlying our issued single-family PCs and certain Structured Transactions as mortgage loans held-for-investment by consolidated trusts, at amortized cost. We also recognized the corresponding single-family PCs and certain Structured Transactions held by third parties on our consolidated balance sheets as debt securities of consolidated trusts held by third parties. After January 1, 2010, new consolidations of trust assets and liabilities are recorded at either their: (a) carrying value if the underlying assets are contributed by us to the trust and consolidated at the time of the transfer; or (b) fair value for the assets and liabilities that are consolidated under the securitization trusts for our guarantor swap program, rather than their unpaid principal balance.

 

In light of the consolidation of our single-family PC trusts and certain Structured Transactions as discussed above, effective January 1, 2010 we elected to change the amortization method for deferred items (e.g., premiums, discounts and other basis adjustments) related to mortgage loans and investments in securities. We made this change to align the amortization method for these assets with the amortization method for deferred items associated with the related

 

liabilities. As a result of this change, deferred items are amortized into interest income using an effective interest method over the contractual lives of these assets instead of the estimated life that was used for periods prior to 2010. It was impracticable to retrospectively apply this change to prior periods, so we recognized this change as a cumulative effect adjustment to the opening balance of retained earnings (accumulated deficit), and future amortization of these deferred items will be recognized using this new method. The effect of the change in the amortization method for deferred items was immaterial to our consolidated financial statements for the current period.

 

The cumulative effect of these changes in accounting principles was a net decrease of $11.7 billion to total equity (deficit) as of January 1, 2010, which includes changes to the opening balances of retained earnings (accumulated deficit) and AOCI, net of taxes. This net decrease was driven principally by: (a) the elimination of unrealized gains resulting from the extinguishment of PCs held as investment securities upon consolidation of the PC trusts, representing the difference between the unpaid principal balance of the loans underlying the PC trusts and the fair value of the PCs, including premiums, discounts and other basis adjustments; (b) the elimination of the guarantee asset and guarantee obligation established for guarantees issued to securitization trusts we consolidated; and (c) the application of our nonaccrual policy to delinquent mortgage loans consolidated as of January 1, 2010.

 

See “NOTE 2: CHANGE IN ACCOUNTING PRINCIPLES” and “NOTE 22: SELECTED FINANCIAL STATEMENT LINE ITEMS” to our consolidated financial statements for additional information regarding these changes.

 

As these changes in accounting principles were applied prospectively, our results of operations for the first quarter of 2010 (on both a GAAP and segment basis), which reflect the consolidation of trusts that issue our single-family PCs and certain Structured Transactions, are not directly comparable with the results of operations for the first quarter of 2009, which reflect the accounting policies in effect during that time (i.e., securitization entities were accounted for off-balance sheet).

 

Consolidated Statements of Operations — GAAP Results

 

Table 6 summarizes the GAAP Consolidated Statements of Operations.

 

Table 6 — Summary Consolidated Statements of Operations — GAAP Results⁽¹⁾

 

 

Net Interest Income

 

Table 7 presents an analysis of net interest income, including average balances and related yields earned on assets and incurred on liabilities.

 

Table 7 — Net Interest Income/Yield and Average Balance Analysis

 

 

Our adoption of the change to the accounting standards for consolidation, as discussed above, had the following impact on net interest income and net interest yield for the first quarter of 2010, and will have similar effects on future periods:

 

 

 

 

See “NOTE 2: CHANGE IN ACCOUNTING PRINCIPLES” to our consolidated financial statements for additional information.

 

Net interest income increased by $266 million during the three months ended March 31, 2010 compared to the three months ended March 31, 2009. Net interest yield decreased substantially during the same period as a result of our adoption of amendments to accounting standards for transfers of financial assets and the consolidation of VIEs. Beginning on January 1, 2010, our net interest yield now reflects a blended rate between the yield on our retained investments portfolio and the yield on our securitization guarantee contracts, adjusted to suspend the recognition of interest income on delinquent loans where the collection of interest is not reasonably assured.

 

The increase in net interest income was primarily due to a decrease in funding costs of other debt as a result of the replacement of higher cost short- and long-term debt with lower cost debt partially offset by: (a) a decrease in interest income resulting from the significantly increased average balance of non-performing mortgage loans, where the collection of interest is not reasonably assured; and (b) the impact of declining interest rates on our floating-rate mortgage-related and non-mortgage-related securities.

 

The decrease in net interest yield was primarily due to: (a) the low net interest yield on the interest-earning assets of our consolidated single-family trusts when compared to our historical net interest yield; and (b) the funding costs associated with the increased balance of non-performing mortgage loans.

 

During the three months ended March 31, 2010, spreads on our debt and our access to the debt markets remained favorable. We believe the Federal Reserve’s purchases in the secondary market of our long-term debt under its purchase program contributed to the favorable spreads on our debt. As a result, when compared to the three months ended March 31, 2009, we were able to replace some higher cost short- and long-term debt with lower cost floating-rate long-and short-term debt, resulting in a decrease in our funding costs. For more information, see “LIQUIDITY AND CAPITAL RESOURCES — Liquidity.”

 

During the three months ended March 31, 2010, compared to the three months ended March 31, 2009, the average balance of our mortgage-related securities declined because we did not purchase sufficient amounts of mortgage-related securities to offset ongoing liquidations of our existing holdings. Our purchase activity has been limited due to continued tight spreads on mortgage assets, which have made investment opportunities less favorable. We believe these tight spreads resulted from the Federal Reserve and Treasury actively purchasing agency mortgage-related securities in the secondary market during 2009 and, with respect to the Federal Reserve, during 2010.

 

Provision for Credit Losses

 

Our allowance for loan losses reflects our best projection of defaults we believe are likely as a result of loss events that have occurred through March 31, 2010 on mortgage loans, held-for-investment. The ongoing weakness in the national housing market, the uncertainty in other macroeconomic factors, such as trends in unemployment rates, and the uncertainty of the effect of government actions to address the economic and housing crisis, make forecasting default rates and loss severity on defaults inherently imprecise. Our allowance for loan losses also reflects: (a) the projected recoveries of losses through credit enhancements; (b) the projected impact of strategic loss mitigation initiatives (such as our efforts under the MHA Program), including an expected higher volume of loan modifications; and (c) the projected recoveries through repurchases by seller/servicers of defaulted loans. An inability to realize the projected benefits of our loss mitigation plans, a lower than projected realized rate of seller/servicer repurchases or default rates that exceed our current projections would cause our losses to be higher than those currently estimated.

 

The provision for credit losses was $5.4 billion in the first quarter of 2010 compared to $8.9 billion in the first quarter of 2009. During the first quarter of 2010, we experienced less significant increases than in the first quarter of 2009 in: (a) average loss severity rates; (b) increases in rates of delinquency; and (c) the rate of growth in the balance of our non-performing assets. These factors moderated the increase in our loan loss reserves and consequently, our provision for credit losses in the first quarter of 2010 was less than that recognized in the first quarter of 2009.

 

For more information regarding how we derive our estimate for the provision for credit losses, see “MD&A — CRITICAL ACCOUNTING POLICIES AND ESTIMATES” in our 2009 Annual Report. See “Table 2 — Credit Statistics, Single-Family Credit Guarantee Portfolio” for quarterly trends in single-family credit statistics.

 

Our charge-offs, net of recoveries, increased to $2.8 billion in the first quarter of 2010, compared to $1.0 billion in the first quarter of 2009, primarily due to an increase in the volume of foreclosure transfers. We also recognized $2.7 billion of provision for credit losses above the level of our charge-offs, net during the first quarter of 2010 primarily as a result of:

 

 

The level of our provision for credit losses in the remainder of 2010 will depend on a number of factors, including the actual level of mortgage defaults, the impact of the MHA Program and our other loss mitigation efforts, changes in property values, regional economic conditions, including unemployment rates, third-party mortgage insurance coverage and recoveries and the realized rate of seller/servicer repurchases. See “RISK MANAGEMENT — Credit Risks — Institutional Credit Risk” for additional information on seller/servicer repurchase obligations.

 

The amount of our loan loss reserve associated with multifamily properties, including our reserve for guarantee losses, was $842 million and $831 million as of March 31, 2010 and December 31, 2009, respectively and our total non-performing multifamily loans were $565 million and $538 million, respectively, as of such dates. Market fundamentals for multifamily properties we monitor continued to be challenging during the first quarter of 2010, particularly in certain states in the Southeast and West regions. See “Table 3 — Credit Statistics, Multifamily Mortgage Portfolio” for quarterly trends in multifamily credit statistics.

 

Non-Interest Income (Loss)

 

Gains (Losses) on Extinguishment of Debt Securities of Consolidated Trusts

 

When we purchase PCs that have been issued by consolidated PC trusts, we extinguish a pro rata portion of the outstanding debt securities of the related consolidated trust. We recognize a gain (loss) on extinguishment of the debt securities to the extent the amount paid to redeem the debt security differs from its carrying value adjusted for any related purchase commitments accounted for as derivatives. For the three months ended March 31, 2010, we extinguished debt securities of consolidated trusts with an unpaid principal balance of $4.4 billion (representing our purchase of single-family PCs with an unpaid principal balance of $4.4 billion) and our gains (losses) on extinguishment of these debt securities of consolidated trusts was $(98) million. For the three months ended March 31, 2009, we did not recognize a gain or loss on extinguishment of debt securities of consolidated trusts as our PCs trusts had not been consolidated prior to the change in the consolidation accounting for VIEs. See “NOTE 2: CHANGE IN ACCOUNTING PRINCIPLES” to our consolidated financial statements for additional information.

 

Gains (Losses) on Retirement of Other Debt

 

Gains (losses) on retirement of other debt were $(38) million and $(104) million during the three months ended March 31, 2010 and 2009, respectively. During the three months ended March 31, 2010, we recognized fewer losses on retirement compared to the three months ended March 31, 2009 due to declines in write-offs of concession fees and write-offs related to basis adjustments from previously discontinued hedging relationships.

 

Derivative Gains (Losses) and Gains (Losses) on Debt Recorded at Fair Value

 

We use derivatives to: (a) regularly adjust or rebalance our funding mix in order to more closely match changes in the interest rate characteristics of our mortgage-related assets; (b) hedge forecasted issuances of debt; (c) synthetically create callable and non-callable funding; and (d) hedge foreign-currency exposure. We account for our derivatives pursuant to the accounting standards for derivatives and hedging. See “NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES — Derivatives” to our consolidated financial statements for additional information.

 

At March 31, 2010 and December 31, 2009, we did not have any derivatives in hedge accounting relationships; however, there are amounts recorded in AOCI related to discontinued cash flow hedges. Changes in fair value and interest accruals on derivatives not in hedge accounting relationships are recorded as derivative gains (losses) in our consolidated statements of operations. The deferred amounts in AOCI related to closed cash flow hedges are reclassified to earnings when the forecasted transactions affect earnings.

 

Derivative Gains (Losses)

 

Table 8 presents derivative gains and losses. Derivative gains (losses) includes the accrual of periodic settlements for derivatives. Although derivatives are an important aspect of our management of interest-rate risk, they generally increase the volatility of reported net income (loss), because not all of the assets and liabilities being hedged are recorded at fair value with changes reported in net income.

 

Table 8 — Derivative Gains (Losses)

 

 

Gains (losses) on derivatives are principally driven by changes in: (a) swap interest rates and implied volatility; and (b) the mix and volume of derivatives in our derivative portfolio.

 

During the first quarter of 2010, the fair value of our derivative portfolio was impacted by a decline in swap interest rates and implied volatility, resulting in a loss on derivatives of $4.7 billion. As a result of these factors, we recorded losses on our pay-fixed swaps, partially offset by gains on our receive-fixed swap positions as illustrated in the table above. We also recorded losses on our purchased put swaptions.

 

During the first quarter of 2009, we recorded a gain on derivatives of $181 million primarily due to rising long-term interest rates while implied volatility decreased. These changes in interest rates and volatility resulted in a gain on our pay-fixed swap positions, partially offset by losses on our receive-fixed swaps and a loss on our purchased call swaptions.

 

Foreign Currency Swaps and Foreign-Currency Denominated Debt

 

Gains (losses) on debt recorded at fair value primarily relates to changes in the fair value of our foreign-currency denominated debt. For the three months ended March 31, 2010, we recognized gains on debt recorded at fair value of $347 million due primarily to the U.S. dollar strengthening relative to the Euro. For the three months ended March 31, 2009, we recognized gains on debt recorded at fair value of $467 million primarily due to an increase in interest rates and the U.S. dollar strengthening relative to the Euro. We mitigate changes in the fair value of our foreign-currency denominated debt by using foreign currency swaps and foreign-currency denominated interest-rate swaps.

 

During the first quarter of 2010 we recognized fair value gains of $346 million on our foreign-currency denominated debt. This amount included:

 

 

During the first quarter of 2009, we recognized fair value gains of $467 million on our foreign-currency denominated debt. This amount included:

 

 

For a discussion of the instrument-specific credit risk and our election to adopt the fair value option on our foreign-currency denominated debt see “NOTE 19: FAIR VALUE DISCLOSURES — Fair Value Election — Foreign-Currency Denominated Debt with Fair Value Option Elected” to our consolidated financial statements.

 

Investment Securities-Related Activities

 

As a result of our adoption of amendments to the accounting standards for transfers of financial assets and consolidation of VIEs, we no longer account for the single-family PCs and certain Structured Transactions we hold as investments in securities. Instead, we now recognize the underlying mortgage loans on our consolidated balance sheets through consolidation of the related trusts. Our adoption of these amendments resulted in a decrease in our investments in securities of $286.5 billion on January 1, 2010. See “NOTE 2: CHANGE IN ACCOUNTING PRINCIPLES” to our consolidated financial statements for additional information.

 

Impairments of Available-for-Sale Securities

 

During the three months ended March 31, 2010, we recorded net impairment of available-for-sale securities recognized in earnings of $510 million, all of which related to expected credit losses on our non-agency mortgage-related securities. During the three months ended March 31, 2009, which was prior to the adoption of an amendment to the accounting standards for investments in debt and equity securities, we recognized in earnings approximately $6.9 billion of other-than-temporary impairment related to non-agency mortgage-related securities backed by subprime, option ARM and Alt-A and other loans that were probable of incurring a contractual principal or interest loss.

 

See “CONSOLIDATED BALANCE SHEETS ANALYSIS — Investments in Securities — Mortgage-Related Securities — Non-Agency Mortgage-Related Securities Backed by Subprime, Option ARM and Alt-A Loans” and “NOTE 7: INVESTMENTS IN SECURITIES” to our consolidated financial statements for additional information regarding the accounting principles for investments in debt and equity securities and the other-than-temporary impairments recorded during the three months ended March 31, 2010 and 2009. See “NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES — Recently Adopted Accounting Standards — Change in the Impairment Model for Debt Securities” in our 2009 Annual Report for information on how other-than-temporary impairments are recorded on our financial statements commencing in the second quarter of 2009.

 

Other Gains (Losses) on Investment Securities Recognized in Earnings

 

We recognized $(417) million and $2.1 billion related to gains (losses) on trading securities during the three months ended March 31, 2010 and 2009, respectively. The impact of declining interest rates on our interest-only securities classified as trading resulted in a mark-to-fair-value loss of $482 million during the three months ended March 31, 2010. The net gains on trading securities during the first quarter of 2009 related primarily to tightening OAS levels. Our sales of agency securities classified as trading with unpaid principal balances of approximately $36 billion generated realized gains of $1.1 billion.

 

The unpaid principal balance of our securities classified as trading was approximately $71 billion at March 31, 2010 compared to approximately $253 billion at March 31, 2009. The decline in unpaid principal balance was primarily due to our adoption of amendments to the accounting standards for transfers of financial assets and consolidation of VIEs on January 1, 2010.

 

Other Income

 

Table 9 summarizes the significant components of other income.

 

Table 9 — Other Income

 

 

Other income primarily includes items associated with our guarantee business activities of non-consolidated trusts, including recoveries of loans impaired upon purchase, management and guarantee income, gains (losses) on guarantee asset and income on guarantee obligation, as well as all other income from non-guarantee related activities. Upon consolidation of our single-family PC trusts and certain Structured Transactions, guarantee-related items no longer have a material impact on our results and are therefore included in other income on our consolidated statements of operations. For additional information on the impact of consolidation of our single-family PC trusts and certain Structured Transactions, see “NOTE 2: CHANGE IN ACCOUNTING PRINCIPLES” and “NOTE 22: SELECTED FINANCIAL STATEMENT LINE ITEMS” to our consolidated financial statements.

 

Management and Guarantee Income

 

Management and guarantee income decreased significantly during the three months ended March 31, 2010 as compared to the three months ended March 31, 2009. The significant decrease was due to the consolidation of our single-family PC trusts and certain Structured Transactions as a result of the change in the accounting for VIEs. Beginning January 1, 2010, the income associated with most of our securitization and guarantee activities relates to our consolidated securitization trusts and is recognized as a component of net interest income. The management and guarantee income recognized during the first quarter of 2010 was earned from our non-consolidated securitization trusts and other mortgage credit guarantees whose ending unpaid principal balance was $40.4 billion as of March 31, 2010 compared to $1.8 trillion as of March 31, 2009.

 

Gains (Losses) on Guarantee Asset

 

Gains (losses) on guarantee asset decreased significantly during the three months ended March 31, 2010 as compared to the three months ended March 31, 2009, primarily due to the decrease in the balance of our recognized guarantee asset resulting from the consolidation of our single-family PC trusts and certain Structured Transactions. Beginning January 1, 2010, we no longer record a guarantee asset on our consolidated balance sheet for guarantees associated with our consolidated trusts, and therefore no longer recognize gains (losses) on guarantee assets related to such trusts. As of March 31, 2010 and December 31, 2009, our guarantee assets on our consolidated balance sheets were $482 million and $10.4 billion, respectively.

 

Income on Guarantee Obligation

 

Income on guarantee obligation decreased significantly during the three months ended March 31, 2010, as compared to the three months ended March 31, 2009 primarily due to the decrease in the balance of our recognized guarantee obligation resulting from the consolidation of our single-family PC trusts and certain Structured Transactions. Beginning January 1, 2010, we no longer recognize income on our guarantee obligation for guarantees associated with our consolidated trusts. As of March 31, 2010 and December 31, 2009, our guarantee obligations on our consolidated balance sheets were $656 million and $12.5 billion, respectively.

 

Recoveries on Loans Impaired Upon Purchase

 

During the three months ended March 31, 2010 and 2009, we recognized recoveries on loans impaired upon purchase of $169 million and $50 million, respectively. Our recoveries on loans impaired upon purchase increased due to a higher volume of foreclosure transfers combined with improvements in home prices in some geographical areas during the first quarter of 2010, as compared to the first quarter of 2009. Our recoveries on these loans may be volatile

 

in the short-term due to the effects of changes in home prices, among other factors. We expect our recoveries to remain higher in 2010, as compared to 2009, due to higher expected volumes of foreclosures in 2010.

 

Low-income Housing Tax Credit Partnerships

 

We wrote down the carrying value of our LIHTC investments to zero in the fourth quarter of 2009, as we will not be able to realize any value either through reductions to our taxable income and related tax liabilities or through a sale to a third party. See “CONSOLIDATED RESULTS OF OPERATIONS — Non-Interest Income (Loss) — Low-Income Housing Tax Credit Partnerships” in our 2009 Annual Report for more information.

 

Trust Management Income (Expense)

 

Due to the change in consolidation accounting for VIEs, which resulted in the consolidation of our single-family PC trusts and certain Structured Transactions, there was no trust management income or expense in the three months ended March 31, 2010. Beginning January 1, 2010, trust management income and expense associated with consolidated trusts is recognized within net interest income.

 

Non-Interest Expense

 

Table 10 summarizes the components of non-interest expense.

 

Table 10 — Non-Interest Expense

 

 

Administrative Expenses

 

Administrative expenses increased for the three months ended March 31, 2010, compared to the three months ended March 31, 2009, in part due to an increase in the number of full-time employees, increased incentive awards as well as higher professional service costs that support corporate initiatives, including our HAMP efforts.

 

REO Operations Expense

 

The table below presents the components of our REO operations expense.

 

Table 11 — REO Operations Expense

 

 

REO operations expense decreased to $159 million for the first quarter of 2010 from $306 million during the first quarter of 2009. Disposition losses during the first quarter of 2010 were lower as compared to the first quarter of 2009 due to the relative stabilization in national home prices in 2010 that included slight improvements in certain geographic

 

areas. Improvement in disposition losses was partially offset by higher property expenses in the first quarter of 2010 as compared to the first quarter of 2009 due to increased property inventory and acquisition volumes in the first quarter of 2010. We expect REO property expense to continue to increase for the remainder of 2010, as single-family REO acquisition volume continues to increase and property inventory continues to grow.

 

Other Expenses

 

Other expenses primarily consists of losses on loans purchased and other miscellaneous expenses. Our losses on loans purchased were $17 million during the first quarter of 2010 compared to $2.0 billion during the first quarter of 2009. Losses on delinquent and modified loans purchased from mortgage pools within our non-consolidated securitization trusts occur when the acquisition basis of the purchased loan exceeds the estimated fair value of the loan on the date of purchase. When a loan underlying our PCs is modified, we generally exercise our repurchase option and hold the modified loan as an unsecuritized mortgage loan, held-for-investment. See “Recoveries on Loans Impaired Upon Purchase” for additional information about the impacts from these loans on our financial results. Beginning January 1, 2010, our single-family PC trusts are consolidated as a result of the change in accounting for consolidation of VIEs. As a result, we no longer record losses on loans purchased when we purchase loans from these consolidated entities since the loans are already recorded on our consolidated balance sheets. In the first quarter of 2010, losses on loans purchased were associated solely with loans purchased pursuant to long-term standby agreements. See “NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES — Impaired Loans” and “NOTE 22: SELECTED FINANCIAL STATEMENT LINE ITEMS” to our consolidated financial statements for additional information.

 

Income Tax Benefit

 

For the three months ended March 31, 2010 and 2009, we reported an income tax benefit of $103 million and $937 million, respectively. See “NOTE 13: INCOME TAXES” to our consolidated financial statements for additional information.

 

Segment Earnings

 

Our operations consist of three reportable segments, which are based on the type of business activities each performs — Investments, Single-family Guarantee and Multifamily. Certain activities that are not part of a reportable segment are included in the All Other category.

 

The Investments segment includes our investment, funding and hedging activities. In our Investments segment, we invest principally in mortgage-related securities and single-family mortgage loans funded by debt issuances and hedged by asset and liability management. Segment Earnings for this segment consists primarily of the returns on these investments, less the related financing, hedging and administrative expenses.

 

The Single-family Guarantee segment includes our single-family credit guarantee activities. In our Single-family Guarantee segment, we purchase single-family mortgage loans originated by our lender customers in the primary mortgage market, primarily through our guarantor swap program. We securitize most of the mortgages we purchase. In this segment, we also guarantee the payment of principal and interest on single-family mortgage loans and mortgage-related securities in exchange for management and guarantee fees received over time and other up-front credit-related fees. Segment Earnings for this segment consist primarily of management and guarantee fee revenues, including amortization of upfront fees, less the related credit costs (i.e., provision for credit losses) and administrative expenses. Segment Earnings for this segment also includes management and guarantee fee revenues earned on loans held in the Investments segment related to single-family guarantee activities, net of allocated funding costs and amounts related to net float benefits or expenses.

 

The Multifamily segment includes our investments and guarantee activities in multifamily mortgage loans and securities. In our Multifamily segment, we primarily purchase multifamily mortgage loans and CMBS for investment and guarantee the payment of principal and interest on multifamily mortgage-related securities and mortgages underlying multifamily housing revenue bonds. These activities support our mission to supply financing for affordable rental housing. Segment Earnings for this segment also includes management and guarantee fee revenues and the interest earned on assets related to multifamily guarantee and investment activities, net of allocated funding costs.

 

We evaluate segment performance and allocate resources based on a Segment Earnings approach, subject to the conduct of our business under the direction of the Conservator. Beginning January 1, 2010, we revised our method for presenting Segment Earnings to reflect changes in how management measures and assesses the performance of each segment and the company as a whole. Under the revised method, the financial performance of our segments is measured based on each segment’s contribution to GAAP net income (loss). Under the revised method, the sum of Segment Earnings for each segment and the All Other category will equal GAAP net income (loss) attributable to Freddie Mac for the first quarter of 2010 and subsequent periods.

 

Segment Earnings for prior periods presented now include the following items that are included in our GAAP-basis earnings, but were deferred or excluded under the previous method for presenting Segment Earnings:

 

 

Under the revised method of presenting Segment Earnings, the All Other category consists of material corporate level expenses that are: (a) non-recurring in nature; and (b) based on management decisions outside the control of the management of our reportable segments. By recording these types of activities to the All Other category, we believe the financial results of our three reportable segments are more representative of the decisions and strategies that are executed within the reportable segments and provide greater comparability across time periods. Items included in the All Other category consist of: (a) the write-down of our LIHTC investments; and (b) the deferred tax asset valuation allowance associated with previously recognized income tax credits carried forward due to our tax net operating loss carryback. Other items previously recorded in the All Other category prior to the revision to our method for presenting Segment Earnings have been allocated to our three reportable segments.

 

Effective January 1, 2010, we also made significant changes to our GAAP consolidated statements of operations as a result of our adoption of changes in accounting standards for transfers of financial assets and the consolidation of VIEs. These changes make it difficult to view results of our Investments, Single-family Guarantee and Multifamily segments. As a result, in presenting Segment Earnings we make significant reclassifications to line items for our segment businesses in order to reflect a measure of net interest income on investments and management and guarantee income on guarantees that is in line with our internal measures of performance.

 

We present Segment Earnings by: (a) reclassifying certain investment-related activities and credit guarantee-related activities between various line items on our GAAP consolidated statements of operations; and (b) allocating certain revenues and expenses, including certain returns on assets and funding costs, and all administrative expenses to our three reportable segments.

 

As a result of these reclassifications and allocations, Segment Earnings for our reportable segments differs significantly from, and should not be used as a substitute for, net income (loss) as determined in accordance with GAAP. Our definition of Segment Earnings may differ from similar measures used by other companies. However, we believe that Segment Earnings provides us with meaningful metrics to assess the financial performance of each segment and our company as a whole.

 

We have restated Segment Earnings for the first quarter of 2009 to reflect changes in our method of measuring and assessing the performance of our reportable segments. The restated Segment Earnings for the first quarter of 2009 do not include changes to the guarantee asset, guarantee obligation or other items that were eliminated or changed as a result of our implementation of the amendments to the accounting standards for transfers of financial assets and consolidation of VIEs adopted on January 1, 2010, as this change was applied prospectively consistent with our GAAP results. See “NOTE 2: CHANGE IN ACCOUNTING PRINCIPLES” to our consolidated financial statements for further information regarding the consolidation of certain of our securitization trusts.

 

See “NOTE 16: SEGMENT REPORTING” to our consolidated financial statements for further information regarding our segments, including the descriptions and activities of the segments and the reclassifications and allocations used to present Segment Earnings.

 

Table 12 provides information about our various segment portfolios.

 

Table 12 — Segment Portfolio Composition⁽¹⁾

 

 

Segment Earnings — Results

 

See “NOTE 16: SEGMENT REPORTING — Segments” to our consolidated financial statements for information regarding the description and activities of our Investments, Single-family Guarantee and Multifamily Segments.

 

Investments

 

Table 13 presents the Segment Earnings of our Investments segment.

 

Table 13 — Segment Earnings and Key Metrics — Investments⁽¹⁾

 

 

Segment Earnings (loss) for this segment decreased to $(1.3) billion for the three months ended March 31, 2010 compared to $518 million for the three months ended March 31, 2009. Investments segment net interest income and net interest yield decreased during the three months ended March 31, 2010 compared to the three months ended March 31, 2009. In addition, our loss increased during the three months ended March 31, 2010 compared to the three months ended March 31, 2009 for Investments segment non-interest income (loss).

 

Segment Earnings net interest income decreased $688 million and Segment Earnings net interest yield decreased 29 basis points to 74 basis points during the three months ended March 31, 2010 compared to the three months ended March 31, 2009. The primary drivers underlying the decreases in Segment Earnings net interest income and Segment Earnings net interest yield were: (a) an increase in derivative interest carry on net pay-fixed interest-rate swaps, which is recognized within net interest income in Segment Earnings, due to short-term interest rate declines; (b) an increase

 

in low-yielding short-term investments during the first quarter of 2010 in order to facilitate the purchase of $56.6 billion in unpaid principal balance of loans from PC trusts, which settled during the three months ended March 31, 2010; and (c) a decrease in the average balance of mortgage-related securities. These items were partially offset by a decrease in funding costs as a result of the replacement of higher cost short- and long-term debt with lower cost debt.

 

Our non-interest losses increased $302 million for the three months ended March 31, 2010 compared to the three months ended March 31, 2009, primarily due to derivative losses for our Investments segment non-interest income (loss). Derivative gains (losses) for this segment were $(2.7) billion during the three months ended March 31, 2010, primarily due to the impact of declines in interest rates on our pay-fixed interest-rate swaps and the impact of the decline in implied volatility on our options portfolio compared to $1.2 billion for the three months ended March 31, 2009 primarily due to the impact of increases in interest rates on our pay-fixed interest-rate swaps. Impairments recorded in our Investments segment decreased by $6.0 billion during the three months ended March 31, 2010 compared to the three months ended March 31, 2009 primarily related to reduced impairment on available-for-sale non-agency mortgage-related securities. As our adoption of the amendment to the accounting standards for investments in debt and equity securities on April 1, 2009 significantly impacted both the identification and measurement of other-than-temporary impairments, the results for the three months ended March 31, 2010 and 2009 are not comparable. However, the underlying collateral performance of loans supporting our non-agency securities deteriorated to a lesser extent during the three months ended March 31, 2010 than during the three months ended March 31, 2009. See “Non-Interest Income (Loss) — Derivative Gains (Losses) and Gains (Losses) on Debt Recorded at Fair Value” and “CONSOLIDATED BALANCE SHEETS ANALYSIS — Investments in Securities — Other-Than-Temporary Impairments on Available-for-Sale Mortgage-Related Securities” for additional information on our derivatives and impairments, respectively.

 

During the three months ended March 31, 2010, the mortgage investments portfolio of our Investments segment decreased at an annualized rate of (30.52)%, compared to an increase of 34.98% for the three months ended March 31, 2009. The unpaid principal balance of the mortgage investments portfolio of our Investments segment decreased from $598 billion at December 31, 2009 to $552 billion at March 31, 2010. The portfolio decreased during the three months ended March 31, 2010 due to a relative lack of favorable investment opportunities caused by tighter spreads on agency mortgage-related securities as a result of the Federal Reserve’s purchases of agency mortgage-related securities.

 

We held $61.1 billion of non-Freddie Mac agency mortgage-related securities and $110.0 billion of non-agency mortgage-related securities as of March 31, 2010 compared to $65.6 billion of non-Freddie Mac agency mortgage-related securities and $113.7 billion of non-agency mortgage-related securities as of December 31, 2009. The decline in the unpaid principal balance of non-agency mortgage-related securities is due primarily 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 these securities. Agency securities comprised approximately 71% and 74% of the unpaid principal balance of the Investments segment mortgage investments portfolio at March 31, 2010 and December 31, 2009, respectively. See “CONSOLIDATED BALANCE SHEETS ANALYSIS — Investments in Securities” for additional information regarding our mortgage-related securities.

 

The objectives set forth for us under our charter and conservatorship and restrictions set forth in the Purchase Agreement may negatively impact our Investments segment results over the long term. For example, the required reduction in our mortgage-related investments portfolio unpaid principal balance limit to $250 billion, through successive annual 10% declines, commencing in 2010, will cause a corresponding reduction in our net interest income from these assets. We expect this will negatively affect our Investments segment results. FHFA stated its expectation in the Acting Director’s February 2, 2010 letter that any net additions to our mortgage-related investments portfolio would be related to purchasing delinquent mortgages out of PC pools.

 

For information on the potential impact of the completion of the Federal Reserve’s purchase program and the requirement to reduce the mortgage-related investments portfolio limit by 10% annually, commencing in 2010, see “MD&A — LIQUIDITY AND CAPITAL RESOURCES — Liquidity” in our 2009 Annual Report and “NOTE 3: CONSERVATORSHIP AND RELATED DEVELOPMENTS — Impact of the Purchase Agreement and FHFA Regulation on the Mortgage-Related Investments Portfolio” to our consolidated financial statements.

 

Single-Family Guarantee Segment

 

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

 

Table 14 — Segment Earnings and Key Metrics — Single-Family Guarantee⁽¹⁾