UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

FORM 10-Q

 

 

 

For the quarterly period ended September 30, 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 October 22, 2010, there were 649,165,351 shares of the registrant’s common stock outstanding.

 

 

TABLE OF CONTENTS

 

 

FINANCIAL STATEMENTS

 

 

 

We continue to operate under the conservatorship that commenced on September 6, 2008, under the direction of FHFA as our Conservator. The Conservator succeeded to all rights, titles, powers and privileges of Freddie Mac, and of any shareholder, officer or director thereof, with respect to the company and its assets. The Conservator has delegated certain authority to our Board of Directors to oversee, and management to conduct, day-to-day operations. See “BUSINESS — Conservatorship and Related Developments” in our Annual Report on Form 10-K for the year ended December 31, 2009, or 2009 Annual Report, for information on the terms of the conservatorship, the powers of the Conservator, and related matters, including the terms of our Purchase Agreement with Treasury.

 

Throughout Part I of this Form 10-Q, we use certain acronyms and terms which are defined in the Glossary.

 

This Quarterly Report on Form 10-Q includes forward-looking statements that are based on current expectations and are subject to significant risks and uncertainties. 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. Actual results might differ significantly from those described in or implied by such statements due to various factors and uncertainties, including those described in: (a) “MD&A — FORWARD-LOOKING STATEMENTS,” and “RISK FACTORS” in this Form 10-Q and in the comparably captioned sections of our 2009 Annual Report, and our Quarterly Reports on Form 10-Q for the first and second quarters of 2010; and (b) the “BUSINESS” section of our 2009 Annual Report.

 

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, 2010 and our 2009 Annual Report.

 

Overview

 

Freddie Mac is a GSE chartered by Congress in 1970 with a public mission to provide liquidity, stability, and affordability to the U.S. housing market. We have maintained a consistent market presence since our inception, providing mortgage liquidity in a wide range of economic environments. During the worst housing and financial crisis since the Great Depression, we are working to support the recovery of the housing market and the nation’s economy by providing essential liquidity to the mortgage market and helping to stem the rate of foreclosures. Taken together, we believe our actions are helping communities across the country by providing America’s families with access to mortgage funding at low rates while helping distressed borrowers keep their homes and avoid foreclosure.

 

Summary of Financial Results

 

Our financial performance in the third quarter of 2010 continues to be impacted by declines in long-term interest rates and the ongoing weakness in the economy, including in the mortgage market. Our total equity (deficit) was $(58) million at September 30, 2010 as our quarterly dividend of $1.6 billion to Treasury exceeded total comprehensive income (loss) for the third quarter of 2010. Our total comprehensive income (loss) was $1.4 billion for the third quarter of 2010 consisting of a net loss of $2.5 billion, reflecting continued significant provision for credit losses, and a $3.9 billion improvement in unrealized losses, net of taxes, related primarily to available-for-sale securities recorded in AOCI. On September 30, 2010, we paid a quarterly dividend to Treasury of $1.6 billion in cash on our senior preferred stock. To address our deficit in net worth, FHFA, as Conservator, will submit a draw request on our behalf to Treasury under the Purchase Agreement for $100 million. Our ability to access funds from Treasury under the Purchase Agreement is critical to keeping us solvent.

 

Our Primary Business Objectives

 

Under conservatorship, we are focused on: (a) meeting the needs of the U.S. residential mortgage market by making home ownership and rental housing more affordable by providing liquidity to mortgage originators and, indirectly, to mortgage borrowers; (b) working to reduce the number of foreclosures and helping to keep families in their homes, including through our role in the MHA Program initiatives, including HAMP, and our relief refinance mortgage initiative; (c) minimizing our credit losses; and (d) maintaining the credit quality of the loans we purchase and guarantee.

 

Providing Mortgage Liquidity and Conforming Loan Availability

 

We provide liquidity to and support for the U.S. mortgage market in a number of important ways:

 

 

During the three and nine months ended September 30, 2010, we guaranteed $91.4 billion and $261.3 billion in UPB of single-family conforming mortgage loans, respectively, representing 0.4 million and 1.2 million families, respectively, who purchased homes or refinanced their mortgages. We estimate that we, Fannie Mae, and Ginnie Mae collectively guaranteed over 95% of the single-family conforming mortgage issuances during the nine months ended September 30, 2010.

 

Borrowers typically pay less on mortgage loans, in the form of lower interest rates, funded by Freddie Mac, Fannie Mae, or Ginnie Mae. Mortgage originators are generally able to offer homebuyers lower mortgage rates on conforming loan products, including ours, because of the value investors place on GSE-guaranteed mortgage-related securities. Prior to 2007, mortgage markets were less volatile, home values were stable or rising, and there were many sources of mortgage funds. We estimate that prior to 2007 the average effective interest rates on conforming single-family mortgage loans were about 30 basis points lower than on non-conforming loans. Since 2007, there have been fewer sources of mortgage funds, and we estimate that interest rates on conforming loans, excluding conforming jumbo loans, have been lower than those on non-conforming loans by as much as 184 basis points. In September 2010, we estimate that borrowers were paying an average of 77 basis points less on these conforming loans than on non-conforming loans. These estimates are based on data provided by HSH Associates.

 

Reducing Foreclosures and Keeping Families in Homes

 

During the current housing crisis, we are focused on reducing the number of foreclosures and helping to keep families in their homes. In addition to our participation in the HAMP program, we introduced several options to eligible borrowers during this crisis, including our relief refinance mortgage initiative. Since the beginning of 2010, we helped more than 210,000 borrowers either stay in their homes or sell their properties and avoid foreclosure through our various workout programs, including HAMP. The following table presents our recent single-family loan workout activities.

 

Table 1 — Total Single-Family Loan Workout Volumes⁽¹⁾

 

 

We continue to execute a high volume of loan workouts. Recent highlights include the following:

 

 

 

 

In addition to these efforts, we continue to focus on assisting consumers through outreach and other efforts. These efforts include: (a) meeting with borrowers nationwide in foreclosure prevention workshops; (b) launching the Borrower Help Network to provide distressed borrowers with one-on-one counseling; (c) opening Borrower Help Centers in several cities nationwide to provide free counseling to distressed borrowers; and (d) in instances where foreclosure has occurred, allowing affected families who qualify to rent back their homes. We have also increased our efforts to directly assist our servicers by: (a) increasing our mortgage-related servicing staff; and (b) placing on-site specialists at mortgage servicers.

 

Minimizing Credit Losses

 

We establish guidelines for our servicers to follow in determining which loan workout solution would be expected to provide the best opportunity for minimizing our credit losses and helping the borrower. For example, if a borrower qualifies for a loan modification, this often provides us a better opportunity to minimize credit losses than a foreclosure. We rely on our servicers to identify the best alternative for each borrower.

 

To help minimize the credit losses related to our guarantee activities, we are focused on:

 

 

We have contractual arrangements with our seller/servicers under which they provide us with mortgage loans that have been originated under specified underwriting standards. If we subsequently discover that contractual standards were not followed, we can exercise certain contractual remedies to mitigate our credit losses. These contractual remedies include the ability to require the seller/servicer to repurchase the loan at its current UPB or make us whole for any credit losses realized with respect to the loan. As of September 30, 2010, the UPB of loans subject to repurchase requests issued to our single-family seller/servicers was approximately $5.6 billion, and approximately 32% of these requests were outstanding for more than four months since issuance of our repurchase demand. The actual amount we collect on these requests and others we may make in the future will be significantly less than their UPB amounts because we expect many of these requests will be satisfied by reimbursement of our realized losses by seller/servicers, instead of repurchase of loans at their UPB, or may be rescinded in the course of the appeals process provided for in our contracts.

 

Historically, our credit loss exposure has also been partially mitigated by mortgage insurance. Primary mortgage insurance is required to be purchased, at the borrower’s expense, for mortgages with higher LTV ratios. We received payments under primary and other mortgage insurance of $525 million and $1.2 billion in the three and nine months ended September 30, 2010, respectively, to help mitigate our credit losses.

 

Credit Quality of New Loan Purchases and Guarantees

 

We continue to focus on maintaining underwriting standards that are appropriate for the extension of credit in the current economic environment and allow us to purchase and guarantee loans made to qualified borrowers that we expect will generate returns that exceed our credit and administrative costs on such loans.

 

As of September 30, 2010, approximately one-third of our single-family credit guarantee portfolio consisted of mortgage loans originated in 2009 and the first nine months of 2010. We believe the credit quality of the single-family loans acquired in 2009 and the first nine months of 2010 (excluding relief refinance mortgages) is better than that of loans acquired from 2005 through 2008 as measured by original LTV ratios, FICO scores, and income documentation standards. These newer loans have also experienced significantly better serious delinquency trends at this stage in their lifecycle than loans acquired from 2006 through 2008. Early serious delinquency performance has historically been an indicator of long-term credit performance.

 

We believe the improvement in credit quality we are experiencing is primarily the result of the combination of: (a) changes in our underwriting guidelines implemented during 2009 and 2010; (b) fewer purchases in 2009 and 2010 of loans with higher risk characteristics; (c) changes in mortgage insurers’ and lenders’ underwriting practices; and

 

(d) an increase in the relative amount of refinance mortgages versus new purchase mortgages we acquired in 2009 and 2010. The following table presents loan characteristics, serious delinquency rates, and credit losses by year of origination for our single-family credit guarantee portfolio at September 30, 2010.

 

Table 2 — Single-Family Credit Guarantee Portfolio Data by Year of Origination

 

 

During the first nine months of 2010, the guarantee-related revenue from the mortgage loans originated in 2009 and 2010 exceeded the credit-related expenses, which consist of our provision for credit losses and REO operations income (expense), associated with these loans. These new vintages reflect the combination of changes in underwriting practices and other factors discussed above and are replacing the older vintages that have a higher composition of higher-risk mortgage products. We currently expect that, over time, this should positively impact the serious delinquency rates and credit losses of our single-family credit guarantee portfolio.

 

Single-Family Credit Guarantee Portfolio

 

Since the beginning of 2008, on an aggregate basis, we recorded provision for credit losses associated with single-family loans of approximately $59.1 billion, and an additional $4.9 billion in losses on loans purchased from our PCs, net of recoveries. The majority of these losses are associated with loans originated in 2005 through 2008. Due in part to the factors discussed below, the loans we purchased or guaranteed that were originated in 2005 through 2008 may give rise to additional losses we have not yet provided for. However, we believe, as of September 30, 2010, we provided for the substantial majority of credit losses we expect to ultimately realize on these loans. Various factors, including increases in unemployment rates or further declines in home prices, could require us to provide for losses on these loans beyond our current expectations.

 

The following table provides certain credit statistics for our single-family credit guarantee portfolio. The UPB of our single-family credit guarantee portfolio decreased 3% during the first nine months of 2010, from approximately $1.90 trillion at December 31, 2009 to $1.84 trillion at September 30, 2010.

 

Table 3 — Credit Statistics, Single-Family Credit Guarantee Portfolio

 

 

As shown in the table above, although the number of seriously delinquent loan additions declined in the third quarter of 2010, our single-family credit guarantee portfolio continued to experience a high level of serious delinquencies. The credit losses of our single-family credit guarantee portfolio continued to increase in the third quarter of 2010 due to the ongoing weakness in the U.S. economy, including the labor and housing markets. Other factors affecting credit losses during the period include:

 

 

Some of our loss mitigation activities create fluctuations in our delinquency statistics. For example, loans that we report as seriously delinquent before they enter the HAMP trial period remain as seriously delinquent for purposes of our delinquency reporting until the modifications become effective and the loans are removed from delinquent status by our servicers. However, under many of our non-HAMP modifications, the borrower would return to a current payment status sooner, because many of these modifications do not have trial periods. Consequently, the volume, timing, and type of loan modifications impact our reported serious delinquency rate.

 

Government Support for Our Business

 

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. While the

 

conservatorship has benefited us, we are subject to certain constraints on our business activities imposed by Treasury due to the terms of, and Treasury’s rights under, the Purchase Agreement and by FHFA, as our Conservator. Neither the U.S. government nor any other agency or instrumentality of the U.S. government is obligated to fund our mortgage purchase or financing activities or to guarantee our securities or other obligations. As of September 30, 2010, our annual cash dividend obligation to Treasury on the senior preferred stock exceeded our annual historical earnings in most periods.

 

On September 30, 2010, we received $1.8 billion in funding from Treasury under the Purchase Agreement relating to our net worth deficit as of June 30, 2010, which increased the aggregate liquidation preference of the senior preferred stock to $64.1 billion. To address our net worth deficit of $58 million as of September 30, 2010, FHFA, as Conservator, will submit a draw request, on our behalf, to Treasury under the Purchase Agreement in the amount of $100 million. Upon funding of the draw request, the aggregate liquidation preference on the senior preferred stock owned by Treasury will increase from $64.1 billion to $64.2 billion and the corresponding annual cash dividend payable to Treasury will increase to $6.42 billion. We have paid cash dividends to Treasury of $8.4 billion to date, an amount equal to 13% of our aggregate draws under the Purchase Agreement.

 

Under the Purchase Agreement, the commitment from Treasury will increase as necessary to eliminate any net worth deficits we may have during 2010, 2011, and 2012. We believe that the support provided by Treasury pursuant to the Purchase Agreement enables us to maintain our access to the debt markets and to have adequate liquidity to conduct our normal business activities, although the costs of our debt funding could vary.

 

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 the guidance applicable to the accounting for transfers of financial assets and the consolidation of VIEs. Effective January 1, 2010, we adopted these new accounting standards prospectively for all existing VIEs. 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. As a result of the adoption, our consolidated balance sheets reflect the consolidation of our single-family PC trusts and certain of our Structured Transactions. This consolidation 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.

 

Because our results of operations for the three and nine months ended September 30, 2010 (on both a GAAP and Segment Earnings basis) include the activities of the consolidated VIEs, they are not directly comparable with the results of operations for the three and nine months ended September 30, 2009, which reflect the accounting policies in effect during that time (i.e., when the majority of the securitization entities were accounted for off-balance sheet).

 

See “NOTE 2: CHANGE IN ACCOUNTING PRINCIPLES” for detailed discussions regarding the new accounting standards and the impact to our financial statements.

 

Financial Results for the Third Quarter of 2010

 

Net loss was $2.5 billion and $5.4 billion for the third quarters of 2010 and 2009, respectively. Key highlights of our financial results for the third quarter of 2010 include:

 

 

Housing, Mortgage Market and Economic Conditions

 

Overview

 

Mortgage and credit market conditions remained weak in the third quarter of 2010 due primarily to a continued weak labor market. The pace of economic recovery increased slightly in the third quarter of 2010, with the U.S. gross domestic product rising by 2.0% on an annualized basis during the period, compared to 1.7% during the second quarter of 2010, according to the Bureau of Economic Analysis advance estimate. Unemployment was 9.6% in September 2010, up 0.1% compared to June 2010, based on data from the U.S. Bureau of Labor Statistics.

 

Single-Family Housing Market

 

The federal homebuyer tax credit program ended in April 2010, which, we believe, contributed to a decline in home sales in the third quarter of 2010. New home sales fell 31.9% in May 2010 to a seasonally adjusted annual rate of 282,000, reflecting the lowest levels since the Census Bureau’s series began in 1963. New home sales recovered modestly in subsequent months, to a 307,000 annualized rate in September. Because existing home sales are reported at closing, typically a month or more after the contract is signed, the full effect of the expiration of the federal homebuyer tax credit program was not felt until July 2010, when existing home sales decreased by 27.0%. Sales of existing homes rose 18.0% over the subsequent two months, however, to an annual rate of 4.5 million in September. Thus, while the federal homebuyer tax credit program was successful in promoting demand for home purchases and accelerated the timing of the home-purchase decision for many buyers, home sales declined following the expiration of the program.

 

We estimate that home prices decreased 1.2% nationwide during the first nine months of 2010, which includes a 1.8% decrease in the third quarter of 2010, based on our own index of our single-family credit guarantee portfolio. Other indices of home prices may have different results, as they are determined using different pools of mortgage loans and calculated under different conventions than our own. The spring and summer months have historically been strong times for home sales, which we believe provided strength to home prices. We believe home prices in the first half of the year were positively impacted by seasonal movement as well as availability of the federal homebuyer tax credit.

 

Despite some signs of stabilization, serious delinquency rates on single-family loans remain at historically high levels for all major product types. The MBA reported in its National Delinquency Survey that delinquency rates on all single-family loans in their survey dipped to 9.1% as of June 30, 2010, the most recent date for which information is available, down from the record 9.7% at year-end 2009. This lower rate is still the third highest delinquency rate in the 50-year history of the MBA’s survey. Residential loan performance was better in areas with lower unemployment rates and where property prices have fallen slightly or not declined at all in the last two years. The MBA, in its survey, presents delinquency rates both for mortgages it classifies as subprime and for mortgages it classifies as prime conventional. The delinquency rates of subprime mortgages are markedly higher than those of prime conventional loan products in the MBA survey; however, the delinquency experience in prime conventional mortgage loans during the last two years has been significantly worse than in any year since the 1930s.

 

Based on data from the Federal Reserve’s Flow of Funds Accounts, there was a sustained and significant increase in single-family mortgage debt outstanding from 2001 to 2006. This increase in mortgage debt was driven by increasing sales of new and existing single-family homes during this same period. As reported by FHFA in its Conservator’s Report on the Enterprises’ Financial Condition, dated August 26, 2010, the market share of mortgage-backed securities issued by the GSEs and Ginnie Mae declined significantly from 2001 to 2006 while the market share of non-GSE, or private label, securities peaked. Non-traditional mortgage types, such as interest-only, Alt-A, and option ARMs, also increased in market share during these years, which we believe introduced greater risk into the market. We believe these shifts in market activity, in part, help explain the significant differentiation in delinquency performance of securitized private label and GSE mortgage loans as discussed below.

 

We estimate that we owned or guaranteed approximately 23% of the outstanding single-family mortgages in the U.S. at September 30, 2010. At June 30, 2010, we held or guaranteed approximately 492,500 seriously delinquent single-family loans, representing approximately 10% of the estimated 5.0 million seriously delinquent single-family mortgages in the market as of June 30, 2010, the most recent date for which the MBA has reported market loan delinquency data in its survey. In contrast, we estimate that private label securities comprised 10% of the single-family mortgages in the U.S. and represented approximately 26% of the seriously delinquent single-family mortgages at June 30, 2010.

 

Concerns Regarding Deficiencies in Foreclosure Practices

 

Recent announcements of deficiencies in foreclosure documentation by several large seller/servicers have raised various concerns relating to foreclosure practices. We are working with all of our seller/servicers to identify deficient foreclosure practices. A number of our seller/servicers, including several of our largest ones, have temporarily

 

suspended foreclosure proceedings in some or all states in which they do business while they conduct their evaluations. We are also evaluating the impact of these foreclosure practices on our REO properties and have suspended certain REO sales and eviction proceedings for REO properties pending the completion of our evaluation. Issues have also been identified with respect to practices of certain legal counsel involved in the foreclosure process. We have terminated the eligibility of one law firm, which was responsible for handling a significant number of foreclosures for our servicers in Florida. We expect that these issues and the related foreclosure suspensions could prolong the foreclosure process nationwide and may delay sales of our REO properties.

 

On October 13, 2010, FHFA made public a four-point policy framework detailing FHFA’s plan to address these issues, including guidance for consistent remediation of identified foreclosure process deficiencies. FHFA has directed Freddie Mac and Fannie Mae to implement this plan.

 

We will face increased expenses related to deficiencies in foreclosure practices and the costs of curing them, which may be significant. These costs will include expenses to remediate issues relating to practices of certain legal counsel that will increase our expenses in future periods. For more information regarding how these deficiencies in foreclosure practices could impact our business, see “RISK MANAGEMENT — Credit Risk — Institutional Credit Risk — Mortgage Seller/Servicers” and “RISK FACTORS — Our expenses could increase and we may otherwise be adversely affected by deficiencies in foreclosure practices, as well as related delays in the foreclosure process.” Throughout this Form 10-Q, we generally refer to these matters as the concerns about foreclosure practices.

 

Multifamily Housing Market

 

National multifamily market fundamentals continued to improve during the third quarter of 2010. Vacancy rates, which had climbed to record levels, improved and effective rents, the principal source of income for property owners, appear to have stabilized and began to increase on a national basis. These improving fundamentals helped to stabilize property values in a number of markets. However, the multifamily market continues to be negatively impacted by high unemployment and ongoing weakness in the economy. Vacancy rates and effective rents are important to loan performance because multifamily loans are generally repaid from the cash flows generated by the underlying property. Prolonged periods of high apartment vacancies and negative or flat effective rent growth will adversely impact a multifamily property’s net operating income and related cash flows, which can strain the borrower’s ability to make loan payments and thereby potentially increase our delinquency rates and credit expenses.

 

Outlook

 

Forward-looking statements involve known and unknown risks and uncertainties, some of which are beyond our control. These statements are not historical facts, but rather represent our expectations based on current information, plans, judgments, assumptions, estimates, and projections. Actual results may differ significantly from those described in or implied by such forward-looking statements due to various factors and uncertainties. See “FORWARD-LOOKING STATEMENTS” for additional information.

 

Overview

 

Mortgage and credit market conditions will likely remain weak during the remainder of 2010 and the first part of 2011. However, we expect that continued focus on loan workouts, a gradual and modest employment recovery, and relative stabilization in national home prices should lead to lower serious delinquency rates for the overall market over time.

 

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 future government actions to address the economic and housing crisis. We believe that it will be a considerable time until the housing market has a sustained recovery. Our expectation for home prices, based on our own index, is that national average home prices will continue to decline over the near term before a long-term recovery in housing begins, due to, among other factors:

 

 

Single-Family Guarantee Business

 

Even if home prices do not continue to decline in the near term as we expect, our credit losses will likely increase in the near term and remain significantly above historical levels for the foreseeable future due to the substantial number of mortgage loans in our single-family credit guarantee portfolio on which borrowers owe more than their

 

home is currently worth, as well as the substantial backlog of seriously delinquent loans. For the near term, we also expect:

 

 

Our expectations with respect to foreclosures, REO acquisitions, REO operations expense, and charge-offs could be impacted by delays in the foreclosure process, including further delays related to the concerns about deficiencies in foreclosure practices of our servicers as discussed above.

 

Multifamily Business

 

While national multifamily market fundamentals continued to improve in the third quarter of 2010, as discussed above, certain local markets continue to exhibit weak fundamentals. We expect that our multifamily non-performing assets will increase due to adverse market conditions particularly in these markets. Delinquency rates have historically been a lagging indicator and, as a result, we may continue to experience an increase in delinquencies and credit losses despite improving market fundamentals.

 

Long-Term Financial Sustainability and Future Status

 

We expect to request additional draws under the Purchase Agreement in future periods. The size and timing of such draws will be determined by a variety of factors that could adversely affect our net worth. While we may experience variability in GAAP total comprehensive income (loss) in future periods negatively impacting our net worth, we expect that our future net worth will continue to be negatively impacted over the long-term by dividend payments on our senior preferred stock. Given our current annual dividend obligation of $6.4 billion, which exceeds our earnings in most historical periods and would increase with additional draws, it is unlikely that we will have net income in excess of our annual dividends payable to Treasury in future periods. In addition, potentially substantial quarterly commitment fees payable to Treasury beginning in 2011 (the amounts of which must be determined by December 31, 2010) will also negatively impact our future net worth over the long-term. For a discussion of factors that could result in additional draws, see “LIQUIDITY AND CAPITAL RESOURCES — Capital Resources.”

 

There continues to be significant uncertainty in the current mortgage market environment, and any changes in the trends in macroeconomic factors, such as home prices and unemployment rates, may cause our results to vary significantly from our expectations. As a result of these factors, there is significant uncertainty as to our long-term financial sustainability.

 

There is also 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. While we are not aware of any current plans of our Conservator to significantly change our business structure in the near-term, the Dodd-Frank Act, which was signed into law on July 21, 2010, requires the Secretary of the Treasury to conduct a study and develop recommendations regarding the options for ending the conservatorship. The Secretary’s report and recommendations are required to be submitted to Congress not later than January 31, 2011. We have no ability to predict the outcome of these deliberations.

 

Legislative and Regulatory Matters

 

On September 14, 2010, FHFA published in the Federal Register a final rule establishing new affordable housing goals for Freddie Mac and Fannie Mae for 2010 and 2011. For additional information regarding this rule and other recent legislative and regulatory actions, see “LEGISLATIVE AND REGULATORY MATTERS.”

 

Investment Activity and Limits Under the Purchase Agreement and by FHFA

 

Under the terms of the Purchase Agreement and FHFA regulation, the UPB of our mortgage-related investments portfolio 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. FHFA has stated its expectation that we will not be a substantial buyer or seller of mortgages for our mortgage-related investments portfolio, except for purchases of seriously delinquent mortgages out of PC trusts.

 

Table 4 presents the UPB of our mortgage-related investments portfolio, for purposes of the limit imposed by the Purchase Agreement and FHFA regulation. 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 UPB of our mortgage-related investments portfolio declined from December 31, 2009 to September 30, 2010, primarily due to liquidations, partially offset by the purchase of $113 billion of seriously delinquent loans from PC trusts.

 

Table 4 — Mortgage-Related Investments Portfolio⁽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 results of operations.

 

Change in Accounting Principles

 

As discussed in “EXECUTIVE SUMMARY,” our adoption of two new accounting standards that amended the guidance applicable to the accounting for transfers of financial assets and the consolidation of VIEs had a significant impact on our consolidated financial statements and other financial disclosures beginning in the first quarter of 2010.

 

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. See “NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES — Consolidation and Equity Method of Accounting,” “NOTE 2: CHANGE IN ACCOUNTING PRINCIPLES,” “NOTE 4: VARIABLE INTEREST ENTITIES,” and “NOTE 22: SELECTED FINANCIAL STATEMENT LINE ITEMS” for additional information regarding these changes.

 

As these changes in accounting principles were applied prospectively, our results of operations for the three and nine months ended September 30, 2010 (on both a GAAP and Segment Earnings 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 three and nine months ended September 30, 2009, which reflect the accounting policies in effect during that time (i.e., when the majority of the securitization entities were accounted for off-balance sheet).

 

Consolidated Statements of Operations — GAAP Results

 

Table 5 summarizes the GAAP Consolidated Statements of Operations.

 

Table 5 — Summary Consolidated Statements of Operations — GAAP Results⁽¹⁾

 

 

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

 

 

Our adoption of the change to the accounting standards for consolidation as of January 1, 2010, as discussed above, had the following impact on net interest income and net interest yield for the three and nine months ended September 30, 2010, and will have similar effects on those items in future periods:

 

 

See “NOTE 2: CHANGE IN ACCOUNTING PRINCIPLES” for additional information.

 

Net interest income decreased by $183 million and $36 million during the three and nine months ended September 30, 2010, respectively, compared to the three and nine months ended September 30, 2009 due mainly to lower balances of mortgage-related investments, partially offset by lower funding costs and the inclusion of amounts previously classified as management and guarantee income. Net interest yield declined substantially during the 2010 periods because the net interest yield of our consolidated single-family trusts was lower than the net interest yield of PCs previously included in net interest income and our balance of non-performing mortgage loans increased.

 

During the nine months ended September 30, 2010, spreads on our debt and our access to the debt markets remained favorable relative to historical levels. For more information, see “LIQUIDITY AND CAPITAL RESOURCES — Liquidity.”

 

Provision for Credit Losses

 

We maintain loan loss reserves at levels we deem adequate to absorb probable incurred losses on mortgage loans held-for-investment and loans underlying our financial guarantees. Increases in our loan loss reserves are reflected in earnings through the provision for credit losses. As discussed in “Net Interest Income,” our provision for credit losses was positively impacted by the changes in accounting standards for transfers of financial assets and consolidation of VIEs effective January 1, 2010 since we no longer account for forgone interest income on non-performing loans within our provision for credit losses. See “NOTE 2: CHANGE IN ACCOUNTING PRINCIPLES” for further information.

 

Since the beginning of 2008, on an aggregate basis, we recorded provision for credit losses associated with single-family loans of approximately $59.1 billion, and an additional $4.9 billion in losses on loans purchased from our PCs, net of recoveries. The majority of these losses are associated with loans originated in 2005 through 2008. Due in part to the factors discussed below, the loans we purchased or guaranteed that were originated in 2005 through 2008 may give rise to additional losses we have not yet provided for. However, we believe, as of September 30, 2010, we provided for the substantial majority of credit losses we expect to ultimately realize on these loans. Various factors, including increases in unemployment rates or further declines in home prices, could require us to provide for losses on these loans beyond our current expectations. See “Table 3 — Credit Statistics, Single-Family Credit Guarantee Portfolio” for certain quarterly credit statistics for our single-family credit guarantee portfolio.

 

The provision for credit losses was $3.7 billion and $8.0 billion for the third quarters of 2010 and 2009, respectively, and was $14.2 billion in the nine months ended September 30, 2010 compared to $22.6 billion in the nine months ended September 30, 2009. During the 2010 periods, the aggregate UPB of our non-performing loans increased, though at a lower rate than in the 2009 periods. Loss severity rates on our single-family mortgage loans

 

remained relatively stable in the first half of 2010, but worsened slightly in the third quarter of 2010, whereas severity rates increased throughout the first half of 2009 before moderating in the third quarter of 2009. The adverse effect of the slight increase in loss severity rates during the third quarter of 2010 was more than offset by higher expectations of recoveries from mortgage insurers.

 

During the second quarter of 2010, we identified a backlog related to the processing of certain loan workout activities reported to us by our servicers, principally loan modifications and short sales. This backlog resulted in erroneous loan data within our loan reporting systems, thereby impacting our financial accounting and reporting systems. The resulting error impacted our provision for credit losses, allowance for loan losses, and provision for income taxes and affected our previously reported financial statements for the interim period ended March 31, 2010, the interim 2009 periods, and the full year ended December 31, 2009. The cumulative effect of this error was recorded as a correction in the second quarter of 2010, which included a $1.0 billion pre-tax cumulative effect of this error associated with the year ended December 31, 2009. For additional information, see “NOTE 1: SUMMARY OF SIGNIFICANT POLICIES — Basis of Presentation — Out-of-Period Accounting Adjustment.”

 

Our charge-offs, net of recoveries, increased to $3.7 billion in the third quarter of 2010, compared to $2.2 billion in the third quarter of 2009, due to an increase in the volume of foreclosure transfers, short sales, and deed-in-lieu transactions associated with single-family loans. Charge-offs, net of recoveries, were $10.2 billion in the nine months ended September 30, 2010 compared to $5.0 billion in the nine months ended September 30, 2009. We believe the level of our charge-offs will continue to increase in 2011 as our inventory of seriously delinquent loans and pending foreclosures is reduced. While the quarterly amount of our provision for credit losses has declined for three consecutive quarters, our charge-offs, net of recoveries continued to increase and slightly exceeded our provision for credit losses during the third quarter of 2010.

 

Our provision for credit losses exceeded the level of our charge-offs, net, by $4.0 billion during the nine months ended September 30, 2010, primarily as a result of a continued increase in non-performing loans, including those in the process of foreclosure. As of September 30, 2010, and December 31, 2009, the UPB of our single-family non-performing loans was $112.7 billion and $98.7 billion, and the UPB of multifamily non-performing loans was $746 million and $538 million, respectively. Although still increasing, the rate of growth in the balance of our non-performing loans slowed during the nine months ended September 30, 2010.

 

Our non-performing single-family loans increased in the 2010 periods primarily due to continued high transition of loans into serious delinquency, which led to higher volumes of loan modifications and consequently, a rise in the number of loans categorized as TDRs. Impairment analysis for TDRs requires giving recognition in the provision for credit losses to the excess of our investment over the present value of the expected future cash flows. Consequently, we recognized provision for credit losses of approximately $2.8 billion related to concessions on single-family TDRs during the nine months ended September 30, 2010. We expect a continued increase in the number of loan modifications that qualify as TDRs in the fourth quarter of 2010 since the majority of our modifications are anticipated to include a significant reduction in the contractual interest rate.

 

Our serious delinquencies have remained high due to the continued weakness in home prices and persistently high unemployment, extended foreclosure timelines in many states, and challenges faced by servicers in building capacity to process large volumes of problem loans. Our seller/servicers have an active role in our loan workout activities, including under the MHA Program, and a decline in their performance could result in a failure to realize the anticipated benefits of our loss mitigation plans.

 

Our allowance for loan losses and amount of charge-offs in the future will be affected by a number of factors, including: (a) the actual level of mortgage defaults; (b) the impact of the MHA Program and our other loss mitigation efforts; (c) changes in property values; (d) regional economic conditions, including unemployment rates; (e) delays in the foreclosure process, including those related to the concerns about deficiencies in foreclosure practices of servicers; (f) third-party mortgage insurance coverage and recoveries; and (g) the realized rate of seller/servicer repurchases. See “RISK MANAGEMENT — Credit Risk — Institutional Credit Risk” for additional information on seller/servicer repurchase obligations.

 

The multifamily market is showing signs of stabilization on a national basis, with three consecutive quarters of positive trends in certain apartment statistics. However, some geographic areas in which we have investments in multifamily mortgage loans, including the states of Nevada, Arizona, and Georgia, continue to exhibit weaker than average fundamentals that increase our risk of future losses. The amount of multifamily loans identified as impaired, where we estimate a specific reserve, increased in both the three and nine months ended September 30, 2010, compared to the 2009 periods. As a result, we increased our loan loss reserves associated with multifamily loans to $931 million as of September 30, 2010 from $831 million as of December 31, 2009.

 

Non-Interest Income (Loss)

 

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

 

Subsequent to January 1, 2010, due to the change in accounting for consolidation of VIEs, 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. For the three and nine months ended September 30, 2010, we extinguished debt securities of consolidated trusts with a UPB of $15.9 billion and $21.2 billion, respectively (representing our purchase of single-family PCs with a corresponding UPB amount), and our gains (losses) on extinguishment of these debt securities of consolidated trusts were $(66) million and $(160) million, respectively. See “NOTE 2: CHANGE IN ACCOUNTING PRINCIPLES” for additional information.

 

Gains (Losses) on Retirement of Other Debt

 

Gains (losses) on retirement of other debt were $(50) million and $(229) million during the three and nine months ended September 30, 2010, respectively, compared to $(215) million and $(475) million during the three and nine months ended September 30, 2009, respectively. During the three and nine months ended September 30, 2010, we recognized fewer losses on debt retirement compared to the three and nine months ended September 30, 2009 primarily due to lower debt repurchase activity in 2010 compared to 2009.

 

Gains (Losses) on Debt Recorded at Fair Value

 

Gains (losses) on debt recorded at fair value primarily relate to changes in the fair value of our foreign-currency denominated debt. For the three and nine months ended September 30, 2010, we recognized gains (losses) on debt recorded at fair value of $(366) million and $525 million, respectively, due primarily to the U.S. dollar strengthening relative to the Euro during the first six months of 2010, followed by the U.S. dollar weakening relative to the Euro during the third quarter of 2010. For the three and nine months ended September 30, 2009, we recognized losses on debt recorded at fair value of $238 million and $568 million, respectively, primarily due to the U.S. dollar weakening 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.

 

Derivative Gains (Losses)

 

Table 7 presents derivative gains (losses) reported in our consolidated statements of operations. See “NOTE 11: DERIVATIVES — Table 11.2 — Gains and Losses on Derivatives” for information about gains and losses related to specific categories of derivatives. 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. At September 30, 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. Amounts deferred in AOCI associated with these closed cash flow hedges are reclassified to earnings when the forecasted transactions affect earnings. While derivatives are an important aspect of our management of interest-rate risk, they generally increase the volatility of reported net income (loss), because, while fair value changes in derivatives affect net income, fair value changes in several of the assets and liabilities being hedged do not affect net income.

 

Table 7 — Derivative Gains (Losses)

 

 

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

 

During the three and nine months ended September 30, 2010, the yield curve flattened with declining longer-term swap interest rates, resulting in a loss on derivatives of $1.1 billion and $9.7 billion, respectively. Specifically, for the three and nine months ended September 30, 2010, the decrease in longer-term swap interest rates resulted in fair value losses on our pay-fixed swaps of $11.5 billion and $34.9 billion, respectively, partially offset by fair value gains on our receive-fixed swaps of $7.5 billion and $20.6 billion, respectively. We recognized fair value gains for the three and nine months ended September 30, 2010 of $3.3 billion and $8.6 billion, respectively, on our option-based derivatives, resulting from gains on our purchased call swaptions primarily due to the declines in forward interest rates during these periods.

 

During the three months ended September 30, 2009, longer-term swap interest rates declined, resulting in a loss on derivatives of $3.8 billion. During the period, the decreasing swap interest rates resulted in fair value losses on our pay-fixed swaps of $8.2 billion, partially offset by gains on our receive-fixed swaps of $4.5 billion. The $1.3 billion increase in fair value of option-based derivatives resulted from gains on our purchased call swaptions due to the impact of the declines in forward interest rates.

 

During the nine months ended September 30, 2009, the mix and volume of our derivative portfolio were impacted by fluctuations in swap interest rates resulting in a loss on derivatives of $1.2 billion. Longer-term swap interest rates and implied volatility both increased during the nine months ended September 30, 2009. As a result of these factors, we recorded gains on our pay-fixed swap positions, partially offset by losses on our receive-fixed swaps. We also recorded losses on our option-based derivatives, primarily from purchased call swaptions, as the impact of the increasing forward interest rates more than offset the impact of higher implied volatility.

 

Investment Securities-Related Activities

 

Since January 1, 2010, 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” for additional information.

 

Impairments of Available-for-Sale Securities

 

We recorded net impairments of available-for-sale securities recognized in earnings of $1.1 billion and $2.0 billion during the three and nine months ended September 30, 2010, respectively, compared to $1.2 billion and $10.5 billion for the three and nine months ended September 30, 2009, respectively. See “CONSOLIDATED BALANCE SHEETS ANALYSIS — Investments in Securities — Mortgage-Related Securities — Other-Than-Temporary Impairments on Available-for-Sale Mortgage-Related Securities” for additional information regarding the other-than-temporary impairments recorded during the three and nine months ended September 30, 2010 and 2009 and “NOTE 7: INVESTMENTS IN SECURITIES” for information regarding the accounting principles for investments in debt and equity securities. 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

 

Other gains (losses) on investment securities recognized in earnings primarily consists of gains (losses) on trading securities. We recognized $(561) million and $(1.3) billion related to gains (losses) on trading securities during the three and nine months ended September 30, 2010, respectively, compared to $2.2 billion and $5.0 billion during the three and nine months ended September 30, 2009, respectively.

 

The fair value of our securities classified as trading was approximately $63.2 billion at September 30, 2010 compared to approximately $235.9 billion at September 30, 2009. The decline in fair value was primarily due to the decrease in our investments in securities resulting from our adoption of amendments to the accounting standards for transfers of financial assets and consolidation of VIEs on January 1, 2010 together with minimal purchase activity during the first three quarters of 2010. This changed the mix of our securities classified as trading to a larger percentage of interest-only securities, which were negatively impacted by the decline in interest rates during 2010. The net gains on trading securities during the three and nine months ended September 30, 2009 related primarily to a decline in interest rates during the three months ended September 30, 2009 and tightening OAS levels during the nine months ended September 30, 2009. In addition, during the three and nine months ended September 30, 2009, we sold

 

agency securities classified as trading with UPB of approximately $48 billion and $135 billion, respectively, which generated realized gains of $213 million and $1.5 billion, respectively.

 

Other Income

 

Table 8 summarizes the significant components of other income.

 

Table 8 — Other Income

 

 

Other income includes items associated with our guarantee business activities of non-consolidated trusts, including management and guarantee income, gains (losses) on guarantee asset, income on guarantee obligation, and trust management income (expense). 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. The management and guarantee income recognized during the nine months ended September 30, 2010 was earned from our non-consolidated securitization trusts and other mortgage credit guarantees which had an aggregate UPB of $41.2 billion as of September 30, 2010 compared to $1.8 trillion as of September 30, 2009. 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.”

 

Lower-of-Cost-or-Fair-Value Adjustments on Held-for-Sale Mortgage Loans

 

During the three months ended September 30, 2010 and 2009, we recognized lower-of-cost-or-fair-value adjustments of $0 million and $(360) million, respectively. During the nine months ended September 30, 2010 and 2009, we recognized lower-of-cost-or-fair-value adjustments of $0 million and $(591) million, respectively. Due to the change in consolidation accounting for VIEs, which we adopted on January 1, 2010, all single-family mortgage loans on our balance sheet were reclassified as held-for-investment. Consequently, beginning in 2010, we no longer record lower-of-cost-or-fair-value adjustments on single-family mortgage loans.

 

Gains (Losses) on Mortgage Loans Recorded at Fair Value

 

We recognized gains (losses) on mortgage loans recorded at fair value of $128 million and $(1) million during the third quarters of 2010 and 2009, respectively, and $154 million and $(90) million during the nine months ended September 30, 2010 and 2009, respectively. We elect fair value on multifamily loans that we expect to securitize and sell. Fair value gains recognized during the 2010 periods reflect declining interest rates and improved multifamily property values during these periods, which increased the estimated fair values of our multifamily loans.

 

Recoveries on Loans Impaired Upon Purchase

 

During the three months ended September 30, 2010 and 2009, we recognized recoveries on loans impaired upon purchase of $247 million and $109 million, respectively, and in the nine months ended September 30, 2010 and 2009 our recoveries were $643 million and $229 million, respectively. Our recoveries on loans impaired upon purchase increased in the 2010 periods due to a higher volume of short sales and foreclosure transfers, combined with improvements in home prices in certain geographical areas during the first nine months of 2010, as compared to the first nine months 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.

 

Low-Income Housing Tax Credit Partnerships

 

We partially wrote down the carrying value of our LIHTC investments in the third quarter of 2009 and the remaining carrying value was reduced 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.

 

Non-Interest Expense

 

Table 9 summarizes the components of non-interest expense.

 

Table 9 — Non-Interest Expense

 

 

Administrative Expenses

 

Administrative expenses decreased for the three and nine months ended September 30, 2010, compared to the three and nine months ended September 30, 2009, in part due to our focus on cost reduction measures in 2010, particularly on professional services costs.

 

REO Operations (Income) Expense

 

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

 

Table 10 — REO Operations (Income) Expense