UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2012
Commission File Number: 001-34139
Federal Home Loan Mortgage Corporation
(Exact name of registrant as specified in its charter)
Freddie Mac
Federally chartered | 8200 Jones Branch Drive | 52-0904874 | (703) 903-2000 | |||
corporation | McLean, Virginia 22102-3110 | (I.R.S. Employer | (Registrants telephone number, | |||
(State or other jurisdiction of incorporation or organization) | (Address of principal executive offices, including zip code) | Identification No.) | including area code) |
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Voting Common Stock, no par value per share (OTCQB: FMCC)
Variable Rate, Non-Cumulative Preferred Stock, par value $1.00 per share (OTCQB: FMCCI)
5% Non-Cumulative Preferred Stock, par value $1.00 per share (OTCQB: FMCKK)
Variable Rate, Non-Cumulative Preferred Stock, par value $1.00 per share (OTCQB: FMCCG)
5.1% Non-Cumulative Preferred Stock, par value $1.00 per share (OTCQB: FMCCH)
5.79% Non-Cumulative Preferred Stock, par value $1.00 per share (OTCQB: FMCCK)
Variable Rate, Non-Cumulative Preferred Stock, par value $1.00 per share (OTCQB: FMCCL)
Variable Rate, Non-Cumulative Preferred Stock, par value $1.00 per share (OTCQB: FMCCM)
Variable Rate, Non-Cumulative Preferred Stock, par value $1.00 per share (OTCQB: FMCCN)
5.81% Non-Cumulative Preferred Stock, par value $1.00 per share (OTCQB: FMCCO)
6% Non-Cumulative Preferred Stock, par value $1.00 per share (OTCQB: FMCCP)
Variable Rate, Non-Cumulative Preferred Stock, par value $1.00 per share (OTCQB: FMCCJ)
5.7% Non-Cumulative Preferred Stock, par value $1.00 per share (OTCQB: FMCKP)
Variable Rate, Non-Cumulative Perpetual Preferred Stock, par value $1.00 per share (OTCQB: FMCCS)
6.42% Non-Cumulative Perpetual Preferred Stock, par value $1.00 per share (OTCQB: FMCCT)
5.9% Non-Cumulative Perpetual Preferred Stock, par value $1.00 per share (OTCQB: FMCKO)
5.57% Non-Cumulative Perpetual Preferred Stock, par value $1.00 per share (OTCQB: FMCKM)
5.66% Non-Cumulative Perpetual Preferred Stock, par value $1.00 per share (OTCQB: FMCKN)
6.02% Non-Cumulative Perpetual Preferred Stock, par value $1.00 per share (OTCQB: FMCKL)
6.55% Non-Cumulative Perpetual Preferred Stock, par value $1.00 per share (OTCQB: FMCKI)
Fixed-to-Floating Rate Non-Cumulative Perpetual Preferred Stock, par value $1.00 per share (OTCQB: FMCKJ)
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes [ ] No [X]
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes [ ] No [X]
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. Yes [X] 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). Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [X]
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.
Large accelerated filer [ ] | Accelerated filer [X] | |||||
Non-accelerated filer (Do not check if a smaller reporting company) [ ] | Smaller reporting company [ ] |
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X]
The aggregate market value of the common stock held by non-affiliates computed by reference to the price at which the common equity was last sold on June 29, 2012 (the last business day of the registrants most recently completed second fiscal quarter) was $162.5 million.
As of February 15, 2013, there were 650,038,674 shares of the registrants common stock outstanding.
DOCUMENTS INCORPORATED BY REFERENCE: None
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Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure |
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Item 10. Directors, Executive Officers and Corporate Governance |
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Item 13. Certain Relationships and Related Transactions, and Director Independence |
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E-1 |
i | Freddie Mac |
MD&A TABLE REFERENCE
ii | Freddie Mac |
Table |
Description |
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50 | 150 | |||||||
51 | Credit Concentrations in the Single-Family Credit Guarantee Portfolio |
151 | ||||||
52 | Single-Family Credit Guarantee Portfolio by Attribute Combinations |
152 | ||||||
53 | Single-Family Credit Guarantee Portfolio Foreclosure and Short Sale Rates |
154 | ||||||
54 | 155 | |||||||
55 | 157 | |||||||
56 | 158 | |||||||
57 | 160 | |||||||
58 | 161 | |||||||
59 | 162 | |||||||
60 | 163 | |||||||
61 | 164 | |||||||
62 | 164 | |||||||
63 | 166 | |||||||
64 | 168 | |||||||
65 | 170 | |||||||
66 | 171 | |||||||
67 | 174 | |||||||
68 | 181 | |||||||
69 | 183 | |||||||
70 | 183 | |||||||
71 | 186 | |||||||
72 | 188 | |||||||
73 | 191 | |||||||
74 | 200 | |||||||
75 | 200 | |||||||
76 | 322 | |||||||
77 | 327 | |||||||
78 | 333 | |||||||
79 | 336 | |||||||
80 | Achievement of Corporate Performance Measures for At-Risk Deferred Salary |
338 | ||||||
81 | 340 | |||||||
82 | 342 | |||||||
83 | Achievement of Performance Measures for Second Installment of 2011 Target Opportunity |
342 | ||||||
84 | 343 | |||||||
85 | 349 | |||||||
86 | 350 | |||||||
87 | 351 | |||||||
88 | 351 | |||||||
89 | 352 | |||||||
90 | 355 | |||||||
91 | Potential Payments Upon Termination of Employment or Change-in-Control as of December 31, 2012 |
357 | ||||||
92 | Board Compensation 2012 Non-Employee Director Compensation Levels |
359 | ||||||
93 | 359 | |||||||
94 | Stock Ownership by Directors, Executive Officers, and Greater-Than-5% Holders |
360 | ||||||
95 | 360 | |||||||
96 | 367 |
iii | Freddie Mac |
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
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iv | Freddie Mac |
This Annual Report on Form 10-K 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-K and we undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date of this Form 10-K. Actual results might differ significantly from those described in or implied by such statements due to various factors and uncertainties, including those described in: the BUSINESS Forward-Looking Statements and RISK FACTORS sections of this Form 10-K.
Throughout this Form 10-K, we use certain acronyms and terms that are defined in the GLOSSARY.
Conservatorship and Government Support for Our Business
We continue to operate under the direction of FHFA, as our Conservator. We are also subject to certain constraints on our business activities imposed by Treasury due to the terms of, and Treasurys rights under, the Purchase Agreement. We are dependent upon the continued support of Treasury and FHFA in order to continue operating 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. The conservatorship and related matters have had a wide-ranging impact on us, including our regulatory supervision, management, business, financial condition, and results of operations.
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. We are not aware of any current plans of our Conservator to significantly change our business model or capital structure in the near-term. Our future structure and role will be determined by the Administration and Congress, and there are likely to be significant changes beyond the near-term. We have no ability to predict the outcome of these deliberations.
As our Conservator, FHFA succeeded to all rights, titles, powers and privileges of Freddie Mac, and of any stockholder, officer or director thereof, with respect to the company and its assets. FHFA, as Conservator, has directed and will continue to direct certain of our business activities and strategies. FHFA has delegated certain authority to our Board of Directors to oversee, and to management to conduct, day-to-day operations. The directors serve on behalf of, and exercise authority as directed by, the Conservator.
In March 2012, FHFA instituted the 2012 conservatorship scorecard, or the Conservatorship Scorecard, for use by both us and Fannie Mae that established business objectives and performance targets and measures, and provided the implementation roadmap for FHFAs strategic plan for Freddie Mac and Fannie Mae. We continue to align our resources and internal business plans to meet the goals and objectives in FHFAs directives. See Regulation and Supervision Legislative and Regulatory Developments FHFAs Strategic Plan for Freddie Mac and Fannie Mae Conservatorships and EXECUTIVE COMPENSATION Compensation Discussion and Analysis for further information.
Our current business objectives reflect direction we have received from the Conservator (including the Conservatorship Scorecard), our charter, other legislation, and public statements from FHFA and Treasury officials. Our business objectives have changed considerably since we entered into 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. However, these changes to our business objectives and strategies may not contribute to our profitability. Some of these changes increase our expenses, while others require us to forego revenue opportunities.
On February 21, 2012, FHFA sent to Congress a strategic plan for the next phase of the conservatorships of Freddie Mac and Fannie Mae. FHFA stated that the steps envisioned in the plan are consistent with each of the housing finance reform frameworks set forth in the report delivered by the Administration to Congress in February 2011, which is described below, as well as with the leading congressional proposals previously introduced. FHFAs plan provides lawmakers and the
1 | Freddie Mac |
public with an outline of how FHFA as Conservator intends to guide Freddie Mac and Fannie Mae over the next few years, and identifies three strategic goals:
| Build. Build a new infrastructure for the secondary mortgage market; |
| Contract. Gradually contract Freddie Mac and Fannie Maes dominant presence in the marketplace while simplifying and shrinking their operations; and |
| Maintain. Maintain foreclosure prevention activities and credit availability for new and refinanced mortgages. |
On February 11, 2011, the Administration delivered a report to Congress that lays out the Administrations plan to reform the U.S. housing finance market, including options for structuring the governments long-term role in a housing finance system in which the private sector is the dominant provider of mortgage credit. The report recommends winding down Freddie Mac and Fannie Mae, and states that the Administration will work with FHFA to determine the best way to responsibly reduce the role of Freddie Mac and Fannie Mae in the market and ultimately wind down both institutions. The report states that these efforts must be undertaken at a deliberate pace, which takes into account the impact that these changes will have on borrowers and the housing market.
The report states that the government is committed to ensuring that Freddie Mac and Fannie Mae have sufficient capital to perform under any guarantees issued now or in the future and the ability to meet any of their debt obligations, and further states that the Administration will not pursue policies or reforms in a way that would impair the ability of Freddie Mac and Fannie Mae to honor their obligations. The report states the Administrations belief that under the companies senior preferred stock purchase agreements with Treasury, there is sufficient funding to ensure the orderly and deliberate wind down of Freddie Mac and Fannie Mae, as described in the Administrations plan.
Based on our Net Worth Amount at December 31, 2012, our dividend obligation to Treasury in March 2013 will be $5.8 billion. On August 17, 2012, Freddie Mac, acting through FHFA, as Conservator, and Treasury entered into an amendment to the Purchase Agreement that, among other items, replaced the fixed 10% dividend rate on the senior preferred stock with a net worth sweep dividend beginning in the first quarter of 2013. Under the net worth sweep dividend provisions, we are required to pay dividends to the extent that our Net Worth Amount exceeds a permitted capital reserve amount (established at $3 billion for 2013 and declining to zero in 2018). This amendment effectively ends the circular practice of taking draws from Treasury to pay dividends to Treasury, thereby helping to preserve remaining funding available to us under the Purchase Agreement. See NOTE 2: CONSERVATORSHIP AND RELATED MATTERS Purchase Agreement for more information.
The aggregate liquidation preference of the senior preferred stock was $72.3 billion and $72.2 billion at December 31, 2012, and 2011, respectively. Beginning January 1, 2013, the remaining funding commitment from Treasury under the Purchase Agreement is $140.5 billion. This amount will be reduced by any future draws. Under the Purchase Agreement, our ability to repay the liquidation preference of the senior preferred stock is limited and we will not be able to do so for the foreseeable future, if at all. The aggregate liquidation preference of the senior preferred stock will increase further if we receive additional draws. For a discussion of factors that could result in additional draws, see RISK FACTORS Conservatorship and Related Matters We may request additional draws under the Purchase Agreement in future periods.
For more information on our current business objectives, see Executive Summary Our Primary Business Objectives. For more information on the conservatorship and government support for our business, including the Purchase Agreement, see Conservatorship and Related Matters and Treasury Agreements.
Executive Summary
You should read this Executive Summary in conjunction with our MD&A and consolidated financial statements and related notes for the year ended December 31, 2012.
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. We are working to support the recovery of the housing market and the nations economy by providing essential liquidity to the mortgage market and helping to stem the rate of
2 | Freddie Mac |
foreclosures. We believe our actions are helping communities across the country by providing Americas families with access to mortgage funding at low rates while helping distressed borrowers keep their homes and avoid foreclosure, where feasible.
Summary of Financial Results
During 2012, we observed certain signs of improvement in the housing market, which contributed positively to our financial results. Our comprehensive income for the year ended December 31, 2012 was $16.0 billion, consisting of $11.0 billion of net income and $5.1 billion of total other comprehensive income. By comparison, our comprehensive income (loss) for the year ended December 31, 2011 was $(1.2) billion, consisting of $(5.3) billion of net income (loss) and $4.0 billion of total other comprehensive income.
Our total equity was $8.8 billion at December 31, 2012, reflecting our total equity balance of $4.9 billion at September 30, 2012, comprehensive income of $5.7 billion for the fourth quarter of 2012 and our dividend payment of $1.8 billion on our senior preferred stock in December 2012. As a result of our positive net worth at December 31, 2012, no draw is being requested from Treasury under the Purchase Agreement for the fourth quarter of 2012.
Our Primary Business Objectives
We are focused on the following primary business objectives: (a) providing credit availability for mortgages and maintaining foreclosure prevention activities; (b) minimizing our credit losses; (c) developing mortgage market enhancements in support of a new infrastructure for the secondary mortgage market; (d) maintaining sound credit quality on the loans we purchase or guarantee; (e) contracting the dominant presence of the GSEs in the marketplace; and (f) strengthening our infrastructure and improving overall efficiency while also focusing on retention of key employees. Our business objectives reflect direction we have received from the Conservator, including the Conservatorship Scorecard. See EXECUTIVE COMPENSATION Compensation Discussion and Analysis for further information.
Providing Credit Availability for Mortgages and Maintaining Foreclosure Prevention Activities
We provide liquidity and support to the U.S. mortgage market in a number of important ways:
| Our support enables borrowers to have access to a variety of conforming mortgage products, including the prepayable 30-year fixed-rate mortgage, which historically has represented the foundation of the mortgage market. |
| Our support provides lenders with a constant source of liquidity for conforming mortgage products. We estimate that we, Fannie Mae, and Ginnie Mae collectively guaranteed more than 90% of the single-family conforming mortgages originated during 2012 and 2011. |
| Our consistent market presence provides assurance to our customers that there will be a buyer for their conforming loans that meet our credit standards. We believe this liquidity provides our customers with confidence to continue lending in difficult environments. |
| We are an important counter-cyclical influence as we stay in the market even when other sources of capital have withdrawn. |
During 2012 and 2011, we purchased or issued other guarantee commitments for $426.8 billion and $320.8 billion in UPB of single-family conforming mortgage loans, representing approximately 2.0 million and 1.5 million homes, respectively.
Borrowers typically pay a lower interest rate on loans acquired or guaranteed by Freddie Mac, Fannie Mae, or Ginnie Mae. Mortgage originators are able to offer homebuyers and homeowners lower mortgage rates on conforming loan products, in part because of the value investors place on GSE-guaranteed mortgage-related securities. In December 2012, we estimated that borrowers were paying an average of 43 basis points less on these conforming loans than on non-conforming loans. These estimates were based on data provided by HSH Associates, a third-party provider of mortgage market data.
We are focused on reducing the number of foreclosures and helping to keep families in their homes. In 2012, we continued to introduce new initiatives designed to help eligible borrowers keep their homes and avoid foreclosure. Since 2009, we have helped more than 785,000 borrowers experiencing hardship complete a loan workout.
3 | Freddie Mac |
Our relief refinance initiative, including HARP (which is the portion of our relief refinance initiative for loans with LTV ratios above 80%), is a significant part of our effort to keep families in their homes. We implemented a number of changes to HARP in late 2011 and 2012. These changes allowed more borrowers to participate in the program and benefit from refinancing their home mortgages, including borrowers whose mortgages have LTV ratios above 125%. Our purchases of HARP loans increased to $86.9 billion in 2012, compared to $39.7 billion in 2011. We have purchased HARP loans provided to nearly 915,000 borrowers since the initiative began in 2009, including more than 434,000 borrowers during 2012.
Under our loan workout programs, our servicers contact borrowers and attempt to help borrowers experiencing hardship stay in their homes or avoid foreclosure. Our servicers seek and also facilitate the completion of foreclosure alternatives when a home retention solution is not possible. Under HAMP and the non-HAMP standard modification, borrowers are required to complete a trial period before the loan modification becomes effective. Based on information provided by the MHA Program administrator, our servicers had completed approximately 217,209 loan modifications under HAMP from the introduction of the initiative in 2009 through December 31, 2012. As of December 31, 2012, approximately 24,000 borrowers were in modification trial periods, including approximately 15,000 borrowers in trial periods for our non-HAMP standard modification. Our new non-HAMP standard loan modification initiative was implemented for all servicers beginning on January 1, 2012. Our completed modification volume during the first half of 2012 was below what otherwise would be expected, as servicers completed the transition to the non-HAMP standard modification initiative; however, the volume of our non-HAMP standard modifications increased in the second half of 2012 compared to the first half of 2012. See Our Business Segments Single-Family Guarantee Segment for more information about loss mitigation activities and our efforts to provide credit availability, including through HAMP, and our relief refinance mortgage initiative, which includes HARP.
Short sale activity increased in 2012 compared to 2011. Short sale activity as a percentage of the combined total of short sales and foreclosure transfers increased from 27% in 2011 to 33% in 2012, primarily resulting from our increased focus on this foreclosure alternative. At the direction of FHFA, and as part of the servicing alignment initiative, we announced a new standard short sale process during the third quarter of 2012 designed to help more struggling borrowers use short sales to avoid foreclosure. We believe this new process may lead to an increase in short sales in 2013.
The table below presents our single-family loan workout activities for the last five quarters.
Table 1 Total Single-Family Loan Workout Volumes(1)
For the Three Months Ended | ||||||||||||||||||||
12/31/2012 | 09/30/2012 | 06/30/2012 | 03/31/2012 | 12/31/2011 | ||||||||||||||||
(number of loans) | ||||||||||||||||||||
Loan modifications |
19,898 | 20,864 | 15,142 | 13,677 | 19,048 | |||||||||||||||
Repayment plans |
6,964 | 7,099 | 8,712 | 10,575 | 8,008 | |||||||||||||||
Forbearance agreements(2) |
2,442 | 2,190 | 4,738 | 3,656 | 3,867 | |||||||||||||||
Short sales and deed in lieu of foreclosure transactions |
13,849 | 14,383 | 12,531 | 12,245 | 12,675 | |||||||||||||||
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Total single-family loan workouts |
43,153 | 44,536 | 41,123 | 40,153 | 43,598 | |||||||||||||||
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(1) | Based on actions completed with borrowers for loans within our single-family credit guarantee portfolio. Excludes those modification, repayment, and forbearance activities for which the borrower has started the required process, but the actions have not been made permanent or effective, such as loans in modification trial periods. Also excludes certain loan workouts where our single-family seller/servicers have executed agreements in the current or prior periods, but these have not been incorporated into certain of our operational systems, due to delays in processing. These categories are not mutually exclusive and a loan in one category may also be included within another category in the same period. |
(2) | Excludes loans with long-term forbearance under a completed loan modification. Many borrowers enter into a short-term forbearance agreement before another loan workout is pursued or completed. We only report forbearance activity for a single loan once during each quarterly period; however, a single loan may be included under separate forbearance agreements in separate periods. |
Minimizing Our Credit Losses
To help minimize the credit losses related to our guarantee activities, we are focused on:
| pursuing a variety of loan workouts, including foreclosure alternatives, in an effort to reduce the severity of losses we experience over time; |
| managing foreclosure timelines to the extent possible, given the lengthy foreclosure process in many states; |
| managing our inventory of foreclosed properties to reduce costs and maximize proceeds; and |
| pursuing contractual remedies against originators, lenders, servicers, and insurers, as appropriate. |
4 | Freddie Mac |
We establish guidelines for our servicers to follow and provide them default management tools to use, in part, in determining which type of loan workout would be expected to provide the best opportunity for minimizing our credit losses. We require our single-family seller/servicers to first evaluate problem loans for a repayment or forbearance plan before considering modification. If a borrower is not eligible for a modification, our seller/servicers pursue foreclosure alternatives (e.g., short sales) before considering foreclosure.
During 2012, we continued to implement the FHFA-directed servicing alignment initiative, under which we and Fannie Mae are aligning certain standards for servicing non-performing loans owned or guaranteed by the companies. We have provided standards to our servicers under this initiative that require them to initiate earlier and more frequent communication with delinquent borrowers, employ consistent requirements for collecting documents from borrowers, and follow consistent timelines for responding to borrowers and for processing foreclosures. Under these new servicing standards, we pay incentives to servicers that exceed certain performance standards with respect to servicing delinquent loans. We also assess compensatory fees from servicers if they do not achieve minimum performance benchmarks with respect to servicing delinquent loans, including foreclosure timelines.
Our servicers pursue repayment plans and loan modifications for borrowers facing financial or other hardships since the level of recovery (if a loan reperforms) may often be much higher than with foreclosure or foreclosure alternatives. In cases where these alternatives are not possible or successful, a short sale transaction typically provides us with a comparable or higher level of recovery than what we would receive through property sales from our REO inventory. In large part, the benefit of short sales arises from the avoidance of costs we would otherwise incur to complete the foreclosure and dispose of the property, including maintenance and other property expenses associated with holding REO property. The foreclosure process is a lengthy one in many jurisdictions with significant associated costs to complete, including, in times of declining home values, foregone recovery we might receive from an earlier sale.
We have contractual arrangements with our seller/servicers under which they agree to sell us mortgage loans, and represent and warrant that those loans have been originated under specified underwriting standards. In addition, our servicers represent and warrant to us that those loans will be serviced in accordance with our servicing contract. If we subsequently discover that the representations and warranties were breached (i.e., contractual standards were not followed), we can exercise certain contractual remedies to mitigate our actual or potential credit losses. These contractual remedies include the ability to require the seller/servicer to repurchase the loan at its current UPB and/or to make us whole for losses realized with respect to the loan, after consideration of other recoveries, if any. The amount we expect to collect on outstanding repurchase requests is significantly less than the UPB of the loans subject to the repurchase requests primarily because many of these requests will likely be satisfied by the seller/servicers reimbursing us for realized credit losses. Some of these requests also may be rescinded in the course of the contractual appeals process. As of December 31, 2012, the UPB of loans subject to repurchase requests issued to our single-family seller/servicers was approximately $3.0 billion, and approximately 41% of these requests were outstanding for more than four months since issuance of our initial repurchase request (this figure includes repurchase requests for which appeals were pending). Of the total amount of repurchase requests outstanding at December 31, 2012, approximately $1.2 billion were issued due to mortgage insurance rescission or mortgage insurance claim denial.
Historically, we have used a process of reviewing a sample of the loans we purchase to validate compliance with our standards. In addition, we review many delinquent loans and loans that have resulted in credit losses, such as through foreclosure or short sale. Beginning in 2012, we made revisions to our selection approach for these loans that expanded the coverage of our loan reviews. Certain of these changes are designed to increase our loss recoveries. We expect that the changes made to our loan review process will increase our repurchase request volumes with our seller/servicers in the future.
We, together with Fannie Mae, also launched a new representation and warranty framework for conventional loans purchased by the GSEs on or after January 1, 2013. The objective of the new framework is to clarify lenders repurchase exposures and liability on future sales of mortgage loans to Freddie Mac and Fannie Mae and, under the new framework, lenders will be relieved of certain repurchase obligations in specific cases, such as for loans that perform for 36 consecutive months (subject to certain exclusions). As a result, if we are unable to identify breaches in representations and warranties timely, we may face greater exposure to credit and other losses under this new framework, as our ability to seek recovery or repurchase from the seller is more limited. The new framework does not affect seller/servicers obligations under their contracts with us with respect to loans sold to us prior to January 1, 2013. The new framework also does not affect their obligation to service these loans in accordance with our servicing standards. For more information, see Our Business
5 | Freddie Mac |
Segments Single-Family Guarantee Segment New Representation and Warranty Framework and MD&A RISK MANAGEMENT Credit Risk Institutional Credit Risk Single-Family Mortgage Seller/Servicers.
Our credit loss exposure is also partially mitigated by mortgage insurance, which is a form of credit enhancement. Primary mortgage insurance is generally required to be purchased, typically at the borrowers expense, for certain mortgages with higher LTV ratios. Although we received payments under primary and other mortgage insurance of $2.0 billion and $2.5 billion in 2012 and 2011, respectively, which helped to mitigate our credit losses, many of our mortgage insurers remain financially weak. As a result, we expect to receive substantially less than full payment of our claims from three of our mortgage insurance counterparties that are currently partially paying claims under orders of their state regulators. We believe that certain other of our mortgage insurance counterparties lack sufficient ability to meet all their expected lifetime claims paying obligations to us as those claims emerge. See NOTE 4: MORTGAGE LOANS AND LOAN LOSS RESERVES Table 4.5 Recourse and Other Forms of Credit Protection for information about credit enhancements of our single-family credit guarantee portfolio.
Developing Mortgage Market Enhancements in Support of a New Infrastructure for the Secondary Mortgage Market
We continue efforts that we believe will create value for the industry by building the infrastructure for a future housing finance system. These efforts include the implementation of the UMDP, which provides us with the ability to collect additional data that we believe will improve our risk management practices. In the first quarter of 2012, we completed a key milestone of the UMDP with the launch of the Uniform Collateral Data Portal for the electronic submission of appraisal reports for conventional mortgages. The implementation of the portal was effective for mortgages with application dates after November 30, 2011 that were delivered to us after March 18, 2012. In the second quarter of 2012, we implemented the ULDD, which provides for the efficient collection and use of consistent information about loan terms, collateral, and borrowers. The implementation of ULDD was effective for mortgages with application dates after November 30, 2011 that were delivered to us after July 22, 2012, with a transition period allowing for optional usage of ULDD for mortgages delivered to us between April 23, 2012 and July 22, 2012.
We are also working with FHFA and others to develop a plan for the design and development of a securitization platform that can be used in a future secondary mortgage market. In October 2012, FHFA released a white paper for industry comment that described a proposed framework for a new securitization platform and a model pooling and servicing agreement. FHFA has stated that it anticipates that Freddie Mac and Fannie Mae will each maintain its own distinct securitization operations and continue to issue its own securities.
We are continuing to work with FHFA and Fannie Mae to develop recommendations to align certain of the terms of the contracts we and Fannie Mae use with our respective single-family seller/servicers, as well as certain practices we follow in managing our remedies and our respective business relationships with these companies. In October 2012, we announced, pursuant to a directive by FHFA, changes to requirements in certain areas related to loan servicing, including a process and criteria for evaluating servicer performance. These changes align our and Fannie Maes requirements in these areas. See MD&A RISK MANAGEMENT Credit Risk Institutional Credit Risk Single-Family Mortgage Seller/Servicers for additional information.
Maintaining Sound Credit Quality on the Loans We Purchase or Guarantee
We continue to focus on maintaining credit policies, including our underwriting standards, that allow us to purchase and guarantee loans made to qualified borrowers that we believe will provide management and guarantee fee income (excluding the amounts associated with the Temporary Payroll Tax Cut Continuation Act of 2011), over the long-term, that exceeds our expected credit-related and administrative expenses on such loans.
The credit quality of the single-family loans we acquired beginning in 2009 (excluding HARP and other relief refinance mortgages) is significantly better than that of loans we acquired from 2005 to 2008, as measured by original LTV ratios, FICO scores, and the proportion of loans underwritten with fully documented income. The improvement in credit quality of loans we have purchased since 2008 (excluding HARP and other relief refinance mortgages) is primarily the result of: (a) changes in our credit policies, including changes in our underwriting standards; (b) fewer purchases of loans with higher risk characteristics; and (c) changes in mortgage insurers and lenders underwriting practices.
Underwriting procedures for relief refinance mortgages are limited in many cases, and such procedures generally do not include all of the changes in underwriting standards we have implemented since 2008. As a result, relief refinance mortgages
6 | Freddie Mac |
generally reflect many of the credit risk attributes of the original loans. However, borrower participation in our relief refinance mortgage initiative may help reduce our exposure to credit risk in cases where the borrowers payments under their mortgages are reduced, thereby strengthening the borrowers potential to make their mortgage payments. Relief refinance mortgages of all LTV ratios comprised approximately 18% and 11% of the UPB in our total single-family credit guarantee portfolio at December 31, 2012 and 2011, respectively.
HARP loans represented 11% and 6% of the UPB of our single-family credit guarantee portfolio as of December 31, 2012 and 2011, respectively. Mortgages originated after 2008, including HARP loans, represented 63% and 51% of the UPB of our single-family credit guarantee portfolio as of December 31, 2012 and 2011, respectively, while the single-family loans originated from 2005 through 2008 represented 24% and 32% of this portfolio at these dates, respectively.
Approximately 96% and 92% of the single-family mortgages we purchased in 2012 and 2011, respectively, were fixed-rate, first lien amortizing mortgages, based on UPB. Approximately 82% and 78% of the single-family mortgages we purchased in 2012 and 2011, respectively, were refinance mortgages, and approximately 24% and 16%, respectively, of these refinance mortgages were HARP loans, based on UPB. HARP loans comprised approximately 20% and 12% of our single-family purchase volume in 2012 and 2011, respectively.
Due to our participation in HARP, we purchase a significant number of loans that have original LTV ratios over 100%. The proportion of loans we purchased with LTV ratios over 100% increased from approximately 4% of our single-family mortgage purchases (including HARP loans) in 2011 to 12% of our single-family mortgage purchases in 2012. This increase was mainly due to the changes in HARP announced in the fourth quarter of 2011, which allow borrowers (whose loans we already hold in our single-family credit guarantee portfolio) with higher LTV ratios to refinance. Over time, HARP loans may not perform as well as other refinance mortgages because the continued high LTV ratios and reduced underwriting standards of these loans increase the probability of default. In addition, HARP loans may not be covered by mortgage insurance for the full excess of their UPB over 80%. See Our Business Relief Refinance Mortgage Initiative and the Home Affordable Refinance Program for further information about our relief refinance initiative and HARP.
The table below presents the composition and certain other information about loans in our single-family credit guarantee portfolio, by year of origination at December 31, 2012 and 2011, and for the years ended December 31, 2012 and 2011.
7 | Freddie Mac |
Table 2 Single-Family Credit Guarantee Portfolio Summary(1)
At December 31, 2012 | Year Ended December 31, 2012 |
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Percent of Portfolio |
Average Credit Score(2) |
Current LTV Ratio(3) |
Current LTV Ratio >100%(3)(4) |
Serious Delinquency Rate(5) |
Percent
of Credit Losses(6) |
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Loans originated 2009 to 2012: |
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Relief refinance loans: |
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HARP loans |
11 | % | 735 | 100 | % | 43 | % | 1.06 | % | 2.1 | % | |||||||||||||
Other relief refinance loans |
7 | 749 | 58 | | 0.29 | 0.1 | ||||||||||||||||||
All other loans |
45 | 757 | 66 | 1 | 0.27 | 1.5 | ||||||||||||||||||
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|
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Subtotal 2009 to 2012 originations |
63 | 753 | 71 | 7 | 0.39 | 3.7 | ||||||||||||||||||
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Loans originated 2005 to 2008 |
24 | 708 | 98 | 42 | 9.56 | 87.2 | ||||||||||||||||||
Loans originated 2004 and prior |
13 | 715 | 56 | 6 | 3.20 | 9.1 | ||||||||||||||||||
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Total |
100 | % | 737 | 75 | 15 | 3.25 | 100.0 | % | ||||||||||||||||
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At December 31, 2011 | Year Ended December 31, 2011 |
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Percent of Portfolio |
Average Credit Score(2) |
Current LTV Ratio(3) |
Current LTV Ratio >100%(3)(4) |
Serious Delinquency Rate(5) |
Percent of Credit Losses(6) |
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Loans originated 2009 to 2011: |
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Relief refinance loans: |
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HARP loans |
6 | % | 737 | 97 | % | 35 | % | 1.08 | % | 1.0 | % | |||||||||||||
Other relief refinance loans |
5 | 751 | 61 | | 0.17 | 0.1 | ||||||||||||||||||
All other loans |
40 | 757 | 69 | 2 | 0.21 | 0.8 | ||||||||||||||||||
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Subtotal- 2009 to 2011 originations |
51 | 754 | 71 | 5 | 0.30 | 1.9 | ||||||||||||||||||
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Loans originated 2005 to 2008 |
32 | 713 | 104 | 48 | 8.75 | 89.5 | ||||||||||||||||||
Loans originated 2004 and prior |
17 | 719 | 61 | 9 | 2.83 | 8.6 | ||||||||||||||||||
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Total |
100 | % | 735 | 80 | 20 | 3.58 | 100.0 | % | ||||||||||||||||
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(1) | Based on the loans remaining in the portfolio at December 31, 2012 and 2011, which totaled $1.6 trillion and $1.7 trillion, respectively, rather than all loans originally guaranteed by us and originated in the respective year. Includes loans acquired under our relief refinance initiative, which began in 2009. For credit scores, LTV ratios, serious delinquency rates, and other information about the loans in our single-family credit guarantee portfolio, see RISK MANAGEMENT Credit Risk Mortgage Credit Risk Single-Family Mortgage Credit Risk. |
(2) | Credit score data is based on FICO scores, which are ranked on a scale of approximately 300 to 850 points. Although we obtain updated credit information on certain borrowers after the origination of a mortgage, such as those borrowers seeking a modification, the scores presented in this table represent the credit score of the borrower at the time of loan origination and may not be indicative of the borrowers creditworthiness at December 31, 2012. |
(3) | We estimate current market values by adjusting the value of the property at origination based on changes in the market value of homes in the same geographical area since origination. See endnote (4) to Table 41 Characteristics of the Single-Family Credit Guarantee Portfolio for information on our calculation of current LTV ratios. |
(4) | Calculated as a percentage of the aggregate UPB of loans with LTV ratios greater than 100% in relation to the total UPB of loans in the category. |
(5) | See RISK MANAGEMENT Credit Risk Mortgage Credit Risk Single-family Mortgage Credit Risk Delinquencies for further information about our reported serious delinquency rates. |
(6) | Historical credit losses for each origination year may not be representative of future results. |
Contracting the Dominant Presence of the GSEs in the Marketplace
We continue to take steps toward the goal of gradually shifting mortgage credit risk from Freddie Mac to private investors, while simplifying and shrinking certain of our operations. In the case of single-family credit guarantees, we are exploring several ways to accomplish this goal, including increasing guarantee fees and evaluating new risk-sharing transactions beyond the traditional charter-required mortgage insurance coverage. Two across-the-board increases in guarantee fees occurred in 2012, and FHFA has proposed additional fee adjustments, as discussed in BUSINESS Our Business Segments Single-Family Guarantee Segment Overview of the Securitization Process.
In the Investments segment, under the terms of the Purchase Agreement, as amended on August 17, 2012, and FHFA regulation, the UPB of our mortgage-related investments portfolio: (a) could not exceed $650 billion on December 31, 2012; and (b) on December 31 of each year thereafter, may not exceed 85% of the aggregate amount of the UPB we were permitted to own as of December 31 of the immediately preceding calendar year, until the portfolio reaches $250 billion. This strategy is designed to reduce the portfolio and provide the best return to the taxpayer while minimizing market disruption.
In the Multifamily segment, our primary business model is to purchase held-for-sale multifamily loans for aggregation and then securitization through multifamily K Certificates, which are considered Other Guarantee Transactions. In substantially all of these transactions we guarantee only the most senior tranches of the securities. As a result, a significant portion of our expected credit risk associated with these loans is sold in subordinated tranches to third party investors.
8 | Freddie Mac |
Strengthening Our Infrastructure and Improving Overall Efficiency While Also Focusing On Retention of Key Employees
We continue to work to both enhance the quality of our infrastructure and to improve our efficiency to preserve the taxpayers investment. We are focusing our resources primarily on key projects, many of which are related to FHFA-mandated strategic initiatives that will likely take several years to fully implement. We are also focused on making significant improvements to our systems infrastructure in order to: (a) replace legacy hardware or software systems at the end of their useful lives and to strengthen our disaster recovery capabilities; and (b) improve our data collection and administration capabilities as well as our ability to assist in the servicing of loans.
We continue to actively manage our general and administrative expenses, while also continuing to focus on retaining key talent. In the first half of 2012, we introduced a new compensation program for employees to help mitigate the uncertainty surrounding compensation. Under the program, the majority of employees have a more predictable income, as the program either reduces or eliminates the amount of compensation that is subject to variability. The variable elements of compensation for our senior executives are subject only to reduction based on the companys and their individual performance, with no upside potential. While employee turnover moderated in 2012 compared to 2011, we are continuing to explore various strategic arrangements with outside firms to provide operational capability and staffing for key functions, as needed.
Our general and administrative expenses increased in 2012 compared to 2011, largely due to an increase in spending for FHFA-mandated strategic initiatives. We believe the various FHFA-mandated strategic initiatives will likely continue to require significant resources and thus continue to affect our level of administrative expenses going forward.
Single-Family Credit Guarantee Portfolio
The UPB of our single-family credit guarantee portfolio declined approximately 6.2% and 3.5% during 2012 and 2011, respectively, as the amount of single-family loan liquidations exceeded new loan purchase and guarantee activity. We believe this is due, in part, to declines in the amount of single-family mortgage debt outstanding in the market and a decline in our single-family competitive position compared to other market participants (primarily Fannie Mae and Ginnie Mae). See RISK FACTORS Competitive and Market Risks A significant decline in the price performance of or demand for our PCs could have an adverse effect on the volume and/or profitability of our new single-family guarantee business for further information on our competitive position in the single-family mortgage market.
The table below provides certain credit statistics for our single-family credit guarantee portfolio.
9 | Freddie Mac |
Table 3 Credit Statistics, Single-Family Credit Guarantee Portfolio
As of | ||||||||||||||||||||
12/31/2012 | 9/30/2012 | 6/30/2012 | 3/31/2012 | 12/31/2011 | ||||||||||||||||
Payment status |
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One month past due |
1.85 | % | 2.02 | % | 1.79 | % | 1.63 | % | 2.02 | % | ||||||||||
Two months past due |
0.66 | % | 0.66 | % | 0.60 | % | 0.57 | % | 0.70 | % | ||||||||||
Seriously delinquent(1) |
3.25 | % | 3.37 | % | 3.45 | % | 3.51 | % | 3.58 | % | ||||||||||
Non-performing loans (in millions)(2) |
$ | 128,599 | $ | 131,106 | $ | 118,463 | $ | 119,599 | $ | 120,514 | ||||||||||
Single-family loan loss reserve (in millions)(3) |
$ | 30,508 | $ | 33,298 | $ | 35,298 | $ | 37,771 | $ | 38,916 | ||||||||||
REO inventory (in properties) |
49,071 | 50,913 | 53,271 | 59,307 | 60,535 | |||||||||||||||
REO assets, net carrying value (in millions) |
$ | 4,314 | $ | 4,459 | $ | 4,715 | $ | 5,333 | $ | 5,548 | ||||||||||
For the Three Months Ended | ||||||||||||||||||||
12/31/2012 | 9/30/2012 | 6/30/2012 | 3/31/2012 | 12/31/2011 | ||||||||||||||||
(in units, unless noted) | ||||||||||||||||||||
Seriously delinquent loan additions(1) |
72,626 | 76,104 | 75,904 | 80,815 | 95,661 | |||||||||||||||
Loan modifications(4) |
19,898 | 20,864 | 15,142 | 13,677 | 19,048 | |||||||||||||||
REO acquisitions |
18,672 | 20,302 | 20,033 | 23,805 | 24,758 | |||||||||||||||
REO disposition severity ratio:(5) |
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California |
34.4 | % | 37.7 | % | 41.6 | % | 44.2 | % | 44.6 | % | ||||||||||
Arizona |
35.9 | % | 36.3 | % | 40.4 | % | 45.0 | % | 46.7 | % | ||||||||||
Florida |
42.6 | % | 44.7 | % | 46.2 | % | 48.6 | % | 50.1 | % | ||||||||||
Nevada |
45.6 | % | 50.6 | % | 54.3 | % | 56.5 | % | 54.2 | % | ||||||||||
Illinois |
46.5 | % | 47.7 | % | 47.8 | % | 49.3 | % | 51.2 | % | ||||||||||
Total U.S |
35.2 | % | 36.2 | % | 37.9 | % | 40.3 | % | 41.2 | % | ||||||||||
Single-family provision (benefit) for credit losses (in millions) |
$ | (658 | ) | $ | 650 | $ | 177 | $ | 1,844 | $ | 2,664 | |||||||||
Single-family credit losses (in millions) |
$ | 2,396 | $ | 2,936 | $ | 2,858 | $ | 3,435 | $ | 3,209 |
(1) | See MD&A RISK MANAGEMENT Credit Risk Mortgage Credit Risk Single-Family Mortgage Credit Risk Delinquencies for further information about our reported serious delinquency rates. |
(2) | Consists of the UPB of loans in our single-family credit guarantee portfolio that have undergone a TDR or that are seriously delinquent. During the third quarter of 2012, we changed the treatment of single-family loans discharged in Chapter 7 bankruptcy to classify these loans as TDRs, regardless of the borrowers payment status. As a result, we newly classified approximately $19.5 billion in UPB of loans discharged in Chapter 7 bankruptcy as TDRs in the third quarter of 2012. As of December 31, 2012 and 2011, approximately $65.8 billion and $44.4 billion in UPB of TDR loans, respectively, were no longer seriously delinquent. |
(3) | Consists of the combination of: (a) our allowance for loan losses on mortgage loans held for investment; and (b) our reserve for guarantee losses associated with non-consolidated single-family mortgage securitization trusts and other guarantee commitments. |
(4) | Represents the number of modification agreements with borrowers completed during the quarter. Excludes forbearance agreements, repayment plans, and loans in modification trial periods. |
(5) | States presented represent the five states where our credit losses were greatest during 2012. Calculated as the amount of our losses recorded on disposition of REO properties during the respective quarterly period, excluding those subject to repurchase requests made to our seller/servicers, divided by the aggregate UPB of the related loans. The amount of losses recognized on disposition of the properties is equal to the amount by which the UPB of the loans exceeds the amount of sales proceeds from disposition of the properties. Excludes sales commissions and other expenses, such as property maintenance and costs, as well as applicable recoveries from credit enhancements, such as mortgage insurance. |
In discussing our credit performance, we often use the terms credit losses and credit-related expenses. These terms are significantly different. Our credit losses consist of charge-offs and REO operations expense, while our credit-related expenses consist of our provision for credit losses and REO operations expense.
Since the beginning of 2008, on an aggregate basis, we have recorded provision for credit losses associated with single-family loans of approximately $75.2 billion, and have recorded an additional $3.9 billion in losses on loans purchased from PC trusts, net of recoveries. The majority of these losses are associated with loans originated in 2005 through 2008. While loans originated in 2005 through 2008 will give rise to additional credit losses that have not yet been incurred and, thus, have not yet been provisioned for, we believe that, as of December 31, 2012, we have reserved for or charged-off the majority of the total expected credit losses for these loans. Nevertheless, various factors, such as continued high unemployment rates or future declines in home prices, could require us to provide for losses on these loans beyond our current expectations.
Our loan loss reserves declined in every quarter of 2012, which reflects improvement in both borrower payment performance and lower severity ratios for both REO dispositions and short sale transactions due to the improvements in home prices in most areas during 2012. Our REO inventory also declined in every quarter of 2012, which reflects that our sales of REO properties exceeded the volume of our REO acquisitions due to lower foreclosure activity as well as an increase in the volume of short sales prior to foreclosure.
Our average REO disposition severity ratio improved to 35.2% for the fourth quarter of 2012 compared to 41.2% for the fourth quarter of 2011. Although this ratio improved for each quarter of 2012, it remains high as compared to our experience in periods before 2007.
10 | Freddie Mac |
The serious delinquency rate for our single-family credit guarantee portfolio improved at December 31, 2012, compared to December 31, 2011. Excluding relief refinance loans, the improvement in borrower payment performance during 2012 reflects an improved credit profile of borrowers with loans originated since 2008. However, several factors, including the lengthening of the foreclosure process, have resulted in loans remaining in serious delinquency for longer periods than experienced prior to 2008, particularly in states that require a judicial foreclosure process. As of December 31, 2012 and 2011, the percentage of seriously delinquent loans that have been delinquent for more than six months was 72% and 70%, respectively.
The balance of our non-performing loans increased during the third quarter of 2012, due to a change in the treatment of single-family loans discharged in Chapter 7 bankruptcy to classify these loans as TDRs (unless they were already classified as TDRs for other reasons), regardless of the borrowers payment status. Except for this change in classification, which resulted in approximately $19.5 billion in UPB of loans being newly classified as TDRs in the third quarter of 2012, the balance of our non-performing loans would have declined in every quarter of 2012. Although we experienced improvement in the amount of our non-performing loans during the year, this balance remained high at the end of 2012, compared to periods prior to 2009.
The credit losses and loan loss reserves associated with our single-family credit guarantee portfolio remained elevated in 2012, due, in part, to:
| Losses associated with the continued high volume of foreclosures and foreclosure alternatives. These actions relate to the continued efforts of our servicers to resolve our large inventory of seriously delinquent loans. Due to the length of time necessary for servicers either to complete the foreclosure process or pursue foreclosure alternatives on seriously delinquent loans in our portfolio, we expect our credit losses will continue to remain elevated even if the volume of new serious delinquencies declines. |
| Continued negative effect of certain loan groups within the single-family credit guarantee portfolio, such as: (a) loans originated in 2005 through 2008; and (b) loans with higher-risk characteristics (such as those underwritten with certain lower documentation standards and interest-only loans), a significant portion of which were originated in 2005 through 2008. These groups continue to be large contributors to our credit losses. |
| Cumulative decline in national home prices of 22% since June 2006, based on our own index. As a result of this price decline, approximately 15% of loans in our single-family credit guarantee portfolio, based on UPB, had estimated current LTV ratios in excess of 100% (i.e., underwater loans) as of December 31, 2012. |
| Weak financial condition of many of our mortgage insurers, which has reduced our actual recoveries from these counterparties as well as our estimates of expected recoveries. |
Some of our loss mitigation activities create fluctuations in our delinquency statistics. See MD&A RISK MANAGEMENT Credit Risk Mortgage Credit Risk Single-family Mortgage Credit Risk Credit Performance Delinquencies for further information about factors affecting our reported delinquency rates.
Consolidated Financial Results 2012 versus 2011
Net income was $11.0 billion for 2012 compared to net income (loss) of $(5.3) billion for 2011. Key highlights of our financial results include:
| Net interest income for 2012 decreased to $17.6 billion from $18.4 billion for 2011, mainly due to the impact of a reduction in the balance of our higher-yielding mortgage-related assets, partially offset by lower funding costs. |
| Provision for credit losses for 2012 declined to $1.9 billion, compared to $10.7 billion for 2011. The significant reduction in provision for credit losses in 2012 primarily reflects declines in the volume of newly delinquent loans (largely due to a decline in the portion of our single-family credit guarantee portfolio originated in 2005 through 2008), and lower estimates of incurred loss due to the positive impact of an increase in national home prices. |
| Non-interest income (loss) was $(4.1) billion for 2012, compared to $(10.9) billion for 2011. The improvement was largely driven by a decrease in derivative losses during 2012 compared to 2011. |
11 | Freddie Mac |
| Non-interest expense declined to $2.2 billion for 2012, from $2.5 billion for 2011, primarily due to a decrease in REO operations expense during 2012 compared to 2011 as a result of improving home prices in certain geographical areas with significant REO activity. |
| Comprehensive income was $16.0 billion for 2012 compared to comprehensive income (loss) of $(1.2) billion for 2011. Comprehensive income for 2012 consisted of $11.0 billion of net income and $5.1 billion of other comprehensive income, primarily due to a reduction in net unrealized losses on our available-for-sale securities. |
Our Business
We conduct business in the U.S. residential mortgage market and the global securities market, subject to the direction of our Conservator, FHFA, and under regulatory supervision of FHFA, the SEC, HUD, and Treasury. The size of the U.S. residential mortgage market is affected by many factors, including changes in interest rates, home ownership rates, home prices, the supply of housing and lender preferences regarding credit risk and borrower preferences regarding mortgage debt. The amount of residential mortgage debt available for us to purchase and the mix of available loan products are also affected by several factors, including the volume of mortgages meeting the requirements of our charter (which is affected by changes in the conforming loan limit determined by FHFA), our own preference for credit risk reflected in our purchase standards and the mortgage purchase and securitization activity of other financial institutions. We conduct our business operations solely in the U.S. and its territories.
In addition to the directives given us by our Conservator, our charter forms the framework for our business activities, the initiatives we bring to market and the services we provide to the nations residential housing and mortgage industries. Our charter also determines the types of mortgage loans that we are permitted to purchase. Our statutory mission as defined in our charter is to:
| provide stability in the secondary market for residential mortgages; |
| respond appropriately to the private capital market; |
| provide ongoing assistance to the secondary market for residential mortgages (including activities relating to mortgages for low- and moderate-income families, involving a reasonable economic return that may be less than the return earned on other activities); and |
| promote access to mortgage credit throughout the U.S. (including central cities, rural areas, and other underserved areas). |
Our charter does not permit us to originate mortgage loans or lend money directly to consumers in the primary mortgage market. We provide liquidity, stability and affordability to the U.S. housing market primarily by providing our credit guarantee for residential mortgages originated by mortgage lenders and investing in mortgage loans and mortgage-related securities. We use mortgage securitization as an integral part of our activities. Mortgage securitization is a process by which we purchase mortgage loans that lenders originate, and pool these loans into guaranteed mortgage securities that are sold in global capital markets, generating proceeds that support future loan origination activity by lenders. The primary Freddie Mac guaranteed mortgage-related security is the single-class PC. We also aggregate and resecuritize mortgage-related securities that are issued by us, other GSEs, HFAs, or private (non-agency) entities, and issue other single-class and multiclass mortgage-related securities to third-party investors. We also enter into certain other guarantee commitments for mortgage loans, HFA bonds under the HFA initiative, and multifamily housing revenue bonds held by third parties.
Our charter limits our purchases of single-family loans to the conforming loan market. The conforming loan market is defined by loans originated with UPBs at or below limits determined annually based on changes in FHFAs housing price index, a method established and maintained by FHFA for determining the national average single-family home price. Since 2006, the base conforming loan limit for a one-family residence has been set at $417,000, and higher limits have been established in certain high-cost areas (currently, up to $625,500 for a one-family residence). Higher limits also apply to two- to four-family residences and for mortgages secured by properties in Alaska, Guam, Hawaii, and the U.S. Virgin Islands.
12 | Freddie Mac |
Our charter generally prohibits us from purchasing first-lien single-family mortgages if the outstanding UPB of the mortgage at the time of our purchase exceeds 80% of the value of the property securing the mortgage unless we have one of the following credit protections:
| mortgage insurance from a mortgage insurer that we determine is qualified on the portion of the UPB of the mortgage that exceeds 80%; |
| a sellers agreement to repurchase or replace any mortgage that has defaulted; or |
| retention by the seller of at least a 10% participation interest in the mortgage. |
Under our charter, our mortgage purchase operations are confined, so far as practicable, to mortgages that we deem to be of such quality, type and class as to meet generally the purchase standards of other private institutional mortgage investors. This is a general marketability standard.
Our charter requirement for credit protection on mortgages with LTV ratios greater than 80% does not apply to multifamily mortgages or to mortgages that have the benefit of any guarantee, insurance or other obligation by the U.S. or any of its agencies or instrumentalities (e.g., the FHA, the VA or the USDA Rural Development). Additionally, as part of HARP, we may purchase single-family mortgages that refinance borrowers whose mortgages we currently own or guarantee without obtaining additional credit enhancement in excess of that already in place for any such loan, even if the LTV ratio of the new loan is above 80%.
Our Business Segments
Our operations consist of three reportable segments, which are based on the type of business activities each performs Single-family Guarantee, Investments, and Multifamily. Certain activities that are not part of a reportable segment are included in the All Other category.
We evaluate segment performance and allocate resources based on a Segment Earnings approach. For more information on our segments, including financial information, see MD&A CONSOLIDATED RESULTS OF OPERATIONS Segment Earnings and NOTE 13: SEGMENT REPORTING.
Single-Family Guarantee Segment
The Single-family Guarantee segment reflects results from our single-family credit guarantee activities. In our Single-family Guarantee segment, we purchase single-family mortgage loans originated by our seller/servicers in the primary mortgage market. In most instances, we use the mortgage securitization process to package the mortgage loans into guaranteed mortgage-related securities. We guarantee the payment of principal and interest on the mortgage-related security in exchange for management and guarantee fees.
Our Customers
Our customers are predominantly lenders in the primary mortgage market that originate mortgages for homeowners. These lenders include mortgage banking companies, commercial banks, savings banks, community banks, credit unions, HFAs, and savings and loan associations.
We acquire a significant portion of our mortgages from several large lenders. These lenders are among the largest mortgage loan originators in the U.S. During 2012, three mortgage lenders, Wells Fargo Bank, N.A, U.S. Bank, N.A., and JPMorgan Chase Bank, N.A., each accounted for 10% or more of our single-family mortgage purchase volume and collectively accounted for approximately 49% of our single-family mortgage purchase volume. In the last two years, a number of our largest mortgage seller/servicers have reduced or eliminated their purchases of mortgage loans from mortgage brokers and correspondent lenders. As a result, we are acquiring an increasing portion of our business volume directly from smaller lenders. Our top ten lenders accounted for approximately 73% and 82% of our single-family mortgage purchase volume during 2012 and 2011, respectively.
We are the master servicer for the loans we purchase, and delegate the primary servicing function to our customers. A significant portion of our single-family mortgage loans are serviced by several of our large customers. If our servicers lack appropriate process controls, experience a failure in their controls, or experience an operating disruption in their ability to service mortgage loans, our business and financial results could be adversely affected. For additional information about our
13 | Freddie Mac |
relationships with our customers, see MD&A RISK MANAGEMENT Credit Risk Institutional Credit Risk Single-Family Mortgage Seller/Servicers.
Our Competition
Historically, our principal competitors have been Fannie Mae, Ginnie Mae and FHA/VA, and other financial institutions that retain or securitize mortgages, such as commercial and investment banks, dealers, and thrift institutions. Since 2008, most of our competitors, other than Fannie Mae and Ginnie Mae, have ceased their activities in the residential mortgage securitization business or severely curtailed these activities relative to their previous levels. We compete on the basis of price, products, the structure of our securities, and service. Competition to acquire single-family mortgages can also be significantly affected by changes in our credit standards.
Ginnie Mae, which became a more significant competitor beginning in 2009, guarantees the timely payment of principal and interest on mortgage-related securities backed by federally insured or guaranteed loans, primarily those insured by FHA or guaranteed by VA. Ginnie Mae maintained a significant market share in 2012 and 2011, in large part due to favorable pricing of loans insured by FHA, the increase in the FHA loan limit and the availability, through FHA, of a mortgage product for borrowers seeking greater than 80% financing who could not otherwise qualify for a conventional mortgage.
The conservatorship, including direction provided to us by our Conservator, and the restrictions on our activities under the Purchase Agreement may affect our ability to compete. FHFA, through its strategic plan activities, has required that we and Fannie Mae adopt uniform approaches in a number of areas. Through the servicing alignment initiative, we and Fannie Mae have aligned many of our policies and procedures with respect to the servicing of single-family loans. We are also aligning certain terms of the contracts we and Fannie Mae use with our respective single-family customers, and are working with Fannie Mae on a new securitization platform. For more information, see RISK FACTORS Conservatorship and Related Matters FHFA directives that we and Fannie Mae adopt uniform approaches in some areas could have an adverse impact on our business or on our competitive position with respect to Fannie Mae.
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Overview of the Mortgage Securitization Process
Mortgage securitization is a process by which we purchase mortgage loans that lenders originate, and pool these loans into mortgage securities that are sold in global capital markets. The following diagram illustrates how we support mortgage market liquidity when we create PCs through mortgage securitizations. These PCs can be sold to investors or held by us or our customers.
The U.S. residential mortgage market consists of a primary mortgage market that links homebuyers and lenders and a secondary mortgage market that links lenders and investors. We participate in the secondary mortgage market by purchasing mortgage loans and mortgage-related securities for investment and by issuing guaranteed mortgage-related securities. In the Single-family Guarantee segment, we purchase and securitize single-family mortgages, which are mortgages that are secured by one- to four-family properties.
In general, the securitization and Freddie Mac guarantee process works as follows: (a) a lender originates a mortgage loan to a borrower purchasing a home or refinancing an existing mortgage loan; (b) we purchase the loan from the lender and place it with other mortgages into a security that is sold to investors (this process is referred to as pooling); (c) the lender may then use the proceeds from the sale of the loan or security to originate another mortgage loan; (d) we provide a credit guarantee, for a fee (generally a portion of the interest collected on the mortgage loan), to those who invest in the security; (e) the borrowers monthly payment of mortgage principal and interest (net of a servicing fee and our management and guarantee fee) is passed through to the investors in the security; and (f) if the borrower stops making monthly payments because a family member loses a job, for example we step in and, pursuant to our guarantee, make the applicable payments to investors in the security. In the event a borrower defaults on the mortgage, our servicer works with the borrower to find a solution to help them stay in the home, or sell the property and avoid foreclosure, through our many different workout options. If this is not possible, we ultimately foreclose and sell the home.
The terms of single-family mortgages that we purchase or guarantee allow borrowers to prepay these loans, thereby allowing borrowers to refinance their loans when mortgage rates decline. Because of the nature of long-term, fixed-rate mortgages, borrowers with these mortgages are protected against rising interest rates, but are able to take advantage of
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declining rates through refinancing. When a borrower prepays a mortgage that we have securitized, the outstanding balance of the security owned by investors is reduced by the amount of the prepayment. Unscheduled reductions in loan principal, regardless of whether they are voluntary or involuntary, result in prepayments of security balances. Consequently, the owners of our guaranteed securities are subject to prepayment risk on the related mortgage loans, which is principally that the investor will receive an unscheduled return of the principal, and therefore may not earn the rate of return originally expected on the investment.
We guarantee these mortgage-related securities in exchange for compensation, which consists primarily of a combination of management and guarantee fees paid on a monthly basis as a percentage of the UPB of the underlying loans (referred to as base fees), and initial upfront payments (referred to as delivery fees). We may also make upfront payments to buy-up the monthly management and guarantee fee rate, or receive upfront payments to buy-down the monthly management and guarantee fee rate. These fees are paid in conjunction with the formation of a PC to provide for a uniform coupon rate for the mortgage pool underlying the issued PC.
We enter into mortgage purchase volume commitments with many of our single-family customers. These commitments provide for the lenders to deliver to us a certain volume of mortgages during a specified period of time. Some commitments may also provide for the lender to deliver to us a minimum percentage of their total sales of conforming loans. The purchase and securitization of mortgage loans from customers under these contracts have pricing schedules for our management and guarantee fees that are negotiated at the outset of the contract with initial terms that may range from one month to one year. We call these transactions flow activity and they represent the majority of our purchase volumes. The remainder of our purchases and securitizations of mortgage loans occurs in bulk transactions for which purchase prices and management and guarantee fees are negotiated on an individual transaction basis. Mortgage purchase volumes from individual customers can fluctuate significantly. If a mortgage lender fails to meet its contractual commitment, we have a variety of contractual remedies, which may include the right to assess certain fees. Our mortgage purchase contracts contain no penalty or liquidated damages clauses based on our inability to take delivery of presented mortgage loans. However, if we were to fail to meet our contractual commitment, we could be deemed to be in breach of our contract and could be liable for damages in a lawsuit. Given the uncertainty of the housing market in recent years, since 2009 we have entered into arrangements with certain existing customers at their renewal dates that allow us to change credit and pricing terms more quickly than in the past, including the ability to change our base management and guarantee fees upon 90 days or less notice to customers, if directed to do so by FHFA.
We seek to issue guarantees with fee terms that we believe will, over the long-term, provide management and guarantee fee income that exceeds our anticipated credit-related and administrative expenses on the underlying loans. To compensate us for higher levels of risk in some mortgage products, we charge upfront delivery fees above the base management and guarantee fee, which are calculated based on credit risk factors such as the mortgage product type, loan purpose, LTV ratio and other loan or borrower characteristics. Historically, we have varied our guarantee and delivery fee pricing for different customers, mortgage products, and mortgage or borrower underwriting characteristics based on our assessment of credit risk and loss mitigation related to single-family loans.
We implemented several increases in delivery fees in recent years that are applicable to single-family mortgages with certain higher-risk loan characteristics. Certain of these fee increases do not apply to relief refinance mortgages with LTV ratios greater than 80% and with settlement dates on or after July 1, 2011. We have established maximum limits on the amount of delivery fees that are imposed for relief refinance mortgages, regardless of the LTV ratio of the loan.
We also implemented two across-the-board increases in guarantee fees in 2012. Effective April 1, 2012, at the direction of FHFA, both we and Fannie Mae increased the guarantee fee on single-family residential mortgages sold to us by 10 basis points. Under the Temporary Payroll Tax Cut Continuation Act of 2011, the proceeds from this increase are being remitted to Treasury to fund the payroll tax cut. We pay these fees to Treasury on a quarterly basis and refer to this fee increase as the legislated 10 basis point increase in guarantee fees. In the fourth quarter of 2012, both we and Fannie Mae implemented, at FHFAs direction, a further increase in guarantee fees on single-family mortgages of an average of 10 basis points. In announcing this increase, FHFA stated that the changes to the guarantee fee pricing represent a step toward encouraging greater participation in the mortgage market by private firms.
In September 2012, FHFA also requested public comment on a proposed approach under which we and Fannie Mae would adjust our delivery fees charged on single-family mortgages in states where costs related to foreclosures are statistically higher than the national average. FHFA stated in its September 2012 announcement that it expects to direct us and Fannie Mae to implement the pricing adjustments in 2013.
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Securitization Activities
The types of mortgage-related securities we issue and guarantee include the following:
| PCs; |
| REMICs and Other Structured Securities; and |
| Other Guarantee Transactions. |
For information about the amount of mortgage-related securities we have issued, see Table 35 Freddie Mac Mortgage-Related Securities. For information about the relative performance of mortgages underlying these securities, see MD&A RISK MANAGEMENT Credit Risk.
PCs
Our PCs are single-class pass-through securities that represent undivided beneficial interests in trusts that hold pools of mortgages we have purchased. Holding investments in single-family loans in the form of PCs rather than as unsecuritized loans gives us greater flexibility in managing the composition of our mortgage-related investments portfolio, as it is generally easier to purchase and sell PCs than unsecuritized mortgage loans, and allows more cost effective interest-rate risk management. For our fixed-rate PCs, we guarantee the timely payment of principal and interest. For our single-family ARM PCs, we guarantee the timely payment of the weighted average coupon interest rate for the underlying mortgage loans. We also guarantee the full and final payment of principal for ARM PCs; however, we do not guarantee the timely payment of principal on ARM PCs. We issue most of our single-family PCs in transactions in which our customers provide us with mortgage loans in exchange for PCs. We refer to these transactions as guarantor swaps. The following diagram illustrates a guarantor swap transaction:
Guarantor Swap
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We also issue PCs in exchange for cash. The following diagram illustrates an exchange for cash in a cash auction of PCs:
Cash Auction of PCs
Institutional and other fixed-income investors, including pension funds, insurance companies, securities dealers, money managers, REITs, and commercial banks, purchase our PCs. For the past several years, the Federal Reserve has purchased significant amounts of mortgage-related securities issued by us, Fannie Mae and Ginnie Mae. These purchases, which are ongoing, have affected mortgage spreads (positively and, in some periods, negatively) and the demand for and values of our PCs.
PCs differ from most other fixed-income securities in several ways. For example, and most significantly, single-family PCs can be partially or fully prepaid at any time. Homeowners have the right to prepay their mortgage at any time (known as the prepayment option), and homeowner mortgage prepayments are passed through to the PC holder. Consequently, mortgage-related securities implicitly have a call option that significantly reduces the average life of the security from the contractual loan maturity. As a result, our PCs generally provide a higher nominal yield than certain other fixed-income products. In addition, in contrast to U.S. Treasury securities, PCs are not backed by the full faith and credit of the United States and are instead backed by interests in real estate, in addition to our own guarantee.
From time to time we undertake actions in an effort to support the liquidity and the relative price performance of our PCs to comparable Fannie Mae securities through a variety of activities, including the resecuritization of PCs into REMICs and Other Structured Securities. Other strategies may include: (a) encouraging sellers to pool mortgages that they deliver to us into PC pools with a larger and more diverse population of mortgages; (b) influencing the volume and characteristics of mortgages delivered to us by tailoring our loan eligibility guidelines and other means; and (c) engaging in portfolio purchase and retention activities. See Investments Segment PC Support Activities and RISK FACTORS Competitive and Market Risks A significant decline in the price performance of or demand for our PCs could have an adverse effect on the volume and/or profitability of our new single-family guarantee business for additional information about our effort to support the liquidity and relative price performance of our PCs.
REMICs and Other Structured Securities
We issue single-class and multiclass securities. Single-class securities (e.g., PCs) involve the straight pass-through of all of the cash flows of the underlying collateral to holders of the beneficial interests. Our primary multiclass securities qualify for tax treatment as REMICs. Multiclass securities divide all of the cash flows of the underlying mortgage-related assets into two or more classes designed to meet the investment criteria and portfolio needs of different investors by creating classes of securities with varying maturities, payment priorities and coupons, each of which represents a beneficial ownership interest in a separate portion of the cash flows of the underlying collateral. Usually, the cash flows are divided to modify the relative exposure of different classes to interest-rate risk, or to create various coupon structures. The simplest division of cash flows is into principal-only and interest-only classes. Other securities we issue can involve the creation of sequential payment and planned or targeted amortization classes. In a sequential payment class structure, one or more classes receive all or a disproportionate percentage of the principal payments on the underlying mortgage assets for a period of time until that class or classes are retired, following which the principal payments are directed to other classes. Planned or targeted amortization
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classes involve the creation of classes that have relatively more predictable amortization schedules across different prepayment scenarios, thus reducing prepayment risk, extension risk, or both.
Our REMICs and Other Structured Securities represent beneficial interests in pools of PCs and/or certain other types of mortgage-related assets. We create these securities primarily by using PCs or previously issued REMICs and Other Structured Securities as the underlying collateral. Similar to our PCs, we guarantee the payment of principal and interest to the holders of tranches of our REMICs and Other Structured Securities. We do not charge a management and guarantee fee for these securities if the underlying collateral is already guaranteed by us since no additional credit risk is introduced. Because the collateral underlying nearly all of our single-family REMICs and Other Structured Securities consists of other mortgage-related securities that we guarantee, there are no economic residual interests in the related securitization trust. We do not issue tranches of securities in these transactions that have concentrations of credit risk beyond those embedded in the underlying assets. The following diagram provides a general example of how we create REMICs and Other Structured Securities.
REMICs and Other Structured Securities
We issue many of our REMICs and Other Structured Securities in transactions in which securities dealers or investors sell us mortgage-related assets or we use our own mortgage-related assets (e.g., PCs and REMICs and Other Structured Securities) in exchange for the REMICs and Other Structured Securities. The creation of REMICs and Other Structured Securities allows for setting differing terms for specific classes of investors, and our issuance of these securities can expand the range of investors in our mortgage-related securities to include those seeking specific security attributes. For REMICs and Other Structured Securities that we issue to third parties, we typically receive a transaction, or resecuritization, fee. This transaction fee is compensation for facilitating the transaction, as well as future administrative responsibilities.
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Other Guarantee Transactions
We also issue mortgage-related securities to third parties in exchange for non-Freddie Mac mortgage-related securities. We refer to these as Other Guarantee Transactions. The non-Freddie Mac mortgage-related securities are transferred to trusts that were specifically created for the purpose of issuing securities, or certificates, in the Other Guarantee Transactions. The following diagram illustrates an example of an Other Guarantee Transaction:
Other Guarantee Transaction
Other Guarantee Transactions can generally be segregated into two different types. In one type, we purchase only senior tranches from a non-Freddie Mac senior-subordinated securitization, place the senior tranches into securitization trusts, and issue Other Guarantee Transaction certificates guaranteeing the principal and interest payments on those certificates. In this type of transaction, our credit risk is reduced by the structural credit protections from the related subordinated tranches, which we do not guarantee. In the second type, we purchase single-class pass-through securities, place them in securitization trusts, and issue Other Guarantee Transaction certificates guaranteeing the principal and interest payments on those certificates. Our Other Guarantee Transactions backed by single-class pass-through securities do not benefit from structural or other credit enhancement protections.
Although Other Guarantee Transactions generally have underlying mortgage loans with varying risk characteristics, we do not issue tranches that have concentrations of credit risk beyond those embedded in the underlying assets, as all cash flows of the underlying collateral are passed through to the holders of the securities and there are no economic residual interests in the securitization trusts. Additionally, there may be other credit enhancements and structural features retained by the seller, such as excess interest or overcollateralization, that provide credit protection to our interests, and reduce the likelihood that we will have to perform under our guarantee of the senior tranches. In exchange for providing our guarantee, we may receive a management and guarantee fee or other delivery fees, if the underlying collateral is not already guaranteed by us.
In 2010 and 2009, we entered into transactions under Treasurys NIBP with HFAs, for the partial guarantee of certain single-family and multifamily HFA bonds, which were Other Guarantee Transactions with significant credit enhancement provided by Treasury. While we have not engaged in any of these transactions since 2010, we continue to participate in and support this program and these guarantees remain outstanding. The securities issued by us pursuant to the NIBP were purchased by Treasury. See NOTE 2: CONSERVATORSHIP AND RELATED MATTERS Housing Finance Agency Initiative for further information.
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Single-Family PC Trust Documents
We establish trusts for all of our issued PCs pursuant to our PC master trust agreement. In accordance with the terms of our PC trust documents, we have the option, and in some instances the requirement, to remove specified mortgage loans from the applicable trust. To remove these loans, we pay the trust an amount equal to the current UPB of the mortgage, less any outstanding advances of principal that have been distributed to PC holders. Our payments to the trust are distributed to the PC holders at the next scheduled payment date.
We have the option to remove a mortgage loan from a PC trust under certain circumstances to resolve an existing or impending delinquency or default. Since 2010, our practice generally has been to remove substantially all single-family mortgage loans that are 120 days or more delinquent from our issued PCs. From time to time, we reevaluate our practice of removing delinquent loans from PCs and alter it if circumstances warrant.
We are required to remove a mortgage loan (or, in some cases, substitute a comparable mortgage loan) from a PC trust in the following situations:
| if a court of competent jurisdiction or a federal government agency, duly authorized to oversee or regulate our mortgage purchase business, determines that our purchase of the mortgage was unauthorized and a cure is not practicable without unreasonable effort or expense, or if such a court or government agency requires us to repurchase the mortgage; |
| if a borrower exercises its option to convert the interest rate from an adjustable-rate to a fixed-rate on a convertible ARM; and |
| in the case of balloon-reset loans, shortly before the mortgage reaches its scheduled balloon-reset date. |
The To Be Announced Market
Because our fixed-rate single-family PCs are considered to be homogeneous, and are issued in high volume and are highly liquid, they generally trade on a generic basis by PC coupon rate, also referred to as trading in the TBA market. A TBA trade in Freddie Mac securities represents a contract for the purchase or sale of PCs to be delivered at a future date; however, the specific PCs that will be delivered to fulfill the trade obligation, and thus the specific characteristics of the mortgages underlying those PCs, are not known (i.e., announced) at the time of the trade, but only shortly before the trade is settled. The use of the TBA market increases the liquidity of mortgage investments and improves the distribution of investment capital available for residential mortgage financing, thereby helping us to accomplish our statutory mission. The Securities Industry and Financial Markets Association publishes guidelines pertaining to the types of mortgages that are eligible for TBA trades. Certain of our PC securities are not eligible for TBA trades, such as those backed by relief refinance mortgages with LTV ratios greater than 105%.
Other Guarantee Commitments
In certain circumstances, we provide our guarantee of mortgage-related assets held by third parties, in exchange for a management and guarantee fee, without our securitization of the related assets. For example, we provide long-term standby commitments to certain of our single-family customers, which obligate us to purchase seriously delinquent loans that are covered by those agreements. In addition, during 2010 and 2009, we issued guarantees under the TCLFP on securities backed by HFA bonds as part of the HFA Initiative. See NOTE 2: CONSERVATORSHIP AND RELATED MATTERS Housing Finance Agency Initiative for further information.
Underwriting Requirements and Quality Control Standards
We use a process of delegated underwriting for the single-family mortgages we purchase or securitize. In this process, our contracts with seller/servicers describe mortgage underwriting standards and the seller/servicers represent and warrant to us that the mortgages sold to us meet these standards. In our contracts with individual seller/servicers, we may waive or modify selected underwriting standards. Through our delegated underwriting process, mortgage loans and the borrowers ability to repay the loans are evaluated using a number of critical risk characteristics, including, but not limited to, the borrowers credit score and credit history, the borrowers monthly income relative to debt payments (or DTI), the original LTV ratio, the type of mortgage product, the property type and market value, and the occupancy type of the loan. Our single-family loans are generally underwritten with a requirement for a maximum original LTV ratio of 95% (excluding jumbo conforming, cash-out refinance, and HARP mortgages). We prescribe maximum LTV ratio limits of 80% for cash-out refinance loans and 90% for jumbo conforming mortgages.
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Due to adverse market and economic conditions, and based in part on our reviews of the underwriting quality for loans originated in 2005 through 2007, we implemented several credit limits since 2008. These credit limits are defined by specified criteria such as the LTV ratio, credit score and DTI ratio. For documentation to substantiate assets and income, we require the borrower to provide at least one paystub, one IRS Form W-2, and one current bank statement. FICO scores are the most commonly used credit scores today. FICO scores are ranked on a scale of approximately 300 to 850 points. Statistically, borrowers with higher credit scores are more likely to repay or have the ability to refinance than those with lower scores. We obtain credit scores of borrowers at the time of origination and do not typically receive updated data on borrower credit scores after origination.
The majority of our single-family mortgage purchase volume is evaluated using automated underwriting software, either our proprietary software (Loan Prospector), the seller/servicers own software, or Fannie Maes proprietary software. The percentage of our single-family mortgage purchase flow activity volume evaluated by the loan originator using Loan Prospector prior to being purchased by us was 45%, 41%, and 39% during 2012, 2011, and 2010, respectively. Beginning in 2009, we added a number of additional credit standards for loans evaluated by other underwriting software to improve the quality of loans we purchase that are evaluated using such other software. Consequently, we do not currently believe that the use of an automated underwriting software other than Loan Prospector significantly increases our loan performance risk.
As part of our quality control process, we review the underwriting documentation for certain loans we have purchased for compliance with our standards. In recent years, we have worked actively with our seller/servicers to improve loan underwriting quality. As a result, we observed improved quality control results for loans funded during 2011 as compared to 2010. As of December 31, 2012, the average aggregate underwriting deficiency rate across all seller/servicers for loans funded during 2011 and 2010 was approximately 5% and 13%, respectively. These rates may change in the future as our seller/servicers may appeal our findings. We have not yet sufficiently compiled our 2012 results for loan reviews due to the normal processing time to complete such reviews. The most common underwriting deficiencies found in the review of loans purchased during 2011 related to insufficient income and inadequate or missing documentation to support borrower qualification. The next most common deficiency was inaccurate data entered into Loan Prospector. We give our seller/servicers an opportunity to appeal ineligible loan determinations in response to our request for the repurchase of the loan. Beginning in the latter half of 2011, we required certain of our larger seller/servicers to maintain ineligible loan rates below a stated threshold (generally 5%), with financial consequences for non-compliance, as part of the renewals of our contracts with them. We expect these changes in seller/servicer contracts to positively impact ineligible loan rates. In addition, for all of our largest seller/servicers, we actively manage the current quality of loan originations by providing monthly written and oral communications regarding loan defect rates and the drivers of those defects as identified in our performing loan quality control sampling reviews. If necessary, we work with seller/servicers to develop an appropriate plan of corrective action.
Through 2012, for loans with identified underwriting deficiencies, we required either immediate repurchase or allowed performing loans to remain in our portfolio subject to our continued right to issue a repurchase request to the seller/servicers at a later date. Beginning January 1, 2013, our practice for lender repurchases is based upon the new framework discussed below. Our right to request repurchase by seller/servicers is intended to protect us against deficiencies in underwriting by our seller/servicers. For more information on our seller/servicers repurchase obligations, including recent performance under those obligations, see MD&A RISK MANAGEMENT Credit Risk Institutional Credit Risk Single-family Mortgage Seller/Servicers.
New Representation and Warranty Framework
At the direction of FHFA, we and Fannie Mae launched a new representation and warranty framework for conventional loans purchased by the GSEs on or after January 1, 2013. The objective of the new framework is to clarify lenders repurchase exposures and liability on future sales of mortgage loans to Freddie Mac and Fannie Mae and, under this new framework, lenders will be relieved of certain repurchase obligations for loans that meet specific payment requirements. Examples, subject to certain exclusions, include:
| loans with 36 months of consecutive, on-time payments after we purchase them; and |
| relief refinance mortgages with 12 months of consecutive, on-time payments after we purchase them. |
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Under the new framework, Freddie Mac and Fannie Mae, under the supervision of FHFA, have established consistent standards for:
| conducting quality control reviews earlier in the loan process, generally between 30 to 120 days after loan purchase; |
| requiring lenders to submit requested loan files for review within specified timelines; |
| evaluating loan files on a more comprehensive basis to ensure a focus on identifying significant deficiencies; and |
| making available more transparent appeals processes for lenders to appeal repurchase requests. |
Additionally, we will use our tools and available data to enable earlier identification of potentially defective loans prior to their purchase and delivery. The changes to the representation and warranty process are key elements of the seller/servicer contract harmonization project that supports FHFAs strategic plan for the Freddie Mac and Fannie Mae conservatorships announced in 2012.
The new framework does not affect seller/servicers obligations under their contracts with us with respect to loans sold to us prior to January 1, 2013. The new framework also does not affect their obligation to service these loans in accordance with our servicing standards. Freddie Mac will continue to work with lenders to resolve contractual claims on loans delivered prior to January 1, 2013.
Credit Enhancements
Our charter requires that single-family mortgages with LTV ratios above 80% at the time of purchase be covered by specified credit enhancements or participation interests. However, we may purchase single-family mortgages under HARP that refinance mortgages we currently own or guarantee without obtaining additional credit enhancement in excess of that already in place, even if the LTV ratio of the new loan is above 80%. Primary mortgage insurance is the most prevalent type of credit enhancement protecting our single-family credit guarantee portfolio, and is typically provided on a loan-level basis. Generally, in order to file a claim under a primary mortgage insurance policy, the insured loan must be in default and the borrowers interest in the underlying property must have been extinguished, such as through a short sale or foreclosure action. The mortgage insurer has a prescribed period of time within which to process a claim and make a determination as to its validity and amount.
For some mortgage loans, we elect to share the default risk by transferring a portion of that risk to various third parties through a variety of other credit enhancements. Other types of credit enhancements that we use are lender recourse (under which we may require a lender to repurchase a loan upon default), indemnification agreements (under which we may require a lender to reimburse us for credit losses realized on mortgages), collateral pledged by lenders, and subordinated security structures. Lender recourse and indemnification agreements are typically entered into contemporaneously with the purchase of a mortgage loan as an alternative to requiring primary mortgage insurance on the loan or in exchange for a lower guarantee fee on the loan.
We also use pool insurance, although we have not purchased pool insurance on single-family loans since March 2008. Pool insurance provides insurance on a pool of loans up to a stated aggregate loss limit. In addition to a pool-level loss coverage limit, some pool insurance contracts may have limits on coverage at the loan level. During 2012, we reached the maximum limit of loss on certain pool insurance contracts before their maturity dates. In order to file a claim under a pool insurance policy, we generally must have finalized the primary mortgage claim, disposed of the foreclosed property, and quantified our net loss with respect to the insured loan to determine the amount due under the pool insurance policy. Certain pool insurance policies have specified loss deductibles that must be met before we are entitled to recover under the policy.
Our use of credit enhancements to reduce our exposure to mortgage credit risk increases our exposure to institutional credit risk. See MD&A RISK MANAGEMENT Credit Risk Institutional Credit Risk for information about our counterparties that provide credit enhancement on loans in our single-family credit guarantee portfolio, including information about pool insurance coverage and our mortgage loan insurers.
Loss Mitigation and Loan Workout Activities
Loan workout activities are a key component of our loss mitigation strategy for managing and resolving troubled assets and lowering credit losses. Our single-family loss mitigation strategy emphasizes early intervention by servicers in delinquent mortgages and provides alternatives to foreclosure. Our single-family loss mitigation activities include providing our single-family servicers with default management tools designed to help them manage non-performing loans more
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effectively and to assist borrowers in maintaining home ownership where possible, or facilitate foreclosure alternatives when continued homeownership is not an option. We require our single-family seller/servicers to first evaluate problem loans for a repayment or forbearance plan before considering modification. If a borrower is not eligible for a modification, our seller/servicers pursue other workout options before considering foreclosure.
Our loan workouts include:
| Forbearance agreements, where reduced payments or no payments are required during a defined period, generally less than one year. They provide additional time for the borrower to return to compliance with the original terms of the mortgage or to implement another loan workout. During 2012, the average time period granted for completed short-term forbearance agreements was between two and three months. |
| Repayment plans, which are contractual plans to make up past due amounts. These plans assist borrowers in returning to compliance with the original terms of their mortgages. During 2012, the average time period granted for completed repayment plans was between two and six months. |
| Loan modifications, which may involve changing the terms of the loan, or adding outstanding indebtedness, such as delinquent interest, to the UPB of the loan, or a combination of both. We require our servicers to examine the borrowers capacity to make payments under the new terms by reviewing the borrowers qualifications, including income. During 2012, we granted principal forbearance but did not utilize principal forgiveness for our loan modifications. Principal forbearance is a change to a loans terms to designate a portion of the principal as non-interest-bearing and non-amortizing. A borrower may only receive one HAMP modification; however, a loan may be modified twice under our standard loan modification program. Generally, a borrower may only receive one standard modification during a 12 month period. However, we reserve the right to approve additional non-HAMP loan modifications to the same borrower, based on the borrowers individual facts and circumstances. |
| Short sale and deed in lieu of foreclosure transactions. |
We also participate in the MHA Program, which is designed to help in the housing recovery, promote liquidity and housing affordability, expand foreclosure prevention efforts, and set market standards. Participation in the MHA Program is an integral part of our mission of providing stability to the housing market. Through our participation in this program, we help borrowers maintain home ownership. Some of the key initiatives of this program include HAMP and HARP, which are discussed below.
Home Affordable Modification Program
HAMP commits U.S. government, Freddie Mac, and Fannie Mae funds to help eligible homeowners avoid foreclosures and keep their homes through mortgage modifications, where possible. HAMP applies to loans originated on or before January 1, 2009. The program is scheduled to end on December 31, 2013.
Under this program, we offer loan modifications to financially struggling homeowners with mortgages on their primary residences that reduce the monthly principal and interest payments on their mortgages. HAMP requires that each borrower complete a trial period during which the borrower will make monthly payments based on the estimated amount of the modification payments. Trial periods are required to be at least three months. After the final trial-period payment is received by our servicer the borrower and servicer will enter into the modification.
To address documentation issues experienced when the program began, guidelines for HAMP provide that, for trial periods that became effective on or after June 1, 2010, borrowers must provide income documentation before entering into the trial period. Prior to the June 1, 2010 changes to HAMP, we experienced approximately a 38% modification completion rate under the program. Subsequent to the June 1, 2010 changes, we have experienced a modification completion rate in excess of 75%. When a borrowers trial period is cancelled, the loan is considered for our other workout activities.
HAMP includes the following features:
| Under HAMP, the goal is to reduce the borrowers monthly mortgage payments to 31% of gross monthly income, which may be achieved through a combination of methods, including interest rate reductions, term extensions, and principal forbearance. Although HAMP contemplates that some servicers will also make use of principal reduction to achieve reduced payments for borrowers, we have only used forbearance and have not used principal reduction in modifying our loans. Borrowers whose loans are modified through HAMP accrue monthly incentive payments (in the |
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form of credits) that are applied annually to reduce up to $1,000 of their principal per year, for five years, as long as they are making timely payments under the modified loan terms. |
| Servicers are paid incentive fees for each completed HAMP modification. Servicers receive additional incentive fees for any modification that reduces a borrowers monthly payment by 6% or more, in each of the first three years after the modification, as long as the modified loan remains current. |
Except in limited instances, each borrowers reduced payment will remain in effect for a minimum of five years, and borrowers whose interest rates were adjusted below market levels will have their interest rate and payment gradually increased after the fifth year to a rate consistent with the market rate at the time of modification. Although mortgage investors under the MHA Program are entitled to certain subsidies from Treasury for reducing the borrowers monthly payments from 38% to 31% of the borrowers income, we do not receive such subsidies on modified mortgages owned or guaranteed by us. We also bear the costs of borrower incentive payments and servicer incentive fees for our HAMP loans, without reimbursement of such costs from Treasury.
Trial periods are required to be at least three months in duration. Our servicers are permitted to add an interim month, which will be reported as a fourth trial period month. In addition, our servicers are authorized to extend a trial period for up to an additional two months when the borrower is in bankruptcy in order to provide additional time to have the mortgage removed from the bankruptcy plan, which is a prerequisite to a modification under HAMP.
We are the compliance agent for Treasury for certain foreclosure avoidance activities under HAMP by mortgage holders other than Freddie Mac and Fannie Mae. Among other duties, as the program compliance agent, we conduct examinations and review servicer compliance with the published requirements for the program. Some of these examinations are on-site, and others involve off-site documentation reviews. We report the results of our examination findings to Treasury. Based on the examinations, we may also provide Treasury with advice, guidance and lessons learned to improve operation of the program.
Relief Refinance Mortgage Initiative and the Home Affordable Refinance Program
Our relief refinance opportunities, including HARP (which is the portion of our relief refinance initiative for loans with LTV ratios above 80%), are a significant part of our effort to keep families in their homes. Only borrowers with Freddie Mac-owned or guaranteed mortgages are eligible for our relief refinance mortgage initiative. Our relief refinance initiative began in 2009 and is designed to provide eligible homeowners with existing loans owned or guaranteed by us an opportunity to refinance their mortgage without obtaining new mortgage insurance in excess of what was already in place. Our relief refinance initiative enables us to assist homeowners by making their mortgage payments more affordable through one or more of the following ways: (a) a reduction in payment; (b) a reduction in interest rate; (c) movement to a more stable mortgage product type (i.e., from an adjustable-rate mortgage to a fixed-rate mortgage); or (d) a reduction in amortization term.
HARP and the relief refinance mortgage initiative originally permitted eligible borrowers with Freddie Mac mortgages (that were sold to us on or before May 31, 2009) and LTVs up to 125% to refinance their mortgages. In October 2011, FHFA, Freddie Mac, and Fannie Mae announced a series of FHFA-directed changes to HARP, in an effort to attract more eligible borrowers who can benefit from refinancing their home mortgages. We subsequently made similar changes to the relief refinance mortgage initiative for loans with LTV ratios of 80% and less. The enhancements to HARP and the relief refinance mortgage initiative included:
| removing the 125% LTV ratio ceiling for fixed-rate mortgages; |
| relieving the lenders of certain underwriting and borrower eligibility representations and warranties on the original mortgage being refinanced; |
| eliminating the need for a new property appraisal where there is a reliable automated valuation model estimate provided by the purchasing GSE; and |
| extending the last application date for HARP loans to December 31, 2013. |
We began purchasing HARP loans under the revised program in January 2012. In September 2012, we announced additional changes to our relief refinance process that are intended to reduce the seller/servicers operational complexities associated with originating these loans.
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Underwriting procedures for relief refinance mortgages are limited in many cases, and such procedures generally do not include all of the changes in underwriting standards we have implemented since 2008. As a result, relief refinance mortgages generally reflect many of the credit risk attributes of the original loans. However, borrower participation in our relief refinance mortgage initiative may help reduce our exposure to credit risk in cases where the borrowers payments under their mortgages are reduced, thereby strengthening the borrowers potential to make their mortgage payments. See MD&A RISK MANAGEMENT Credit Risk Mortgage Credit Risk Single-family Mortgage Credit Risk Single-Family Loan Workouts and the MHA Program for additional information about HARP and our relief refinance mortgage initiative.
Non-HAMP Standard Modifications
In late 2011, as part of the servicing alignment initiative (described below), we implemented a new non-HAMP standard loan modification initiative, replacing our previous non-HAMP modification initiative. The standard modification requires a three-month trial period (our previous non-HAMP modification program did not require a trial period). The standard modification provides an extension of the loans term to 480 months. In addition, the standard modification initiative currently provides for a standard modified interest rate of 4% (though the rate could change in the future). This initiative also provides for a servicer incentive fee schedule for non-HAMP modifications, comparable to the current HAMP servicer incentive fee structure. The incentive fees are intended to provide greater incentives to our servicers to modify loans earlier in the delinquency. Unlike with HAMP modifications, our non-HAMP standard modification does not provide for borrower incentive payments or recurring servicer incentive fees after the initial servicer incentive payment.
Servicing Alignment Initiative
During 2012, we continued to implement the FHFA-directed servicing alignment initiative, under which we and Fannie Mae are aligning certain standards for servicing non-performing loans owned or guaranteed by the companies. We believe that the servicing alignment initiative will continue to: (a) change, among other things, the way servicers communicate and work with troubled borrowers; (b) bring greater consistency and accountability to the servicing industry; and (c) help more distressed homeowners avoid foreclosure. We have provided standards to our servicers under this initiative that require them to initiate earlier and more frequent communication with delinquent borrowers, employ consistent requirements for collecting documents from borrowers, and follow consistent timelines for responding to borrowers and for processing foreclosures. These standards have resulted in greater alignment of servicer processes for both HAMP and most non-HAMP workouts.
Under these new servicing standards, we pay incentives to servicers that exceed certain performance standards with respect to servicing delinquent loans. We also assess compensatory fees if servicers do not achieve a minimum performance benchmark with respect to servicing delinquent loans. Incentive fees paid to servicers and compensatory fees received from servicers are recorded in other expenses and other income, respectively, within our consolidated statements of comprehensive income. These incentives may result in our payment of increased fees to our seller/servicers, the cost of which may be partially mitigated by the compensatory fees paid to us by our servicers that do not perform as required.
In August 2012, as part of the servicing alignment initiative we announced a new standard short sale process, aligned with Fannie Mae, which is designed to help more struggling borrowers use short sales to avoid foreclosure. This new process became effective November 1, 2012, and changes many of the operational procedures required to complete a transaction, including: (a) expanding the eligibility for borrowers to qualify for these transactions; (b) delegating the authority to complete these transactions to our seller/servicers in most cases; and (c) providing for a standardized and simplified method for seller/servicers to value the property and evaluate the transaction on a more timely basis.
In addition, in November 2012 we announced a new process, aligned with Fannie Mae, for deed in lieu of foreclosure transactions. This new process will become effective on March 1, 2013.
For more information regarding credit risk, see MD&A RISK MANAGEMENT Credit Risk, NOTE 4: MORTGAGE LOANS AND LOAN LOSS RESERVES, and NOTE 5: INDIVIDUALLY IMPAIRED AND NON-PERFORMING LOANS.
Investments Segment
The Investments segment reflects results from our investment, funding and hedging activities. In our Investments segment, we invest principally in mortgage-related securities and single-family performing mortgage loans, which are funded by other debt issuances and hedged using derivatives. In our Investments segment, we also provide funding and hedging
26 | Freddie Mac |
management services to the Single-family Guarantee and Multifamily segments. In the Investments segment, we are not currently a substantial buyer or seller of mortgage assets.
Our Customers
Our customers for our debt securities predominantly include insurance companies, money managers, central banks, depository institutions, and pension funds. Within the Investments segment, we buy securities and single-family mortgage loans through various market sources. We purchase a significant portion of these loans from a variety of lenders, as discussed in Single-Family Guarantee Segment Our Customers.
Our Competition
Historically, our principal competitors have been Fannie Mae and other financial institutions that invest in mortgage-related securities and mortgage loans, such as commercial and investment banks, dealers, thrift institutions, REITs, and insurance companies. The conservatorship, including direction provided to us by our Conservator and the restrictions on our activities under the Purchase Agreement, has affected and will continue to affect our ability to compete in the business of investing in mortgage-related securities and mortgage loans.
We compete for debt funding with Fannie Mae, the FHLBs and other institutions. Competition for debt funding from these entities can vary with changes in economic, financial market and regulatory environments.
Assets
Historically, we have primarily been a buy-and-hold investor in mortgage-related securities and single-family performing mortgage loans. We purchase these assets to improve profitability, support our customers, and support the liquidity and price performance of our PCs. We may sell assets to reduce risk, provide liquidity, and improve our returns. However, due to limitations under the Purchase Agreement and those imposed by FHFA, our ability to acquire and sell mortgage assets is significantly constrained. For more information, see Conservatorship and Related Matters Limits on Investment Activity and Our Mortgage-Related Investments Portfolio and MD&A CONSOLIDATED RESULTS OF OPERATIONS Segment Earnings Segment Earnings-Results Investments.
We may enter into a variety of transactions to improve investment returns, including: (a) dollar roll transactions; (b) purchases of agency securities (including agency REMICs); and (c) purchases of performing single-family mortgage loans. In addition, we may create REMICs from existing agency securities and sell tranches that are in demand by investors to reduce our asset balance, while conserving value for the taxpayer. We estimate our expected investment returns using an OAS approach, which is an estimate of the yield spread between a given financial instrument and a benchmark (LIBOR, agency or Treasury) yield curve. In this approach, we consider potential variability in the instruments cash flows resulting from any options embedded in the instrument, such as the prepayment option. Additionally, in this segment we hold reperforming and modified single-family mortgage loans related to our single-family business. For our liquidity needs, we maintain a portfolio comprised primarily of cash and cash equivalents, non-mortgage-related securities (primarily Treasury securities), and securities purchased under agreements to resell.
Debt Financing
We fund our investment activities by issuing short-term and long-term debt. The conservatorship, and the resulting support we receive from Treasury, has enabled us to access debt funding on terms sufficient for our needs. While we believe that the support provided by Treasury pursuant to the Purchase Agreement currently enables us to maintain our access to the debt markets and to have adequate liquidity to conduct our normal business activities, the costs of our debt funding could vary for a number of reasons, including the uncertainty about the future of the GSEs. Additionally, the Purchase Agreement limits the amount of indebtedness we can incur.
For more information, see Conservatorship and Related Matters and MD&A LIQUIDITY AND CAPITAL RESOURCES Liquidity.
Risk Management
Our Investments segment has responsibility for managing our interest rate risk and certain liquidity risks. Derivatives are an important part of our risk management strategy. We use derivatives primarily to: (a) hedge forecasted issuances of debt; (b) synthetically create callable and non-callable funding; (c) adjust or rebalance our funding mix in response to
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changes in the interest-rate characteristics of our mortgage-related assets; and (d) hedge foreign-currency exposure. For more information regarding our use of derivatives, see QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK and NOTE 10: DERIVATIVES. For information regarding our liquidity management, see MD&A LIQUIDITY AND CAPITAL RESOURCES.
PC Support Activities
Our PCs are an integral part of our mortgage purchase program. Our Single-family Guarantee segment purchases many of our mortgages by issuing PCs in exchange for those mortgage loans in guarantor swap transactions. We also issue PCs backed by mortgage loans that we purchased for cash. The relative price performance of our PCs and comparable Fannie Mae securities can directly affect the volume and/or profitability of our new single-family guarantee business.
From time to time, we undertake actions in an effort to support the liquidity and the relative price performance of our PCs to comparable Fannie Mae securities through a variety of activities. These activities can include the purchase and sale of Freddie Mac mortgage-related securities, purchases of loans, and dollar roll transactions, as well as the issuance of REMICs and Other Structured Securities. Our purchases and sales of mortgage-related securities and our issuances of REMICs and Other Structured Securities influence the relative supply and demand (i.e., liquidity) for these securities, helping to support the price performance of our PCs. Depending upon market conditions, including the relative prices, supply and demand for our PCs and comparable Fannie Mae securities, as well as other factors, there may be substantial variability in any period in the total amount of securities we purchase or sell, and in the success of our efforts to support the liquidity and price performance of our PCs. In the first half of 2012, we curtailed mortgage-related investments portfolio purchase and retention activities that were undertaken primarily in an effort to support the liquidity and price performance of our PCs. However, due to a decline in our single-family competitive position compared to other market participants (primarily Fannie Mae and Ginnie Mae) in the first half of 2012, we resumed certain of the activities noted above during the second half of 2012 in an effort to support the price performance of our PCs while minimizing market disruption. For more information about our efforts to support the liquidity and relative price performance for PCs, see Single-Family Credit Guarantee Segment Securitization Activities.
We incur costs in connection with our efforts to support the liquidity and price performance of our PCs, including engaging in transactions that yield less than our target rate of return. We may increase, reduce or discontinue these or other related activities at any time, which could affect the liquidity and price performance of our PCs. For more information, see RISK FACTORS Competitive and Market Risks A significant decline in the price performance of or demand for our PCs could have an adverse effect on the volume and/or profitability of our new single-family guarantee business.
Multifamily Segment
The Multifamily segment reflects results from our investment (both purchases and sales), securitization, and guarantee activities in multifamily mortgage loans and securities. Although historically we were primarily a buy and hold investor in multifamily mortgage assets (both loans held for investment and investment securities, primarily CMBS), since 2009 our primary business model is to purchase held-for-sale multifamily loans for aggregation and then securitization through multifamily K Certificates, which are considered Other Guarantee Transactions. In substantially all of these transactions we guarantee only the most senior tranches of the securities. As a result, a significant portion of our expected credit risk associated with these loans is sold in subordinated tranches to third party investors. With this model, we utilize securitization to substantially reduce our credit risk while providing liquidity to the multifamily market. See Single-Family Guarantee Segment Securitization Activities Other Guarantee Transactions for a diagram that illustrates these transactions.
To a lesser extent, we provide guarantees of the payment of principal and interest on tax-exempt multifamily pass-through certificates backed by multifamily housing revenue bonds. These housing revenue bonds are collateralized by mortgage loans on low- and moderate-income multifamily housing developments. In addition, we guarantee the payment of principal and interest on tax-exempt multifamily housing revenue bonds secured by low- and moderate-income multifamily mortgage loans.
The multifamily property market is affected by local and regional economic factors, such as employment rates, construction cycles, and relative affordability of single-family home prices, all of which influence the supply and demand for multifamily properties and pricing for apartment rentals. Our multifamily loan volume is largely sourced through established institutional channels where we are generally providing post-construction financing to larger apartment project operators with established performance records.
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Our lending decisions are largely based on the assessment of the propertys ability to provide rents that will generate sufficient operating cash flows to support payment of debt service obligations (both principal and interest) as measured by the expected DSCR and the loan amount relative to the value of the property as measured by the LTV ratio. Multifamily mortgages generally are without recourse to the borrower (i.e., the borrower is not personally liable for any deficiency remaining after foreclosure and sale of the property), except in the event of fraud or certain other specified types of default. Therefore, repayment of the mortgage depends on the ability of the underlying property to generate cash flows sufficient to cover the related debt obligations. That, in turn, depends on conditions in the local rental market, local and regional economic conditions, the physical condition of the property, the quality of property management, and the level of operating expenses.
Our Customers
We acquire a significant portion of our multifamily mortgage loans from several large seller/servicers. For 2012, our top two multifamily sellers, CBRE Capital Markets, Inc. and Berkadia Commercial Mortgage, LLC, each accounted for more than 10% of our multifamily purchase volume, and together accounted for approximately 34% of our multifamily purchase volume. Our top 10 multifamily lenders represented an aggregate of approximately 80% of our multifamily purchase volume for 2012.
A significant portion of our multifamily mortgage loans are serviced by several of our large customers. See MD&A RISK MANAGEMENT Credit Risk Institutional Credit Risk Seller/Servicers for additional information.
Our Competition
We compete on the basis of: (a) price; (b) products, including our use of certain securitization structuring; and (c) service. Historically, our principal competitors have been Fannie Mae, FHA, and other financial institutions that retain or securitize multifamily mortgages, such as commercial and investment banks, dealers, thrift institutions, and insurance companies. During the period of significant market volatility (primarily during 2008 and 2009), many of our competitors, other than Fannie Mae and FHA, significantly curtailed their activities in the multifamily mortgage business relative to their previous levels. Beginning in 2010, as multifamily fundamentals were improving, more market participants began to re-emerge in the multifamily market, and we have faced increased competition.
Underwriting Requirements and Quality Control Standards
Our process and standards for underwriting multifamily mortgages differ from those used for single-family mortgages. Unlike single-family mortgages, we currently do not use a delegated underwriting process for the newly-originated multifamily mortgages we purchase or securitize. Instead, we typically underwrite and evaluate each mortgage prior to purchase or providing our guarantee. This process includes review of third-party appraisals and cash flow analysis. Our underwriting standards focus on loan quality measurement based, in part, on the LTV ratio and DSCR. The DSCR estimates a multifamily borrowers ability to service its mortgage obligation using the secured propertys cash flow, after deducting non-mortgage expenses from income. The higher the DSCR, the more likely a multifamily borrower will be able to continue servicing its mortgage obligation. Our standards for multifamily loans specify maximum original LTV ratio and minimum DSCR that vary based on the loan characteristics, such as loan type (new acquisition or supplemental financing), loan term (intermediate or longer-term), and loan features (interest-only or amortizing, fixed- or variable-rate). Our multifamily loans are generally underwritten with requirements for a maximum original LTV ratio of 80% and a DSCR of greater than 1.25 (which for interest-only and partial interest-only loans is based on an assumed monthly payment that reflects amortization of principal). In certain circumstances, our standards for multifamily loans allow for certain types of loans to have an original LTV ratio over 80% and/or a DSCR of less than 1.25, typically where this will serve our mission and contribute to achieving our affordable housing goals. In cases where we commit to purchase or guarantee a permanent loan upon completion of construction or rehabilitation, we generally require additional credit enhancements, because underwriting for these loans typically requires estimates of future cash flows for calculating the DSCR that is expected after construction or rehabilitation is completed.
Multifamily seller/servicers make representations and warranties to us about the mortgage and about certain information submitted to us in the underwriting process. We have the right to require that a seller/servicer repurchase a multifamily mortgage for which there has been a breach of representation or warranty. However, because of our evaluation of underwriting information for most multifamily properties prior to purchase, repurchases have been rare.
We generally require multifamily seller/servicers to service mortgage loans they have sold to us in order to mitigate potential losses. This includes property monitoring tasks beyond those typically performed by single-family servicers. We
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are not the master servicer for multifamily loans we have securitized (i.e., K Certificates) since we transfer the master servicing responsibilities to the trustees on behalf of the bondholders in accordance with the securitization and trust documents. For loans over $1 million where we own the servicing rights, servicers must generally submit an annual assessment of the mortgaged property to us based on the servicers analysis of the property as well as the borrowers quarterly financial statements. In situations where a borrower or property is in distress, the frequency of communications with the borrower may be increased. Because the activities of multifamily seller/servicers are an important part of our loss mitigation process, we rate their performance regularly and may conduct on-site reviews of their servicing operations in an effort to confirm compliance with our standards.
For loans for which we are the master servicer, if a borrower is in distress, we may offer a workout option to the borrower. For example, we may modify the terms of a multifamily mortgage loan, which gives the borrower an opportunity to bring the loan current and retain ownership of the property. These arrangements are made with the expectation that we will recover our initial investment or minimize our losses. We do not enter into these arrangements in situations where we believe we would experience a loss in the future that is greater than or equal to the loss we would experience if we foreclosed on the property at the time of the agreement.
Conservatorship and Related Matters
Overview and Entry into Conservatorship
We have been operating under conservatorship, with FHFA acting as our conservator, since September 6, 2008. The conservatorship and related matters have had a wide-ranging impact on us, including our regulatory supervision, management, business, financial condition and results of operations.
On September 7, 2008, the then Secretary of the Treasury and the then Director of FHFA announced several actions taken by Treasury and FHFA regarding Freddie Mac and Fannie Mae. These actions included the execution of the Purchase Agreement, pursuant to which we issued to Treasury both senior preferred stock and a warrant to purchase common stock. At that time, FHFA set forth the purpose and goals of the conservatorship as follows: The purpose of appointing the Conservator is to preserve and conserve the companys assets and property and to put the company in a sound and solvent condition. The goals of the conservatorship are to help restore confidence in Fannie Mae and Freddie Mac, enhance their capacity to fulfill their mission, and mitigate the systemic risk that has contributed directly to the instability in the current market. We refer to the Purchase Agreement and the warrant as the Treasury Agreements.
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. We are not aware of any current plans of our Conservator to significantly change our business model or capital structure in the near-term. Our future structure and role will be determined by the Administration and Congress, and there are likely to be significant changes beyond the near-term. We have no ability to predict the outcome of these deliberations.
On February 21, 2012, FHFA sent to Congress a strategic plan for the next phase of the conservatorships of Freddie Mac and Fannie Mae. The plan outlines how FHFA, as Conservator, intends to guide us and Fannie Mae over the next few years, and identifies the strategic goals of (a) building a new infrastructure for the secondary mortgage market; (b) gradually contracting Freddie Mac and Fannie Maes dominant presence in the marketplace while simplifying and shrinking their operations; and (c) maintaining foreclosure prevention activities and credit availability for new and refinanced mortgages. In March 2012, FHFA instituted the Conservatorship Scorecard that established objectives, performance targets and measures, and provided the implementation roadmap for FHFAs strategic plan.
We receive substantial support from Treasury and FHFA, as our Conservator and regulator, and are dependent upon their continued support in order to continue operating our business. This support includes our ability to access funds from Treasury under the Purchase Agreement, which is critical to: (a) keeping us solvent; (b) allowing us to focus on our primary business objectives under conservatorship; and (c) avoiding the appointment of a receiver by FHFA under statutory mandatory receivership provisions. For the past several years, the Federal Reserve has purchased significant amounts of mortgage-related securities issued by us, Fannie Mae, and Ginnie Mae. These purchases, which are ongoing, have affected mortgage spreads (positively and, in some periods, negatively) and the demand for and value of our PCs.
For a description of certain risks to our business relating to the conservatorship and Treasury Agreements, see RISK FACTORS.
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Supervision of Our Company During Conservatorship
Upon its appointment, FHFA, as Conservator, immediately succeeded to all rights, titles, powers and privileges of Freddie Mac, and of any stockholder, officer or director of Freddie Mac with respect to Freddie Mac and its assets, and succeeded to the title to all books, records and assets of Freddie Mac held by any other legal custodian or third party. Under conservatorship, we have additional heightened supervision and direction from our regulator, FHFA, which is also acting as our Conservator.
During the conservatorship, the Conservator has delegated certain authority to the Board of Directors to oversee, and to management to conduct, day-to-day operations so that the company can continue to operate in the ordinary course of business. The directors serve on behalf of, and exercise authority as directed by, the Conservator. The Conservator retains the authority to withdraw or revise its delegations of authority at any time. The Conservator also retained certain significant authorities for itself, and did not delegate them to the Board. For more information on limitations on the Boards authority during conservatorship, see DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE Authority of the Board and Board Committees.
Because the Conservator succeeded to the powers, including voting rights, of our stockholders, who therefore do not currently have voting rights of their own, we do not expect to hold stockholders meetings during the conservatorship, nor will we prepare or provide proxy statements for the solicitation of proxies.
We describe the powers of our Conservator in detail below under Powers of the Conservator.
Impact of Conservatorship and Related Actions on Our Business
We conduct our business subject to the direction of FHFA as our Conservator. While the conservatorship has benefited us through, for example, improved access to the debt markets because of the support we receive from Treasury, we are also subject to certain constraints on our business activities by Treasury due to the terms of, and Treasurys rights under, the Purchase Agreement.
The Conservator continues to determine, and direct the efforts of the Board of Directors and management to address, the strategic direction for the company. While the Conservator has delegated certain authority to management to conduct day-to-day operations, many management decisions are subject to review and approval by FHFA and Treasury. In addition, management frequently receives directions from FHFA on various matters involving day-to-day operations.
Our current business objectives reflect direction we received from the Conservator (including the Conservatorship Scorecard). Our business objectives changed considerably since we entered into conservatorship. See Executive Summary Our Primary Business Objectives for more information. At the direction of the Conservator, we made changes to certain business practices that 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 our profitability. Certain of these objectives are intended to help homeowners and the mortgage market and may help to mitigate future credit losses. However, some of our initiatives are expected to have an adverse impact on our near- and long-term financial results. The Conservator stated that it is taking actions in support of the objectives of a gradual transition to greater private capital participation in housing finance and greater distribution of risk to participants other than the government. The Conservator also stated that it is focusing on retaining value in the business operations of Freddie Mac and Fannie Mae, overseeing remediation of identified weaknesses in corporate operations and risk management, and ensuring that sound corporate governance principles are followed. Given the important role the Administration and our Conservator have placed on Freddie Mac in addressing housing and mortgage market conditions and our public mission, we may be required to take additional actions that could have a negative impact on our business, operating results or financial condition, and thus could contribute to a need for additional draws under the Purchase Agreement.
These actions and objectives create risks and uncertainties that we discuss in RISK FACTORS Conservatorship and Related Matters. For more information on the impact of conservatorship and our current business objectives, see NOTE 2: CONSERVATORSHIP AND RELATED MATTERS.
Limits on Investment Activity and Our Mortgage-Related Investments Portfolio
The conservatorship has significantly affected our investment activity. FHFA has stated that we will not be a substantial buyer or seller of mortgages for our mortgage-related investments portfolio. Under the terms of the Purchase Agreement, as amended on August 17, 2012, and FHFA regulation, the UPB of our mortgage-related investments portfolio: (a) could not
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exceed $650 billion on December 31, 2012; and (b) on December 31 of each year thereafter, may not exceed 85% of the aggregate amount of the UPB we were permitted to own as of December 31 of the immediately preceding calendar year, until the portfolio reaches $250 billion. As a result, the UPB of our mortgage-related investments portfolio may not exceed $553 billion as of December 31, 2013. FHFA has indicated that such portfolio reduction targets should be viewed as minimum reductions and has encouraged us to reduce the mortgage-related investments portfolio at a faster rate than required, while indicating that the pace of reducing the portfolio may be moderated by conditions in the housing and financial markets. This strategy is designed to reduce the portfolio and provide the best return to the taxpayer while minimizing market disruption.
The table below presents the UPB of our mortgage-related investments portfolio, for purposes of the limit imposed by the Purchase Agreement and FHFA regulation.
Table 4 Mortgage-Related Investments Portfolio(1)
December 31, 2012 | December 31, 2011 | |||||||
(in millions) | ||||||||
Investments segment Mortgage investments portfolio |
$ | 375,924 | $ | 449,273 | ||||
Single-family Guarantee segment Single-family unsecuritized mortgage loans(2) |
53,333 | 62,469 | ||||||
Multifamily segment Mortgage investments portfolio |
128,287 | 141,571 | ||||||
|
|
|
|
|||||
Total mortgage-related investments portfolio |
$ | 557,544 | $ | 653,313 | ||||
|
|
|
|
(1) | Based on UPB and excludes mortgage loans and mortgage-related securities traded, but not yet settled. |
(2) | Represents unsecuritized seriously delinquent single-family loans managed by the Single-family Guarantee segment. |
The UPB of our mortgage-related investments portfolio at December 31, 2012 was $557.5 billion, a decline of $95.8 billion compared to $653.3 billion at December 31, 2011. The reduction in UPB resulted primarily from liquidations and is consistent with our efforts to reduce the size of our mortgage-related investments portfolio as described above. The mortgage-related investments portfolio is comprised of agency securities, single-family non-agency mortgage-related securities, CMBS, housing revenue bonds, and single-family and multifamily unsecuritized mortgage loans.
We consider the liquidity of the assets in our mortgage-related investments portfolio based on three categories: (a) agency securities; (b) assets that are less liquid than agency securities; and (c) illiquid assets. Assets that are less liquid than agency securities include unsecuritized performing single-family mortgage loans, multifamily mortgage loans, CMBS, and housing revenue bonds. Our less liquid assets collectively represented approximately 28% of the UPB of the portfolio at December 31, 2012, compared to 32% as of December 31, 2011. Illiquid assets include unsecuritized seriously delinquent and modified single-family mortgage loans which we removed from PC trusts, and our investments in non-agency mortgage-related securities backed by subprime, option ARM, and Alt-A and other loans. Our illiquid assets collectively represented approximately 35% of the UPB of the portfolio at December 31, 2012, as compared to 29% as of December 31, 2011. The increase in the percentage of illiquid assets at December 31, 2012 compared to December 31, 2011 is primarily due to our agency securities balance decreasing at a faster rate than our assets that are less liquid than agency securities and illiquid assets.
Powers of the Conservator
Under the GSE Act, the conservatorship provisions applicable to Freddie Mac are based generally on federal banking law. As discussed below, FHFA has broad powers when acting as our conservator. For more information on the GSE Act, see Regulation and Supervision.
General Powers of the Conservator
Upon its appointment, the Conservator immediately succeeded to all rights, titles, powers and privileges of Freddie Mac, and of any stockholder, officer or director of Freddie Mac with respect to Freddie Mac and its assets. The Conservator also succeeded to the title to all books, records and assets of Freddie Mac held by any other legal custodian or third party.
Under the GSE Act, the Conservator may take any actions it determines are necessary and appropriate to carry on our business, support public mission objectives, and preserve and conserve our assets and property. The Conservators powers include the ability to transfer or sell any of our assets or liabilities (subject to certain limitations and post-transfer notice provisions for transfers of qualified financial contracts, as defined below under Special Powers of the Conservator Security Interests Protected; Exercise of Rights Under Qualified Financial Contracts) without any approval, assignment of
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rights or consent of any party. The GSE Act, however, provides that mortgage loans and mortgage-related assets that have been transferred to a Freddie Mac securitization trust must be held for the beneficial owners of the trust and cannot be used to satisfy our general creditors.
Under the GSE Act, in connection with any sale or disposition of our assets, the Conservator must conduct its operations to maximize the NPV return from the sale or disposition of such assets, to minimize the amount of any loss realized in the resolution of cases, and to ensure adequate competition and fair and consistent treatment of offerors. The Conservator is required to maintain a full accounting of the conservatorship and make its reports available upon request to stockholders and members of the public.
We remain liable for all of our obligations relating to our outstanding debt and mortgage-related securities. FHFA has stated that our obligations will be paid in the normal course of business during the conservatorship.
Special Powers of the Conservator
Disaffirmance and Repudiation of Contracts
Under the GSE Act, the Conservator may disaffirm or repudiate contracts (subject to certain limitations for qualified financial contracts) that we entered into prior to its appointment as Conservator if it determines, in its sole discretion, that performance of the contract is burdensome and that disaffirmance or repudiation of the contract promotes the orderly administration of our affairs. The GSE Act requires FHFA to exercise its right to disaffirm or repudiate most contracts within a reasonable period of time after its appointment as Conservator. In a final rule published in June 2011, FHFA defines a reasonable period of time following appointment of a conservator or receiver to be 18 months. The Conservator has advised us that it has no intention of repudiating any guarantee obligation relating to Freddie Macs mortgage-related securities because it views repudiation as incompatible with the goals of the conservatorship. We can, and have continued to, enter into, perform and enforce contracts with third parties.
Limitations on Enforcement of Contractual Rights by Counterparties
The GSE Act provides that the Conservator may enforce most contracts entered into by us, notwithstanding any provision of the contract that provides for termination, default, acceleration, or exercise of rights upon the appointment of, or the exercise of rights or powers by, a conservator.
Security Interests Protected; Exercise of Rights Under Qualified Financial Contracts
Notwithstanding the Conservators powers under the GSE Act described above, the Conservator must recognize legally enforceable or perfected security interests, except where such an interest is taken in contemplation of our insolvency or with the intent to hinder, delay or defraud us or our creditors. In addition, the GSE Act provides that no person will be stayed or prohibited from exercising specified rights in connection with qualified financial contracts, including termination or acceleration (other than solely by reason of, or incidental to, the appointment of the Conservator), rights of offset, and rights under any security agreement or arrangement or other credit enhancement relating to such contract. Such rights in connection with qualified financial contracts that arise solely by reason of, or incidental to, the appointment of a receiver may be exercised only after: (a) 5:00 p.m. on the business day following the receivers appointment; or (b) notice to such person that such contract has been transferred by the receiver to another person. The term qualified financial contract means any securities contract, commodity contract, forward contract, repurchase agreement, swap agreement, and any similar agreement as determined by FHFA by regulation, resolution or order.
Avoidance of Fraudulent Transfers
Under the GSE Act, the Conservator may avoid, or refuse to recognize, a transfer of any property interest of Freddie Mac or of any of our debtors, and also may avoid any obligation incurred by Freddie Mac or by any debtor of Freddie Mac, if the transfer or obligation was made: (a) within five years of September 6, 2008; and (b) with the intent to hinder, delay, or defraud Freddie Mac, FHFA, the Conservator or, in the case of a transfer in connection with a qualified financial contract, our creditors. To the extent a transfer is avoided, the Conservator may recover, for our benefit, the property or, by court order, the value of that property from the initial or subsequent transferee, other than certain transfers that were made for value, including satisfaction or security of a present or antecedent debt, and in good faith. These rights are superior to any rights of a trustee or any other party, other than a federal agency, under the U.S. bankruptcy code.
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Modification of Statutes of Limitations
Under the GSE Act, notwithstanding any provision of any contract, the statute of limitations with regard to any action brought by the Conservator is: (a) for claims relating to a contract, the longer of six years or the applicable period under state law; and (b) for tort claims, the longer of three years or the applicable period under state law, in each case, from the later of September 6, 2008 or the date on which the cause of action accrues. In addition, notwithstanding the state law statute of limitation for tort claims, the Conservator may bring an action for any tort claim that arises from fraud, intentional misconduct resulting in unjust enrichment, or intentional misconduct resulting in substantial loss to us, if the states statute of limitations expired not more than five years before September 6, 2008.
Suspension of Legal Actions
Under the GSE Act, in any judicial action or proceeding to which we are or become a party, the Conservator may request, and the applicable court must grant, a stay for a period not to exceed 45 days.
Treatment of Breach of Contract Claims
Under the GSE Act, any final and unappealable judgment for monetary damages against the Conservator for breach of an agreement executed or approved in writing by the Conservator will be paid as an administrative expense of the Conservator.
Attachment of Assets and Other Injunctive Relief
Under the GSE Act, the Conservator may seek to attach assets or obtain other injunctive relief without being required to show that any injury, loss or damage is irreparable and immediate.
Subpoena Power
The GSE Act provides the Conservator, with the approval of the Director of FHFA, with subpoena power for purposes of carrying out any power, authority or duty with respect to Freddie Mac.
Treasury Agreements
Treasury entered into several agreements with us in connection with our entry into conservatorship, as described below.
Purchase Agreement, Senior Preferred Stock, and Common Stock Warrant
Purchase Agreement
On September 7, 2008, we, through FHFA, in its capacity as Conservator, and Treasury entered into the Purchase Agreement. The Purchase Agreement was subsequently amended and restated on September 26, 2008, and further amended on May 6, 2009, December 24, 2009, and August 17, 2012. Pursuant to the Purchase Agreement, on September 8, 2008 we issued to Treasury: (a) one million shares of Variable Liquidation Preference Senior Preferred Stock (with an initial liquidation preference of $1 billion), which we refer to as the senior preferred stock; and (b) a warrant to purchase, for a nominal price, shares of our common stock equal to 79.9% of the total number of shares of our common stock outstanding on a fully diluted basis at the time the warrant is exercised, which we refer to as the warrant. The terms of the senior preferred stock and warrant are summarized in separate sections below. We did not receive any cash proceeds from Treasury as a result of issuing the senior preferred stock or the warrant. However, deficits in our net worth have made it necessary for us to make substantial draws on Treasurys funding commitment under the Purchase Agreement. As a result, the aggregate liquidation preference of the senior preferred stock has increased from $1.0 billion as of September 8, 2008 to $72.3 billion at December 31, 2012. Under the Purchase Agreement, our ability to repay the liquidation preference of the senior preferred stock is limited and we will not be able to do so for the foreseeable future, if at all.
The senior preferred stock and warrant were issued to Treasury as an initial commitment fee in consideration of the initial commitment from Treasury to provide up to $100 billion (subsequently increased to $200 billion and further increased as necessary to accommodate any cumulative reduction in our net worth during 2010, 2011, and 2012) in funds to us under the terms and conditions set forth in the Purchase Agreement. Beginning January 1, 2013, the amount of available funding remaining under the Purchase Agreement is $140.5 billion. This amount will be reduced by any future draws. The provisions of the Purchase Agreement whereby Treasurys funding commitment would increase as necessary to accommodate any cumulative reduction in our net worth during 2010, 2011, and 2012 no longer apply.
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In addition to the issuance of the senior preferred stock and warrant, we are required under the Purchase Agreement to pay a quarterly commitment fee to Treasury. Under the Purchase Agreement, the fee is to be determined in an amount mutually agreed to by us and Treasury with reference to the market value of Treasurys funding commitment as then in effect. However, pursuant to the August 2012 amendment to the Purchase Agreement, for each quarter commencing January 1, 2013, and for as long as the net worth sweep dividend provisions remain in form and content substantially the same, no periodic commitment fee under the Purchase Agreement will be set, accrue or be payable. Treasury had waived the fee for all applicable quarters prior to that date.
The Purchase Agreement provides that, on a quarterly basis, we generally may draw funds up to the amount, if any, by which our total liabilities exceed our total assets, as reflected on our GAAP balance sheet for the applicable fiscal quarter (referred to as the deficiency amount), provided that the aggregate amount funded under the Purchase Agreement may not exceed Treasurys commitment. The Purchase Agreement provides that the deficiency amount will be calculated differently if we become subject to receivership or other liquidation process. The deficiency amount may be increased above the otherwise applicable amount upon our mutual written agreement with Treasury. In addition, if the Director of FHFA determines that the Director will be mandated by law to appoint a receiver for us unless our capital is increased by receiving funds under the commitment in an amount up to the deficiency amount (subject to the maximum amount that may be funded under the agreement), then FHFA, in its capacity as our Conservator, may request that Treasury provide funds to us in such amount. The Purchase Agreement also provides that, if we have a deficiency amount as of the date of completion of the liquidation of our assets, we may request funds from Treasury in an amount up to the deficiency amount (subject to the maximum amount that may be funded under the agreement). Any amounts that we draw under the Purchase Agreement will be added to the liquidation preference of the senior preferred stock. No additional shares of senior preferred stock are required to be issued under the Purchase Agreement.
The Purchase Agreement provides that the Treasurys funding commitment will terminate under any of the following circumstances: (a) the completion of our liquidation and fulfillment of Treasurys obligations under its funding commitment at that time; (b) the payment in full of, or reasonable provision for, all of our liabilities (whether or not contingent, including mortgage guarantee obligations); and (c) the funding by Treasury of the maximum amount of the commitment under the Purchase Agreement. In addition, Treasury may terminate its funding commitment and declare the Purchase Agreement null and void if a court vacates, modifies, amends, conditions, enjoins, stays or otherwise affects the appointment of the Conservator or otherwise curtails the Conservators powers. Treasury may not terminate its funding commitment under the Purchase Agreement solely by reason of our being in conservatorship, receivership or other insolvency proceeding, or due to our financial condition or any adverse change in our financial condition.
The Purchase Agreement provides that most provisions of the agreement may be waived or amended by mutual written agreement of the parties; however, no waiver or amendment of the agreement is permitted that would decrease Treasurys aggregate funding commitment or add conditions to Treasurys funding commitment if the waiver or amendment would adversely affect in any material respect the holders of our debt securities or Freddie Mac mortgage guarantee obligations.
In the event of our default on payments with respect to our debt securities or Freddie Mac mortgage guarantee obligations, if Treasury fails to perform its obligations under its funding commitment and if we and/or the Conservator are not diligently pursuing remedies in respect of that failure, the holders of these debt securities or Freddie Mac mortgage guarantee obligations may file a claim in the United States Court of Federal Claims for relief requiring Treasury to fund to us the lesser of: (a) the amount necessary to cure the payment defaults on our debt and Freddie Mac mortgage guarantee obligations; and (b) the lesser of: (i) the deficiency amount; and (ii) the maximum amount of the commitment less the aggregate amount of funding previously provided under the commitment. Any payment that Treasury makes under those circumstances will be treated for all purposes as a draw under the Purchase Agreement that will increase the liquidation preference of the senior preferred stock.
The Purchase Agreement has an indefinite term and can terminate only in limited circumstances, which do not include the end of the conservatorship. The Purchase Agreement therefore could continue after the conservatorship ends.
Senior Preferred Stock
Shares of the senior preferred stock have a par value of $1, and have a stated value and initial liquidation preference equal to $1,000 per share. The liquidation preference of the senior preferred stock is subject to adjustment. Dividends that are not paid in cash for any dividend period will accrue and be added to the liquidation preference of the senior preferred stock. In addition, any amounts Treasury pays to us pursuant to its funding commitment under the Purchase Agreement and any
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quarterly commitment fees that are not paid in cash to Treasury nor waived by Treasury will be added to the liquidation preference of the senior preferred stock. As described below, we may make payments to reduce the liquidation preference of the senior preferred stock in limited circumstances.
Treasury, as the holder of the senior preferred stock, is entitled to receive quarterly cash dividends, when, as and if declared by our Board of Directors. Through December 31, 2012, the senior preferred stock accrued quarterly cumulative dividends at a rate of 10% per year. However, under the August 2012 amendment to the Purchase Agreement, the fixed dividend rate was replaced with a net worth sweep dividend beginning in the first quarter of 2013. For more information regarding our net worth sweep dividend, see NOTE 2: CONSERVATORSHIP AND RELATED MATTERS.
The senior preferred stock is senior to our common stock and all other outstanding series of our preferred stock, as well as any capital stock we issue in the future, as to both dividends and rights upon liquidation. The senior preferred stock provides that we may not, at any time, declare or pay dividends on, make distributions with respect to, or redeem, purchase or acquire, or make a liquidation payment with respect to, any common stock or other securities ranking junior to the senior preferred stock unless: (a) full cumulative dividends on the outstanding senior preferred stock (including any unpaid dividends added to the liquidation preference) have been declared and paid in cash; and (b) all amounts required to be paid with the net proceeds of any issuance of capital stock for cash (as described in the following paragraph) have been paid in cash. Shares of the senior preferred stock are not convertible. Shares of the senior preferred stock have no general or special voting rights, other than those set forth in the certificate of designation for the senior preferred stock or otherwise required by law. The consent of holders of at least two-thirds of all outstanding shares of senior preferred stock is generally required to amend the terms of the senior preferred stock or to create any class or series of stock that ranks prior to or on parity with the senior preferred stock.
We are not permitted to redeem the senior preferred stock prior to the termination of Treasurys funding commitment set forth in the Purchase Agreement; however, we are permitted to pay down the liquidation preference of the outstanding shares of senior preferred stock to the extent of: (a) accrued and unpaid dividends previously added to the liquidation preference and not previously paid down; and (b) quarterly commitment fees previously added to the liquidation preference and not previously paid down. In addition, if we issue any shares of capital stock for cash while the senior preferred stock is outstanding, the net proceeds of the issuance must be used to pay down the liquidation preference of the senior preferred stock; however, the liquidation preference of each share of senior preferred stock may not be paid down below $1,000 per share prior to the termination of Treasurys funding commitment. Following the termination of Treasurys funding commitment, we may pay down the liquidation preference of all outstanding shares of senior preferred stock at any time, in whole or in part. If, after termination of Treasurys funding commitment, we pay down the liquidation preference of each outstanding share of senior preferred stock in full, the shares will be deemed to have been redeemed as of the payment date.
Common Stock Warrant
The warrant gives Treasury the right to purchase shares of our common stock equal to 79.9% of the total number of shares of our common stock outstanding on a fully diluted basis on the date of exercise. The warrant may be exercised in whole or in part at any time on or before September 7, 2028, by delivery to us of: (a) a notice of exercise; (b) payment of the exercise price of $0.00001 per share; and (c) the warrant. If the market price of one share of our common stock is greater than the exercise price, then, instead of paying the exercise price, Treasury may elect to receive shares equal to the value of the warrant (or portion thereof being canceled) pursuant to the formula specified in the warrant. Upon exercise of the warrant, Treasury may assign the right to receive the shares of common stock issuable upon exercise to any other person.
As of February 28, 2013, Treasury has not exercised the warrant.
Covenants Under Treasury Agreements
The Purchase Agreement and warrant contain covenants that significantly restrict our business activities. For example, as a result of these covenants, we can no longer obtain additional equity financing (other than pursuant to the Purchase Agreement) and we are limited in the amount and type of debt financing we may obtain.
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Purchase Agreement Covenants
The Purchase Agreement provides that, until the senior preferred stock is repaid or redeemed in full, we may not, without the prior written consent of Treasury:
| declare or pay any dividend (preferred or otherwise) or make any other distribution with respect to any Freddie Mac equity securities (other than with respect to the senior preferred stock or warrant); |
| redeem, purchase, retire or otherwise acquire any Freddie Mac equity securities (other than the senior preferred stock or warrant); |
| sell or issue any Freddie Mac equity securities (other than the senior preferred stock, the warrant and the common stock issuable upon exercise of the warrant and other than as required by the terms of any binding agreement in effect on the date of the Purchase Agreement); |
| terminate the conservatorship (other than in connection with a receivership); |
| sell, transfer, lease or otherwise dispose of any assets, other than dispositions for fair market value: (a) to a limited life regulated entity (in the context of a receivership); (b) of assets and properties in the ordinary course of business, consistent with past practice; (c) of assets and properties having fair market value individually or in aggregate less than $250 million in one transaction or a series of related transactions; (d) in connection with our liquidation by a receiver; (e) of cash or cash equivalents for cash or cash equivalents; or (f) to the extent necessary to comply with the covenant described below relating to the reduction of our mortgage-related investments portfolio; |
| issue any subordinated debt; |
| enter into a corporate reorganization, recapitalization, merger, acquisition or similar event; or |
| engage in transactions with affiliates unless the transaction is: (a) pursuant to the Purchase Agreement, the senior preferred stock or the warrant; (b) upon arms length terms; or (c) a transaction undertaken in the ordinary course or pursuant to a contractual obligation or customary employment arrangement in existence on the date of the Purchase Agreement. |
These covenants also apply to our subsidiaries.
The Purchase Agreement also requires us to reduce the amount of mortgage assets we own. The Purchase Agreement, as revised in the August 2012 amendment, provides that we could not own mortgage assets with UPB in excess of $650 billion on December 31, 2012 and on December 31 of each year thereafter, may not own mortgage assets with UPB in excess of 85% of the aggregate amount of mortgage assets we are permitted to own as of December 31 of the immediately preceding calendar year, provided that we are not required to own less than $250 billion in mortgage assets. Under the Purchase Agreement, we also may not incur indebtedness that would result in the par value of our aggregate indebtedness exceeding 120% of the amount of mortgage assets we are permitted to own on December 31 of the immediately preceding calendar year. The mortgage asset and indebtedness limitations are determined without giving effect to the changes to the accounting guidance for transfers of financial assets and consolidation of VIEs, under which we consolidated our single-family PC trusts and certain of our Other Guarantee Transactions in our financial statements as of January 1, 2010.
In addition, the Purchase Agreement provides that we may not enter into any new compensation arrangements or increase amounts or benefits payable under existing compensation arrangements of any named executive officer or other executive officer (as such terms are defined by SEC rules) without the consent of the Director of FHFA, in consultation with the Secretary of the Treasury.
The Purchase Agreement also provides that, on an annual basis, we are required to deliver a risk management plan to Treasury setting out our strategy for reducing our enterprise-wide risk profile and the actions we will take to reduce the financial and operational risk associated with each of our reportable business segments.
As of February 28, 2013, we believe we were in compliance with the covenants under the Purchase Agreement.
Warrant Covenants
The warrant we issued to Treasury includes, among others, the following covenants: (a) we may not permit any of our significant subsidiaries to issue capital stock or equity securities, or securities convertible into or exchangeable for such securities, or any stock appreciation rights or other profit participation rights; (b) we may not take any action to avoid the observance or performance of the terms of the warrant and we must take all actions necessary or appropriate to protect
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Treasurys rights against impairment or dilution; and (c) we must provide Treasury with prior notice of specified actions relating to our common stock, such as setting a record date for a dividend payment, granting subscription or purchase rights, authorizing a recapitalization, reclassification, merger or similar transaction, commencing a liquidation of the company or any other action that would trigger an adjustment in the exercise price or number or amount of shares subject to the warrant.
As of February 28, 2013, we believe we were in compliance with the covenants under the warrant.
Effect of Conservatorship and Treasury Agreements on Existing Stockholders
The conservatorship, the Purchase Agreement and the senior preferred stock and warrant issued to Treasury have materially limited the rights of our common and preferred stockholders (other than Treasury as holder of the senior preferred stock) and had a number of adverse effects on our common and preferred stockholders. See RISK FACTORS Conservatorship and Related Matters The conservatorship and investment by Treasury has had, and will continue to have, a material adverse effect on our common and preferred stockholders.
As described above, the conservatorship and Treasury Agreements also impact our business in ways that indirectly affect our common and preferred stockholders. By their terms, the Purchase Agreement, senior preferred stock and warrant will continue to exist even if we are released from the conservatorship. For a description of the risks to our business relating to the conservatorship and Treasury Agreements, see RISK FACTORS.
Regulation and Supervision
In addition to our oversight by FHFA as our Conservator, we are subject to regulation and oversight by FHFA under our charter and the GSE Act, which was modified substantially by the Reform Act. We are also subject to certain regulation by other government agencies.
Federal Housing Finance Agency
FHFA is an independent agency of the federal government responsible for oversight of the operations of Freddie Mac, Fannie Mae and the FHLBs. The Director of FHFA is appointed by the President and confirmed by the Senate for a five-year term, removable only for cause. In the discussion below, we refer to Freddie Mac and Fannie Mae as the enterprises.
The Federal Housing Finance Oversight Board, or the Oversight Board, is responsible for advising the Director of FHFA with respect to overall strategies and policies. The Oversight Board consists of the Director of FHFA as Chairperson, the Secretary of the Treasury, the Chair of the SEC and the Secretary of HUD.
Under the GSE Act, FHFA has safety and soundness authority that is comparable to, and in some respects, broader than that of the federal banking agencies. The GSE Act also provides FHFA with powers that, even if we were not in conservatorship, include the authority to raise capital levels above statutory minimum levels, regulate the size and content of our mortgage-related investments portfolio, and approve new mortgage products.
FHFA is responsible for implementing the various provisions of the GSE Act that were added by the Reform Act. In general, we remain subject to existing regulations, orders and determinations until new ones are issued or made.
Receivership
Under the GSE Act, FHFA must place us into receivership if FHFA determines in writing that our assets are less than our obligations for a period of 60 days. FHFA notified us that the measurement period for any mandatory receivership determination with respect to our assets and obligations would commence no earlier than the SEC public filing deadline for our quarterly or annual financial statements and would continue for 60 calendar days after that date. FHFA also advised us that, if, during that 60-day period, we receive funds from Treasury in an amount at least equal to the deficiency amount under the Purchase Agreement, the Director of FHFA will not make a mandatory receivership determination.
In addition, we could be put into receivership at the discretion of the Director of FHFA at any time for other reasons, including conditions that FHFA has already asserted existed at the time the then Director of FHFA placed us into conservatorship. These include: (a) a substantial dissipation of assets or earnings due to unsafe or unsound practices; (b) the existence of an unsafe or unsound condition to transact business; (c) an inability to meet our obligations in the ordinary course of business; (d) a weakening of our condition due to unsafe or unsound practices or conditions; (e) critical undercapitalization; (f) the likelihood of losses that will deplete substantially all of our capital; or (g) by consent.
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On June 20, 2011, FHFA published a final rule that addresses conservatorship and receivership operations of Freddie Mac, Fannie Mae and the FHLBs. The final rule establishes a framework to be used by FHFA when acting as conservator or receiver, supplementing and clarifying statutory authorities. Among other provisions, the final rule indicates that FHFA will not permit payment of securities litigation claims during conservatorship and that claims by current or former shareholders arising as a result of their status as shareholders would receive the lowest priority of claim in receivership. In addition, the final rule indicates that administrative expenses of the conservatorship will also be deemed to be administrative expenses of a subsequent receivership and that capital distributions may not be made during conservatorship, except as specified in the final rule.
Capital Standards
FHFA suspended capital classification of us during conservatorship in light of the Purchase Agreement. The existing statutory and FHFA-directed regulatory capital requirements are not binding during the conservatorship. We continue to provide our submission to FHFA on minimum capital. FHFA continues to publish relevant capital figures (minimum capital requirement, core capital, and GAAP net worth) but does not publish our critical capital, risk-based capital or subordinated debt levels during conservatorship.
On October 9, 2008, FHFA also announced that it will engage in rulemaking to revise our minimum capital and risk-based capital requirements. The GSE Act provides that FHFA may increase minimum capital levels from the existing statutory percentages either by regulation or on a temporary basis by order. On March 3, 2011, FHFA issued a final rule setting forth procedures and standards for such a temporary increase in minimum capital levels. FHFA may also, by regulation or order, establish capital or reserve requirements with respect to any product or activity of an enterprise, as FHFA considers appropriate. In addition, under the GSE Act, FHFA must, by regulation, establish risk-based capital requirements to ensure the enterprises operate in a safe and sound manner, maintaining sufficient capital and reserves to support the risks that arise in their operations and management. In developing the new risk-based capital requirements, FHFA is not bound by the risk-based capital standards in effect prior to the amendment of the GSE Act by the Reform Act.
Our regulatory minimum capital is a leverage-based measure that is generally calculated based on GAAP and reflects a 2.50% capital requirement for on-balance sheet assets and 0.45% capital requirement for off-balance sheet obligations. Pursuant to regulatory guidance from FHFA, our minimum capital requirement was not automatically affected by our January 1, 2010 adoption of amendments to the accounting guidance for transfers of financial assets and consolidation of VIEs. Specifically, upon adoption of this accounting guidance, FHFA directed us, for purposes of minimum capital, to continue reporting our PCs held by third parties and other aggregate off-balance sheet obligations using a 0.45% capital requirement. Notwithstanding this guidance, FHFA reserves the authority under the GSE Act to raise the minimum capital requirement for any of our assets or activities.
For additional information, see MD&A LIQUIDITY AND CAPITAL RESOURCES Capital Resources and NOTE 14: REGULATORY CAPITAL. Also, see RISK FACTORS Legal and Regulatory Risks for more information.
New Products
The GSE Act requires the enterprises to obtain the approval of FHFA before initially offering any product, subject to certain exceptions. The GSE Act provides for a public comment process on requests for approval of new products. FHFA may temporarily approve a product without soliciting public comment if delay would be contrary to the public interest. FHFA may condition approval of a product on specific terms, conditions and limitations. The GSE Act also requires the enterprises to provide FHFA with written notice of any new activity that we or Fannie Mae consider not to be a product.
On July 2, 2009, FHFA published an interim final rule on prior approval of new products, implementing the new product provisions for us and Fannie Mae in the GSE Act. The rule establishes a process for Freddie Mac and Fannie Mae to provide prior notice to the Director of FHFA of a new activity and, if applicable, to obtain prior approval from the Director if the new activity is determined to be a new product. On August 31, 2009, Freddie Mac and Fannie Mae filed joint public comments on the interim final rule with FHFA. FHFA stated that permitting us to engage in new products is inconsistent with the goals of conservatorship and instructed us not to submit such requests under the interim final rule. This could have an adverse effect on our business and profitability in future periods. We cannot currently predict when or if FHFA will permit us to engage in new products under the interim final rule, nor when the rule will be finalized.
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Affordable Housing Goals
We are subject to annual affordable housing goals. In light of these housing goals, we may make adjustments to our mortgage loan sourcing and purchase strategies, which could potentially increase our credit losses. These strategies could include entering into some purchase and securitization transactions with lower expected economic returns than our typical transactions. We have at times relaxed some of our underwriting criteria to obtain goal-qualifying mortgage loans and made additional investments in higher risk mortgage loan products that we believe are more likely to serve the borrowers targeted by the goals, but have not done so to a significant extent since we entered into conservatorship. The Acting Director of FHFA stated that FHFA does not intend for us to undertake uneconomic or high risk activities in support of the housing goals nor does it intend for the state of conservatorship to be a justification for withdrawing our support from these market segments.
If the Director of FHFA finds that we failed to meet a housing goal and that achievement of the housing goal was feasible, the GSE Act states that the Director may require the submission of a housing plan with respect to the housing goal for approval by the Director. The housing plan must describe the actions we would take to achieve the unmet goal in the future. FHFA has the authority to take actions against us, including issuing a cease and desist order or assessing civil money penalties, if we: (a) fail to submit a required housing plan or fail to make a good faith effort to comply with a plan approved by FHFA; or (b) fail to submit certain data relating to our mortgage purchases, information or reports as required by law. See RISK FACTORS Legal and Regulatory Risks We may make certain changes to our business in an attempt to meet our housing goals and subgoals.
FHFA has established four goals and one subgoal for single-family owner-occupied housing, one multifamily special affordable housing goal, and one multifamily special affordable housing subgoal. Three of the single-family housing goals and the subgoal target purchase money mortgages for: (a) low-income families; (b) very low-income families; and/or (c) families that reside in low-income areas. The single-family housing goals also include one that targets refinancing mortgages for low-income families. The multifamily special affordable housing goal targets multifamily rental housing affordable to low-income families. The multifamily special affordable housing subgoal targets multifamily rental housing affordable to very low-income families.
The single-family goals are expressed as a percentage of the total number of eligible mortgages underlying our total single-family mortgage purchases. The multifamily goals are expressed in terms of minimum numbers of units financed.
The single-family goals include: (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. 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 mortgages to low-income families relative to all mortgages originated to finance owner-occupied single-family properties is lower than the 23% benchmark rate, we would still satisfy this goal if we achieve that actual market percentage.
Affordable Housing Goals for 2012 to 2014
FHFAs affordable housing goals for Freddie Mac for 2012 to 2014 are set forth below.
Table 5 Affordable Housing Goals for 2012 to 2014
Goals for 2012 | Goals for 2013 | Goals for 2014 | ||||||||||
Single-family purchase money goals (benchmark levels): |
||||||||||||
Low-income |
23 | % | 23 | % | 23 | % | ||||||
Very low-income |
7 | % | 7 | % | 7 | % | ||||||
Low-income areas(1) |
20 | % | TBD | TBD | ||||||||
Low-income areas subgoal |
11 | % | 11 | % | 11 | % | ||||||
Single-family refinance low-income goal (benchmark level) |
20 | % | 20 | % | 20 | % | ||||||
Multifamily low-income goal (in units) |
225,000 | 215,000 | 200,000 | |||||||||
Multifamily low-income subgoal (in units) |
59,000 | 50,000 | 40,000 |
(1) | FHFA will annually set the benchmark level for the low-income areas goal based on the benchmark level for the low-income areas subgoal, plus an adjustment factor reflecting the additional incremental share of mortgages for low- and moderate-income families in designated disaster areas in the three most recent years for which such data are available. For 2012, FHFA set the benchmark level at 20%. |
We expect to report our performance with respect to the 2012 affordable housing goals in March 2013. We anticipate that the difficult market conditions and our financial condition will affect our affordable housing activities in 2013. However, we view the purchase of mortgage loans that are eligible to count toward our affordable housing goals to be a principal part
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of our mission and business and we are committed to facilitating the financing of affordable housing for low- and moderate-income families.
Duty to Serve Underserved Markets
The GSE Act establishes a duty for Freddie Mac and Fannie Mae to serve three underserved markets (manufactured housing, affordable housing preservation and rural areas) by developing loan products and flexible underwriting guidelines to facilitate a secondary market for mortgages for very low-, low- and moderate-income families in those markets. Effective for 2010 and subsequent years, FHFA is required to establish a manner for annually: (a) evaluating whether and to what extent Freddie Mac and Fannie Mae have complied with the duty to serve underserved markets; and (b) rating the extent of compliance.
In June 2010, FHFA published in the Federal Register a proposed rule regarding the duty of Freddie Mac and Fannie Mae to serve the underserved markets. FHFA has not yet issued a final rule. We cannot predict the content of any such final rule, or the impact that the final rule will have on our business or operations.
Affordable Housing Goals and Results for 2010 and 2011
In October 2012, FHFA informed us that it had reviewed our performance with respect to the affordable housing goals for 2011, and determined that we achieved the single-family refinance low-income goal and both multifamily goals.
Our housing goals and results for 2010 and 2011 are set forth in the table below.
Table 6 Affordable Housing Goals and Results for 2010 and 2011
Goals for 2010 and 2011 |
Market Level
for 2010(1) |
Results for 2010 | Market Level
for 2011(1) |
Results for 2011 | ||||||||||||||||
Single -family purchase money goals (benchmark levels): |
||||||||||||||||||||
Low-income |
27 | % | 27.2 | % | 27.8 | % | 26.5 | % | 23.3 | % | ||||||||||
Very low-income |
8 | % | 8.1 | % | 8.4 | % | 8.0 | % | 6.6 | % | ||||||||||
Low-income areas(2) |
24 | % | 24.0 | % | 23.8 | % | 22.0 | % | 19.2 | % | ||||||||||
Low-income areas subgoal |
13 | % | 12.1 | % | 10.8 | % | 11.4 | % | 9.2 | % | ||||||||||
Single -family refinance low-income goal (benchmark level) |
21 | % | 20.2 | % | 22.0 | % | 21.5 | % | 23.4 | % | ||||||||||
Multifamily low-income goal (in units) |
161,250 | N/A | 161,500 | N/A | 229,001 | |||||||||||||||
Multifamily low-income subgoal (in units) |
21,000 | N/A | 29,656 | N/A | 35,471 |
(1) | Determined by FHFA based on its analysis of market data. |
(2) | FHFA annually sets the benchmark level for the low-income areas goal based on the benchmark level for the low-income areas subgoal, plus an adjustment factor reflecting the additional incremental share of mortgages for low- and moderate-income families in designated disaster areas in the three most recent years for which such data are available. For both 2010 and 2011, FHFA set the benchmark level for the low-income areas goal at 24%. |
We failed to achieve two of the single-family purchase money goals in 2010, and failed to achieve all four of the single-family purchase money goals for 2011. FHFA has not required us to submit housing plans for goals that we did not achieve in 2010 or 2011.
Affordable Housing Allocations
The GSE Act requires us to set aside in each fiscal year an amount equal to 4.2 basis points for each dollar of the UPB of total new business purchases, and allocate or transfer such amount to: (a) HUD to fund a Housing Trust Fund established and managed by HUD; and (b) a Capital Magnet Fund established and managed by Treasury. FHFA has the authority to suspend our allocation upon finding that the payment would contribute to our financial instability, cause us to be classified as undercapitalized or prevent us from successfully completing a capital restoration plan. In November 2008, FHFA advised us that it has suspended the requirement to set aside or allocate funds for the Housing Trust Fund and the Capital Magnet Fund until further notice.
Prudential Management and Operations Standards
FHFA has established prudential standards relating to the management and operations of Freddie Mac, Fannie Mae, and the FHLBs. The standards address a number of business, controls, and risk management areas. The standards specify the possible consequences for any entity that fails to meet any of the standards or otherwise fails to comply (including submission of a corrective plan, limits on asset growth, increases in capital, limits on dividends and stock redemptions or repurchases, a minimum level of retained earnings or any other action that the FHFA Director determines will contribute to
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bringing the entity into compliance with the standards). In addition, a failure to meet any standard also may constitute an unsafe or unsound practice, which may form the basis for FHFA initiating an administrative enforcement action.
Portfolio Activities
The GSE Act requires FHFA to establish, by regulation, criteria governing portfolio holdings to ensure the holdings are backed by sufficient capital and consistent with the enterprises mission and safe and sound operations. In establishing these criteria, FHFA must consider the ability of the enterprises to provide a liquid secondary market through securitization activities, the portfolio holdings in relation to the mortgage market and the enterprises compliance with the prudential management and operations standards prescribed by FHFA.
On December 28, 2010, FHFA issued a final rule adopting the portfolio holdings criteria established in the Purchase Agreement, as it may be amended from time to time, for so long as we remain subject to the Purchase Agreement.
See Conservatorship and Related Matters Limits on Investment Activity and Our Mortgage-Related Investments Portfolio for additional information on restrictions on our portfolio activities.
Anti-Predatory Lending
Predatory lending practices are in direct opposition to our mission, our goals and our practices. We instituted anti-predatory lending policies intended to prevent the purchase or assignment of mortgage loans with unacceptable terms or conditions or resulting from unacceptable practices. These policies include processes related to the origination, delivery and validation of loans sold to us. In addition to the purchase policies we instituted, we promote consumer education and financial literacy efforts to help borrowers avoid abusive lending practices and we provide competitive mortgage products to reputable mortgage originators so that borrowers have a greater choice of financing options.
Subordinated Debt
FHFA directed us to continue to make interest and principal payments on our subordinated debt, even if we fail to maintain required capital levels. As a result, the terms of any of our subordinated debt that provide for us to defer payments of interest under certain circumstances, including our failure to maintain specified capital levels, are no longer applicable. In addition, the requirements in the agreement we entered into with FHFA in September 2005 with respect to issuance, maintenance, and reporting and disclosure of Freddie Mac subordinated debt have been suspended during the term of conservatorship and thereafter until directed otherwise. See NOTE 14: REGULATORY CAPITAL Subordinated Debt Commitment for more information regarding subordinated debt.
Department of Housing and Urban Development
HUD has regulatory authority over Freddie Mac with respect to fair lending. Our mortgage purchase activities are subject to federal anti-discrimination laws. In addition, the GSE Act prohibits discriminatory practices in our mortgage purchase activities, requires us to submit data to HUD to assist in its fair lending investigations of primary market lenders with which we do business and requires us to undertake remedial actions against such lenders found to have engaged in discriminatory lending practices. In addition, HUD periodically reviews and comments on our underwriting and appraisal guidelines for consistency with the Fair Housing Act and the anti-discrimination provisions of the GSE Act.
Department of the Treasury
Treasury has significant rights and powers with respect to our company as a result of the Purchase Agreement. In addition, under our charter, the Secretary of the Treasury has approval authority over our issuances of notes, debentures and substantially identical types of unsecured debt obligations (including the interest rates and maturities of these securities), as well as new types of mortgage-related securities issued subsequent to the enactment of the Financial Institutions Reform, Recovery and Enforcement Act of 1989. The Secretary of the Treasury has performed this debt securities approval function by coordinating GSE debt offerings with Treasury funding activities. In addition, our charter authorizes Treasury to purchase Freddie Mac debt obligations not exceeding $2.25 billion in aggregate principal amount at any time.
Securities and Exchange Commission
We are subject to the reporting requirements applicable to registrants under the Exchange Act, including the requirement to file with the SEC annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on
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Form 8-K. Although our common stock is required to be registered under the Exchange Act, we continue to be exempt from certain federal securities law requirements, including the following:
| Securities we issue or guarantee are exempted securities under the Securities Act and may be sold without registration under the Securities Act; |
| We are excluded from the definitions of government securities broker and government securities dealer under the Exchange Act; |
| The Trust Indenture Act of 1939 does not apply to securities issued by us; and |
| We are exempt from the Investment Company Act of 1940 and the Investment Advisers Act of 1940, as we are an agency, authority or instrumentality of the U.S. for purposes of such Acts. |
Legislative and Regulatory Developments
We discuss certain significant legislative and regulatory developments below. For more information regarding these and other legislative and regulatory developments that could impact our business, see RISK FACTORS Conservatorship and Related Matters and Legal and Regulatory Risks.
Administration Report on Reforming the U.S. Housing Finance Market
On February 11, 2011, the Administration delivered a report to Congress that lays out the Administrations plan to reform the U.S. housing finance market, including options for structuring the governments long-term role in a housing finance system in which the private sector is the dominant provider of mortgage credit. The report recommends winding down Freddie Mac and Fannie Mae, stating that the Administration will work with FHFA to determine the best way to responsibly reduce the role of Freddie Mac and Fannie Mae in the market and ultimately wind down both institutions. The report states that these efforts must be undertaken at a deliberate pace, which takes into account the impact that these changes will have on borrowers and the housing market.
The report states that the government is committed to ensuring that Freddie Mac and Fannie Mae have sufficient capital to perform under any guarantees issued now or in the future and the ability to meet any of their debt obligations, and further states that the Administration will not pursue policies or reforms in a way that would impair the ability of Freddie Mac and Fannie Mae to honor their obligations. The report states the Administrations belief that under the companies senior preferred stock purchase agreements with Treasury, there is sufficient funding to ensure the orderly and deliberate wind down of Freddie Mac and Fannie Mae, as described in the Administrations plan.
The report identifies a number of policy levers that could be used to wind down Freddie Mac and Fannie Mae, shrink the governments footprint in housing finance, and help bring private capital back to the mortgage market, including increasing guarantee fees, phasing in a 10% down payment requirement, reducing conforming loan limits, and winding down Freddie Mac and Fannie Maes investment portfolios, consistent with the senior preferred stock purchase agreements. These recommendations, if implemented, would have a material impact on our business volumes, market share, results of operations and financial condition.
As discussed in Our Business Segments Single-Family Guarantee Segment, we were directed by FHFA to implement two across-the-board increases in guarantee fees in 2012. Temporary high-cost area loan limits that had been in place since 2008 expired on September 30, 2011 (effectively reducing the conforming loan limits in certain high-cost areas). In addition, the annual rate at which the mortgage-related investments portfolio limit declines increased from 10% to 15%, as a result of the August 2012 amendment to the Purchase Agreement.
We cannot predict the extent to which the other recommendations in the report will be implemented or when any actions to implement them may be taken. However, we are not aware of any current plans of our Conservator to significantly change our business model or capital structure in the near-term.
FHFAs Strategic Plan for Freddie Mac and Fannie Mae Conservatorships
On February 21, 2012, FHFA sent to Congress a strategic plan for the next phase of the conservatorships of Freddie Mac and Fannie Mae. The plan sets forth objectives and steps FHFA is taking or will take to meet FHFAs obligations as Conservator. FHFA stated that the steps envisioned in the plan are consistent with each of the housing finance reform frameworks set forth in the report delivered by the Administration to Congress in February 2011, as well as with the leading
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congressional proposals previously introduced. FHFA indicated that the plan leaves open all options for Congress and the Administration regarding the resolution of the conservatorships and the degree of government involvement in supporting the secondary mortgage market in the future.
FHFAs plan provides lawmakers and the public with an outline of how FHFA as Conservator intends to guide Freddie Mac and Fannie Mae over the next few years, and identifies three strategic goals:
| Build. Build a new infrastructure for the secondary mortgage market; |
| Contract. Gradually contract Freddie Mac and Fannie Maes dominant presence in the marketplace while simplifying and shrinking their operations; and |
| Maintain. Maintain foreclosure prevention activities and credit availability for new and refinanced mortgages. |
The first of these goals establishes the steps FHFA, Freddie Mac, and Fannie Mae will take to create the necessary infrastructure, including a new securitization platform and national standards for mortgage securitization, that Congress and market participants may use to develop the secondary mortgage market of the future. This securitization platform would replace our and Fannie Maes current separate proprietary systems. In addition, we completed a key milestone of the UMDP with the launch of the Uniform Collateral Data Portal for the electronic submission of appraisal reports for conventional mortgages. We also implemented ULDD, which provides for the efficient collection and use of consistent information about loan terms, collateral, and borrowers. In October 2012, we announced, pursuant to a directive by FHFA, changes to requirements in certain areas related to loan servicing, including a process and criteria for evaluating servicer performance. These changes align our and Fannie Maes requirements in these areas.
The second goal describes steps that FHFA plans to take to gradually shift mortgage credit risk from Freddie Mac and Fannie Mae to private investors and eliminate the direct funding of mortgages by the enterprises. The plan states that the goal of gradually shifting mortgage credit risk from Freddie Mac and Fannie Mae to private investors could be accomplished, in the case of single-family credit guarantees, in several ways, including increasing guarantee fees, establishing loss-sharing arrangements and expanding reliance on mortgage insurance. To evaluate how to accomplish the goal of contracting enterprise operations in the multifamily business, the plan states that Freddie Mac and Fannie Mae will each undertake a market analysis of the viability of its respective multifamily operations without government guarantees.
For the third goal, the plan states that programs and strategies to ensure ongoing mortgage credit availability, assist troubled homeowners, and minimize taxpayer losses while restoring stability to housing markets continue to require energy, focus, and resources. The plan states that activities that must be continued and enhanced include: (a) successful implementation of HARP, including the significant program changes announced in October 2011; (b) continued implementation of the Servicing Alignment Initiative; (c) renewed focus on short sales, deeds-in-lieu, and deeds-for-lease options that enable households and Freddie Mac and Fannie Mae to avoid foreclosure; and (d) further development and implementation of the REO disposition initiative announced by FHFA in 2011.
The Conservatorship Scorecard provides the implementation roadmap for the strategic plan. For information about our performance with respect to the scorecard, see EXECUTIVE COMPENSATION Compensation Discussion and Analysis.
Legislation Related to the Future Status of Freddie Mac and Fannie Mae
Our future structure and role will be determined by the Administration and Congress, and there are likely to be significant changes beyond the near-term. Congress did not adopt any significant legislation on the future status of Freddie Mac and Fannie Mae in 2012. However, a number of bills were introduced in Congress in 2011 relating to the future status of Freddie Mac, Fannie Mae, and the secondary mortgage market. Several of the bills would have revoked our charter and wound us down or placed us into receivership. Other bills would have limited the companies operations or altered FHFAs or Treasurys authority over the companies. These bills were not enacted prior to the adjournment of the 112th Congress on January 3, 2013 and would need to be reintroduced in the 113th Congress. It is likely that similar or new bills will be introduced and considered in the 113th Congress.
For more information, see RISK FACTORS Conservatorship and Related Matters The future status and role of Freddie Mac is uncertain and could be materially adversely affected by legislative and regulatory action that alters the ownership, structure, and mission of the company.
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Dodd-Frank Act
The Dodd-Frank Act, which was signed into law on July 21, 2010, significantly changed the regulation of the financial services industry, including by creating new standards related to regulatory oversight of systemically important financial companies, derivatives, capital requirements, asset-backed securitization, mortgage underwriting, and consumer financial protection. The Dodd-Frank Act has directly affected and will continue to directly affect the business and operations of Freddie Mac by subjecting us to new and additional regulatory oversight and standards, including with respect to our activities and products. We may also be affected by provisions of the Dodd-Frank Act and implementing regulations that affect the activities of other financial services entities that are our customers and counterparties.
Implementation of the Dodd-Frank Act is being accomplished through numerous rulemakings, many of which are still in process. Accordingly, it is difficult to assess fully the impact of the Dodd-Frank Act on Freddie Mac and the financial services industry at this time. The final effects of the legislation will not be known with certainty until these rulemakings are complete. The Dodd-Frank Act also mandates the preparation of studies on a wide range of issues, which could lead to additional legislation or regulatory changes.
Recent developments with respect to Dodd-Frank rulemakings that may have a significant impact on Freddie Mac include the following:
| CFPB final rules: The Consumer Financial Protection Bureau, or CFPB, adopted a number of final rules in early 2013 relating to mortgage finance and servicing practices. The rules generally will become effective by January 2014, although some provisions have earlier effective dates. The ability-to-repay rule requires mortgage originators to make a reasonable and good faith determination that a borrower has a reasonable ability to repay the loan according to its terms. This rule provides certain protection from liability for originators making loans that satisfy the definition of a qualified mortgage. The rule includes several alternative definitions of a qualified mortgage, one of which is a loan that, in addition to meeting certain other requirements, is eligible to be purchased or guaranteed by Freddie Mac or Fannie Mae. This provision expires on January 10, 2021 (or earlier if Freddie Mac and Fannie Mae cease operating under FHFA conservatorship or receivership). The CFPB concurrently proposed an amendment to the rule to add an exemption for the GSEs refinancing programs, subject to certain conditions. |
Other CFPB rules include: (a) the high-cost mortgage and homeownership counseling rule, which extends consumer protections related to high-cost mortgages; (b) the mortgage servicing rule, which substantially reforms servicers procedural obligations to borrowers when servicing mortgage loans; (c) the escrow accounts rule, which requires that escrow accounts be established for a minimum of five years for higher-cost mortgages; (d) the loan originator compensation rule, which expands and strengthens loan originator qualification requirements and regulates loan originator compensation practices; and (e) the appraisals rule, which sets disclosure and delivery requirements for appraisals and other written valuations. In addition, the CFPB, FHFA, and four other agencies jointly adopted a rule on appraisals for higher priced mortgage loans, which requires creditors for certain mortgages to obtain an appraisal or appraisals meeting specified standards, among other requirements.
These rules will, individually and in combination, significantly change many aspects of the mortgage industry and may affect us both directly and indirectly. Certain of these rules establish requirements that apply directly to us, and may cause operational and compliance challenges. These rules also may lead to significant changes in the structure of the mortgage industry or the business practices of our customers and counterparties, which may affect us indirectly. For example, customers and counterparties could change their pricing practices, which could cause the volume of mortgage originations to decline, which would in turn adversely affect our business and financial results. Some of these changes could slow the rate of foreclosures generally and result in significant changes to mortgage servicing and foreclosure practices that could adversely affect our business. Mortgage originators and assignees, including Freddie Mac, may be subject to increased legal risk for loans that do not meet the requirements of the new rules.
| Derivatives: Pursuant to rules adopted by the U.S. Commodity Futures Trading Commission, or CFTC, many of the types of interest rate swaps that we use will become subject to central clearing requirements in 2013. For more information, see MD&A RISK MANAGEMENT Credit Risk Institutional Credit Risk Derivative Counterparties. |
| Annual stress tests: On October 5, 2012, FHFA proposed a rule that would require Freddie Mac, Fannie Mae and the FHLBs to conduct annual stress tests. If adopted as proposed, the rule would require Freddie Mac to conduct annual stress tests using scenarios specified by FHFA. |
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We continue to review and assess the impact of rulemakings and other activities under the Dodd-Frank Act. For more information, see RISK FACTORS Legal and Regulatory Risks The Dodd-Frank Act and related regulation may adversely affect our business activities and financial results.
Developments Concerning Single-Family Servicing Practices
In addition to regulatory changes related to the Dodd-Frank Act discussed above, there have been a number of legislative and regulatory developments in recent periods impacting single-family mortgage servicing and foreclosure practices, including those discussed below. It is possible that these developments will result in significant changes to mortgage servicing and foreclosure practices that could adversely affect our business. New compliance requirements placed on servicers as a result of these developments could expose Freddie Mac to financial risk as a result of further extensions of foreclosure timelines if home prices remain weak or decline. We may need to make additional significant changes to our practices, which could increase our operational risk. It is difficult to predict other impacts on our business of these changes, though such changes could adversely affect our credit losses and costs of servicing, and make it more difficult for us to transfer mortgage servicing rights to a successor servicer should we need to do so. The legislative and regulatory developments and changes include the following:
| On February 9, 2012, a coalition of state attorneys general and federal agencies announced that it had entered into a settlement with five large seller/servicers concerning certain issues related to mortgage servicing practices. The settlement includes changes to mortgage servicing practices. We believe that resource constraints on these servicers foreclosure activities affected our REO acquisition volumes in 2012. |
| On July 11, 2012, the Governor of California signed into law a package of foreclosure prevention bills that will likely slow foreclosures in California. |
For more information on operational risks related to these developments in mortgage servicing, see MD&A RISK MANAGEMENT Operational Risks.
FHFA Advisory Bulletin
On April 9, 2012, FHFA issued an advisory bulletin, Framework for Adversely Classifying Loans, Other Real Estate Owned, and Other Assets and Listing Assets for Special Mention, which was effective upon issuance and is applicable to Freddie Mac, Fannie Mae, and the FHLBs. The advisory bulletin establishes guidelines for adverse classification and identification of specified assets and off-balance sheet credit exposures. The Advisory Bulletin indicates that this guidance considers and is generally consistent with the Uniform Retail Credit Classification and Account Management Policy issued by the federal banking regulators in June 2000. Among other provisions, the advisory bulletin requires that we classify a single-family loan as loss when the loan is no more than 180 days delinquent. The advisory bulletin, and subsequent FHFA guidance, specify that, once a loan is classified as loss, we generally are required to charge off the portion of the loan balance that exceeds the fair value of the property, less cost to sell and other available cash flows. The advisory bulletin also specifies that, if we subsequently receive full or partial payment of a previously charged-off loan, we may report a recovery of the amount, either through our loan loss reserves or as a reduction in REO operations expenses.
We continue to work with FHFA and Fannie Mae to determine how to apply the guidance to loans that reperform after having previously been 180 days or more delinquent. Our historical experience shows that a significant number of single-family loans that are 180 days or more delinquent will subsequently return to a current payment status either under the original loans terms or after a modification is completed. FHFA has informed us that we are required to implement the advisory bulletin by phasing in the adverse classification and charge-off requirements in 2014 and 2015, respectively. On January 31, 2013, we submitted a comprehensive implementation plan for the advisory bulletin to FHFA. We are currently assessing the operational and accounting impacts of this advisory bulletin and have not yet determined its impact on our consolidated financial statements.
Bank Regulatory Guidance on Accounting for Loans Discharged in Chapter 7 Bankruptcy
Regulatory guidance from the Office of the Comptroller of the Currency in 2012 effectively changed industry practice to require single-family mortgage loans discharged in Chapter 7 bankruptcy to be classified as TDRs, regardless of delinquency status or payment history. As a result of this guidance, in the third quarter of 2012, we changed our accounting treatment for single-family loans discharged in Chapter 7 bankruptcy to classify these loans as TDRs (unless they were already classified as such for other reasons). For information on our accounting policy regarding TDRs and the impact of this
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guidance, see NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Impaired Loans and Basis of Presentation, respectively.
Employees
At February 15, 2013, we had 4,961 full-time and 56 part-time employees. Our principal offices are located in McLean, Virginia.
Available Information
SEC Reports
We file reports and other information with the SEC. In view of the Conservators succession to all of the voting power of our stockholders, we have not prepared or provided proxy statements for the solicitation of proxies from stockholders since we entered into conservatorship, and do not expect to do so while we remain in conservatorship. We make available free of charge through our website at www.freddiemac.com our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all other SEC reports and amendments to those reports as soon as reasonably practicable after we electronically file the material with, or furnish it to, the SEC. In addition, materials that we file with the SEC are available for review and copying at the SECs Public Reference Room at 100 F Street, N.E., Washington, D.C. 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC also maintains an internet site (www.sec.gov) that contains reports, proxy and information statements, and other information regarding companies that file electronically with the SEC.
We are providing our website addresses and the website address of the SEC here or elsewhere in this Form 10-K solely for your information. Information appearing on our website or on the SECs website is not incorporated into this Form 10-K.
Information about Certain Securities Issuances by Freddie Mac
Pursuant to SEC regulations, public companies are required to disclose certain information when they incur a material direct financial obligation or become directly or contingently liable for a material obligation under an off-balance sheet arrangement. The disclosure must be made in a current report on Form 8-K under Item 2.03 or, if the obligation is incurred in connection with certain types of securities offerings, in prospectuses for that offering that are filed with the SEC.
Freddie Macs securities offerings are exempted from SEC registration requirements. As a result, we are not required to and do not file registration statements or prospectuses with the SEC with respect to our securities offerings. To comply with the disclosure requirements of Form 8-K relating to the incurrence of material financial obligations, we report our incurrence of these types of obligations either in offering circulars (or supplements thereto) that we post on our website or in a current report on Form 8-K, in accordance with a no-action letter we received from the SEC staff. In cases where the information is disclosed in an offering circular posted on our website, the document will be posted on our website within the same time period that a prospectus for a non-exempt securities offering would be required to be filed with the SEC.
The website address for disclosure about our debt securities is www.freddiemac.com/debt. From this address, investors can access the offering circular and related supplements for debt securities offerings under Freddie Macs global debt facility, including pricing supplements for individual issuances of debt securities.
Disclosure about the mortgage-related securities we issue, some of which are off-balance sheet obligations, can be found at www.freddiemac.com/mbs. From this address, investors can access information and documents about our mortgage-related securities, including offering circulars and related offering circular supplements.
Forward-Looking Statements
We regularly communicate information concerning our business activities to investors, the news media, securities analysts, and others as part of our normal operations. Some of these communications, including this Form 10-K, contain forward-looking statements, including statements pertaining to the conservatorship, our current expectations and objectives for our efforts under the MHA Program, the servicing alignment initiative and other programs to assist the U.S. residential mortgage market, future business plans, liquidity, capital management, economic and market conditions and trends, market share, the effect of legislative and regulatory developments, implementation of new accounting guidance, credit losses, internal control remediation efforts, and results of operations and financial condition on a GAAP, Segment Earnings, and fair value basis. Forward-looking statements involve known and unknown risks and uncertainties, some of which are beyond our
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control. Forward-looking statements are often accompanied by, and identified with, terms such as objective, expect, trend, forecast, anticipate, believe, intend, could, future, may, will, and similar phrases. 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, including those described in the RISK FACTORS section of this Form 10-K, and:
| the actions FHFA, Treasury, the Federal Reserve, the SEC, HUD, other federal agencies, the Administration, Congress, and our management may take, including actions related to implementing FHFAs strategic plan for Freddie Mac and Fannie Maes conservatorships and the Conservatorship Scorecard; |
| the effect of the restrictions and other terms of the conservatorship and the Treasury Agreements on our business, including payment of our dividend obligation on the senior preferred stock; |
| our ability to maintain adequate liquidity to fund our operations, including following any changes in the support provided to us by Treasury or FHFA, a change in the credit ratings of our debt securities or a change in the credit rating of the U.S. government; |
| changes in our charter or applicable legislative or regulatory requirements (including any restructuring or reorganization in the form of our company, whether we will remain a stockholder-owned company or continue to exist and whether we will be wound down or placed under receivership), regulations under the GSE Act, the Reform Act, or the Dodd-Frank Act, regulatory or legislative actions that require us to support non-mortgage market initiatives, changes to affordable housing goals regulation, reinstatement of regulatory capital requirements, or the exercise or assertion of additional regulatory or administrative authority; |
| changes in the regulation of the mortgage, housing finance, and financial services industries, including changes caused by the Dodd-Frank Act, or any other legislative, regulatory, or judicial action at the federal, state, or local level; |
| actions against mortgage originators and servicers, mortgage insurers, and other mortgage industry participants by federal or state authorities; |
| the scope of various initiatives designed to help in the housing recovery (including the extent to which borrowers participate in HAMP, HARP, the non-HAMP standard loan modification initiative, and the new short sale initiative), and the effect of such programs on our credit losses, expenses, and the size and composition of our mortgage-related investments portfolio; |
| the effect of any deficiencies in foreclosure documentation practices and related lengthening of the foreclosure timeline; |
| the ability of our financial, accounting, data processing, and other operating systems or infrastructure, and those of our vendors to process the complexity and volume of our transactions; |
| changes in accounting or tax guidance or in our accounting policies or estimates, and our ability to effectively implement any such changes in guidance, policies, or estimates; |
| changes in general regional, national, or international economic, business, or market conditions and competitive pressures, including changes in employment rates and interest rates, and changes in the federal governments fiscal and monetary policy; |
| changes in the U.S. residential mortgage market, including changes in the rate of growth in total outstanding U.S. residential mortgage debt, the size of the U.S. residential mortgage market, and home prices; |
| our ability to effectively implement our business strategies, including any efforts to improve the supply and liquidity of, and demand for, our mortgage-related and debt securities, and restrictions on our ability to offer new products or engage in new activities; |
| our ability to recruit and retain executive officers and other key employees; |
| our ability to effectively identify and manage credit, interest-rate, operational, and other risks in our business, including changes to the credit environment and the levels and volatilities of interest rates, as well as the shape and slope of the yield curves; |
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| the effects of internal control deficiencies and our ability to effectively identify, assess, evaluate, manage, mitigate, or remediate control deficiencies and risks, including material weaknesses and significant deficiencies, in our internal control over financial reporting and disclosure controls and procedures; |
| incomplete or inaccurate information provided by customers and counterparties; |
| consolidation among, or adverse changes in the financial condition of, our customers and counterparties; |
| the failure of our customers and counterparties to fulfill their obligations to us, including (a) the failure of seller/servicers to meet their obligations to repurchase loans sold to us in breach of their representations and warranties, and the potential cost and difficulty of legally enforcing those obligations, and (b) the failure of mortgage insurers to pay our claims in full; |
| changes in our judgments, assumptions, forecasts, or estimates regarding the volume of our business and spreads we expect to earn; |
| the availability of options, interest-rate and currency swaps, and other derivative financial instruments of the types and quantities, on acceptable terms, and with acceptable counterparties needed for investment funding and risk management purposes; |
| changes in pricing, valuation or other methodologies, models, assumptions, judgments, estimates and/or other measurement techniques, or their respective reliability; |
| changes in mortgage-to-debt OAS; |
| the potential effect on the market for our securities resulting from any purchases or sales by any large investor, including the Federal Reserve, of Freddie Mac debt or mortgage-related securities; |
| adverse judgments or settlements in connection with legal proceedings, governmental investigations, and IRS examinations; |
| volatility of reported results due to changes in the fair value of certain instruments or assets; |
| the development of different types of mortgage servicing structures and servicing compensation; |
| preferences of originators in selling into the secondary mortgage market; |
| changes to our underwriting or servicing requirements (including servicing alignment efforts under the servicing alignment initiative), our practices with respect to the disposition of REO properties, or investment standards for mortgage-related products; |
| investor preferences for mortgage loans and mortgage-related and debt securities compared to other investments; |
| borrower preferences for fixed-rate mortgages versus ARMs; |
| the occurrence of a major natural or other disaster in geographic areas in which our offices or portions of our total mortgage portfolio are concentrated; |
| other factors and assumptions described in this Form 10-K, including in the MD&A section; |
| our assumptions and estimates regarding the foregoing and our ability to anticipate the foregoing factors and their effects; and |
| market reactions to the foregoing. |
Forward-looking statements speak only as of the date they are made, and we undertake no obligation to update any forward-looking statements we make to reflect events or circumstances occurring after the date of this Form 10-K.
Investing in our securities involves risks, including the risks described below and in BUSINESS, MD&A, and elsewhere in this Form 10-K. These risks and uncertainties could, directly or indirectly, adversely affect our business, financial condition, results of operations, cash flows, strategies and/or prospects.
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Conservatorship and Related Matters
The future status and role of Freddie Mac is uncertain and could be materially adversely affected by legislative and regulatory action that alters the ownership, structure, and mission of the company.
The Acting Director of FHFA stated on November 15, 2011 that the long-term outlook is that neither [Freddie Mac nor Fannie Mae] will continue to exist, at least in its current form, in the future. Future legislation will likely materially affect the role of the company, our business model, our structure, and future results of operations. Some or all of our functions could be transferred to other institutions, and we could cease to exist as a stockholder-owned company or at all. If any of these events were to occur, our shares could further diminish in value, or cease to have any value, and there can be no assurance that our stockholders would receive any compensation for such loss in value.
While there have not been significant legislative developments on the future status of Freddie Mac and Fannie Mae in recent quarters, it is likely that bills related to GSE reform will be introduced and considered during the 113th Congress that began in January 2013. There were a number of significant developments in 2011, including the Administrations February 2011 report to Congress that, among other items, recommends reducing the role of Freddie Mac and Fannie Mae and ultimately winding down both companies. In addition, a number of bills were introduced in Congress in 2011 concerning the future status of Freddie Mac and Fannie Mae, including several bills that would have wound down Freddie Mac and Fannie Mae (or completely restructured the companies).
FHFA is driving significant changes in our business model, primarily in our single-family guarantee business, through its strategic plan for Freddie Mac and Fannie Mae and the Conservatorship Scorecard. At the time FHFA released its strategic plan, it stated that the steps envisioned in the plan were consistent with each of the housing finance reform frameworks set forth in the Administrations February 2011 report, as well as with the leading congressional proposals previously introduced. In addition, FHFA has expansive regulatory authority over us, and the manner in which FHFA will use its authority in the future is unclear. FHFA could take a number of regulatory actions that could materially adversely affect our company, such as changing or reinstating our current capital requirements, which are not binding during conservatorship, or imposing additional restrictions on our portfolio activities or new initiatives.
For more information on the Administrations February 2011 report, proposed GSE reform legislation, and FHFAs strategic plan and the Conservatorship Scorecard, see BUSINESS Regulation and Supervision Legislative and Regulatory Developments.
The conservatorship is indefinite in duration and the timing, conditions, and likelihood of our emerging from conservatorship are uncertain. Even if the conservatorship is terminated, we would remain subject to the Purchase Agreement, senior preferred stock, and warrant.
FHFA has stated that there is no exact time frame as to when the conservatorship may end. Termination of the conservatorship (other than in connection with receivership) also requires Treasurys consent under the Purchase Agreement. There can be no assurance as to when, and under what circumstances, Treasury would give such consent. There is also significant uncertainty as to what changes may occur to our business structure during or following our conservatorship, including whether we will continue to exist. It is possible that the conservatorship will end with us being placed into receivership.
In addition, Treasury has the ability to acquire almost 80% of our common stock for nominal consideration by exercising the warrant we issued to it pursuant to the Purchase Agreement. Consequently, the company could effectively remain under the control of the U.S. government even if the conservatorship was ended and the voting rights of common stockholders restored. The warrant held by Treasury, the restrictions on our business contained in the Purchase Agreement, and the senior status of the senior preferred stock issued to Treasury under the Purchase Agreement, if the senior preferred stock has not been redeemed, also could adversely affect our ability to attract new private sector capital in the future should the company be in a position to seek such capital.
Moreover, we do not have the ability over the long-term to retain any capital generated by our business operations. Under the Purchase Agreement, as revised on August 17, 2012, we are required to pay dividends to the extent that our Net Worth Amount exceeds a permitted capital reserve amount. The amount of this reserve decreases over time. Accordingly, over the long-term, we will not be able to build or retain any net worth surplus or return capital to stockholders other than Treasury.
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We may request additional draws under the Purchase Agreement in future periods.
We may request additional draws under the Purchase Agreement in future periods. The need for any such future draws will be determined by a variety of factors that could adversely affect our net worth or our ability to generate comprehensive income, including the following:
| how long and to what extent the U.S. economy and housing market, including home prices, remain weak, which could increase credit expenses and cause additional other-than-temporary impairments of the non-agency mortgage-related securities we hold; |
| foreclosure prevention and other loss mitigation efforts, and foreclosure processing delays, which could increase our expenses; |
| competitiveness with other mortgage market participants, including Fannie Mae; |
| adverse changes in interest rates, the yield curve, implied volatility or mortgage-to-debt OAS, which could increase realized and unrealized mark-to-fair value losses recorded in earnings or AOCI; |
| required reductions in the size of our mortgage-related investments portfolio and other limitations on our investment activities that reduce the earnings capacity of our investment activities; |
| adverse changes in our funding costs or limitations in our access to public debt markets; |
| changes in accounting practices or guidance; |
| effects of the MHA Program and other government initiatives, including any future requirements to reduce the principal amount of loans; |
| losses resulting from control failures, including any control failures because of our inability to retain staff; |
| prohibition on developing new products and limitations on our ability to enter into new lines of business; |
| introduction of additional public mission-related initiatives that may adversely affect our financial results; |
| establishment of additional valuation allowances for our remaining net deferred tax asset; or |
| changes in business practices resulting from legislative and regulatory developments or direction from our Conservator. |
Through the fourth quarter of 2012, we paid cash dividends to Treasury on the senior preferred stock at an annual rate of 10%. In past periods, this fixed-rate dividend obligation substantially contributed to draws under the Purchase Agreement. However, on August 17, 2012, Freddie Mac, acting through FHFA, as Conservator, and Treasury entered into an amendment to the Purchase Agreement. Under this amendment, the fixed dividend rate was replaced with a net worth sweep dividend beginning in the first quarter of 2013. This effectively ends the circular practice of Treasury advancing funds to us to pay dividends back to Treasury. As a result, beginning in 2013, the need for future draws will not be driven by the dividend obligation. This amendment also suspended the periodic commitment fee, beginning in the first quarter of 2013. The amount of the net worth sweep dividend could vary substantially from quarter to quarter for a number of reasons, including as a result of non-cash changes in net worth. It is possible that, due to non-cash changes in net worth, the amount of our dividend for a quarter could exceed the amount of available cash, which could have an adverse effect on our financial results.
Although additional draws under the Purchase Agreement will allow us to remain solvent and avoid mandatory receivership, they will also increase the liquidation preference of the senior preferred stock, which was $72.3 billion as of December 31, 2012. In addition, draws we take for deficits in our net worth will reduce the amount of available funding remaining under the Purchase Agreement, which beginning January 1, 2013, is $140.5 billion. Additional draws and corresponding increases in the already substantial liquidation preference, along with limited flexibility to redeem the senior preferred stock, may add to the uncertainty regarding our long-term financial sustainability.
Our business objectives and strategies have in some cases been significantly altered since we were placed into conservatorship, and may continue to change, in ways that negatively affect our future financial condition and results of operations.
Our current business objectives reflect direction we have received from the Conservator (including the Conservatorship Scorecard), and have changed considerably since we entered into conservatorship. See BUSINESS Executive Summary Our Primary Business Objectives for more information.
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At the direction of the Conservator, we have made changes to certain business practices that 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 our profitability. Some of these changes have increased our expenses or caused us to forego revenue opportunities. For example, FHFA has directed that we implement various initiatives under the MHA Program. We have incurred significant costs associated with the implementation of these initiatives and we cannot currently estimate whether, or the extent to which, costs incurred in the near term from these initiatives may be offset, if at all, by the prevention or reduction of potential future costs of serious delinquencies and foreclosures due to these initiatives. The Conservator and Treasury have also not authorized us to engage in certain business activities and transactions, including the purchase or sale of certain assets, which we believe might have had a beneficial impact on our results of operations or financial condition, if executed. Other agencies of the U.S. government, as well as Congress, also have an interest in the conduct of our business. We do not know what actions they may request us to take.
In view of the conservatorship and the reasons stated by FHFA for its establishment, it is likely that our business model and strategic objectives will continue to change, possibly significantly, including in pursuit of our public mission and other non-financial objectives. Among other things, we could experience significant changes in the size, growth, and characteristics of our guarantee activities, and we could further change our operational objectives, including our pricing strategy in our core mortgage guarantee business.
One of FHFAs goals for conservatorship, as set forth in its strategic plan, is to contract our presence in the mortgage market and shrink our operations. The conservatorship has significantly affected our investment activity, and we may face further restrictions on this activity. For example, on August 17, 2012, the Purchase Agreement was amended to, among other items, accelerate the wind-down of our mortgage-related investments portfolio. Accordingly, our strategic and operational focus may not always be consistent with the generation of net income. It is possible that we will make material changes to our capital strategy and to our accounting policies, methods, and estimates. In addition, we may be directed to engage in initiatives that are operationally difficult or costly to implement, unprofitable, or that otherwise adversely affect our financial results. For example, FHFA has directed us to take various actions in support of the objectives of a gradual transition to greater private capital participation in housing finance and greater distribution of risk to participants other than the government, such as developing security structures that allow for private sector risk sharing.
FHFA, as our Conservator, could further change our business objectives and strategies at any time. As our Conservator, FHFA possesses all of the powers of our stockholders, officers, and directors. During the conservatorship, the Conservator has delegated certain authority to the Board of Directors to oversee, and to management to conduct, day-to-day operations so that the company can continue to operate in the ordinary course of business. However, FHFA has the ability to withdraw or revise its delegations of authority and override actions of our Board of Directors or management at any time. The directors serve on behalf of, and exercise authority as directed by, the Conservator. In addition, FHFA has the power to take actions without our knowledge that could be material to investors and could significantly affect our financial performance.
These changes and other factors could have material adverse effects on, among other things, our portfolio growth, net worth, credit losses, net interest income, guarantee fee income, net deferred tax assets, loan loss reserves, and future results of operations and financial condition, and thus could contribute to a need for additional draws under the Purchase Agreement. In light of the significant uncertainty surrounding these changes, there can be no assurances regarding our future profitability.
We have a variety of different, and potentially competing, objectives that could lead to suboptimal outcomes for these objectives.
We have a variety of different, and potentially competing, objectives. For example, we are focused on the following primary business objectives: (a) providing credit availability for mortgages and maintaining foreclosure prevention activities; (b) minimizing our credit losses; (c) developing mortgage market enhancements in support of a new infrastructure for the secondary mortgage market; (d) maintaining sound credit quality on the loans we purchase or guarantee; (e) contracting the dominant presence of the GSEs in the marketplace; and (f) strengthening our infrastructure and improving overall efficiency while also focusing on retention of key employees. However, FHFA has also stated that the focus of the conservatorship is on, among other items, conserving assets and minimizing corporate losses.
These objectives can create conflicts in strategic and day-to-day decision making that could lead to suboptimal outcomes for one or more, or possibly all, of these objectives. For example, our efforts to provide credit availability for mortgages and maintain foreclosure prevention activities could increase our expenses, thereby affecting our ability to
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conserve assets and minimize corporate losses. Failure to achieve a satisfactory outcome with respect to any one objective could lead to negative publicity and damage our reputation. We may face increased operational risk from these competing objectives, particularly given the difficulty of devoting sufficient resources and management attention to multiple priorities.
FHFA directives that we and Fannie Mae adopt uniform approaches in many areas could have an adverse impact on our business or on our competitive position with respect to Fannie Mae.
FHFA is also Conservator of Fannie Mae, our primary competitor. On multiple occasions, FHFA has directed us and Fannie Mae to confer and suggest to FHFA possible uniform approaches to particular business and accounting issues and problems. It is likely that we will receive additional directives in the future. In most such cases, FHFA subsequently directed us and Fannie Mae to adopt a specific uniform approach. For example, we and Fannie Mae:
| have aligned many of our standards and approaches for addressing non-performing loans, including certain standards relating to our respective loan workout activities; |
| have aligned certain aspects of our respective relief refinance initiatives (including HARP); |
| have been directed to adopt a new framework for representation and warranty obligations; |
| were directed to implement certain across-the-board guarantee fee price increases in 2012 to make certain aspects of our pricing more uniform; and |
| are working together in a number of areas to develop mortgage market enhancements in support of a new infrastructure for the secondary mortgage market, including (a) improving and standardizing certain mortgage data requirements; (b) aligning certain terms of the contracts we and Fannie Mae use with our respective single-family seller/servicers, as well as certain practices we follow in managing our remedies and our respective business relationships with these companies; and (c) designing and developing a new securitization platform. |
We cannot predict the impact on our business of these actions or any similar actions FHFA may require us and Fannie Mae to take in the future. It is possible that in some areas FHFA could require us and Fannie Mae to take a uniform approach that, because of differences in our respective businesses, could place Freddie Mac at a competitive disadvantage to Fannie Mae. We may be required to adopt approaches that are operationally difficult for us to implement. It also is possible that in some cases identifying, adopting and maintaining a uniform approach could entail higher costs than would a unilateral approach, and that when market conditions merit a change in a uniform approach, coordinating the change might entail additional cost and delay. If and when conservatorship ends, market acceptance of a uniform approach could make it difficult to depart from that approach even if doing so would be economically desirable.
We are subject to significant limitations on our business under the Purchase Agreement and Senior Preferred Stock that could have a material adverse effect on our results of operations and financial condition.
The Purchase Agreement and terms of the senior preferred stock include significant restrictions on our ability to manage our business, including limitations on the amount of indebtedness we may incur, the size of our mortgage-related investments portfolio, and the circumstances in which we may pay dividends, transfer certain assets, raise capital, and pay down the liquidation preference on the senior preferred stock. Over the long-term, as a result of the net worth sweep dividend provisions of the senior preferred stock, we do not have the ability to retain any capital generated by our business operations and will not be able to build or retain any net worth surplus or return capital to stockholders other than Treasury. In addition, the Purchase Agreement provides that we may not enter into any new compensation arrangements or increase amounts or benefits payable under existing compensation arrangements of any executive officers without the consent of the Director of FHFA, in consultation with the Secretary of the Treasury. In deciding whether or not to consent to any request for approval it receives from us under the Purchase Agreement, Treasury has the right to withhold its consent for any reason and is not required by the agreement to consider any particular factors, including whether or not management believes that the transaction would benefit the company. The limitations under the Purchase Agreement and terms of the senior preferred stock could have a material adverse effect on our future results of operations and financial condition.
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Our regulator may, and in some cases must, place us into receivership, which would result in the liquidation of our assets and terminate all rights and claims that our stockholders and creditors may have against our assets or under our charter; if we are liquidated, there may not be sufficient funds to pay the secured and unsecured claims of the company, repay the liquidation preference of any series of our preferred stock, or make any distribution to the holders of our common stock.
We could be put into receivership at the discretion of the Director of FHFA at any time for a number of reasons, including conditions that FHFA has already asserted existed at the time the then Director of FHFA placed us into conservatorship. These include: (a) a substantial dissipation of assets or earnings due to unsafe or unsound practices; (b) the existence of an unsafe or unsound condition to transact business; (c) an inability to meet our obligations in the ordinary course of business; (d) a weakening of our condition due to unsafe or unsound practices or conditions; (e) critical undercapitalization; (f) the likelihood of losses that will deplete substantially all of our capital; or (g) by consent. In addition, FHFA could be required to place us in receivership if Treasury is unable to provide us with funding requested under the Purchase Agreement to address a deficit in our net worth. For more information, see If Treasury is unable to provide us with funding requested under the Purchase Agreement to address a deficit in our net worth, FHFA could be required to place us into receivership.
A receivership would terminate the conservatorship. The appointment of FHFA as our receiver would terminate all rights and claims that our stockholders and creditors may have against our assets or under our charter arising as a result of their status as stockholders or creditors, other than the potential ability to be paid upon our liquidation. Unlike conservatorship, the purpose of which is to conserve our assets and return us to a sound and solvent condition, the purpose of receivership is to liquidate our assets and resolve claims against us.
In the event of a liquidation of our assets, there can be no assurance that there would be sufficient proceeds to pay the secured and unsecured claims of the company, repay the liquidation preference of any series of our preferred stock or make any distribution to the holders of our common stock. To the extent that we are placed into receivership and do not or cannot fulfill our guarantee to the holders of our mortgage-related securities, such holders could become unsecured creditors of ours with respect to claims made under our guarantee. Only after paying the secured and unsecured claims of the company, the administrative expenses of the receiver and the liquidation preference of the senior preferred stock, which ranks senior to our common stock and all other series of preferred stock upon liquidation, would any liquidation proceeds be available to repay the liquidation preference on any other series of preferred stock. Finally, only after the liquidation preference on all series of preferred stock is repaid would any liquidation proceeds be available for distribution to the holders of our common stock. The aggregate liquidation preference on the senior preferred stock owned by Treasury is $72.3 billion as of December 31, 2012. The liquidation preference will increase further if we make additional draws under the Purchase Agreement.
If we are placed into receivership or no longer operate as a going concern, we would no longer be able to assert that we will realize assets and satisfy liabilities in the normal course of business, and, therefore, our basis of accounting would change to liquidation-based accounting. Under the liquidation basis of accounting, assets are stated at their estimated net realizable value and liabilities are stated at their estimated settlement amounts, which could adversely affect our net worth. In addition, the amounts in AOCI would be reclassified to earnings, which could also adversely affect our net worth.
If Treasury is unable to provide us with funding requested under the Purchase Agreement to address a deficit in our net worth, FHFA could be required to place us into receivership.
Under the Purchase Agreement, Treasury made a commitment to provide funding, under certain conditions, to eliminate deficits in our net worth. Under the GSE Act, FHFA must place us into receivership if FHFA determines in writing that our assets are less than our obligations for a period of 60 calendar days. FHFA has notified us that the measurement period for any mandatory receivership determination with respect to our assets and obligations would commence no earlier than the SEC public filing deadline for our quarterly or annual financial statements and would continue for 60 calendar days after that date. FHFA has also advised us that, if, during that 60-day period, we receive funds from Treasury in an amount at least equal to the deficiency amount under the Purchase Agreement, the Director of FHFA will not make a mandatory receivership determination. If funding has been requested under the Purchase Agreement to address a deficit in our net worth, and Treasury is unable to provide us with such funding within the 60-day period specified by FHFA, FHFA would be required to place us into receivership if our assets remain less than our obligations during that 60-day period.
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The conservatorship, uncertainty concerning our future, and restrictions on our ability to compensate employees have had, and may continue to have, an adverse effect on the retention and recruitment of executives and other employees, which could have a material adverse effect on our ability to operate our business.
Our ability to recruit and retain executives and other employees with the necessary skills to conduct our business has been, and may continue to be, adversely affected by the actions taken by Congress, Treasury, and the Conservator to date, or that may be taken by them or other government agencies in the future, the uncertainty regarding the duration of the conservatorship, the potential for future legislative or regulatory actions that could significantly affect our existence and our role in the secondary mortgage market, and the negative publicity concerning the GSEs. Accordingly, we may not be able to retain or replace executives or other employees with the requisite institutional knowledge and the technical, operational, risk management, and other key skills needed to conduct our business effectively.
For example, we are subject to restrictions on the amount and type of compensation we may pay our executives under conservatorship. Also contributing to our concerns regarding executive retention risk is the aggregate level of target compensation paid to our executive officers, which for 2012 performance was below the 25th percentile of the competitive market. See EXECUTIVE COMPENSATION for more information. We cannot offer equity-based compensation, which is both common in our industry and provides a key incentive for employees to stay with the company. Our senior executives are prohibited by law from receiving bonuses during any period of conservatorship.
Voluntary turnover moderated in 2012 compared to 2011. However, we may find it difficult to retain critical employees and attract people with the skills and experience we need for the reasons discussed above. In addition, the level of scrutiny from FHFA and its Office of Inspector General and other regulators has contributed to stress levels throughout the organization and placed additional burdens on staff. For more information about risks related to employee retention, see MD&A RISK MANAGEMENT Operational Risks.
In 2011, the Financial Services Committee of the House of Representatives approved a bill that would generally put our employees on the federal governments pay scale. If this or similar legislation were to become law, many of our employees would experience a sudden and sharp decrease in compensation. The Acting Director of FHFA stated on November 15, 2011 that this would certainly risk a substantial exodus of talent, the best leaving first in many instances. [Freddie Mac and Fannie Mae] likely would suffer a rapidly growing vacancy list and replacements with lesser skills and no experience in their specific jobs. A significant increase in safety and soundness risks and in costly operational failures would, in my opinion, be highly likely. The Acting Director noted that [s]hould the risks I fear materialize, FHFA might well be forced to limit [Freddie Mac and Fannie Maes] business activities. Some of the business [Freddie Mac and Fannie Mae] would be unable to undertake might simply not occur, with potential disruption in housing markets and the economy.
The conservatorship and investment by Treasury has had, and will continue to have, a material adverse effect on our common and preferred stockholders.
Prior to our entry into conservatorship, the market price for our common stock declined substantially. After our entry into conservatorship, the market price of our common stock continued to decline, and has been $1 or less per share since June 2010. As a result, the investments of our common and preferred stockholders lost substantial value, which they may never recover. There is significant uncertainty as to what changes may occur to our business structure during or following our conservatorship, including whether we will continue to exist. Therefore, it is likely that our shares could further diminish in value, and they are not likely to have any value in the longer-term. The Acting Director of FHFA has stated that [Freddie Mac and Fannie Maes] equity holders retain an economic claim on the companies but that claim is subordinate to taxpayer claims. As a practical matter, taxpayers are not likely to be repaid in full, so [Freddie Mac and Fannie Mae] stock lower in priority is not likely to have any value.
The conservatorship and investment by Treasury has had, and will continue to have, other material adverse effects on our common and preferred stockholders, including the following:
| No voting rights during conservatorship. The rights and powers of our stockholders are suspended during the conservatorship and our common stockholders do not have the ability to elect directors or to vote on other matters. |
| Our future profits will effectively be distributed to Treasury. Under the Purchase Agreement, we are required to pay dividends to the extent that our Net Worth Amount exceeds a permitted capital reserve amount. The amount of this reserve decreases over time. Accordingly, over the long-term, we will not be able to build or retain any net worth surplus, and our future profits will effectively be distributed to Treasury. Therefore, the holders of our common stock and non-senior preferred stock will not receive benefits that would otherwise flow from any such future profits. |
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| Priority of Senior Preferred Stock. The senior preferred stock ranks senior to the common stock and all other series of preferred stock as to both dividends and distributions upon dissolution, liquidation or winding up of the company. |
| Dividends have been eliminated. The Conservator has eliminated dividends on Freddie Mac common and preferred stock (other than dividends on the senior preferred stock) during the conservatorship. In addition, under the terms of the Purchase Agreement, dividends may not be paid to common or preferred stockholders (other than on the senior preferred stock) without the consent of Treasury, regardless of whether or not we are in conservatorship. |
| Warrant may substantially dilute investment of current stockholders. If Treasury exercises its warrant to purchase shares of our common stock equal to 79.9% of the total number of shares of our common stock outstanding on a fully diluted basis, the ownership interest in the company of our then existing common stockholders will be substantially diluted. It is possible that stockholders, other than Treasury, will not own more than 20.1% of our total common stock for the duration of our existence. Under our charter, bylaws and applicable law, 20.1% is insufficient to control the outcome of any vote that is presented to the common stockholders. Accordingly, existing common stockholders have no assurance that, as a group, they will be able to control the election of our directors or the outcome of any other vote after the time, if any, that the conservatorship ends. |
Competitive and Market Risks
Our investment activity is significantly limited under the Purchase Agreement and by FHFA, which will reduce our earnings from investment activities over time and result in greater reliance on our guarantee activities to generate revenue.
We are subject to significant limitations on our investment activity, which have and will continue to adversely affect the earnings capacity of our mortgage-related investments portfolio. These limitations include: (a) a requirement to reduce the size of our mortgage-related investments portfolio; and (b) significant constraints on our ability to purchase or sell mortgage assets.
Under the terms of the Purchase Agreement and FHFA regulation, our mortgage-related investments portfolio is subject to a cap that decreases each year until the portfolio reaches $250 billion. As a result of the August 2012 amendment to the Purchase Agreement, the annual rate at which the mortgage-related investments portfolio limit declines increased from 10% to 15%. As a result, the UPB of our mortgage-related investments portfolio could not exceed $650 billion as of December 31, 2012 and may not exceed $553 billion as of December 31, 2013. FHFA has indicated that such portfolio reduction targets should be viewed as minimum reductions and has encouraged us to reduce the mortgage-related investments portfolio at a faster rate than required, while indicating that the pace of reducing the portfolio may be moderated by conditions in the housing and financial markets. Our mortgage-related investments portfolio has contracted considerably since we entered into conservatorship. Our ability to take advantage of opportunities to purchase or sell mortgage assets at attractive prices has been, and likely will continue to be, limited. In addition, we can provide no assurance that the cap on our mortgage-related investments portfolio will not, over time, force us to sell mortgage assets at unattractive prices. For more information on the various restrictions and limitations on our investment activity and our mortgage-related investments portfolio, see BUSINESS Conservatorship and Related Matters Limits on Investment Activity and Our Mortgage-Related Investments Portfolio.
These limitations will reduce the earnings capacity of our mortgage-related investments portfolio business and require us to place greater emphasis on our guarantee activities to generate revenue. However, under conservatorship, our ability to generate revenue through guarantee activities may be limited, as we may be required to adopt business practices that provide support for the mortgage market in a manner that serves our public mission and other non-financial objectives, but that may negatively impact our future financial results from guarantee activities. In addition, the overall volume of our guarantee business will likely decline over time, as one of FHFAs goals for conservatorship, as set forth in its strategic plan, is to contract our presence in the mortgage market and shrink our operations. The combination of the restrictions on our business activities under the Purchase Agreement and FHFA regulation, combined with our potential inability to generate sufficient revenue through our guarantee activities to offset the effects of those restrictions, may have an adverse effect on our results of operations and financial condition. There can be no assurance that current or future profitability levels on our new single-family business would be sufficient to attract new private sector capital in the future, should the company be in a position to seek such capital. We generally must obtain FHFAs approval to implement across-the-board price increases in our guarantee business, and although FHFA has recently directed us to increase our prices, there can be no assurance FHFA will approve any such increase requests in the future. It is also possible that we could be required to increase our guarantee fees, but not receive the benefit from such an increase. For example, effective April 1, 2012, at the direction of FHFA, we increased the
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guarantee fee on single-family residential mortgages sold to us by 10 basis points. However, under the Temporary Payroll Tax Cut Continuation Act of 2011, the proceeds from this legislated increase are being remitted to Treasury to fund the payroll tax cut that occurred in 2012. Therefore, our business and financial condition will not benefit from this increase in guarantee fees. For more information, see BUSINESS Our Business Segments Single-Family Guarantee Segment Overview of the Mortgage Securitization Process.
We are subject to mortgage credit risks, including mortgage credit risk relating to off-balance sheet arrangements; increased credit costs related to these risks could adversely affect our financial condition and/or results of operations.
Mortgage credit risk is the risk that a borrower will fail to make timely payments on a mortgage we own or guarantee, exposing us to the risk of credit losses and credit-related expenses. We are primarily exposed to mortgage credit risk with respect to the single-family and multifamily loans that we own or guarantee and hold on our consolidated balance sheets. We are also exposed to mortgage credit risk with respect to securities and guarantee arrangements that are not reflected as assets on our consolidated balance sheets. These relate primarily to: (a) Freddie Mac mortgage-related securities backed by multifamily loans; (b) certain Other Guarantee Transactions; and (c) other guarantee commitments, including long-term standby commitments and liquidity guarantees.
Single-family mortgage credit risk is primarily influenced by the credit profile of the borrower (e.g., credit score, credit history, and monthly income relative to debt payments), documentation level, the number of borrowers, the features of the mortgage itself, the purpose of the mortgage, occupancy type, the type of property securing the mortgage, the LTV ratio of the loan, and local and regional economic conditions, including home prices and unemployment rates. Our credit losses will remain elevated for the near term 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 inventory of seriously delinquent loans.
While mortgage interest rates remained low in 2012, there can be no assurance that continued low mortgage interest rates or efforts to modify and refinance mortgages pursuant to the MHA Program (including pursuant to the revisions to HARP announced in October 2011) and to modify mortgages under our other loss mitigation initiatives will reduce our overall mortgage credit risk.
We also continue to have significant amounts of mortgage loans in our single-family credit guarantee portfolio with certain characteristics, such as Alt-A, interest-only, option ARMs, loans with original LTV ratios greater than 90%, and loans where borrowers had FICO scores less than 620 at the time of origination, that expose us to greater credit risk than do other types of mortgage loans. As of December 31, 2012, loans with one or more of the above characteristics comprised approximately 22% of our single-family credit guarantee portfolio. See Table 46 Certain Higher-Risk Categories in the Single-Family Credit Guarantee Portfolio for more information.
Our multifamily mortgage credit risk is affected by the mortgaged propertys ability to generate rental income from which debt service can be paid. That ability in turn is affected by rental market conditions (e.g., rental and vacancy rates), the physical condition of the property, the quality of the propertys management, and the level of operating costs. Our primary multifamily business strategy is to purchase loans for aggregation and then securitization through K Certificates, whereby we mitigate our credit risk exposure by structuring our securities to shift a significant portion of expected losses to third party investors through the sale of subordinate tranches. The subordinate tranches that we do not guarantee provide credit loss protection to the senior classes that we do guarantee. While the subordination is set at an amount we believe is adequate to cover expected credit losses, the amount of such subordination may not be sufficient to prevent us from incurring credit losses with respect to any senior classes that we guarantee.
A risk we continue to monitor is that multifamily borrowers will default if they are unable to refinance their loans at an affordable rate. This risk is particularly important with respect to multifamily loans because such loans generally have a balloon payment and typically have a shorter contractual term than single-family mortgages. Borrowers may be less able to refinance their obligations during periods of rising interest rates, reduced demand for rental housing, or weak economic conditions, which could lead to default if the borrower is unable to find affordable refinancing. However, of the $127.4 billion in UPB of loans in our multifamily mortgage portfolio as of December 31, 2012, only approximately 3% and 5% will reach their maturity during 2013 and 2014, respectively.
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We are exposed to significant credit risk related to the subprime, Alt-A, and option ARM loans that back the non-agency mortgage-related securities we hold.
Our investments in non-agency mortgage-related securities include securities that are backed by subprime, Alt-A, and option ARM loans. As of December 31, 2012, we held $69.0 billion of such securities, which represented approximately 12% of our total mortgage-related investments portfolio. Since 2007, mortgage loan delinquencies and credit losses in the U.S. mortgage market have substantially increased, particularly in the subprime, Alt-A, and option ARM sectors of the residential mortgage market. In addition, home prices have experienced significant cumulative declines, after extended periods during which home prices appreciated. As a result, the fair value of these investments has declined significantly since 2007, and we have recorded substantial other-than-temporary impairments, which has adversely impacted our net worth. In addition, most of these investments do not trade in a liquid secondary market and the size of our holdings relative to normal market activity is such that, if we were to attempt to sell a significant quantity of these securities, the pricing in such markets could be significantly disrupted and the price we ultimately realize may be materially lower than the value at which we carry these investments on our consolidated balance sheets.
We could experience additional GAAP losses due to other-than-temporary impairments on our investments in these non-agency mortgage-related securities if, among other things: (a) interest rates change; (b) delinquency and loss rates on subprime, Alt-A, and option ARM loans further increase; (c) there is a future decline in actual or forecasted home prices; or (d) there is a deterioration in servicing performance on the underlying loans. In addition, the fair value of these investments may decline in the future due to additional ratings downgrades or market events, including overall uncertainty related to recovery efforts, capital requirements or regulatory changes. Any such declines would adversely affect our net worth. Any credit enhancements covering these securities, including subordination and other structural enhancements, may not prevent us from incurring losses. During 2012, we continued to experience the erosion of structural credit enhancements on many securities backed by subprime, option ARM, and Alt-A loans due to poor performance of the underlying mortgages. The financial condition of bond insurers also continued to deteriorate in 2012. See MD&A CONSOLIDATED BALANCE SHEETS ANALYSIS Investments in Securities for information about the credit ratings for these securities and the extent to which these securities have been downgraded.
Certain strategies to mitigate our losses as an investor in non-agency mortgage-related securities may adversely affect our relationships with some of our largest seller/servicers and counterparties.
In 2011, FHFA, as Conservator for Freddie Mac and Fannie Mae, filed lawsuits against 18 corporate families of financial institutions and related defendants seeking to recover losses and damages sustained by Freddie Mac and Fannie Mae as a result of their investments in certain residential non-agency mortgage-related securities issued or sold by, or backed by mortgages originated by, these financial institutions or control persons thereof. These institutions include some of our largest seller/servicers and counterparties, including counterparties to debt funding and derivatives transactions. One of these lawsuits was settled recently.
At the direction of our Conservator, we are also working to enforce contractual rights of certain trusts with respect to the non-agency mortgage-related securities we hold, and are engaged in other efforts to mitigate losses on our investments in these securities, in some cases in conjunction with other investors. We have directed the trustees of certain of these non-agency mortgage-related securities to initiate litigation on behalf of certificate holders against several financial institutions (many of whom are Freddie Mac counterparties) for breach of contract claims.
These and other loss mitigation efforts may lead to further disputes with some of our largest seller/servicers and counterparties that may result in further litigation. This could adversely affect our relationship with any such company and could, for example, result in the loss of some or all of our business with a large seller/servicer. For more information, see Our financial condition or results of operations may be adversely affected if mortgage seller/servicers fail to repurchase loans sold to us in breach of representations and warranties or fail to honor any related indemnification or recourse obligations and NOTE 15: CONCENTRATION OF CREDIT AND OTHER RISKS.
The effectiveness of these various loss mitigation efforts is highly uncertain, in part because our rights as an investor are limited, and any potential recoveries may take significant time to realize.
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The credit losses we experience in future periods could be larger, perhaps substantially larger in the event of another recession or another sharp drop in home prices, than our current loan loss reserves.
Our loan loss reserves, as reflected on our consolidated balance sheets, do not reflect the total of all future credit losses we will ultimately incur with respect to our single-family and multifamily mortgage loans, including those underlying our financial guarantees. Rather, pursuant to GAAP, our reserves only reflect probable losses we believe we have already incurred as of the balance sheet date. Accordingly, it is likely that the credit losses we ultimately incur on the loans we currently own or guarantee will exceed the amounts we have already reserved for such loans. If we were to experience another recession or another sharp drop in home prices, it is possible that the credit losses we ultimately incur related to such an event could be larger, perhaps substantially larger, than our current loan loss reserves. Additional credit losses we incur in future periods will adversely affect our business, results of operations, financial condition, liquidity, and net worth.
Future declines in U.S. home prices or other adverse changes in the U.S. housing market could negatively impact our business and increase our losses.
Our financial results and business volumes can be significantly, negatively affected by declines in home prices and other adverse changes in the housing market. Although the single-family housing market exhibited certain signs of improvement in 2012, our credit losses remained high, in part because home prices have experienced significant cumulative declines in many geographic areas since 2006. While we expect modest home price increases in 2013, there can be no assurance that this will occur. In addition, it is likely that we will continue to experience a high rate of serious delinquencies or defaults and an elevated level of credit losses.
We prepare internal forecasts of future home prices, which we use for certain business activities, including: (a) hedging prepayment risk; (b) setting fees for new guarantee business; and (c) portfolio activities. It is possible that a sustained recovery in home prices would not begin until much later than we anticipate, or that home prices could decline in the future, which could adversely affect our performance of these business activities. For example, this could cause the return we earn on new single-family guarantee business to be less than expected. This could also result in higher losses due to other-than-temporary impairments on our investments in non-agency mortgage-related securities (which would be recognized in earnings) or fair value declines on our investments in non-agency mortgage-related securities (which would be recognized in AOCI). Government programs designed to strengthen the U.S. housing market, such as the MHA Program, may fail to achieve expected results, and new programs could be instituted that cause our credit losses to increase. For more information, see MD&A RISK MANAGEMENT Credit Risk.
Our business volumes are closely tied to the rate of growth in total outstanding U.S. residential mortgage debt and the size of the U.S. residential mortgage market. Total residential mortgage debt declined approximately 2.3% in the first nine months of 2012 (the most recent data available) compared to a decline of approximately 2.4% in 2011. If total outstanding U.S. residential mortgage debt were to continue to decline, there would likely be fewer mortgage loans available for us to purchase, and we could face more competition to purchase a smaller number of loans.
While multifamily market fundamentals (i.e., vacancy rates and effective rents) improved on a national level during 2012, this trend may not continue. The multifamily market is affected by regional and local economic factors, such as employment rates, construction cycles, and the relative affordability of single-family home prices, all of which influence supply and demand for multifamily properties and pricing for apartment rentals. Any softening of the broader economy could have negative impacts on multifamily markets, which could cause delinquencies and credit losses relating to our multifamily activities to increase beyond our current expectations.
Our refinance volumes could decline if interest rates rise, which could cause our overall new mortgage-related security issuance volumes to decline.
We continued to experience a high percentage of refinance mortgages in our purchase volume during 2012 due to continued low interest rates and the impact of our relief refinance initiatives. However, originations of refinance mortgages will likely decline if HARP expires as currently scheduled in December 2013. Interest rates have been at historically low levels for an extended period of time. In addition, many eligible borrowers have already refinanced at least once during this period of low interest rates, and therefore may be unlikely to do so again in the near future. Overall originations of refinance mortgages, and our purchases of them, will likely decrease if interest rates rise. It is possible that our overall mortgage-related security issuance volumes could decline if our volumes of purchase money mortgages do not increase to offset any such decrease in refinance mortgages. This could adversely affect the amount of revenue we receive from our guarantee activities.
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We could incur significant credit losses and credit-related expenses in the event of a major natural disaster or other catastrophic event in geographic areas in which portions of our total mortgage portfolio and REO holdings are concentrated.
We own or guarantee mortgage loans and own REO properties throughout the United States. The occurrence of a major natural or environmental disaster (such as an earthquake, hurricane, tsunami, flood, or widespread damage caused to the environment by commercial entities), terrorist attack, pandemic, or similar catastrophic event in a regional geographic area of the United States could negatively impact our credit losses and credit-related expenses in the affected area.
The occurrence of a catastrophic event could negatively impact a geographic area in a number of different ways, depending on the nature of the event. A catastrophic event that either damaged or destroyed residential real estate underlying mortgage loans we own or guarantee or negatively impacted the ability of homeowners to continue to make principal and interest payments on mortgage loans we own or guarantee could increase our serious delinquency rates and average loan loss severity in the affected region or regions, which could have a material adverse effect on our business, results of operations, financial condition, liquidity and net worth. Such an event could also damage or destroy REO properties we own. While we attempt to maintain a geographically diverse portfolio, there can be no assurance that a catastrophic event, depending on its magnitude, scope and nature, will not generate significant credit losses and credit-related expenses. We may not have insurance coverage for some of these catastrophic events. In some cases, we may be prohibited by state law from requiring such insurance as a condition to our purchasing or guaranteeing loans. In addition, any efforts we make to assist borrowers in affected areas could increase our expenses.
We depend on our institutional counterparties to provide services that are critical to our business, and our results of operations or financial condition may be adversely affected if one or more of our institutional counterparties do not meet their obligations to us.
We face the risk that one or more of the institutional counterparties that has entered into a business contract or arrangement with us may fail to meet its obligations to us. We face similar risks with respect to contracts or arrangements we benefit from indirectly or that we enter into on behalf of our securitization trusts. Our primary exposures to institutional counterparty risk are with:
| mortgage seller/servicers; |
| mortgage insurers; |
| issuers, guarantors or third-party providers of other credit enhancements (including bond insurers); |
| counterparties to short-term lending and other investment-related agreements and cash equivalent transactions, including such agreements and transactions we manage for our PC trusts; |
| derivative counterparties; |
| hazard and title insurers; |
| mortgage investors; and |
| document custodians and funds custodians. |
Many of our counterparties provide several types of services to us. In some cases, our business with institutional counterparties is concentrated. The concentration of our exposure to our counterparties has increased in recent years due to industry consolidation and counterparty failures or downgrades, and we continue to face challenges in reducing our risk concentrations with counterparties. Efforts we take to reduce exposure to financially weakened counterparties could further increase our exposure to other individual counterparties. A significant failure by a major institutional counterparty could harm our business and financial results in a variety of ways, including by adversely affecting our ability to conduct operations efficiently and at cost-effective rates, and have a material adverse effect on our investments in mortgage loans, investments in securities, our derivative portfolio or our credit guarantee activities.
Some of our counterparties may become subject to serious liquidity problems affecting their businesses, either temporarily or permanently, which may adversely affect their ability to meet their obligations to us. In recent years, challenging market conditions have, at times, adversely affected the liquidity and financial condition of our counterparties. These trends may continue. In particular, we believe all of our derivative portfolio and cash and other investments portfolio counterparties are exposed to fiscally troubled European countries. It is possible that continued adverse developments in the
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Eurozone could significantly impact such counterparties. In turn, this could adversely affect their ability to meet their obligations to us.
In the past few years, some of our largest seller/servicers have experienced ratings downgrades and liquidity constraints, and certain large lenders have failed. These challenging market conditions could also increase the likelihood that we will have disputes with our counterparties concerning their obligations to us, especially with respect to counterparties that have experienced financial strain and/or have large exposures to us. See MD&A RISK MANAGEMENT Credit Risk Institutional Credit Risk and NOTE 15: CONCENTRATION OF CREDIT AND OTHER RISKS for additional information regarding our credit risks to certain categories of counterparties and how we seek to manage them.
The servicing of mortgage loans backing our single-family non-agency mortgage-related securities investments is concentrated in a small number of institutions. We could experience losses on these investments from servicing performance deterioration should one of these institutions come under financial distress. Furthermore, Freddie Macs rights as a non-agency mortgage-related securities investor to transfer servicing are limited.
Our financial condition or results of operations may be adversely affected if mortgage seller/servicers fail to repurchase loans sold to us in breach of representations and warranties or fail to honor any related indemnification or recourse obligations.
We require seller/servicers to make certain representations and warranties regarding the loans they sell to us. If loans are sold to us in breach of those representations and warranties, we have the contractual right to require the seller/servicer to repurchase those loans from us. In lieu of repurchase, we may agree to allow a seller/servicer to indemnify us against losses on such mortgages or otherwise compensate us for the risk of continuing to hold the mortgages. Sometimes a seller/servicer sells us mortgages with recourse, meaning that the seller/servicer agrees to repurchase any mortgage that is delinquent for more than a specified period (usually 120 days), regardless of whether there has been a breach of representations and warranties. If a seller/servicer does not satisfy its repurchase or indemnification obligations with respect to a loan, we will be subject to the full range of credit risks posed by the loan if the loan fails to perform, including the risk that a mortgage insurer may deny or rescind coverage on the loan (if the loan is insured) and the risk that we will incur credit losses on the loan through the workout or foreclosure process.
As of December 31, 2012 and 2011, the UPB of loans subject to repurchase requests based on breaches of representations and warranties issued to our single-family seller/servicers was approximately $3.0 billion and $2.7 billion, respectively. As of December 31, 2012, approximately $1.2 billion of such loans were subject to repurchase requests issued due to mortgage insurance rescission or mortgage insurance claim denial.
Our contracts require that a seller/servicer repurchase a mortgage within 30 days after we issue a repurchase request, unless the seller/servicer avails itself of an appeal process provided for in our contracts, in which case the deadline for repurchase is extended until we decide the appeal. As of December 31, 2012 and 2011, approximately 41% and 39%, respectively, of these repurchase requests were outstanding more than four months since issuance of our repurchase request (these figures include repurchase requests for which appeals were pending).
The amount we collect on these requests and others we may make in the future could be significantly less than the UPB of the loans subject to the repurchase requests primarily because we expect many of these requests will likely be satisfied by reimbursement of our realized credit losses by seller/servicers, instead of repurchase of loans at their UPB, or may be rescinded in the course of the contractual appeals process. Based on our historical loss experience and the fact that many of these loans are covered by credit enhancement, we expect the actual credit losses experienced by us should we fail to collect on these repurchase requests will also be less than the UPB of the loans. We may also enter into agreements with seller/servicers to resolve claims for repurchases. The amounts we receive under any such agreements may be less than the losses we ultimately incur.
Our credit losses may increase to the extent our seller/servicers do not fully perform their repurchase obligations. Enforcing repurchase obligations of seller/servicers could also negatively impact our relationships with such customers and could result in the loss of some or all of our business with such customers, which could negatively impact our ability to retain market share. This could also lead to further disputes with such customers. It may be difficult, expensive, and time-consuming to legally enforce a seller/servicers repurchase obligations, in the event a seller/servicer continues to fail to perform such obligations. We are also acquiring an increasing portion of single-family business volume directly from smaller
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financial institutions. We may face increased risk that these institutions would not be able to satisfy their repurchase obligations, as these institutions may not have the same financial strength as our larger seller/servicers.
At the direction of FHFA, we have launched a new representation and warranty framework for conventional loans purchased by us on or after January 1, 2013. We may face greater exposure to credit and other losses under this new framework since it relieves lenders of certain repurchase obligations in specific cases, such as for loans that perform for 36 consecutive months after we purchase them, with certain exclusions. For more information, see MD&A RISK MANAGEMENT Credit Risk Institutional Credit Risk Single-Family Mortgage Seller/Servicers.
In 2012 and late 2011, we changed our relief refinance program (which includes HARP) such that we are relieving lenders of certain representations and warranties on the original mortgage being refinanced. As a result, we may face greater exposure to credit and other losses on these loans. For more information, see MD&A RISK MANAGEMENT Credit Risk Mortgage Credit Risk Single-Family Mortgage Credit Risk Single-Family Loan Workouts and the MHA Program Relief Refinance Mortgage Initiative and the Home Affordable Refinance Program.
We also have exposure to seller/servicers with respect to mortgage insurance. When a mortgage insurer rescinds coverage or denies or curtails a claim, we may require the seller/servicer to repurchase the mortgage or to indemnify us for additional loss. The volume of rescissions, claim denials, and curtailments by mortgage insurers remains high.
Seller/servicers may fail to perform their obligations to service loans in our single-family and multifamily mortgage portfolios or their servicing performance could decline.
Our seller/servicers have a significant role in servicing loans in our single-family credit guarantee portfolio, which includes an active role in our loss mitigation efforts. Therefore, a decline in their performance could impact our credit performance (including through missed opportunities for mortgage modifications), which could adversely affect our financial condition or results of operations and have a significant impact on our ability to mitigate credit losses. The risk of such a decline in performance remains high. The high levels of seriously delinquent loan volume, the weak conditions of the mortgage market, and the number and variety of additions and changes to our loan modification and other loss mitigation initiatives have placed a strain on the loss mitigation resources of many of our seller/servicers. This has also increased the operational complexity of the servicing function, as well as the risk that errors will occur. A number of seller/servicers have had to address issues relating to the improper preparation and execution of certain documents used in foreclosure proceedings, which has further strained their resources. There have also been a number of legislative and regulatory developments that have increased, or could increase, the complexity of the servicing function. It is also possible that we could be directed to introduce additional changes to the servicing function that increase its complexity, such as new or revised loan modification or loss mitigation initiatives or new compensation arrangements. Our expected ability to partially mitigate losses through loan modifications and other alternatives to foreclosure is a factor we consider in determining our allowance for loan losses. Therefore, the inability to realize the anticipated benefits of our loss mitigation plans could cause our losses to be significantly higher than those currently estimated. Weak economic conditions continue to affect the liquidity and financial condition of many of our seller/servicers, including some of our largest seller/servicers. Any efforts we take to attempt to improve our servicers performance could adversely affect our relationships with such servicers, many of which also sell loans to us.
In recent periods, a number of our servicers who specialize in servicing troubled loans have experienced rapid growth in their servicing portfolios, including an increase in troubled loans they service for Freddie Mac. Although the ability of these servicers to service troubled loans may benefit us by reducing our credit losses, the rapid expansion of their servicing portfolios could expose us to increased risks in the event that it results in operational strains that adversely affect their servicing performance or weakens their financial strength.
If a servicer does not fulfill its servicing obligations (including its repurchase or other responsibilities), we may seek partial or full recovery of the amounts that such servicer owes us, such as by attempting to sell the applicable mortgage servicing rights to a different servicer and applying the proceeds to such owed amounts, or by contracting the servicing responsibilities to a different servicer and retaining the net servicing fee. The weakness in the housing market has negatively affected the market for mortgage servicing rights, which increases the risk that we might not receive a sufficient price for such rights or that we may be unable to find buyers who: (a) have sufficient capacity to service the affected mortgages in compliance with our servicing standards; (b) are willing to assume the representations and warranties of the former servicer regarding the affected mortgages (which we typically require); and (c) have sufficient capacity to service all of the affected mortgages. Increased industry consolidation, bankruptcies of mortgage bankers or bank failures may also make it more
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difficult for us to sell such rights, because there may not be sufficient capacity in the market, particularly in the event of multiple failures. This option may be difficult to accomplish with respect to our larger seller/servicers due to operational and capacity challenges of transferring a large servicing portfolio.
Our seller/servicers also have a significant role in servicing loans in our multifamily mortgage portfolio. We are exposed to the risk that multifamily seller/servicers could come under financial pressure, which could potentially cause degradation in the quality of the servicing they provide us including their monitoring of each propertys financial performance and physical condition. This could also, in certain cases, reduce the likelihood that we could recover losses through lender repurchases, recourse agreements, or other credit enhancements, where applicable.
See MD&A RISK MANAGEMENT Credit Risk Institutional Credit Risk Single-family Mortgage Seller/Servicers and Multifamily Mortgage Seller/Servicers for additional information on our institutional credit risk related to our mortgage seller/servicers.
Our financial condition or results of operations may be adversely affected by the financial distress of our counterparties to derivatives, funding, and other transactions.
We use derivatives for several purposes, including to adjust or rebalance our funding mix in response to changes in the interest-rate characteristics of our mortgage-related assets and to hedge forecasted issuances of debt. The relative concentration of our derivative exposure among our primary derivative counterparties remains high as compared to historical levels. This concentration increased in the last several years due to industry consolidation and the failure or downgrade of certain counterparties, and could further increase. Five of our derivative counterparties each accounted for greater than 10% of our net uncollateralized exposure, excluding commitments, at December 31, 2012. For a further discussion of our exposure to derivative counterparties, see MD&A RISK MANAGEMENT Credit Risk Institutional Credit Risk Derivative Counterparties and NOTE 15: CONCENTRATION OF CREDIT AND OTHER RISKS.
Some of our derivative and other capital markets counterparties have experienced various degrees of financial distress in the past few years, including liquidity constraints, and credit downgrades. Our financial condition and results of operations may be adversely affected by the financial distress of these derivative and other capital markets counterparties to the extent that they fail to meet their obligations to us. For example, our OTC derivative counterparties are required to post collateral to us in certain circumstances to cover our net exposure to them on derivative contracts. We may incur losses if the collateral held by us cannot be liquidated at prices that are sufficient to cover the amount of such exposure. We also face the risk that, if a counterparty becomes insolvent, we may not be able to recover any collateral we posted to the counterparty.
Our ability to engage in routine derivatives, funding, and other transactions could be adversely affected by the actions of other financial institutions. Financial services institutions are interrelated as a result of trading, clearing, counterparty, or other relationships. As a result, defaults by, or even rumors or questions about, one or more financial services institutions, or the financial services industry generally, could lead to market-wide disruptions in which it may be difficult for us to find acceptable counterparties for such transactions.
We also use derivatives to synthetically create the substantive economic equivalent of various debt funding structures. Thus, if our access to the derivative markets were disrupted, it may become more difficult or expensive to fund our business activities and achieve the funding mix we desire, which could adversely affect our business and results of operations.
Our credit losses and other-than-temporary impairments recognized in earnings could increase if more of our mortgage or bond insurers become insolvent or fail to perform their obligations to us.
A number of our mortgage insurers (that insure single-family mortgages we purchase or guarantee) and bond insurers (that insure certain of the non-agency mortgage-related securities we hold) are insolvent or are not fully performing their obligations to us. We are exposed to the risk that additional mortgage or bond insurance counterparties could become insolvent or fail to fully perform their obligations to us. The weakened financial condition and liquidity position of many of these counterparties increases the risk that additional entities will fail to fully reimburse us for claims under insurance policies. This risk could increase if home prices decline in the future or if the economy worsens.
As a guarantor, we remain responsible for the payment of principal and interest if a mortgage insurer fails to meet its obligations to reimburse us for claims. Thus, if any of our mortgage insurers that provide credit enhancement fails to fulfill its obligation, we could experience increased credit losses. In addition, if a regulator determined that a mortgage insurer lacked sufficient capital to pay all claims when due, the regulator could take action that might impact the timing and amount
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of claim payments made to us. We independently assess the financial condition, including the claims-paying resources, of each of our mortgage insurers. Based on our analysis of the financial condition of a mortgage insurer and pursuant to our eligibility requirements for mortgage insurers, we could take action against a mortgage insurer intended to protect our interests that may impact the timing and amount of claims payments received from that insurer.
We believe that certain of our mortgage insurers are not sufficiently capitalized to withstand the stress of the current weak economic environment. We expect to receive substantially less than full payment of our claims from Triad Guaranty Insurance Corporation, Republic Mortgage Insurance Company and PMI Mortgage Insurance Co. We also believe that certain other of our mortgage insurance counterparties lack sufficient ability to meet all their expected lifetime claims paying obligations to us as such claims emerge. In the future, we believe our mortgage insurance exposure will likely be concentrated among a smaller number of counterparties.
In the event one or more of our bond insurers were to become insolvent, it is likely that we would not collect our claims from the affected insurer. This would impact our ability to recover certain unrealized losses on our investments in non-agency mortgage-related securities, and could contribute to net impairment of available-for-sale securities recognized in earnings. We evaluate the expected recovery from primary bond insurance policies as part of our impairment analysis for our investments in securities. If a bond insurers performance with respect to its obligations on our investments in securities is worse than expected, this could contribute to additional net impairment of those securities.
Some of our larger bond insurers are in runoff mode and are not writing new business. We expect to receive substantially less than full payment from Ambac Assurance Corporation and Financial Guaranty Insurance Company, as these companies are insolvent. Financial Guaranty Insurance Company is currently not paying any of its claims. Ambac, which had not paid claims since March 2010, began paying a portion of its claims in cash in the fall of 2012. We believe that we will likely receive substantially less than full payment of our claims from some of our other bond insurers, because we believe they also lack sufficient ability to fully meet all of their expected lifetime claims-paying obligations to us as such claims emerge.
For more information on developments concerning our mortgage insurers and bond insurers, see MD&A RISK MANAGEMENT Credit Risk Institutional Credit Risk Mortgage Insurers and Bond Insurers.
If mortgage insurers were to tighten their standards or fall out of compliance with regulatory capital requirements, the volume of high LTV ratio mortgages available for us to purchase could be reduced, which could reduce our overall volume of new business. Mortgage insurance standards could constrain our future ability to purchase loans with LTV ratios over 80%.
Our charter requires that single-family mortgages with LTV ratios above 80% at the time of purchase be covered by specified credit enhancements or participation interests. Our purchases of mortgages with LTV ratios above 80% (other than relief refinance mortgages) have generally been low in recent years, as compared to 2005 2008 levels, in part because mortgage insurers tightened their eligibility requirements with respect to the issuance of insurance on new mortgages with such higher LTV ratios. However, our acquisitions of non-HARP mortgages with LTV ratios greater than 90% increased during 2012 compared to 2011, in part because most mortgage insurance companies lowered their premiums in 2011 for certain higher-risk loans. For more information, see MD&A RISK MANAGEMENT Credit Risk Mortgage Credit Risk Single-Family Mortgage Credit Risk Other Categories of Single-Family Mortgage Loans Higher-Risk Loans in the Single-Family Credit Guarantee Portfolio. There can be no assurance that this will continue. If mortgage insurers restrict their eligibility requirements or increase premiums for loans with LTV ratios over 80%, or if we are no longer willing or able to obtain mortgage insurance from these counterparties under terms we find reasonable, and we are not able to avail ourselves of suitable alternative methods of obtaining credit enhancement for these loans, we may be restricted in our ability to purchase or securitize such loans. This could reduce our overall volume of new business. This could also negatively impact our ability to participate in a significant segment of the mortgage market (i.e., loans with LTV ratios over 80%) should we seek, or be directed, to do so. See Table 40 Characteristics of Purchases for the Single-Family Credit Guarantee Portfolio for more information about our mortgage purchases.
If a mortgage insurance company were to fall out of compliance with regulatory capital requirements and not obtain appropriate waivers, it could become subject to regulatory actions that restrict its ability to write new business in certain, or in some cases all, states. Over the past several years, three of our mortgage insurers (Triad Guaranty Insurance Corporation, Republic Mortgage Insurance Company and PMI Mortgage Insurance Co.) were each prohibited from writing new business by their primary state regulators and none of them writes new business in any state any longer. Given the difficulties in the
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mortgage insurance industry, we believe it is likely that other companies may be unable to meet regulatory capital requirements.
A mortgage insurer may attempt a corporate restructuring designed to enable it to continue to write new business through a new entity in the event the insurer falls out of compliance with regulatory capital requirements. However, there can be no assurance that an insurer would be able to accomplish such a restructuring, as the restructured entity would be required to satisfy regulatory requirements as well as our own conditions. We monitor the claim paying ability of our mortgage insurers. As these restructuring plans are presented to us for review, we attempt to determine whether the insurers plans make available sufficient resources to meet their obligations to policyholders of the insurance entities involved in the restructuring. However, there can be no assurance that any such restructuring will enable payment in full of all claims in the future. See NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Allowance for Loan Losses and Reserve for Guarantee Losses Single-Family Loans for more information.
The loss of business volume from key mortgage originators could result in a decline in our market share and revenues.
Our business depends on our ability to acquire a steady flow of mortgage loans. We purchase a significant percentage of our single-family mortgages from several large mortgage originators. During 2012 and 2011, approximately 73% and 82%, respectively, of our single-family mortgage purchase volume was associated with our ten largest customers. During 2012, three mortgage lenders (Wells Fargo Bank, N.A., U.S. Bank N.A., and JPMorgan Chase Bank, N.A.) each accounted for more than 10% of our single-family mortgage purchase volume and collectively accounted for approximately 49% of our single-family mortgage purchase volume. Similarly, we acquire a significant portion of our multifamily mortgage loans from several large lenders.
We enter into mortgage purchase volume commitments with many of our single-family customers that provide for the customers to deliver to us a certain volume of mortgages during a specified period of time. Some commitments may also provide for the lender to deliver to us a minimum percentage of their total sales of conforming loans. There is a risk that we will not be able to enter into new commitments with our single-family customers that will maintain mortgage purchase volume following the expiration of our existing commitments with them. The loss of business from any one of our major lenders could adversely affect our market share and our revenues. Many of our seller/servicers also have tightened their lending criteria in recent years, which has reduced their loan volume, thus reducing the volume of loans available for us to purchase.
Weak business and economic conditions in the U.S. and abroad may adversely affect our business and results of operations.
Our business and results of operations are significantly affected by general business and economic conditions, including conditions in the international markets for our mortgage-related and debt securities and for the various types of securities we hold as investments. These conditions include employment rates, fluctuations in both debt and equity capital markets, the value of the U.S. dollar as compared to foreign currencies, the strength of the U.S. financial markets and national economy and the local economies in which we conduct business, the regulatory environment, and the economies of other countries that purchase our mortgage-related and debt securities. Concerns about fiscal challenges in several Eurozone economies continued during 2012, creating significant uncertainty in the financial markets and potential increased risk exposure for our counterparties and for us. There is also significant uncertainty regarding fiscal challenges facing the U.S. and the strength of the U.S. economic recovery. Weak economic conditions in the U.S. could result in high serious delinquencies and credit losses, which would adversely affect our results of operations and financial condition.
The mortgage credit markets continue to be impacted by relatively low levels of corporate credit and liquidity within the mortgage industry, which has at times caused disruptions to normal operations of major mortgage servicers and originators, including some of our largest customers. This has, at times, also contributed to significant volatility, wide credit spreads and a lack of price transparency, and the potential for further consolidation within the financial services industry.
Competition from banking and non-banking companies may harm our business.
Competition in the secondary mortgage market combined with a decline in the amount of residential mortgage debt outstanding may make it more difficult for us to purchase mortgages. Furthermore, competitive pricing pressures may make our products less attractive in the market and negatively impact our financial results. Increased competition from Fannie Mae, Ginnie Mae, FHA/VA, and new entrants may alter our product mix, lower volumes, and reduce revenues on new business. FHFA is also Conservator of Fannie Mae, our primary competitor, and FHFAs actions as Conservator of both
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companies could affect competition between us and Fannie Mae. It is possible that FHFA could require us and Fannie Mae to take a uniform approach that, because of differences in our respective businesses, could place Freddie Mac at a competitive disadvantage to Fannie Mae. FHFA may also prevent us from taking actions that could provide us with a competitive advantage. Efforts we may make or may be directed to make to increase the profitability of new single-family guarantee business, such as by tightening credit standards or raising guarantee fees, could cause our market share to decrease and the volume of our single-family guarantee business to decline. Historically, we also competed with other financial institutions that retain or securitize mortgages, such as commercial and investment banks, dealers, thrift institutions, and insurance companies. Many of these institutions have ceased or substantially reduced their activities in the secondary market for single-family mortgages since 2008. However, one of FHFAs goals for conservatorship, as set forth in its strategic plan, is to contract our presence in the mortgage market and shrink our operations, and FHFA is taking a number of actions designed to encourage these other financial institutions to return to the mortgage market.
We could be prevented from competing efficiently and effectively by competitors who use their patent portfolios to prevent us from using necessary business processes and products, or to require us to pay significant royalties to use those processes and products.
Beginning in 2010, as multifamily market fundamentals were starting to improve, more market participants began to re-enter the multifamily market, and as a result we have faced increased competition. Although we continued to be a significant participant in the multifamily market in 2012, other participants, including life insurers, banks, and CMBS issuers, also were active in acquiring multifamily mortgages and we expect continued competition in the multifamily market.
Our investment activities may be adversely affected by limited availability of financing and increased funding costs.
The amount, type and cost of our funding, including financing from other financial institutions and the capital markets, directly impacts our interest expense and results of operations. A number of factors could make such financing more difficult to obtain, more expensive or unavailable on any terms, both domestically and internationally, including:
| changes in our government support; |
| reduced demand for our debt securities; |
| competition for debt funding from other debt issuers; and |
| downgrades in our credit ratings or the credit ratings of the U.S. government. |
Our ability to obtain funding in the public debt markets or by pledging mortgage-related securities as collateral to other financial institutions could cease or change rapidly, and the cost of available funding could increase significantly, due to changes in market confidence and other factors. For example, in the fall of 2008, we experienced significant deterioration in our access to the unsecured medium- and long-term debt markets, and were forced to rely on short-term debt to fund our purchases of mortgage assets and refinance maturing debt and to rely on derivatives to synthetically create the substantive economic equivalent of various debt funding structures.
We follow certain liquidity management practices and procedures. However, in the event we were unable to obtain funding from the public debt markets, there can be no assurance that such practices and procedures would provide us with sufficient liquidity to meet ongoing cash obligations for an extended period.
Since 2008, the ratings on the non-agency mortgage-related securities we hold backed by Alt-A, subprime, and option ARM loans have decreased, limiting their availability as a significant source of liquidity for us through sales or use as collateral in secured lending transactions.
The composition of our mortgage-related investments portfolio has changed significantly since we entered into conservatorship, as the proportion of single-family whole loans has significantly increased and the proportion of agency mortgage-related securities has significantly declined. This changing composition presents heightened liquidity risk, which influences managements decisions regarding funding and hedging.
Changes in Government Support
Changes or perceived changes in the governments support of us could have a severe negative effect on our access to the debt markets and our debt funding costs. Beginning January 1, 2013, the amount of available funding remaining under the Purchase Agreement is $140.5 billion. This amount will be reduced by any future draws. The provisions of the Purchase Agreement whereby Treasurys funding commitment would increase as necessary to accommodate any cumulative reduction
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in our net worth during 2010, 2011, and 2012 no longer apply. While we believe that the support provided by Treasury pursuant to the Purchase Agreement currently enables us to maintain our access to the debt markets and to have adequate liquidity to conduct our normal business activities, the costs of our debt funding could vary due to the uncertainty about the future of the GSEs. The cost of our debt funding could increase if debt investors believe that the risk that we could be placed into receivership is increasing. Our access to the debt markets and the cost of funding could also be adversely affected if we were to make significant draws in the future, and thereby significantly reduce the amount of available funding remaining under the Purchase Agreement. In addition, under the Purchase Agreement, without the prior consent of Treasury, we may not increase our total indebtedness above a specified limit or become liable for any subordinated indebtedness. For more information, see MD&A LIQUIDITY AND CAPITAL RESOURCES Liquidity Actions of Treasury and FHFA.
We do not currently have a liquidity backstop available to us (other than draws from Treasury under the Purchase Agreement and Treasurys ability to purchase up to $2.25 billion of our obligations under its permanent statutory authority) if we are unable to obtain funding from issuances of debt or other conventional sources. At present, we are not able to predict the likelihood that a liquidity backstop will be needed, or to identify the alternative sources of liquidity that might be available to us if needed, other than from Treasury as referenced above.
Demand for Debt Funding
The willingness of investors to purchase or hold our debt securities, and any changes to such willingness, may materially affect our liquidity, business and results of operations. The willingness of domestic and foreign investors to purchase and hold our debt securities can be influenced by many factors, including changes in the world economy, changes in foreign-currency exchange rates, regulatory and political factors, as well as the availability of and preferences for other investments. If investors were to divest their holdings or reduce their purchases of our debt securities, our funding costs could increase and our business activities could be curtailed.
Competition for Debt Funding
We compete for debt funding with Fannie Mae, the FHLBs, and other institutions. Competition for debt funding from these entities can vary with changes in economic, financial market, and regulatory environments. Increased competition for debt funding may result in a higher cost to finance our business, which could negatively affect our financial results. An inability to issue debt securities at attractive rates in amounts sufficient to fund our business activities and meet our obligations could have an adverse effect on our business, liquidity, financial condition, and results of operations. See MD&A LIQUIDITY AND CAPITAL RESOURCES Liquidity Other Debt Securities for a description of our debt issuance programs. Our funding costs may also be affected by changes in the amount of, and demand for, debt issued by Treasury.
Line of Credit
We maintain a secured intraday line of credit to provide additional intraday liquidity to fund our activities through the Fedwire system. This line of credit requires us to post collateral to a third party. In certain circumstances, this secured counterparty may be able to repledge the collateral underlying our financing without our consent. In addition, because the secured intraday line of credit is uncommitted, we may not be able to continue to draw on it if and when needed.
Any downgrade in the credit ratings of the U.S. government would likely be followed by a downgrade in our credit ratings. A downgrade in the credit ratings of our debt could adversely affect our liquidity and other aspects of our business.
Nationally recognized statistical rating organizations play an important role in determining, by means of the ratings they assign to issuers and their debt, the availability and cost of funding. Our credit ratings are important to our liquidity. We currently receive ratings from three nationally recognized statistical rating organizations (S&P, Moodys, and Fitch) for our unsecured borrowings. These ratings are primarily based on the support we receive from Treasury, and therefore are affected by changes in the credit ratings of the U.S. government. Any downgrade in the credit ratings of the U.S. government would be expected to be followed or accompanied by a downgrade in our credit ratings.
In August 2011, S&P lowered our senior long-term debt credit rating to AA+ from AAA and assigned a negative outlook to the rating. This action followed S&Ps downgrade of the credit rating of the U.S. government. In addition, Moodys confirmed our senior long-term debt and subordinated debt ratings and assigned a negative outlook to the ratings in August 2011. This action accompanied Moodys confirmation of the U.S. governments AAA long-term credit rating and assignment of a negative outlook to the rating. In November 2011, Fitch affirmed our long-term Issuer Default Rating (IDR)
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at AAA and revised the outlook to negative from stable. This action followed Fitchs affirmation of the U.S. governments AAA IDR and revision of its long-term rating to negative from stable. S&P, Moodys, and Fitch have indicated that additional actions on the U.S. governments ratings could occur if steps toward a credible deficit reduction plan are not taken or if the U.S. experiences a weaker than expected economic recovery.
In addition to a downgrade in the credit ratings of or outlook on the U.S. government, a number of other events could adversely affect our debt credit ratings, including actions by governmental entities or others, changes in government support for us, future GAAP losses, and additional draws under the Purchase Agreement. Any such downgrades could lead to major disruptions in the mortgage market and to our business due to lower liquidity, higher borrowing costs, lower asset values, and higher credit losses, and could cause us to experience net losses and net worth deficits. The full range and extent of the adverse effects to our business that would result from any such ratings downgrades and market disruptions cannot be predicted with certainty. However, we expect that they could: (a) adversely affect our liquidity and cause us to limit or suspend new business activities that entail outlays of cash; (b) make new issuances of debt significantly more costly, or potentially prohibitively expensive, and adversely affect the supply of debt financing available to us; (c) reduce the value of our guarantee to investors and adversely affect our ability to issue our guaranteed mortgage-related securities; (d) reduce the value of Treasury and agency mortgage securities we hold; (e) increase the cost of mortgage financing for borrowers, thereby reducing the supply of mortgages available to us to purchase; (f) adversely affect home prices, reducing the value of our REO and likely leading to additional borrower defaults on mortgage loans we guarantee; and (g) trigger additional collateral requirements under our derivatives contracts.
A significant decline in the price performance of or demand for our PCs could have an adverse effect on the volume and/or profitability of our new single-family guarantee business.
Security performance is one of Freddie Macs more significant risks and competitive issues, with both short- and long-term implications. Our PCs are an integral part of our mortgage purchase program. Our competitiveness in purchasing single-family mortgages from our seller/servicers, and thus the volume and/or profitability of our new single-family guarantee business, can be directly affected by the relative price performance of our PCs and comparable Fannie Mae securities.
The profitability of our securitization financing and our ability to compete for mortgage purchases are affected by the price differential between PCs and comparable Fannie Mae securities. Freddie Mac fixed-rate PCs provide for faster remittance of mortgage principal and interest payments to investors than Fannie Mae fixed-rate securities. However, our PCs have typically traded at prices below the level that we believe reflects the full value of their faster remittance cycle, resulting in a pricing discount relative to comparable Fannie Mae securities. This difference in relative pricing creates an economic incentive for customers to conduct a disproportionate share of their single-family business with Fannie Mae and negatively affects the financial performance of our business.
Recent deterioration in the pricing of our PCs relative to comparable Fannie Mae securities has adversely affected our competitiveness. Our 2012 mortgage purchase market share was volatile and at times significantly below its average levels during 2010 and 2011. We believe the primary factor adversely affecting our security performance was the substantially lower liquidity of our PCs versus comparable Fannie Mae securities. If this trend continues, the volume and/or profitability of our new single-family guarantee business could be adversely affected. Market conditions can also affect the price performance of our PCs.
We may be unable to maintain a liquid market for our PCs, which could adversely affect the price performance of PCs and our single-family market share. A significant reduction in our market share, and thus in the volume of mortgage loans that we securitize, could further reduce the liquidity of our PCs. While we may employ a variety of strategies in an effort to support the liquidity and price performance of our PCs and may consider additional strategies, any such strategies may fail or adversely affect our business or we may cease such activities if deemed appropriate. In addition, we believe the liquidity-related price differences between our PCs and comparable Fannie Mae securities are, in part, the result of factors that are largely outside of our control. Thus, while we may employ strategies in an effort to support the liquidity-related price differences, we do not believe the strategies currently available to us can fully eliminate these price differences over the long-term. A curtailment of such mortgage-related investments portfolio purchase and retention activities that are undertaken primarily in an effort to support the price performance of our PCs may result in a decline in the volume and/or profitability of our new single-family guarantee business, lower comprehensive income, and an accelerated decline in the size of our total mortgage portfolio.
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In certain circumstances, we compensate customers for the difference in price between our PCs and comparable Fannie Mae securities, and this could adversely affect the volume and/or profitability of our new single-family guarantee business. We also incur costs in connection with our efforts to support the liquidity and price performance of our PCs, including engaging in transactions that yield less than our target rate of return. For more information, see BUSINESS Our Business Segments Single-Family Guarantee Segment Securitization Activities and Investments Segment PC Support Activities.
Mortgage fraud could result in significant financial losses and harm to our reputation.
We rely on representations and warranties by seller/servicers about the characteristics of the single-family mortgage loans we purchase and securitize, and we do not independently verify most of the information that is provided to us before we purchase the loan. This exposes us to the risk that one or more of the parties involved in a transaction (such as the borrower, seller, broker, appraiser, title agent, loan officer, lender or servicer) will engage in fraud by misrepresenting facts about the property underlying the real estate transaction, borrower, or mortgage loan. While we subsequently review a sample of these loans to determine if such loans are in compliance with our contractual standards, there can be no assurance that this would detect or deter mortgage fraud, or otherwise reduce our exposure to the risk of fraud. We are also exposed to fraud by third parties in the mortgage servicing function, particularly with respect to sales of REO properties, single-family short sales, and other dispositions of non-performing assets. We may experience significant financial losses and reputational damage as a result of such fraud.
The value of mortgage-related securities guaranteed by us and held as investments may decline if we are unable to perform under our guarantee or if investor confidence in our ability to perform under our guarantee diminishes.
A portion of our investments in mortgage-related securities are securities guaranteed by us. Our valuation of these securities is consistent with GAAP and the legal structure of the guarantee transaction. These securities are collateralized by Freddie Mac assets transferred to the securitization trusts and include: (a) REMICs and Other Structured Securities; (b) certain Other Guarantee Transactions; and (c) multifamily PCs. The valuation of our guaranteed mortgage-related securities reflects investor confidence in our ability to perform under our guarantee and the liquidity that our guarantee provides. If we were unable to perform under our guarantee or if investor confidence in our ability to perform under our guarantee were to diminish, the value of our guaranteed securities may decline, thereby reducing the value of the securities reported on our consolidated balance sheets, which could have an adverse effect on our financial condition and results of operations. This could also adversely affect our ability to sell or otherwise use these securities for liquidity purposes.
Changes in interest rates could negatively impact our results of operations, net worth, and fair value of net assets.
Our investment activities and credit guarantee activities expose us to interest rate and other market risks. Changes in interest rates, up or down, could adversely affect our net interest yield. Although the yield we earn on our assets and our funding costs tend to move in the same direction in response to changes in interest rates, either can rise or fall faster than the other, causing our net interest yield to expand or compress. For example, due to the timing of maturities or rate reset dates on variable-rate instruments, when interest rates rise, our funding costs may rise faster than the yield we earn on our assets. This rate change could cause our net interest yield to compress until the effect of the increase is fully reflected in asset yields. Changes in the slope of the yield curve could also reduce our net interest yield.
Our GAAP results can be significantly affected by changes in interest rates, and adverse changes in interest rates could adversely affect our net income or net worth. For example, changes in interest rates affect the fair value of our derivative portfolio. Since we generally record changes in fair values of our derivatives in current income, such changes could significantly impact our GAAP results. 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 types of assets and liabilities being hedged do not affect net income. We could record substantial gains or losses from derivatives in any period, which could significantly contribute to our overall results for the period and affect our net worth as of the end of such period. It is difficult for us to predict the amount or direction of derivative results. Additionally, increases in interest rates could increase other-than-temporary impairments on our investments in non-agency mortgage-related securities. Higher interest rates can result in a reduction in the benefit from expected structural credit enhancements on these securities.
Changes in interest rates may also affect prepayment assumptions, thus potentially impacting the fair value of our assets, including our investments in mortgage-related assets. When interest rates fall, borrowers are more likely to prepay
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their mortgage loans by refinancing them at a lower rate. An increased likelihood of prepayment on the mortgages underlying our mortgage-related securities may adversely impact the value of these securities.
When interest rates increase, our credit losses from ARM and interest-only ARM loans may increase as borrower payments increase at their reset dates, which increases the borrowers risk of default. Rising interest rates may also reduce the opportunity for these borrowers to refinance into a fixed-rate loan.
Interest rates can fluctuate for a number of reasons, including changes in the fiscal and monetary policies of the federal government and its agencies, such as the Federal Reserve. Federal Reserve policies directly and indirectly influence the yield on our interest-earning assets and the cost of our interest-bearing liabilities.
Changes in OAS could materially impact our fair value of net assets and adversely affect future results of operations and net worth.
OAS is an estimate of the incremental yield spread between a particular financial instrument and a benchmark yield curve. This includes consideration of potential variability in the instruments cash flows resulting from any options embedded in the security, such as prepayment options. The OAS between the mortgage and agency debt sectors can significantly affect the fair value of our net assets. The fair value impact of changes in OAS for a given period represents an estimate of the net unrealized increase or decrease in the fair value of net assets arising from net fluctuations in OAS during that period. We do not attempt to hedge or actively manage the impact of changes in mortgage-to-debt OAS.
Changes in market conditions, including changes in interest rates, liquidity, prepayment and/or default expectations, and the level of uncertainty in the market for a particular asset class may cause fluctuations in OAS. A widening of the OAS on a given asset, which typically causes a decline in the current fair value of that asset, may cause significant mark-to-fair value losses, and may adversely affect our financial results and net worth. Conversely, a narrowing or tightening of the OAS typically causes an increase in the current fair value of that asset, but may reduce the number of attractive investment opportunities in mortgage loans and mortgage-related securities. Consequently, a tightening of the OAS may adversely affect our future financial results and net worth. See MD&A FAIR VALUE MEASUREMENTS AND ANALYSIS Consolidated Fair Value Balance Sheets Analysis Discussion of Fair Value Results for a more detailed description of the impacts of changes in mortgage-to-debt OAS.
While wider spreads might create favorable investment opportunities, we are limited in our ability to take advantage of any such opportunities due to various restrictions on our mortgage-related investments portfolio activities. See BUSINESS Conservatorship and Related Matters Limits on Investment Activity and Our Mortgage-Related Investments Portfolio.
We could experience significant reputational harm, which could affect the future of our company, if our efforts to support the U.S. residential mortgage market do not succeed.
We are focused on a number of initiatives designed to support the U.S. residential mortgage market, including the MHA Program and other foreclosure avoidance programs, the servicing alignment initiative and various other alignment initiatives, and the development of various mortgage market enhancements. If these initiatives do not achieve their desired results, or are otherwise perceived to have failed to achieve their objectives, we may experience damage to our reputation, which may impact the extent of future government support for our business and government decisions with respect to the future status and role of Freddie Mac.
Negative publicity causing damage to our reputation could adversely affect our business prospects, financial results, or net worth.
Reputation risk, or the risk to our financial results and net worth from negative public opinion, is inherent in our business. Negative public opinion could adversely affect our ability to keep and attract customers or otherwise impair our customer relationships, adversely affect our ability to obtain financing, impede our ability to hire and retain qualified personnel, hinder our business prospects, or adversely impact the trading price of our securities. Perceptions regarding the practices of our competitors, our seller/servicers or the financial services and mortgage industries as a whole, particularly as they relate to the recent housing and economic downturn, may also adversely impact our reputation. Adverse reputation impacts on third parties with whom we have important relationships may impair market confidence or investor confidence in our business operations as well. In addition, negative publicity could expose us to adverse legal and regulatory consequences, including greater regulatory scrutiny or adverse regulatory or legislative changes, and could affect what changes may occur
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to our business structure during or following conservatorship, including whether we will continue to exist. These adverse consequences could result from perceptions concerning our activities and role in addressing the housing and economic downturn, concerns about our compensation practices, concerns about deficiencies in foreclosure documentation practices or our actual or alleged action or failure to act in any number of areas, including corporate governance, regulatory compliance, financial reporting and disclosure, purchases of products perceived to be predatory, safeguarding or using nonpublic personal information, or from actions taken by government regulators in response to our actual or alleged conduct.
The servicing alignment initiative, MHA Program, and other efforts to reduce foreclosures, modify loan terms and refinance mortgages, including HARP, may fail to mitigate our credit losses and may adversely affect our results of operations or financial condition.
The servicing alignment initiative, MHA Program, and other loss mitigation activities are a key component of our strategy for managing and resolving troubled assets and lowering credit losses. However, our loss mitigation strategies may not be successful and our credit losses may continue to remain high. The costs we incur related to loan modifications and other activities have been, and will likely continue to be, significant because we bear the full cost of the monthly payment reductions related to modifications of loans we own or guarantee, and all applicable servicer and borrower incentives. We are not reimbursed for these costs by Treasury. For information on our loss mitigation activities, see MD&A RISK MANAGEMENT Credit Risk Mortgage Credit Risk Single-Family Mortgage Credit Risk Single-Family Loan Workouts and the MHA Program.
We could be required or elect to make changes to our implementation of our loss mitigation activities that could make these activities more costly to us, both in terms of credit expenses and the cost of implementing and operating the activities. For example, we could be required to use principal reduction to achieve reduced payments for borrowers. This could further increase our losses, as we could bear some or all of the costs of such reductions.
A significant number of loans are in the trial period of HAMP or our non-HAMP standard loan modification. For information on completion rates for HAMP and non-HAMP modifications, see MD&A RISK MANAGEMENT Credit Risk Mortgage Credit Risk Single-Family Mortgage Credit Risk Single-Family Loan Workouts and the MHA Program. A number of loans will fail to complete the applicable trial period or qualify for our other loss mitigation programs. For these loans, the trial period will have effectively delayed the foreclosure process and could increase our losses, to the extent the prices we ultimately receive for the foreclosed properties are less than the prices we could have received had we foreclosed upon the properties earlier. These delays in foreclosure could also cause our REO operations expense to increase, perhaps substantially.
Mortgage modification initiatives, particularly any future focus on principal reductions (which at present we do not offer to borrowers), have the potential to change borrower behavior and mortgage underwriting. Principal reductions may create an incentive for borrowers that are current to become delinquent in order to receive a principal reduction. This, coupled with the phenomenon of widespread underwater mortgages, could significantly affect borrower attitudes towards homeownership, the commitment of borrowers to making their mortgage payments, the way the market values residential mortgage assets, the way in which we conduct business and, ultimately, our financial results.
Depending on the type of loss mitigation activities we pursue, those activities could result in accelerating or slowing prepayments on our PCs and REMICs and Other Structured Securities, either of which could affect the pricing of such securities. At the direction of FHFA, we implemented a series of changes to HARP in late 2011 and 2012. We subsequently made similar changes to the relief refinance mortgage initiative for loans with LTV ratios of 80% and less. There can be no assurance that the benefits from the revised programs will exceed our costs. We may face greater exposure to credit and other losses on HARP and other relief refinance loans (starting in late 2012) because we are relieving lenders of certain representations and warranties on the original mortgage being refinanced. Due to the impact of HARP and other refinance initiatives of Freddie Mac and Fannie Mae, we could experience declines in the fair values of certain agency security investments classified as available-for-sale or trading resulting from changes in expectations of mortgage prepayments and lower net interest yields over time on other mortgage-related investments. The ultimate impact of the HARP revisions on our financial results will be driven by the level of borrower participation and the volume of loans with high LTV ratios that we acquire under the program. Over time, relief refinance mortgages with LTV ratios above 80% may not perform as well as relief refinance mortgages with LTV ratios of 80% and below because of the continued high LTV ratios of these loans. Based on our historical experience, there is an increase in borrower default risk as LTV ratios increase. In addition, relief refinance mortgages may not be covered by mortgage insurance for the full excess of their UPB over 80%. For more information, see MD&A RISK MANAGEMENT Credit Risk Mortgage Credit Risk Single-Family Mortgage Credit Risk Single-Family Loan Workouts and the MHA Program.
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We are devoting significant internal resources to the implementation of the servicing alignment initiative and the MHA Program. The costs we incur related to these initiatives have been, and will likely continue to be, significant. The size and scope of these efforts may also limit our ability to pursue other business opportunities or corporate initiatives.
We may experience further write-downs and losses relating to our assets, including our investment securities, net deferred tax assets, REO properties or mortgage loans, that could materially adversely affect our business, results of operations, financial condition, liquidity and net worth.
We experienced significant losses and write-downs relating to certain of our assets during the past several years, including significant declines in market value, impairments of our investment securities, write-downs of REO properties, losses on non-performing loans removed from PC pools, and impairments on other assets. The fair value of our assets may be further adversely affected by continued weakness in the economy, any further deterioration in the housing and financial markets, additional ratings downgrades, or other events.
Since we entered into conservatorship in September 2008, we have established a significant valuation allowance on our deferred tax assets. If future events significantly alter our current outlook, additional valuation allowances may need to be established for the remaining deferred tax asset. The future status and role of Freddie Mac could be affected by actions of the Conservator, and legislative and regulatory action that alters the ownership, structure, and mission of the company. The uncertainty of these developments could materially affect our operations, which could in turn affect our ability or intent to hold investments until the recovery of any temporary unrealized losses.
We may experience additional write-downs and losses relating to our assets, including those that are currently AAA-rated, and the fair values of our assets may decline in the future. This could adversely affect our results of operations, financial condition, liquidity, and net worth.
There may not be an active, liquid trading market for our equity securities.
Our common stock and classes of preferred stock that previously were listed and traded on the NYSE were delisted from the NYSE effective July 8, 2010, and now trade on the OTCQB Marketplace. The market price of our common stock declined significantly between June 16, 2010, the date we announced our intention to delist these securities, and July 8, 2010, the first day the common stock traded exclusively on the OTC market, and may decline further. Trading volumes on the OTCQB Marketplace have generally been, and will likely continue to be, less than those on the NYSE, which would make it more difficult for investors to execute transactions in our securities and could make the prices of our securities decline or be more volatile.
Operational Risks
We face significant levels of operational risk. Our risk management efforts may not effectively mitigate the risks we seek to manage.
We face significant levels of operational risk, due to a variety of factors, including: (a) the level and pace of organizational change within our company; (b) the complexity of our business operations; (c) limitation in our core systems; (d) the fact that we face a variety of different, and potentially competing, business objectives and new FHFA-mandated activities (e.g., the initiatives we are pursuing under the Conservatorship Scorecard); and (e) employee turnover.
We could incur substantial losses and our business operations could be disrupted if we are unable to effectively identify, manage, monitor and mitigate operational risks related to our business. Our risk management policies, procedures and techniques may not be sufficient to mitigate the risks we have identified or to appropriately identify additional risks to which we are subject. See QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK and MD&A RISK MANAGEMENT for a discussion of our approach to managing certain of the risks we face.
We have incurred, and will continue to incur, expenses and we may otherwise be adversely affected by delays and deficiencies in the foreclosure process.
We have been, and will likely continue to be, adversely affected by delays and deficiencies in the foreclosure process, which could increase our expenses.
The average length of time for foreclosure of a Freddie Mac loan significantly increased in recent years, particularly in states that require a judicial foreclosure process, and may further increase. A number of factors have contributed to this
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increase, including: (a) the increasingly lengthy foreclosure process in many states (affected, in some states, by new foreclosure requirements); (b) the difficulty of servicers in processing the high volume of seriously delinquent loans, due in part to general constraints on servicer capacity and the increasing complexity of the servicing function; and (c) concerns about deficiencies in seller/servicers conduct of the foreclosure process. For more information on these developments, see BUSINESS Regulation and Supervision Legislative and Regulatory Developments Developments Concerning Single-Family Servicing Practices.
Delays in the foreclosure process could cause our credit losses to increase for a number of reasons. For example, properties awaiting foreclosure could deteriorate until we acquire ownership of them through foreclosure. This would increase our expenses to repair and maintain the properties when we do acquire them. Such delays may also adversely affect the values of, and our losses on, the non-agency mortgage-related securities we hold. Delays in the foreclosure process may also adversely affect trends in home prices regionally or nationally, which could also adversely affect our financial results.
It also is possible that mortgage insurance claims could be reduced if delays caused by servicers deficient foreclosure practices prevent servicers from completing foreclosures within required timelines defined by mortgage insurers. Mortgage insurance companies establish foreclosure timelines that vary by state and range between 60 and 990 days.
Delays in the foreclosure process could create fluctuations in our single-family credit statistics. For example, our realization of credit losses, which consists of REO operations income (expense) plus charge-offs, net, could be delayed because we typically record charge-offs at the time we take ownership of a property through foreclosure. Delays could also temporarily increase the number of seriously delinquent loans that remain in our single-family mortgage portfolio, which could result in higher reported serious delinquency rates and a larger number of non-performing loans than would otherwise have been the case.
In the fall of 2010, several large seller/servicers announced issues relating to the improper preparation and execution of certain documents used in foreclosure proceedings. These announcements raised various concerns relating to foreclosure practices, and caused significant delays in the foreclosure process, particularly during 2011. It is possible that additional deficiencies in foreclosure practices will be identified in the future. The integrity of the foreclosure process is critical to our business, and our financial results could be adversely affected by deficiencies in the conduct of that process.
Issues related to mortgages recorded through the MERS System could delay or disrupt foreclosure activities and have an adverse effect on our business.
The Mortgage Electronic Registration System, or the MERS® System, is an electronic registry that is widely used by seller/servicers, Freddie Mac, and other participants in the mortgage finance industry, to maintain records of beneficial ownership of mortgages. The MERS System is owned, operated, and maintained by MERSCORP Holdings, Inc., a privately held company (which we refer to below as MERSCORP), the shareholders of which include a number of organizations in the mortgage industry, including Freddie Mac, Fannie Mae, and certain seller/servicers, mortgage insurance companies, and title insurance companies.
Mortgage Electronic Registration Systems, Inc., or MERS, a wholly-owned subsidiary of MERSCORP, has the ability to serve as a nominee for the owner of a mortgage loan and in that role become the mortgagee of record for the loan in local land records. Freddie Mac seller/servicers may choose to use MERS as a nominee, though they are no longer permitted to initiate foreclosures in MERS name with respect to mortgages owned or guaranteed by us. Approximately 41% of the loans Freddie Mac owns or guarantees were registered in MERS name as of December 31, 2012; the beneficial ownership and the ownership of the servicing rights related to those loans are tracked in the MERS System.
MERS has been the subject of numerous lawsuits challenging foreclosures on mortgages for which MERS is mortgagee of record as nominee for the beneficial owner. It is possible that adverse judicial decisions, regulatory proceedings or action, or legislative action related to MERS, could delay or disrupt foreclosure of mortgages that are registered on the MERS System. Negative publicity about MERS could adversely affect the mortgage industry and negatively impact public confidence in the foreclosure process, which could lead to legislative or regulatory action. Because MERS often executes legal documents in connection with foreclosure proceedings, it is possible that investigations by governmental authorities and others into deficiencies in foreclosure practices may negatively impact MERS and the MERS System.
Federal or state legislation or regulatory action could prevent us from using the MERS System for mortgages that we own, guarantee, and securitize, or could create additional requirements for the transfer of mortgages that could affect the process for and costs of acquiring, transferring, servicing, and foreclosing on mortgages. Such legislation or regulatory action
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could increase our costs or otherwise adversely affect our business. For example, we could be required to transfer mortgages out of the MERS System. There is also uncertainty regarding the extent to which seller/servicers will choose to use the MERS System in the future.
Failures by MERS to apply prudent and effective process controls and to comply with legal and other requirements in the foreclosure process could pose legal and operational risks for us. We may also face significant reputational risk due to our ties to MERS, as we are a shareholder of MERSCORP and a Freddie Mac officer serves on MERSCORPs board of directors. In April 2011, federal banking regulators and FHFA entered into a consent order with MERSCORP and MERS, which stated that such regulators had identified a number of deficiencies and unsafe or unsound practices by both entities that present financial, operational, compliance, legal and reputational risk to both entities and to participating members, including Freddie Mac. The regulators required MERSCORP and MERS to take certain corrective actions, including simplifying MERSCORPs governance structures. Such changes have resulted in our giving up certain governance rights. For example, while Freddie Mac had the right to appoint a Freddie Mac officer to serve on MERS board of directors in the past, it is not certain if this will continue. It is unclear what the consequent impact of these changes will be on Freddie Macs relationship with and rights with respect to the two entities.
Weaknesses in internal control over financial reporting and in disclosure controls could result in errors and inadequate disclosures, affect operating results, and cause investors to lose confidence in our reported results.
We face continuing challenges because of deficiencies in our controls. Control deficiencies could result in errors, and lead to inadequate or untimely disclosures, and affect operating results. Control deficiencies could also cause investors to lose confidence in our reported financial results, which may have an adverse effect on the trading price of our securities. For information about our ineffective disclosure controls and one material weakness in internal control over financial reporting, see CONTROLS AND PROCEDURES.
There are a number of factors that may impede our efforts to establish and maintain effective disclosure controls and internal control over financial reporting, including: (a) the nature of the conservatorship and our relationship with FHFA; (b) the complexity of, and significant changes in, our business activities and related GAAP requirements; (c) employee and management turnover; (d) internal reorganizations; (e) uncertainty regarding the sustainability of newly established controls; (f) data quality or servicing-related issues; and (g) the uncertain long-term impacts of the recent housing and economic downturn on the results of our models, which are used for financial accounting and reporting purposes. Disruptive levels of employee turnover could negatively impact our internal control environment, including internal control over financial reporting, and ability to issue timely financial statements. We cannot be certain that our efforts to improve and maintain our internal control over financial reporting will ultimately be successful.
Effectively designed and operated internal control over financial reporting provides only reasonable assurance that material errors in our financial statements will be prevented or detected on a timely basis. A failure to maintain effective internal control over financial reporting increases the risk of a material error in our reported financial results and delay in our financial reporting timeline. Depending on the nature of a control failure and any required remediation, ineffective controls could have a material adverse effect on our business.
We face risks and uncertainties associated with the models that we use for financial accounting and reporting purposes, to make business decisions, and to manage risks. Market conditions have raised these risks and uncertainties.
We make significant use of business and financial models for financial accounting and reporting purposes and to manage risk. We face risk associated with our use of models. First, there is inherent uncertainty associated with model results. Second, we could fail to properly implement, operate, or use our models. Either of these situations could adversely affect our financial statements and our ability to manage risks.
We use market-based information as inputs to our models. However, it can take time for data providers to prepare information, and thus the most recent information may not be available for the preparation of our financial statements. When market conditions change quickly and in unforeseen ways, there is an increased risk that the inputs reflected in our models are not representative of current market conditions.
The severe deterioration of the housing and credit markets beginning in 2008 and, more recently, the extended period of economic weakness and uncertainty have increased the risks associated with our use of models. For example, certain economic events or the implementation of government policies could create increased model uncertainty as models may not fully capture these events, which makes it more difficult to assess model performance and requires a higher degree of
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management judgment. Our models may not perform as well in situations for which there are few or no recent historical precedents. We have adjusted our models in response to recent events, but there remains considerable uncertainty about model results.
Models are inherently imperfect predictors of actual results. Our models rely on various assumptions that may be incorrect, including that historical experience can be used to predict future results. It has been more difficult to predict the behaviors of the housing and credit capital markets and market participants over the past several years, due to, among other factors: (a) the uncertainty concerning trends in home prices; (b) the lack of historical evidence about the behavior of deeply underwater borrowers, the effect of an extended period of extremely low interest rates on prepayments, and the impact of widespread loan refinancing and modification programs (such as HARP and HAMP), including the potential for the extensive use of principal reductions; and (c) the impact of the concerns about deficiencies in foreclosure documentation practices and related delays in the foreclosure process.
We face the risk that we could fail to implement, operate, or adjust or use our models properly. For example, the assumptions underlying a model could be invalid, or we could apply a model to events or products outside the models intended use. We may fail to code a model correctly or we could use incorrect data. The complexity and interconnectivity of our models create additional risk regarding the accuracy of model output. While we have processes and controls in place designed to mitigate these risks, there can be no assurances that such processes and controls will be successful. This risk may be elevated to the extent that we have difficulty attracting and retaining employees with the necessary experience and skills.
We have increased our use of third-party models. This may expose us to additional risk, as third-parties typically do not provide us with proprietary information regarding their models. As a result, we may not fully understand the risks associated with the use of such models.
Management often needs to exercise judgment to interpret or adjust modeled results to take into account new information or changes in conditions. The dramatic changes in the housing and credit capital markets in recent years have required frequent adjustments to our models and the application of greater management judgment in the interpretation and adjustment of the results produced by our models. This further increases both the uncertainty about model results and the risk of errors in the implementation, operation, or use of the models.
We face the risk that the valuations, risk metrics, amortization results, loan loss reserve estimations, and security impairment charges produced by our models may be different from actual results, which could adversely affect our business results, cash flows, fair value of net assets, business prospects, and future financial results. For example, our models may under-predict the losses we will suffer in various aspects of our business. Changes in, or replacements of, any of our models or in any of the assumptions, judgments, or estimates used in the models may cause the results generated by the model to be materially different from those generated by the prior model. The different results could cause a revision of previously reported financial condition or results of operations, depending on when the change to the model, assumption, judgment, or estimate is implemented. Any such changes may also cause difficulties in comparisons of the financial condition or results of operations of prior or future periods.
Due to increased uncertainty about model results, we also face increased risk that we could make poor business decisions in areas where model results are an important factor, including loan purchases, management and guarantee fee pricing, asset and liability management, market risk management, and quality-control sampling strategies for loans in our single-family credit guarantee portfolio. Furthermore, any strategies we employ to attempt to manage the risks associated with our use of models may not be effective. See MD&A CRITICAL ACCOUNTING POLICIES AND ESTIMATES and QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Interest-Rate Risk and Other Market Risks for more information on our use of models.
Changes in our accounting policies, as well as estimates we make, could materially affect how we report our financial condition or results of operations.
Our accounting policies are fundamental to understanding our financial condition and results of operations. Certain of our accounting policies, as well as estimates we make, are critical, as they are both important to the presentation of our financial condition and results of operations and they require management to make particularly difficult, complex or subjective judgments and estimates, often regarding matters that are inherently uncertain. Actual results could differ from our estimates and the use of different judgments and assumptions related to these policies and estimates could have a material
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impact on our consolidated financial statements. For a description of our critical accounting policies, see MD&A CRITICAL ACCOUNTING POLICIES AND ESTIMATES.
From time to time, the FASB and the SEC change the financial accounting and reporting guidance that governs the preparation of our financial statements. These changes are beyond our control, can be difficult to predict and could materially impact how we report our financial condition and results of operations. We could be required to apply new or revised guidance retrospectively, which may result in the revision of prior period financial statements by material amounts. The implementation of new or revised accounting guidance could result in material adverse effects to our net worth and result in or contribute to the need for additional draws under the Purchase Agreement.
FHFA may require us to change our accounting policies, including to align more closely with those of Fannie Mae. FHFA may also require us and Fannie Mae to have the same independent public accounting firm. Either of these events could significantly increase our expenses and require a substantial time commitment of management. For example, in April 2012, FHFA issued an advisory bulletin that could have an effect on our provision for credit losses in the future. The accounting methods outlined in FHFAs advisory bulletin are significantly different from our current methods of accounting for single-family loans that are 180 days or more delinquent. For more information, see BUSINESS Regulation and Supervision Legislative and Regulatory Developments FHFA Advisory Bulletin.
See NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES for more information.
A failure in our operational systems or infrastructure, or those of third parties, could impair our liquidity, disrupt our business, damage our reputation, and cause losses.
Shortcomings or failures in our internal processes, people, or systems could lead to impairment of our liquidity, financial loss, errors in our financial statements, disruption of our business, liability to customers, further legislative or regulatory intervention, or reputational damage. Servicing and loss mitigation processes are currently under considerable stress, which increases the risk that we may experience further operational problems in the future. Our core systems and technical architecture include many legacy systems and applications that lack scalability and flexibility, which increases the risk of system failure. While we are working to enhance the quality of our infrastructure, we have had difficulty in the past conducting large-scale infrastructure improvement projects.
Our business is highly dependent on our ability to process a large number of transactions on a daily basis and manage and analyze significant amounts of information, much of which is provided by third parties. The transactions we process are complex and are subject to various legal, accounting, and regulatory standards. The types of transactions we process and the standards relating to those transactions can change rapidly in response to external events, such as the implementation of government-mandated programs and changes in market conditions. Our financial, accounting, data processing, or other operating systems and facilities may fail to operate properly or become disabled, adversely affecting our ability to process these transactions. The information provided by third parties may be incorrect, or we may fail to properly manage or analyze it. The inability of our systems to accommodate an increasing volume of transactions or new types of transactions or products could constrain our ability to pursue new business initiatives or change or improve existing business activities.
Our employees could act improperly for their own gain and cause unexpected losses or reputational damage. While we have processes and systems in place designed to prevent and detect fraud, there can be no assurance that such processes and systems will be successful.
We also face the risk of operational failure or termination of any of the clearing agents, exchanges, clearinghouses, or other financial intermediaries we use to facilitate our securities and derivatives transactions. Any such failure or termination could adversely affect our ability to effect transactions, service our customers, and manage our exposure to risk.
Most of our key business activities are conducted in our principal offices located in McLean, Virginia and represent a concentrated risk of people, technology, and facilities. Despite the contingency plans and local recovery facilities we have in place, our ability to conduct business would be adversely impacted by a disruption in the infrastructure that supports our business and the geographical area in which we are located. Potential disruptions may include outages or disruptions to electrical, communications, transportation, or other services we use or that are provided to us. If a disruption occurs and our employees are unable to occupy our offices or communicate with or travel to other locations, our ability to service and interact with our customers or counterparties may deteriorate and we may not be able to successfully implement contingency plans that allow us to carry out critical business functions at an acceptable level.
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This geographical concentration also creates exposure to the risk that a catastrophic event, such as a terrorist event or natural disaster, could result in a significant business disruption and an inability to process transactions through normal business operations. Any measures we take to mitigate this risk may not be sufficient to respond to the full range of catastrophic events that may occur. Freddie Mac management has determined that current business recovery capabilities would not be effective in the event of a catastrophic regional business event and could result in a significant business disruption and inability to process transactions through normal business processes. While management has developed a remediation plan to address the current capability gaps, any measures we take to mitigate this risk may not be sufficient to respond to the full range of catastrophic events that may occur.
Management changes and turnover of key staff could increase our operational and control risks and have a material adverse effect on our ability to do business and our results of operations.
Disruptive levels of turnover among both executives and other employees could lead to operational or control failures, affect our ability to execute ongoing business activities, cause delays and disruptions in the implementation of FHFA-directed and other important business initiatives, delay or disrupt critical technology and other projects, and erode our business, modeling, internal audit, risk management, information security, financial reporting, legal, compliance, and other capabilities. Internal reorganizations could have a similar effect. Any such event could add to the risk of operational or control failures, including a failure in the effective operation of our internal control over financial reporting or our disclosure controls and procedures. Operational or control failures could result in material adverse effects on our financial condition and results of operations. For more information, see MD&A RISK MANAGEMENT Operational Risks and CONTROLS AND PROCEDURES.
We may not be able to protect the security of our systems or the confidentiality of our information from cyber attack and other unauthorized access, disclosure, and disruption.
Our operations rely on the secure receipt, processing, storage, and transmission of confidential and other information in our computer systems and networks and with our business partners. Like many corporations and government entities, from time to time we have been, and likely will continue to be, the target of attempted cyber attacks. Although Freddie Mac devotes significant resources to maintain and regularly upgrade its systems and processes which are designed to protect the security of its computer systems, software, networks and other technology assets and the confidentiality, integrity and availability of information belonging to Freddie Mac and its customers, there is no assurance that all of Freddie Macs security measures will provide fully effective security. Our computer systems, software, and networks may be vulnerable to cyber attack, unauthorized access, computer viruses or other malicious code, or other attempts to harm our systems or misuse our confidential information. If one or more of such events were to occur, this potentially could jeopardize or result in the unauthorized disclosure, misuse or corruption of confidential and other information (including information of our customers or our counterparties), or otherwise cause interruptions or malfunctions in our operations or the operations of our customers or counterparties. This could result in significant losses or reputational damage, adversely affect our relationships with our customers and counterparties, and otherwise harm our business. We could also face regulatory action. We might be required to expend significant additional resources to modify our protective measures or to investigate and remediate vulnerabilities or other exposures, and we might be subject to litigation and financial losses that are not fully insured.
We rely on third parties for certain important functions, including some that are critical to financial reporting, our mortgage-related investment activity, and mortgage loan underwriting. Any failures by those vendors could disrupt our business operations.
At times, we outsource certain key functions to external parties, which may include processes related to: (a) functions for trade capture, market risk management analytics, and financial instrument valuation, (b) modeling, (c) custody and recordkeeping for our mortgage-related investments; (d) processing functions for mortgage loan underwriting and servicing; (e) certain services we provide to Treasury in our role as program compliance agent under HAMP; and (f) certain technology infrastructure and operations. We may enter into other key outsourcing relationships in the future. If one or more of these key external parties were not able to perform their functions for a period of time, at an acceptable service level, or for increased volumes, our business operations could be constrained, disrupted, or otherwise negatively impacted. Our use of vendors also exposes us to the risk of a loss of intellectual property or of confidential information or other harm. We may also be exposed to reputational harm, to the extent vendors do not conduct their activities under appropriate ethical standards. Our ability to monitor the activities or performance of vendors may be constrained. Financial or operational difficulties of an outside vendor could also hurt our operations if those difficulties interfere with the vendors ability to provide services to us.
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Legal and Regulatory Risks
The Dodd-Frank Act and related regulation may adversely affect our business activities and financial results.
The Dodd-Frank Act, which was signed into law on July 21, 2010, significantly changed the regulation of the financial services industry and could affect us in substantial and unforeseeable ways and have an adverse effect on our business, results of operations, financial condition, liquidity, and net worth. For example, the Dodd-Frank Act and related current and future regulatory changes could affect the value of assets that we hold, require us to change certain of our business practices, impose significant additional costs on us, limit the products we offer, require us to increase our regulatory capital, or make it more difficult for us to retain and recruit executives and other employees. We will also face a more complicated regulatory environment due to the Dodd-Frank Act and related current and future regulatory changes, which will increase compliance costs and could divert management attention or other resources. The Dodd-Frank Act and related current and future regulatory changes also significantly affect many aspects of the financial services industry and may significantly change the business practices of our customers and counterparties; it is possible that any such changes will adversely affect our business and financial results.
Implementation of the Dodd-Frank Act is being accomplished through numerous rulemakings, many of which are still in process. The final effects of the legislation will not be known with certainty until these rulemakings are complete. The Dodd-Frank Act also mandates the preparation of studies of a wide range of issues, which could lead to additional legislative or regulatory changes. It could be difficult for us to comply with any future regulatory changes in a timely manner, due to the potential scope and number of such changes, which could limit our operations and expose us to liability.
The long-term impact of the Dodd-Frank Act and related current and future regulatory changes on our business and the financial services industry will depend on a number of factors that are difficult to predict, including our ability to successfully implement any changes to our business, changes in consumer behavior, and our competitors and customers responses to the Dodd-Frank Act and related current and future regulatory changes.
Examples of aspects of the Dodd-Frank Act that may significantly affect us include the following:
| The Financial Stability Oversight Council could designate Freddie Mac as a non-bank financial company to be subject to supervision and regulation by the Federal Reserve. If this occurs, the Federal Reserve will have authority to examine Freddie Mac and we may be required to meet more stringent prudential standards than those applicable to other non-bank financial companies. New prudential standards could include requirements related to risk-based capital and leverage, liquidity, single-counterparty credit limits, overall risk management and risk committees, stress tests, and debt-to-equity limits, among other requirements. |
| The Dodd-Frank Act will create new standards and requirements related to asset-backed securities, including requiring securitizers and potentially originators to retain a portion of the underlying loans credit risk. Any such new standards and requirements could modify or remove incentives for financial institutions to sell mortgage loans to us. |
| The Dodd-Frank Act and related current and future regulatory changes could have a negative effect on the volume of mortgage originations, and thus adversely affect the number of mortgages available for us to purchase or guarantee. |
For more information on the Dodd-Frank Act, see BUSINESS Regulation and Supervision Legislative and Regulatory Developments.
Legislative or regulatory actions could adversely affect our business activities and financial results.
In addition to the Dodd-Frank Act discussed in the immediately preceding risk factor, and possible GSE reform discussed in Conservatorship and Related Matters The future status and role of Freddie Mac is uncertain and could be materially adversely affected by legislative and regulatory action that alters the ownership, structure, and mission of the company, our business initiatives may be directly adversely affected by other legislative and regulatory actions at the federal, state, and local levels. We could be negatively affected by legislation or regulatory action that changes the foreclosure process of any individual state. For example, various states and local jurisdictions have implemented mediation programs designed to bring servicers and borrowers together to negotiate workout options. These actions could delay the foreclosure process and increase our expenses, including by potentially delaying the final resolution of seriously delinquent mortgage loans and the disposition of non-performing assets. We could also be affected by any legislative or regulatory changes that would expand the responsibilities and liability of servicers and assignees for maintaining vacant properties prior to foreclosure. These laws and regulatory changes could significantly expand mortgage costs and liabilities. We could be affected by legislative or regulatory changes that permit or require principal reductions, including through the bankruptcy
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process. Our business could also be adversely affected by any modification, reduction, or repeal of the federal income tax deductibility of mortgage interest payments. A number of local governments are considering or may consider using eminent domain to seize mortgage loans and forgive principal on the loans. Such seizures, if they are successful, could result in further losses and write-downs relating to our investment securities and could increase our credit losses.
We are subject to a number of lawsuits challenging our statutory exemption from real estate transfer taxes imposed on the transfer of real property for which we were the grantor or grantee. If we were to become subject to transfer taxes in a large number of states and localities, and if we were required to pay a number of years of past transfer taxes in these states and localities, it would increase our costs going forward and could have an adverse effect on our financial results. For more information, see NOTE 17: LEGAL CONTINGENCIES Lawsuits Involving Real Estate Transfer Taxes.
Pursuant to the Temporary Payroll Tax Cut Continuation Act of 2011, FHFA required Freddie Mac and Fannie Mae to increase guarantee fees by no less than 10 basis points above the average guarantee fees charged in 2011 on single-family mortgage-backed securities to fund the payroll tax cut that occurred in 2012. If we are found to be out of compliance with this requirement of the Act for two consecutive years, we will be precluded from providing any guarantee for a period to be determined by FHFA, but in no case less than one year.
Legislation or regulatory actions could indirectly adversely affect us to the extent such legislation or actions affect the activities of banks, savings institutions, insurance companies, securities dealers, and other regulated entities that constitute a significant part of our customer base or counterparties, or could indirectly affect us to the extent that they modify industry practices. Legislative or regulatory provisions that remove incentives for these entities to sell mortgage loans to us, purchase our securities or enter into derivatives, or other transactions with us could have a material adverse effect on our business results and financial condition.
The Office of the Comptroller of the Currency, the Federal Reserve and the FDIC (collectively, the Banking Agencies) are in the process of substantially revising capital requirements applicable to banking organizations. In June 2012, the Banking Agencies jointly released three notices of proposed rulemaking that would revise and replace the Banking Agencies current capital rules by implementing the Basel III regulatory reforms as well as certain provisions of the Dodd-Frank Act. In addition, in June 2012, the Banking Agencies jointly announced the finalization of a market risk capital rule applicable to banking organizations with significant trading assets and liabilities. Phase-in of new bank capital requirements is expected to take several years and there is significant uncertainty about how the proposed regulations will be finalized and what effects any new bank capital requirements will have on us. For example, it is possible that any new regulations on the capital treatment of mortgage servicing rights, risk-based capital requirements for credit risk, and liquidity treatment of our debt and guarantee obligations could adversely affect our business results and financial condition.
We may make certain changes to our business in an attempt to meet our housing goals and subgoals.
We may make adjustments to our mortgage loan sourcing and purchase strategies in an effort to meet our housing goals and subgoals, including changes to our underwriting standards and the expanded use of targeted initiatives to reach underserved populations. For example, we may purchase loans that offer lower expected returns on our investment and potentially increase our exposure to credit losses. Doing so could cause us to forgo other purchase opportunities that we would expect to be more profitable. If our current efforts to meet the goals and subgoals prove to be insufficient, we may need to take additional steps that could potentially adversely affect our profitability. FHFA has not yet published a final rule with respect to our duty to serve underserved markets. However, it is possible that we could also make changes to our business in the future in response to this duty. If we do not meet our housing goals or duty to serve requirements, and FHFA finds that the goals or requirements were feasible, we may become subject to a housing plan that could require us to take additional steps that could have an adverse effect on our results of operations and financial condition.
We are involved in legal proceedings and governmental investigations that could result in the payment of substantial damages or otherwise harm our business.
We are a party to various legal actions. In addition, certain of our former directors and officers are involved in legal proceedings for which they may be entitled to reimbursement by us for costs and expenses of the proceedings. The defense of these or any future claims or proceedings could divert managements attention and resources from the needs of the business. We may be required to establish reserves and to make substantial payments in the event of adverse judgments or settlements of any such claims, investigations, proceedings, or examinations. Any legal proceeding, governmental investigation, or IRS examination issue, even if resolved in our favor, could result in negative publicity or cause us to incur significant legal and
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other expenses. Furthermore, developments in, outcomes of, impacts of, and costs, expenses, settlements, and judgments related to these legal proceedings and governmental investigations and examinations may differ from our expectations and exceed any amounts for which we have reserved or require adjustments to such reserves. We are also cooperating with other investigations. These proceedings could divert managements attention or other resources. See LEGAL PROCEEDINGS and NOTE 17: LEGAL CONTINGENCIES for information about our pending legal proceedings.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
Our principal offices consist of five office buildings in McLean, Virginia. We own four of the office buildings, comprising approximately 1.3 million square feet. We occupy the fifth building, comprising approximately 200,000 square feet, under a lease from a third party.
We are involved as a party to a variety of legal proceedings arising from time to time in the ordinary course of business. See NOTE 17: LEGAL CONTINGENCIES for more information regarding our involvement as a party to various legal proceedings.
ITEM 4. MINE SAFETY DISCLOSURES
Not applicable.
ITEM 5. MARKET FOR REGISTRANTS COMMON EQUITY, RELATED
STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Market Information
Our common stock, par value $0.00 per share, trades on the OTCQB Marketplace, operated by the OTC Markets Group Inc., under the ticker symbol FMCC. As of February 15, 2013, there were 650,038,674 shares of our common stock outstanding.
The table below sets forth the high and low bid information for our common stock on the OTCQB Marketplace for the indicated periods and reflects inter-dealer prices, without retail mark-up, mark-down, or commission, and may not necessarily represent actual transactions.
T able 7 Quarterly Common Stock Information
High | Low | |||||||
2012 Quarter Ended |
||||||||
December 31 |
$ | 0.32 | $ | 0.24 | ||||
September 30 |
0.33 | 0.14 | ||||||
June 30 |
0.33 | 0.24 | ||||||
March 31 |
0.42 | 0.21 | ||||||
2011 Quarter Ended |
||||||||
December 31 |
$ | 0.27 | $ | 0.18 | ||||
September 30 |
0.41 | 0.24 | ||||||
June 30 |
0.54 | 0.34 | ||||||
March 31 |
1.00 | 0.13 |
Holders
As of February 15, 2013, we had 2,023 common stockholders of record.
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Dividends and Dividend Restrictions
We did not pay any cash dividends on our common stock during 2012 or 2011.
Our payment of dividends is subject to the following restrictions:
Restrictions Relating to the Conservatorship
As Conservator, FHFA announced on September 7, 2008 that we would not pay any dividends on Freddie Macs common stock or on any series of Freddie Macs preferred stock (other than the senior preferred stock). FHFA has instructed our Board of Directors that it should consult with and obtain the approval of FHFA before taking actions involving dividends. In addition, FHFA has adopted a regulation prohibiting us from making capital distributions during conservatorship, except as authorized by the director of FHFA.
Restrictions Under the Purchase Agreement
The Purchase Agreement prohibits us and any of our subsidiaries from declaring or paying any dividends on Freddie Mac equity securities (other than with respect to the senior preferred stock or warrant) without the prior written consent of Treasury.
Restrictions Under the GSE Act
Under the GSE Act, FHFA has authority to prohibit capital distributions, including payment of dividends, if we fail to meet applicable capital requirements. Under the GSE Act, we are not permitted to make a capital distribution if, after making the distribution, we would be undercapitalized, except the Director of FHFA may permit us to repurchase shares if the repurchase is made in connection with the issuance of additional shares or obligations in at least an equivalent amount and will reduce our financial obligations or otherwise improve our financial condition. If FHFA classifies us as undercapitalized, we are not permitted to make a capital distribution that would result in our being reclassified as significantly undercapitalized or critically undercapitalized. If FHFA classifies us as significantly undercapitalized, approval of the Director of FHFA is required for any dividend payment; the Director may approve a capital distribution only if the Director determines that the distribution will enhance the ability of the company to meet required capital levels promptly, will contribute to the long-term financial safety-and-soundness of the company, or is otherwise in the public interest. Our capital requirements have been suspended during conservatorship.
Restrictions Under our Charter
Without regard to our capital classification, we must obtain prior written approval of FHFA to make any capital distribution that would decrease total capital to an amount less than the risk-based capital level or that would decrease core capital to an amount less than the minimum capital level. As noted above, our capital requirements have been suspended during conservatorship.
Restrictions Relating to Subordinated Debt
During any period in which we defer payment of interest on qualifying subordinated debt, we may not declare or pay dividends on, or redeem, purchase or acquire, our common stock or preferred stock. Our qualifying subordinated debt provides for the deferral of the payment of interest for up to five years if either: (a) our core capital is below 125% of our critical capital requirement; or (b) our core capital is below our statutory minimum capital requirement, and the Secretary of the Treasury, acting on our request, exercises his or her discretionary authority pursuant to Section 306(c) of our charter to purchase our debt obligations. FHFA has directed us to make interest and principal payments on our subordinated debt, even if we fail to maintain required capital levels. As a result, the terms of any of our subordinated debt that provide for us to defer payments of interest under certain circumstances, including our failure to maintain specified capital levels, are no longer applicable. As noted above, our capital requirements have been suspended during conservatorship.
Restrictions Relating to Preferred Stock
Payment of dividends on our common stock is also subject to the prior payment of dividends on our 24 series of preferred stock and one series of senior preferred stock, representing an aggregate of 464,170,000 shares and 1,000,000 shares, respectively, outstanding as of December 31, 2012. Payment of dividends on all outstanding preferred stock, other than the senior preferred stock, is subject to the prior payment of dividends on the senior preferred stock. We paid dividends on the senior preferred stock during 2012 at the direction of the Conservator, as discussed in MD&A
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LIQUIDITY AND CAPITAL RESOURCES Liquidity Dividend Obligation on the Senior Preferred Stock and NOTE 11: STOCKHOLDERS EQUITY (DEFICIT) Dividends Declared During 2012. We did not declare or pay dividends on any other series of preferred stock outstanding in 2012.
Recent Sales of Unregistered Securities
The securities we issue are exempted securities under the Securities Act of 1933, as amended. As a result, we do not file registration statements with the SEC with respect to offerings of our securities.
Following our entry into conservatorship, we suspended the operation of, and ceased making grants under, equity compensation plans. Previously, we had provided equity compensation under these plans to employees and members of our Board of Directors. Under the Purchase Agreement, we cannot issue any new options, rights to purchase, participations, or other equity interests without Treasurys prior approval. However, grants outstanding as of the date of the Purchase Agreement remain in effect in accordance with their terms.
No stock options were exercised during the three months ended December 31, 2012, and all remaining restrictions on restricted stock units lapsed during the first quarter of 2012.
See NOTE 11: STOCKHOLDERS EQUITY (DEFICIT) for more information.
Issuer Purchases of Equity Securities
We did not repurchase any of our common or preferred stock during 2012. Additionally, we do not currently have any outstanding authorizations to repurchase common or preferred stock. Under the Purchase Agreement, we cannot repurchase our common or preferred stock without Treasurys prior consent, and we may only purchase or redeem the senior preferred stock in certain limited circumstances set forth in the Amended and Restated Certificate of Creation, Designation, Powers, Preferences, Rights, Privileges, Qualifications, Limitations, Restrictions, Terms and Conditions of Variable Liquidation Preference Senior Preferred Stock.
Transfer Agent and Registrar
Computershare Trust Company, N.A.
P.O. Box 43078
Providence, RI 02940-3078
Telephone: 781-575-2879
http://www.computershare.com/investors
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IT EM 6. SELECTED FINANCIAL DATA(1)
The selected financial data presented below should be reviewed in conjunction with MD&A and our consolidated financial statements and related notes.
At or For The Year Ended December 31, | ||||||||||||||||||||
2012 | 2011 | 2010 | 2009 | 2008 | ||||||||||||||||
(dollars in millions, except share-related amounts) | ||||||||||||||||||||
Statements of Comprehensive Income Data |
||||||||||||||||||||
Net interest income |
$ | 17,611 | $ | 18,397 | $ | 16,856 | $ | 17,073 | $ | 6,796 | ||||||||||
Provision for credit losses |
(1,890 | ) | (10,702 | ) | (17,218 | ) | (29,530 | ) | (16,432 | ) | ||||||||||
Non-interest income (loss) |
(4,083 | ) | (10,878 | ) | (11,588 | ) | (2,732 | ) | (29,175 | ) | ||||||||||
Non-interest expense |
(2,193 | ) | (2,483 | ) | (2,932 | ) | (7,195 | ) | (5,753 | ) | ||||||||||
Net income (loss) attributable to Freddie Mac |
10,982 | (5,266 | ) | (14,025 | ) | (21,553 | ) | (50,119 | ) | |||||||||||
Total comprehensive income (loss) attributable to Freddie Mac |
16,039 | (1,230 | ) | 282 | (2,913 | ) | (70,483 | ) | ||||||||||||
Net loss attributable to common stockholders(2) |
(2,074 | ) | (11,764 | ) | (19,774 | ) | (25,658 | ) | (50,795 | ) | ||||||||||
Net loss per common share basic and diluted |
(0.64 | ) | (3.63 | ) | (6.09 | ) | (7.89 | ) | (34.60 | ) | ||||||||||
Cash dividends per common share |
| | | | 0.50 | |||||||||||||||
Weighted average common shares outstanding (in thousands) basic and diluted(3) |
3,240,028 | 3,244,896 | 3,249,369 | 3,253,836 | 1,468,062 | |||||||||||||||
Balance Sheets Data |
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Mortgage loans held-for-investment, at amortized cost by consolidated trusts (net of allowances for loan losses) |
$ | 1,495,932 | $ | 1,564,131 | $ | 1,646,172 | $ | | $ | | ||||||||||
Total assets |
1,989,856 | 2,147,216 | 2,261,780 | 841,784 | 850,963 | |||||||||||||||
Debt securities of consolidated trusts held by third parties |
1,419,524 | 1,471,437 | 1,528,648 | | | |||||||||||||||
Other debt |
547,518 | 660,546 | 713,940 | 780,604 | 843,021 | |||||||||||||||
All other liabilities |
13,987 | 15,379 | 19,593 | 56,808 | 38,576 | |||||||||||||||
Total Freddie Mac stockholders equity (deficit) |
8,827 | (146 | ) | (401 | ) | 4,278 | (30,731 | ) | ||||||||||||
Portfolio Balances(4) |
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Mortgage-related investments portfolio |
$ | 557,544 | $ | 653,313 | $ | 696,874 | $ | 755,272 | $ | 804,762 | ||||||||||
Total Freddie Mac mortgage-related securities(5) |
1,562,040 | 1,624,684 | 1,712,918 | 1,854,813 | 1,807,553 | |||||||||||||||
Total mortgage portfolio(6) |
1,956,276 | 2,075,394 | 2,164,859 | 2,250,539 | 2,207,476 | |||||||||||||||
Non-performing assets(7) |
135,677 | 129,152 | 125,405 | 104,984 | 46,620 | |||||||||||||||
Ratios(8) |
||||||||||||||||||||
Return on average assets(9) |
0.5 | % | (0.2 | )% | (0.6 | )% | (2.5 | )% | (6.1 | )% | ||||||||||
Non-performing assets ratio(10) |
7.5 | 6.8 | 6.4 | 5.2 | 2.4 | |||||||||||||||
Equity to assets ratio(11) |
0.2 | | (0.2 | ) | (1.6 | ) | (0.2 | ) |
(1) | See NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES for information regarding our accounting policies and the impact of new accounting policies on our consolidated financial statements. Effective January 1, 2010, we adopted amendments to the accounting guidance for transfers of financial assets and the consolidation of VIEs. This had a significant impact on our consolidated financial statements. Consequently, certain of the line items in our consolidated financial statements for 2008 and 2009 are not comparable with those of more recent years. |
(2) | For a discussion of how the change in the manner in which the senior preferred stock dividend is determined affects net income (loss) attributable to common stockholders beginning in the fourth quarter of 2012, see NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Earnings Per Common Share. |
(3) | Includes the weighted average number of shares that are associated with the warrant for our common stock issued to Treasury as part of the Purchase Agreement, because it is unconditionally exercisable by the holder at a cost of $0.00001 per share. |
(4) | Represents the UPB and excludes mortgage loans and mortgage-related securities traded, but not yet settled. |
(5) | See Table 35 Freddie Mac Mortgage-Related Securities for the composition of this line item. |
(6) | See Table 16 Composition of Segment Mortgage Portfolios and Credit Risk Portfolios for the composition of our total mortgage portfolio. |
(7) | See Table 55 Non-Performing Assets for a description of our non-performing assets. |
(8) | The dividend payout ratio on common stock is not presented because: (a) the amount of cash dividends per common share is zero for all periods presented after 2008; and (b) we reported a net loss attributable to common stockholders in 2008. The return on common equity ratio is not presented because the simple average of the beginning and ending balances of total Freddie Mac stockholders equity (deficit), net of preferred stock (at redemption value) is less than zero for all periods presented. |
(9) | Ratio computed as net income (loss) attributable to Freddie Mac divided by the simple average of the beginning and ending balances of total assets. |
(10) | Ratio computed as non-performing assets divided by the ending UPB of our total mortgage portfolio, excluding non-Freddie Mac mortgage-related securities. |
(11) | Ratio computed as the simple average of the beginning and ending balances of total Freddie Mac stockholders equity (deficit) divided by the simple average of the beginning and ending balances of total assets. |
83 | Freddie Mac |
ITEM 7. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
You should read this MD&A in conjunction with BUSINESS Executive Summary and our consolidated financial statements and related notes.
MORTGAGE MARKET AND ECONOMIC CONDITIONS, AND OUTLOOK
Mortgage Market and Economic Conditions
Overview
The U.S. real gross domestic product rose by 1.5% during 2012, compared to 2.0% in 2011, according to the Bureau of Economic Analysis. The national unemployment rate was 7.8% in December 2012, compared to 8.5% in December 2011, based on data from the U.S. Bureau of Labor Statistics. In the data underlying the unemployment rate, an average of approximately 181,000 monthly net new jobs (non-farm) were added to the economy during 2012, which shows evidence of a slow, but steady positive trend for the economy and the labor market.
Table 8 Mortgage Market Indicators
Year Ended December 31, | ||||||||||||
2012 | 2011 | 2010 | ||||||||||
Home sale units (in thousands)(1) |
5,027 | 4,566 | 4,513 | |||||||||
Home price change(2) |
6.4 | % | (3.7 | )% | (5.4 | )% | ||||||
Single-family originations (in billions)(3) |
$ | 1,835 | $ | 1,470 | $ | 1,630 | ||||||
ARM share(4) |
11 | % | 12 | % | 10 | % | ||||||
Refinance share(5) |
84 | % | 79 | % | 80 | % | ||||||
U.S. single-family mortgage debt outstanding (in billions)(6) |
$ | 9,926 | $ | 10,158 | $ | 10,413 | ||||||
U.S. multifamily mortgage debt outstanding (in billions)(6) |
$ | 847 | $ | 830 | $ | 835 |
(1) | Consists of sales of new and existing homes in the U.S. Source: National Association of Realtors news release dated February 21, 2013 (sales of existing homes) and U.S. Census Bureau news release dated January 25, 2013 (sales of new homes). |
(2) | Calculated internally using estimates of changes in single-family home prices by state, which are weighted using the property values underlying our single-family credit guarantee portfolio to obtain a national index. The rate for each year presented incorporates property value information on loans purchased by both Freddie Mac and Fannie Mae through December 31, 2012 and the percentage change will be subject to revision based on more recent purchase information. 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. |
(3) | Source: Inside Mortgage Finance estimates of originations of single-family first-and second liens dated February 1, 2013. |
(4) | ARM share of the dollar amount of total mortgage applications. Source: Mortgage Bankers Associations Mortgage Applications Survey. Data reflect annual average of weekly figures. |
(5) | Refinance share of the number of conventional mortgage applications. Source: Mortgage Bankers Associations Mortgage Applications Survey. Data reflect annual average of weekly figures. |
(6) | Source: Federal Flow of Funds Accounts of the United States dated December 6, 2012. The outstanding amounts for 2012 presented above reflect balances as of September 30, 2012. |
Single-Family Housing Market
The single-family housing market showed significant improvement in 2012 despite continued weakness in the employment market and a significant inventory of seriously delinquent loans and REO properties in the market.
Based on data from the National Association of Realtors, sales of existing homes in 2012 were 4.66 million, increasing 9.4% from 4.26 million in 2011. Based on data from the U.S. Census Bureau and HUD, sales of new homes in 2012 were 367,000, increasing 19.9% from 306,000 in 2011. Home prices increased during 2012, with our nationwide index registering approximately a 6.4% increase from December 2011 through December 2012 and a 0.4% increase from September 2012 to December 2012 without seasonal adjustment. The increase in national home prices during 2012 represents the first such full-year increase since 2006. These estimates were based on our own price index of mortgage loans on one-family homes funded by us or Fannie Mae. 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 serious delinquency rate of our single-family loans declined during 2012, but remained near historically high levels. The Mortgage Bankers Association reported in its National Delinquency Survey that serious delinquency rates on all single-family loans in the survey declined to 6.8% as of December 31, 2012, down from 7.7% at year-end 2011. Residential loan performance has been generally worse in areas with higher unemployment rates and where declines in property values have been more significant during recent years. In its survey, the Mortgage Bankers Association presents delinquency rates both
84 | Freddie Mac |
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 Mortgage Bankers Association survey; however, the delinquency experience in prime conventional mortgage loans during the last five years has been significantly worse than in any year since the 1930s.
Based on data from the Federal Reserves 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 Conservators Report on the Enterprises Financial Condition, dated June 13, 2011, 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 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 non-GSE and GSE mortgage loans as discussed below.
Based on the National Delinquency Surveys data, we estimate that we owned or guaranteed approximately 23% of the outstanding single-family mortgages in the U.S. at December 31, 2012, based on number of loans. At December 31, 2012, we held or guaranteed approximately 353,000 seriously delinquent single-family loans, representing approximately 11% of the seriously delinquent single-family mortgages in the market as of that date. We estimate that loans backing non-GSE securities comprised approximately 8% of the single-family mortgages in the U.S. and represented approximately 26% of the seriously delinquent single-family mortgages at September 30, 2012 (based on the latest information available). As of December 31, 2012, we held non-GSE single-family mortgage-related securities with a UPB of $71.2 billion as investments.
The foreclosure process has lengthened significantly in recent years, due to a number of factors, but particularly in states that require a judicial foreclosure process. A number of legislative and regulatory developments in recent periods have resulted in significant changes to mortgage servicing and foreclosure practices that could adversely affect our business. For information on these matters, see RISK FACTORS Operational Risks We have incurred, and will continue to incur, expenses and we may otherwise be adversely affected by delays and deficiencies in the foreclosure process and BUSINESS Legislative and Regulatory Developments Developments Concerning Single-Family Servicing Practices.
Multifamily Housing Market
Multifamily market fundamentals continued to improve on a national level during 2012, although at a slower pace as compared to 2011. As reported by REIS, Inc., the national apartment vacancy rate was 4.5% and 5.2% at the end of 2012 and 2011, respectively, and remained at the lowest levels since 2001. The multifamily sector continued to experience strong investor interest and continued to outperform other commercial real estate sectors. 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 and these factors significantly influence those cash flows. We believe positive market fundamentals, such as low vacancy rates and increasing effective rents, as well as optimism about demand for multifamily housing have contributed to improvement in property values in most markets during 2012.
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. For example, a number of factors could adversely impact the performance of the housing and mortgage markets and the U.S. economy in the near term, including adverse changes in national or international economic conditions and changes in the federal governments fiscal or monetary policies. See FORWARD-LOOKING STATEMENTS for additional information.
Overview
We continue to expect key macroeconomic drivers of the economy, such as income growth, employment, and inflation, to affect the performance of the housing and mortgage markets in 2013. Since we expect that economic growth will continue and mortgage interest rates will remain low in 2013, we believe that housing affordability will remain relatively high in 2013 for potential home buyers. We also expect that the volume of home sales will likely increase in 2013, but still remain relatively low compared to historical levels. Important factors that we believe will continue to negatively affect single-family housing demand are the relatively high unemployment rate and relatively low consumer confidence measures. Consumer
85 | Freddie Mac |
confidence measures, while up from recession lows of 2009, remain below long-term averages and suggest that households will likely continue to be cautious in home buying. We also expect to continue to experience high levels of refinancing activity in the near term, due to the impact of the expanded HARP initiative as well as the historically low interest rates on fixed-rate single-family mortgages. For information on the HARP initiative, see RISK MANAGEMENT Credit Risk Mortgage Credit Risk Single-Family Mortgage Credit Risk Single-Family Loan Workouts and the MHA Program.
While home prices remained at significantly lower levels from their peak in most areas during 2012, declines in the markets inventory of vacant housing have supported stabilization in home prices in a number of metropolitan areas. However, to the extent a large volume of loans complete the foreclosure process in a short period, the resulting increase in the markets inventory of homes for sale could have a negative effect on home prices. Our expectation is that national average home prices will experience a modest increase in 2013.
Single-Family
Our charge-offs remained elevated during 2012 and we expect they will remain elevated during 2013. This is in part due to the substantial number of underwater mortgage loans in our single-family credit guarantee portfolio. For the near term, we also expect:
| REO disposition severity ratios and losses on short sale transactions to remain high. However, our recovery rates have been positively impacted by recent improvements in home prices and home sales, as well as, to a lesser extent, by recent changes in our process for determining our estimate of market values for properties, which we use to determine the list price for our REO; |
| the amount of non-performing assets and the volume of our loan workouts to remain high; |
| continued high volume of loans in the foreclosure process as well as prolonged foreclosure timelines; and |
| continued high rates of rescission and reduced payments for mortgage insurance coverage compared to periods before 2008. |
Multifamily
During 2012, we continued to serve as a stable source of liquidity and continued our support of the multifamily market and the nations renters, as evidenced by our $28.8 billion of multifamily loan purchases and issuance of other guarantee commitments in 2012, which provided financing for more than 1,600 properties amounting to more than 435,000 apartment units. The majority of these apartments were affordable to low and moderate income families. We expect similar purchase and guarantee volumes for 2013, as demand for multifamily financing is expected to remain strong.
We expect continued strength in the multifamily market during 2013. As a result of the positive market fundamentals and continuing strong portfolio performance, we expect our credit losses and delinquency rates to remain low in 2013. We believe that the supply of multifamily housing will remain relatively low in the near term and that new construction, while increasing, will continue to be constrained by the availability of financing and rising construction costs.
CONSOLIDATED RESULTS OF OPERATIONS
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 information concerning certain significant accounting policies and estimates applied in determining our reported results of operations.
86 | Freddie Mac |
Table 9 Summary Consolidated Statements of Comprehensive Income
Year Ended December 31, | ||||||||||||
2012 | 2011 | 2010 | ||||||||||
(in millions) | ||||||||||||
Net interest income |
$ | 17,611 | $ | 18,397 | $ | 16,856 | ||||||
Provision for credit losses |
(1,890 | ) | (10,702 | ) | (17,218 | ) | ||||||
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|
|
|
|
|
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Net interest income (loss) after provision for credit losses |
15,721 | 7,695 | (362 | ) | ||||||||
|
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|
|
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|
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Non-interest income (loss): |
||||||||||||
Gains (losses) on extinguishment of debt securities of consolidated trusts |
(58 | ) | (219 | ) | (164 | ) | ||||||
Gains (losses) on retirement of other debt |
(77 | ) | 44 | (219 | ) | |||||||
Gains (losses) on debt recorded at fair value |
16 | 91 | 580 | |||||||||
Derivative gains (losses) |
(2,448 | ) | (9,752 | ) | (8,085 | ) | ||||||
Impairment of available-for-sale securities: |
||||||||||||
Total other-than-temporary impairment of available-for-sale securities |
(1,236 | ) | (2,101 | ) |   |