Freddie Mac is one of two mortgage giants established by the U.S. federal government to provide liquidity in the secondary mortgage market, along with sister company Fannie Mae (FNM). Freddie buys mortgages from banks and other financial institutions and packages them into bonds called mortgage-backed securities (MBS), which it sells to investors of all sizes. Freddie was structured to play a dominant role in the secondary mortgage market and ensure a steady and reliable supply of funds for U.S. homebuyers. In 2010, Freddie Mac had net interest income of $16.9 billion and a net loss of $14 billion.
Investors' fears were realized when Paulson announced a comprehensive plan to take Freddie and Fannie under "conservatorship", essentially placing the companies under government control and giving the Treasury the right to pump as much as $100 billion into each company, as well as buy a 79.9% share of both Freddie and Fannie.
Freddie Mac is a Government Sponsored Enterprise (GSE), a hybridized enterprise endowed with an advantageous set of special privileges. It is a non-bank financial institution created by the U.S. federal government and given a range of special privileges, including exemption from state and local taxes, a $2.25 billion line of credit with the U.S. Treasury, and the implicit backing of the federal government. Freddie Mac's business model is that it earns income from the mortgages it owns, using some of it to pay interest on its mortgage backed securities (MBS); rising default and foreclosure rates, however, meant that more and more of its mortgages weren't generating any income at all, forcing the company to write these mortgages off as losses on its income statement.
The purpose of Freddie Mac is to make it easier for Americans to own a home. Freddie Mac accomplishes this goal by expanding the supply of funds available for mortgages. For example, when a bank lends out a mortgage, it normally has to wait until the loan is repaid before lending the funds out again. Freddie Mac, however, steps in and buys out the mortgage from the bank, allowing the bank to make a second loan sooner; Freddie Mac meanwhile earns the interest from the mortgage. Freddie Mac also sells bonds tied to the mortgages, called mortgage-backed securities. While the mortgage might not be repaid, Fannie Mae guarantees full repayment of its bonds, allowing Fannie Mae to charge a security premium.
Together, Fannie Mae and Freddie Mac (FRE) hold approximately $5.3 trillion of the $12 trillion total in U.S. residential mortgage. Because of this high concentration, many thought a failure at Fannie Mae would wreak havoc in the residential housing market and the economy as a whole because many other large financial institutions held Fannie Mae bonds. Although the government was not obligated to assist Fannie Mae, the potential mayhem caused by Fannie's demise is what many believe led the to government ensure Fannie Mae's continued viability.
In 2010, Freddie Mac had net interest income of $16.9 billion, a slight decrease from its 2009 net interest income of $17.1 billion. However, despite the decrease in revenues, Freddie Mac was able to decrease its net loss from $21.6 billion in 2009 to $14.0 billion in 2010.
Freddie Mac breaks its business operations into three reportable segments: i) Investments, ii) Single Family Guarantee, and iii) Multifamily. Activities that do not fall under any of the three above segments are categorized as an "All Other" category.
Freddie Mac's Investments segment manages the investments for the broader company, and its roles include debt financing, managing Freddie Mac's interest rate risk, and managing its liquidity and capital positions. It mainly invests in mortgage-related securities and single-family mortgages.
Freddie Mac's Single Family Guarantee segment essentially acts as insurance on single family mortgage related securities. In other words, it guarantees the interest and principal payments on these securities in the event of a default, and earns revenues by charging a premium for this guarantee.
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The Mortgage Bankers Association has since urged the Federal Government to place both Fannie Mae and Freddie Mac into "receivership", the next step past its current "conservatorship". Right now the government controls 79.9% of Fannie Mae and Freddie Mac, with 80% being the threshold for placing them on the federal books. Conservatorship is intended for firms that could be restored to health, while receivership is the end-of-the-line liquidation phase. Freddie has also begun lobbying the Treasury to reduce its dividend payments on the preferred shares the Treasury owns. This would help Freddie Mac help pay back some of the funds it owes, and it also allows it to begin restructuring by reducing the amount of preferred shares the government owns.
The Obama administration has yet to reach an agreement on whether the U.S. Treasury should provide guarantees for new mortgages once the market stabilizes. The issue is becoming relatively urgent because of a January deadline for that the Treasury Department must meet with a recommendation for the future of the U.S. housing finance system. Some top experts are in favor of an explicit but limited Federal guarantee of mortgages, while others believe this exposes the government to too much risk. The ultimate recommendation by the Treasury Department may hold significant importance to Freddie Mac's future.
The collapse of the U.S. subprime mortgage market has led to a decreased demand for mortgage-backed securities (MBS), which has hurt Freddie Mac’s ability to issue and sell its bonds. With the default rates on adjustable-rate subprime mortgages as high as 8%, the demand for securities backed by these mortgages has turned investors away, since there is a fear the bonds might not be repaid. These MBS’s form the base of Freddie’s business, as much of its cash flow is generated by revenue from the sale of these bonds. When demand for its bonds falls, the sale price for these bonds fall, putting Freddie Mac in the position of having to either sell the bonds at a lower price or hold onto them until times improve. In the meantime, the securities that Freddie can’t or chooses not to sell have seen their values decline as the market demand for them falls.
Freddie Mac’s business depends on a steady supply of new mortgages to purchase and repackage into securities; since the slump in the U.S. housing market, this supply has diminished. With fewer mortgages to purchase from banks and lenders, Freddie would see a decrease in the volume of its business for the duration of the slump. In general, downturns in the housing market lead to fewer mortgage originations, which, in turn, leads to fewer mortgages that Freddie can purchase. Additionally, housing slumps often lead to a decline in residential real estate prices, meaning that the properties backing mortgages are worth less; any homes Freddie repossesses will be worth less than before, possibly even less than Freddie paid for the mortgage originally. The same applies in reverse, however. Housing booms lead to higher mortgage originations and higher home prices, all of which can boost Freddie’s business.
Because of Freddie Mac's relatively specific purpose and its GSE status, comparisons to other corporations are difficult to make. The best comparison would be to its sister company, Fannie Mae (FNM). Both have similar charters, are similar in size, and both hold status as GSEs.