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Freddie Mac (NYSE:FRE) 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. Though Freddie Mac is a private sector company, it is a government-sponsored enterprise, which gives it a range of special benefits, including exemption from state and local taxes, a line of credit with the U.S. Treasury, and the implied support of the U.S. federal government.
Despite the privileges afforded by Freddie Mac's GSE status, the collapse of the U.S. subprime mortgage industry and concurrent credit crunch hit the company hard, resulting in net losses of over $4.6 billion between June 30, 2007, and June 30, 2008.[1] Freddie's business model is that it pays interests on its mortgage-backed securities using income from the mortgages it owns; rising default and foreclosure rates, however, meant that more and more of Freddie's mortgages weren't generating any income at all, reducing its cash flow and forcing the company to write those mortgages off as losses on its income statement. Additionally, declining demand for mortgage-backed securities in 2007 and 2008 has made it harder for Freddie to find buyers for its MBS.
In August 2008, the U.S. federal government's implicit backing of Freddie Mac became very explicit, with Treasury Secretary Henry Paulson announcing that Congress had approved a plan giving the Treasury the authority to bail out Freddie if its capital levels dipped too low. This move sought to reassure the markets that Freddie and its sister company, Fannie Mae, would be able to continue serving their purpose of providing liquidity in the U.S. housing market. Investors, who feared that a significant infusion of capital from the U.S. government would dilute the value of their holdings, punished Freddie's stock, which fell by as much as 90% in 2008.[2] On September 8, 2008, investors' fears were realized when Paulson announced a comprehensive plan to take Freddie and Fannie under "conservatorship", essentially placing the companies under temporary 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.[3] In January, 2009, Mitch McConnell, the Senate GOP leader, proposed that the government use Freddie and Fannie Mae (FNM) to subsidize mortgages at a 30 year fixed rate of 4% with the goal of spurring the housing market.[4]
[edit] Business Overview
The Federal Home Loan Mortgage Corporation, or Freddie Mac, is a non-bank financial institution originally created by the U.S. government to expand the supply of funds available for mortgages. When a bank lends out money for a mortgage, it normally has to wait until the loan is repaid before it can lend money for another mortgage; Freddie Mac, however, steps in and buys out the mortgage from the bank. The bank can then make a second loan, while Freddie profits off the interest from the mortgage. Freddie Mac also sells bonds tied to the mortgages, called mortgage-backed securities. Whereas the mortgages backing these securities might not be repaid, Freddie Mac guarantees full repayment of its bonds, allowing Freddie to charge a security premium, which provides another basis of the company’s profit.
Freddie Mac is therefore highly leveraged, as it loans out much of its surplus cash by buying mortgages and then generates revenue by issuing additional securities. High leverage ensures a high return on equity, meaning that Freddie Mac makes a lot of money for every dollar it lends. On the other hand, this leverage implies a lot of risk, since a default on one of the mortgages it owns can impact Freddie’s ability to repay multiple bonds. To offset this risk, Freddie maintains some capital stock, or money on hand, which it can use to repay bonds in the event that a mortgage defaults. Federal legislation now requires Freddie to hold a capital stock equal to 30% of its outstanding debt, which helps manage risk, though at the expense of potential profit.
| FRE Financials (In Millions) | 2006[5] | 2007[5] | 2008[5] | 2009Q1[6] |
| Net Interest Income | 3,412 | 3,099 | 6,796 | 3,859 |
| Non-Interest Income | 1,679 | -275 | -29,175 | -3,088 |
| Non-Interest Expense | -2,809 | -8,801 | -22,190 | -11,559 |
| Net Income | 2,327 | -3,094 | -50,119 | -9,851 |
[edit] Trends and Forces
[edit] Subprime fallout diminishing demand for mortgage-backed securities
The 2007 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%[7], the demand for securities backed by these mortgages has led investors to shy away, fearing that their 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, Freddie can’t sell them for as high a price as it might like, putting it 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; this resulted in large write-downs leading to a net loss of $2bn in the third quarter of 2007.[8]
[edit] Housing slump decreasing new mortgage originations
Freddie Mac’s business depends on a steady supply of new mortgages to purchase and repackage into securities; with the 2007 slump in the U.S. housing market, this supply could diminish. 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.
[edit] Rate cuts could lower future profitability
With the rate cuts by the U.S. Federal Reserve in 2007, new fixed-rate mortgages originated will be signed with lower interest rates. When Freddie purchases these mortgages, it may find it difficult to sell bonds backed by these mortgages later on when interest rates rise once again. For example, if Freddie buys a mortgage that pays 4% per year, but interest rates rise to 5%, it won’t be able to pay a return attractive enough to find buyers while still making a profit; investors would be better off putting their money somewhere else. This could negatively impact profitability if the Fed were to raise interest rates.
[edit] Freddie Mac has trouble finding a long term Chief Executive Officer (CEO)
When the U.S. government took control of Freddie Mac in September of 2008, it replaced then CEO Richard Syron with David Moffett. However, after just six months, Moffett resigned from the post on March 12, 2009[9], citing frustration in being required to consult with regulators and to abide by public policies he thought were not in the best interest of the company.[10] Despite the importance of the position, finding a replacement will not be easy, as compensation will be relatively low compared to comparable positions in non-government regulated companies. As of May 2, 2009, John Koskinen was appointed interim CEO, although a permanent replacement has not yet been decided upon.[11]
[edit] Competition
Given its special status as a government-sponsored enterprise (GSE) and very specific purpose, Freddie Mac doesn’t compare well with many other firms. Its sister company, Fannie Mae (FNM) makes for an apt comparison, however, since both share GSE status, have similar charters, and are of similar size.
| 9M2007 data, millions USD | Net Revenue | Operating Income | Net Income | Profit Margin | Total Assets | Total Liability | Total Equity | Return on Equity (5 Yr. Avg.) | Debt-to-Equity |
|---|---|---|---|---|---|---|---|---|---|
| Fannie Mae | $33,744 | $1,041 | $1,509 | 4.5% | $839,783 | $799,861 | $39,922 | 20.39% | 20:1 |
| Freddie Mac | $32,095 | -$3,182 | -$1,476 | -4.6% | $792,873 | $767,053 | $25,820 | 17.34% | 30:1 |
[edit] References
- ↑ Freddie Mac (FRE) Financial Statements | Reuters.com
- ↑ U.S. seizes Fannie, Freddie, aims to calm markets | U.S. | Reuters.com
- ↑ U.S. seizes Fannie, Freddie, aims to calm markets | U.S. | Reuters.com
- ↑ A Republican Fannie Mae, The Wall Street Journal, 2/6/2009
- ↑ 5.0 5.1 5.2 FRE 10-K 2008 Item 8 Pg. 182
- ↑ FRE 10-Q 2009 Item 2 Pg. 92
- ↑ Default rate on U.S. subprime mortgages continues to rise - International Herald Tribune
- ↑ Freddie Mac shares dive after posting loss - Reuters.co.uk
- ↑ Chief of Freddie Mac Resigns. The New York Times.
- ↑ Fannie, Freddie Both Need CEOs. James R. Hagerty. The Wall Street Journal.
- ↑ Freddie Mac Names John A. Koskinen Interim CEO.
- ↑ Freddie Mac (FRE) Income Statement | Stocks | Reuters.com
- ↑ Fannie Mae (FNM) Income Statement | Stocks | Reuters.com
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