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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. In August 2008, the U.S. federal government's implicit backing of Freddie Mac became 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.^[1] Investors feared a significant infusion of capital from the U.S. government would dilute the value of their holdings, and they punished Freddie's stock, which fell by as much as 90% in 2008.^[2]

On September 8, 2008, these 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.^[3]

For the third quarter of 2009, Freddie Mac posted a net loss of $5 billion, predicting it would need more government support in the future; however, rising security values during the quarter helped it avoid going to the government this quarter.^[4] The company attributes the loss to a $7.6 billion increase in provision for credit losses.^[4] As of November 11, 2009, Freddie Mac had taken in $51.7 billion in government aid, compared to Fannie Mae (FNM) who has received $60.9 billion. On December 24, 2009, The U.S. Treasury Department uncapped the credit line given to Fannie Mae and Freddie Mac for three years, essentially guaranteeing that the companies will survive and eliminating uncertainty about continued government support.^[5]

Business Overview

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 in 1938 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.^[6] 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.

Freddie Mac is also highly leveraged, as it loans out much of its surplus cash by buying mortgages and then generating revenue by issuing additional securities. High leverage often leads to a high return on equity (ROE), or a high profit per dollar invested. However, this leverage carries substantial risk, since a default on one of the mortgages it owns can impact Freddie’s ability to repay multiple bonds.

For the second quarter of 2009, Freddie Mac posted a net loss of $242 million; however, excluding a $1.1 billion dividend paid to the Treasury, Freddie Mac actually had an operating profit of $768 million.^[7] This was a sharp turnaround from its 2009 first quarter net loss of $9.9 billion.^[8] The company attributed this to a one time accounting gain of $5.1 billion as well as a $4.2 billion gain from its derivatives.^[8]

Trends and Forces

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%,^[11] 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.

Housing slump decreasing new mortgage originations

U.S. interest rate trends over time

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. 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.

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.

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^[12], 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.^[13] 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.^[14] On July 2, 2009, the Board of directors called on Charles Haldeman Jr. to serve as its CEO.^[15]

Competition

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.

• Fannie Mae is slightly larger than Freddie Mac, with approximately $3.1 trillion in mortgages and other guarantees as of the end of 2008.^[16] In 2008 Fannie Mae had $8.8 billion in net interest income and $7.6 billion guaranty fee income^[17]; however, it had losses of $7.2 billion in investment income, $20.1 billion in losses related to derivatives, and a $29.8 billion loss related to its provision for credit losses as well as foreclosed property expense.^[17] Combined, this led to a net loss in 2008 of $59.8 billion, compared to its 2007 net loss of $2.6 billion.^[17]

References

1. ↑ Jason Simpkins. As Treasury’s Paulson Prescribes Bailout for Fannie Mae and Freddie Mac, Guru Jim Rogers Predicts an “Unmitigated Disaster”. Money Morning.
2. ↑ U.S. seizes Fannie, Freddie, aims to calm markets | U.S. | Reuters.com
3. ↑ U.S. seizes Fannie, Freddie, aims to calm markets | U.S. | Reuters.com
4. ↑ ^{4.0 4.1} Freddie Mac posts $5 billion loss. Al Yoon. Reuters
5. ↑ Treasury uncaps credit line for Fannie, Freddie. Corbett B. Daly. Reuters.
6. ↑ Fannie Mae Charter Act.
7. ↑ Lauren Tara LaCapra. Freddie Mac Outshines Fannie Mae. TheStreet.com
8. ↑ ^{8.0 8.1} Freddie Mac reports first profit in two years. Reuters.
9. ↑ ^{9.0 9.1 9.2} FRE 10-K 2008 Item 8 Pg. 182
10. ↑ FRE 10-Q 2009 Item 2 Pg. 92
11. ↑ Default rate on U.S. subprime mortgages continues to rise - International Herald Tribune
12. ↑ Chief of Freddie Mac Resigns. The New York Times.
13. ↑ Fannie, Freddie Both Need CEOs. James R. Hagerty. The Wall Street Journal.
14. ↑ Freddie Mac Names John A. Koskinen Interim CEO.
15. ↑ Freddie Mac board chooses new CEO. United Press International.
16. ↑ FNM 10-K 2008 Item 6 Pg. 81
17. ↑ ^{17.0 17.1 17.2 17.3} FNM 10-K 2008 Item 6 Pg. 80
18. ↑ FRE 10-K 2008 Item 6 Pg. 58