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Freddie Mac (NYSE:FRE) is one of two mortgage giants established by the 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, 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.

Though Freddie Mac is a powerhouse in the secondary mortgage market, it is not immune to conditions affecting the larger economy. Changes in interest rates can affect the profitability of the mortgages it purchases, both in the short- and long-term. The contraction in the debt market following the collapse of the U.S. subprime mortgage industry has had a serious material impact on the value of Freddie's mortgages and mortgage-backed securities, leading to a 3Q2007 loss of $2 billion.^[1] The demand for asset-backed securities has fallen as well, limiting Freddie's ability to sell its bonds on the public markets. With the continued housing slump in the U.S., Freddie Mac could face continued challenges throughout 2008.

Contents 1 Business Overview 2 Trends and Forces 2.1 Subprime fallout diminishing demand for mortgage-backed securities 2.2 Housing slump decreasing new mortgage originations 2.3 Rate cuts could lower future profitability 3 Competition 4 References

[edit] Business Overview

The Federal Home Loan Mortgage Corporation, or Freddie Mac, is a non-bank financial institution created by the US 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.

	2003	2004	2005	2006	9M2007
Total Revenue	$36,854	$32,564	$36,526	$44,002	$32,095
Operating Expenses	$29,836	$28,837	$33,970	$41,899	$35,277
Operating Income (Loss)	$7,018	$3,727	$2,556	$2,103	(-$3,182)
Income Tax Provision	$2,202	$790	$367	-$108	-$1,706
Net Income (Loss)	$4,816	$2,937	$2,189	$2,211	(-$1,476)

Source: Reuters.com^[2]

[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%^[3], 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.^[4]

[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. In general, downturns in the housing market lead to fewer mortgage originations, which, in turn, leads to fewer mortgages that Freddie can purchase and securitize. 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.

[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] 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

Source: Reuters.com^[5][6]

[edit] References

1. ↑ Freddie Mac (FRE) Income Statement | Stocks | Reuters.com
2. ↑ Freddie Mac (FRE) Income Statement | Stocks | Reuters.com
3. ↑ Default rate on U.S. subprime mortgages continues to rise - International Herald Tribune
4. ↑ Freddie Mac shares dive after posting loss - Reuters.co.uk
5. ↑ Freddie Mac (FRE) Income Statement | Stocks | Reuters.com
6. ↑ Fannie Mae (FNM) Income Statement | Stocks | Reuters.com

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