UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2013
Commission File Number: 001-34139
Federal Home Loan Mortgage Corporation
(Exact name of registrant as specified in its charter)
8200 Jones Branch Drive
McLean, Virginia 22102-3110
(Registrant’s telephone number,
(State or other jurisdiction of incorporation or organization)
(Address of principal executive offices, including zip code)
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 registrant’s 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. [ ]
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 [ X ]
Accelerated filer [ ]
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 28, 2013 (the last business day of the registrant’s most recently completed second fiscal quarter) was $877.6 million.
As of February 14, 2014, there were 650,039,533 shares of the registrant’s common stock outstanding.
DOCUMENTS INCORPORATED BY REFERENCE: None
TABLE OF CONTENTS
MD&A TABLE REFERENCE
Total Single-Family Loan Workout Volumes
Mortgage-Related Investments Portfolio
Affordable Housing Goals for 2013 and 2014
Affordable Housing Goals and Results for 2011 and 2012
Quarterly Common Stock Information
Selected Financial Data
Mortgage Market Indicators
Summary Consolidated Statements of Comprehensive Income
Net Interest Income/Yield, Average Balance, and Rate/Volume Analysis
Net Interest Income
Derivative Gains (Losses)
Other Income (Loss)
REO Operations (Income) Expense
Composition of Segment Mortgage Portfolios and Credit Risk Portfolios
Segment Earnings and Key Metrics — Single-Family Guarantee
Segment Earnings Composition — Single-Family Guarantee Segment
Segment Earnings and Key Metrics — Investments
Segment Earnings and Key Metrics — Multifamily
Investments in Available-For-Sale Securities
Investments in Trading Securities
Characteristics of Mortgage-Related Securities on Our Consolidated Balance Sheets
Additional Characteristics of Mortgage-Related Securities on Our Consolidated Balance Sheets
Mortgage-Related Securities Purchase Activity
Non-Agency Mortgage-Related Securities Backed by Subprime First Lien, Option ARM, and Alt-A Loans and Certain Related Credit Statistics
Non-Agency Mortgage-Related Securities Backed by Subprime, Option ARM, Alt-A and Other Loans
Net Impairment of Available-For-Sale Mortgage-Related Securities Recognized in Earnings
Ratings of Non-Agency Mortgage-Related Securities Backed by Subprime, Option ARM, Alt-A and Other Loans, and CMBS
Mortgage Loan Purchases and Other Guarantee Commitment Issuances
Derivative Fair Values and Maturities
Reconciliation of the Par Value and UPB to Total Debt, Net
Other Short-Term Debt
Freddie Mac Mortgage-Related Securities
Issuances and Extinguishments of Debt Securities of Consolidated Trusts
Changes in Total Equity (Deficit)
Single-Family Credit Guarantee Portfolio Data by Year of Origination
Characteristics of Purchases for the Single-Family Credit Guarantee Portfolio
Characteristics of the Single-Family Credit Guarantee Portfolio
Single-Family Loans Scheduled Payment Change to Include Principal by Year at December 31, 2013
Serious Delinquency Rates by Year of Payment Change to Include Principal
Single-Family Next Scheduled Adjustable-Rate Resets by Year at December 31, 2013
Serious Delinquency Rates by Year of First Rate Reset
Certain Higher-Risk Categories in the Single-Family Credit Guarantee Portfolio
Step-Rate Modified Loans
Single-Family Loan Workout, Serious Delinquency, and Foreclosure Volumes
Quarterly Percentages of Modified Single-Family Loans — Current and Performing
Single-Family Relief Refinance Loans
Single-Family Serious Delinquency Statistics
Credit Concentrations in the Single-Family Credit Guarantee Portfolio
Single-Family Credit Guarantee Portfolio by Attribute Combinations
Single-Family Credit Guarantee Portfolio Foreclosure and Short Sale Rates
Multifamily Mortgage Portfolio — by Attribute
REO Activity by Region
Single-Family REO Property Status
Credit Loss Performance
Severity Ratios for Single-Family Loans
Single-Family Charge-offs and Recoveries by Region
Loan Loss Reserves Activity
Single-Family Impaired Loans with Specific Reserve Recorded
Single-Family Credit Loss Sensitivity
Repurchase Request Activity
Loans Released from Repurchase Obligations
Mortgage Insurance by Counterparty
Bond Insurance by Counterparty
Derivative Counterparty Credit Exposure
Activity in Other Debt
Freddie Mac Credit Ratings
Consolidated Fair Value Balance Sheets
Summary of Change in the Fair Value of Net Assets
Contractual Obligations by Year at December 31, 2013
PMVS and Duration Gap Results
Derivative Impact on PMVS-L (50 bps)
2014 Target TDC
Board of Directors Committee Membership
2013 Target TDC
Achievement of Conservatorship Scorecard Performance Measures
Achievement of Complementary Corporate Goals
2013 Deferred Salary
Summary Compensation Table — 2013
Grants of Plan-Based Awards — 2013
Outstanding Equity Awards at Fiscal Year-End — 2013
Pension Benefits — 2013
Non-Qualified Deferred Compensation
Potential Payments Upon Termination of Employment or Change-in-Control as of December 31, 2013
Board Compensation — 2013 Non-Employee Director Compensation Levels
2013 Director Compensation
Stock Ownership by Directors, Executive Officers, and Greater-Than-5% Holders
Equity Compensation Plan Information
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
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.”
ITEM 1. BUSINESS
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, 2013.
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 essential mortgage liquidity in a wide range of economic environments. We are working to support the continued recovery of the housing market and the nation’s economy by: (a) providing America’s families with access to mortgage funding at low rates while helping distressed borrowers keep their homes and avoid foreclosure, where possible; and (b) providing consistent liquidity to the multifamily mortgage market, which includes providing financing for affordable rental housing. At the same time, we are working with FHFA, our customers and the industry to build a stronger housing finance system for the nation.
Conservatorship and Government Support for Our Business
We continue to operate in conservatorship that began in September 2008, under the direction of FHFA, as our Conservator. The conservatorship and related matters continue to have a wide-ranging impact on us, including our management, business, financial condition, and results of operations. There is significant uncertainty as to our future, as conservatorship has no specified termination date, and it is unknown what changes may occur to our business model during or following conservatorship, including whether we will continue to exist.
We are also subject to certain constraints on our business activities imposed by Treasury due to the terms of, and Treasury’s rights under, the Purchase Agreement. We are dependent upon the continued support of Treasury and FHFA in order to continue operating our business. We do not have the authority over the long term to build and retain capital from the earnings generated by our business operations, or return capital to stockholders other than Treasury.
For more information on the conservatorship and government support for our business, including the Purchase Agreement, see “Conservatorship and Related Matters” and “NOTE 2: CONSERVATORSHIP AND RELATED MATTERS."
Consolidated Financial Results for 2013
During 2013, we continued to see improvement in the housing market, which contributed positively to our financial results. Comprehensive income was $51.6 billion for 2013 compared to $16.0 billion for 2012. Comprehensive income for 2013 consisted of $48.7 billion of net income and $2.9 billion of other comprehensive income. Our net income for 2013 includes: (a) a benefit for federal income taxes of $23.3 billion that primarily resulted from our conclusion to release our valuation allowance against our net deferred tax assets; (b) improvements in the fair value of our derivatives from increases in long-term interest rates; (c) benefits for credit losses resulting from declines in the volume of newly delinquent loans, lower estimates of incurred losses largely resulting from an increase in national home prices and representation and warranty settlements of pre-conservatorship loan origination activity; and (d) settlements of $5.5 billion primarily related to lawsuits regarding our investments in certain residential non-agency mortgage-related securities. Our total equity was $12.8 billion at December 31, 2013. As a result of our positive net worth at December 31, 2013, no draw is being requested from Treasury under the Purchase Agreement for the fourth quarter of 2013. Through December 31, 2013, we have paid aggregate cash dividends to Treasury that slightly exceed our aggregate draws received under the Purchase Agreement. At December 31, 2013, our aggregate funding received from Treasury under the Purchase Agreement was $71.3 billion. For a discussion of the factors that led to our conclusion to release the valuation allowance against our net deferred tax assets, see “MD&A — CONSOLIDATED BALANCE SHEETS ANALYSIS — Deferred Tax Assets and Liabilities” and “NOTE 12: INCOME TAXES.”
The level of earnings we have experienced in recent periods is not sustainable over the long term. While our recent financial results, particularly our benefit (provision) for credit losses, benefited significantly from strong home price appreciation we are beginning to see moderation in home price growth. In addition, our recent financial results include large benefits related to the release of our deferred tax asset valuation allowance and settlements of residential non-agency mortgage-related securities litigation and claims for breaches of representations and warranties by our sellers. These trends are not expected to continue over the long term. Our settlements with sellers for claims for breaches of representations and warranties
primarily related to pre-conservatorship loan activity are largely complete. Our residential non-agency mortgage-related securities litigation is ongoing with many large institutions and we expect additional settlements in 2014. In addition, declines in the size of our mortgage-related investments portfolio, as required by FHFA and the Purchase Agreement, will reduce earnings over time. Our financial results will also continue to be positively or negatively affected by changes in interest rates, yield curves, and mortgage spreads, which can cause significant earnings and net worth variability.
Our Primary Business Objectives
We are focused on the following primary business objectives: (a) reducing taxpayer exposure to losses by reducing and managing our overall risk profile, especially to mortgage-related risks; (b) supporting U.S. homeowners and renters by providing lenders with a constant source of liquidity for mortgage products even when other sources of financing are scarce; (c) building a commercially strong and efficient business enterprise; and (d) positioning the company, in particular our people and infrastructure, to succeed in a to-be-determined “future state.”
Reducing Taxpayer Exposure to Losses by Reducing and Managing Our Overall Risk Profile, Especially to Mortgage-Related Risks
We continue to actively manage and reduce the high credit risk related to our 2005-2008 Legacy single-family book by: (a) providing homeowners with alternatives that allow them to stay in their homes; (b) maximizing the proceeds from short sales and REO sales; (c) actively managing our servicers; (d) pursuing our rights with our sellers; (e) enforcing our rights with other counterparties; and (f) reducing our mortgage-related investments portfolio. The 2005-2008 Legacy single-family book represented 16% of our single-family credit guarantee portfolio at December 31, 2013, but comprised 81% of our credit losses during 2013.
Providing Homeowners with Alternatives that Allow Them to Stay in Their Homes
We establish guidelines for our servicers to follow and provide them default management programs to use, in part, in determining which type of loan workout would be expected to provide us with an opportunity to manage our exposure to credit losses. Our servicers pursue repayment plans and loan modifications for borrowers facing financial or other hardships because the level of recovery on a reperforming loan may often be much higher than would be the case with foreclosure or foreclosure alternatives. Since 2009, we have helped approximately 953,000 borrowers experiencing hardship complete a loan workout. Under our loan workout programs, our servicers contact borrowers experiencing hardship with a goal of helping them 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.
Beginning in 2009, we introduced a variety of borrower-assistance programs, including HAMP, to help keep families in their homes. We continued to expand these programs in 2013. In July 2013, as part of the servicing alignment initiative, we implemented a new streamlined modification initiative, which provides an additional modification opportunity to many delinquent borrowers who are at least 90 (but not more than 720) days delinquent. Across all our modification programs, we modified $17.4 billion and $15.1 billion in UPB of loans in 2013 and 2012, respectively.
Our relief refinance initiative, including HARP (which is the portion of our relief refinance initiative for loans with LTV ratios above 80%), is another key program used by our seller/servicers to help keep families in their homes. In 2013 and 2012, we purchased or guaranteed $99.2 billion and $122.8 billion in UPB of relief refinance loans, respectively, which included $62.5 billion and $86.9 billion in UPB of HARP loans, respectively. We have purchased HARP loans provided to nearly 1.3 million borrowers since the initiative began in 2009, including approximately 340,000 borrowers during 2013. See “Table 47 — Single-Family Relief Refinance Loans” for more information about the volume of our relief refinance purchases.
As of December 31, 2013, the borrower’s monthly payment for all of our completed HAMP modifications was reduced on average by an estimated $531, which amounts to an average of $6,372 per year, and a total of $1.5 billion in annual reductions (these amounts are calculated by multiplying the number of completed modifications by the average reduction in monthly payment, and have not been adjusted to reflect the actual performance of the loans following modification).
The table below presents our single-family loan workout activities for the last five years.
Table 1 — Total Single-Family Loan Workout Volumes(1)
Based on workouts 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.
As of December 31, 2013, approximately 21,000 borrowers were in modification trial periods, including approximately 16,000 borrowers in trial periods for our non-HAMP modification.
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 within the year; however, a single loan may be included under separate forbearance agreements in each year.
While we believe our home retention programs have been largely successful, many borrowers still need our assistance. See “MD&A — RISK MANAGEMENT — Credit Risk — Mortgage Credit Risk — Single-Family Mortgage Credit Risk” for more information about loss mitigation activities and our efforts to keep families in their homes, including through our loan modification initiatives and our relief refinance mortgage initiative.
Maximizing the Proceeds from Short Sales and REO Sales
In cases where repayment plans and loan modifications are not possible or successful, a short sale transaction typically provides us with a comparable or higher level of recovery than a foreclosure and subsequent property sale from our REO inventory. In large part, the benefit of a short sale is that we avoid costs we would otherwise incur to complete the foreclosure and dispose of the property, including maintenance, property taxes, and other expenses associated with holding REO property.
We believe our REO disposition and short sale severity ratios in 2013 were positively affected by changes made in 2012 to our process for evaluating the market value and determining the list price for our REO properties when we offer them for sale, as well as repairing a higher percentage of our REO properties prior to listing them.
Actively Managing our Servicers
We continue to face challenges with respect to the performance of certain of our single-family servicers in managing our seriously delinquent loans. Our servicers represent and warrant to us that loans serviced on our behalf will be serviced in accordance with our servicing contract. These contractual obligations provide us with remedies for breaches in servicing. These contractual remedies include the ability to require the servicer to pay compensatory or other fees, repurchase the loan at its current UPB, and/or reimburse us for losses realized. During 2013, we began to increase our review of servicing related violations, including by issuing notices of defect to our servicers for certain violations of our servicing standards. As of December 31, 2013, we had: (a) $0.6 billion of outstanding repurchase requests; and (b) $0.3 billion of outstanding notices of
defect, with our servicers, based on the UPB of the related loans. We also recognized $0.4 billion of compensatory fees during 2013 primarily for servicer failures to complete a foreclosure within our timelines.
We continue to have a large population of seriously delinquent loans, many of which have been delinquent for more than one year; these loans tend to be more challenging to resolve. As of December 31, 2013, our serious delinquency rate for the aggregate of those states that require a judicial foreclosure and all other states was 3.31% and 1.63%, respectively. Foreclosures generally take longer to complete in states where judicial foreclosures are required, compared to other states. During 2013, the average time to foreclose on properties in judicial states was 943 days compared to 567 days in non-judicial states for loans in our single-family credit guarantee portfolio, excluding those underlying our Other Guarantee Transactions.
As part of our efforts to maximize foreclosure alternatives, increase problem loan workouts, and mitigate our credit losses, we have continued to facilitate the transfer of servicing for certain pools of loans with higher credit risk from underperforming servicers to other servicers that specialize in workouts of problem loans. During 2013, we facilitated the transfer of servicing for $55.6 billion in UPB of loans from our primary servicers to specialty servicers.
Pursuing Our Rights with Our Sellers
We have contractual arrangements with our sellers under which they agree to sell us mortgage loans, and represent and warrant that those loans have been originated under specified underwriting standards. If we subsequently discover that the representations and warranties were breached (i.e., that contractual standards were not followed), we can exercise certain contractual remedies to mitigate our actual or potential credit losses. These remedies include the ability to require the seller to repurchase the loan at its current UPB and/or reimburse us for losses realized.
We continue to recover credit losses from seller/servicers in the normal course of business related to breaches of representations and warranties for loans they sold to us or service for us. In addition, in 2013, we also actively pursued seller representation and warranty settlements of pre-conservatorship loan activity, agreeing to settlements with nine of our larger sellers and several of our smaller sellers covering approximately 49% of the 2005-2008 Legacy single-family book as of December 31, 2013. During 2013, we recovered amounts from seller/servicers with respect to $5.6 billion in UPB of loans subject to our repurchase requests, including $2.1 billion related to settlement agreements. Approximately 23% of the $5.6 billion in UPB associated with repurchase requests were satisfied by the reimbursement of losses (excluding amounts related to settlement agreements). As of December 31, 2013, we had $1.6 billion of outstanding repurchase requests with sellers, based on UPB of the loans. In November 2013, FHFA announced that we had substantially achieved the 2013 Conservatorship Scorecard goal to complete our requests for remedies for breaches of seller representations and warranties related to pre-conservatorship loan origination activity.
Enforcing Our Rights with Other Counterparties
We continue to pursue claims for coverage under mortgage insurance policies in the normal course of business. We also continued to actively pursue settlements with mortgage insurance counterparties. We use mortgage insurance, which is a form of credit enhancement, to mitigate our credit loss exposure. Primary mortgage insurance is generally required to be purchased at loan origination, typically at the borrower’s expense, for certain mortgages with higher LTV ratios, from an insurer that is typically selected by the lender. We received payments under primary and other mortgage insurance of $2.0 billion in each of 2013 and 2012 which helped to mitigate our credit losses. Although the financial condition of certain of our mortgage insurers improved moderately in 2013 as a result of strong home price appreciation and their having raised additional capital, there is still a significant risk that these counterparties may fail to meet their obligations to pay our claims. We expect to receive substantially less than full payment of our claims from three of our seven larger mortgage insurance counterparties, as they are currently partially paying claims under orders of their regulators and are no longer rated by S&P or Moody's. Of our four largest mortgage insurers, three are rated B, and one is rated BBB+, as of February 14, 2014. We consider the collectability of our claims against our mortgage insurers when determining the receivables and estimating our allowance for loan losses on our consolidated balance sheets.
Our ability to manage our exposure to mortgage insurers may be limited as: (a) certain of our mortgage insurers are operating below our eligibility thresholds; and (b) our ability to revoke a mortgage insurer's status as an eligible insurer may require FHFA approval. We are working with FHFA and Fannie Mae to improve mortgage insurance standards. We are developing counterparty risk management standards for mortgage insurers that include revised eligibility requirements. In December 2013, FHFA announced that we and Fannie Mae, in collaboration with our mortgage insurers, had completed development of new master policies, for which the mortgage insurers are expected to seek state regulatory approval. These changes to the master policies are intended to provide greater certainty of coverage, facilitate timely claims processing, and help address the significant problems we faced in recent years in resolving repurchase requests related to mortgage insurance rescission. We expect to finalize changes to financial requirements and other standards for mortgage insurer eligibility in 2014.
At the direction of our Conservator, we are also working to enforce our rights as an investor with respect to the non-agency mortgage-related securities we hold, and are engaged in various efforts, in some cases in conjunction with other investors, to mitigate or recover losses on our investments in these securities. During 2013, we and FHFA reached settlements with a number of institutions pursuant to which we received an aggregate of $5.5 billion. In addition, in February 2014, we and
FHFA entered into an agreement with Morgan Stanley, and related parties, to settle litigation related to certain residential non-agency mortgage-related securities we hold for $625 million. This settlement will be reflected in our consolidated financial results for the first quarter of 2014. Lawsuits against a number of large institutions are currently pending. See “NOTE 15: CONCENTRATION OF CREDIT AND OTHER RISKS” for more information about our recent agreements with non-agency mortgage-related security issuers.
We are also working to enforce our rights in the Lehman bankruptcy. In February 2014, we reached a settlement with Lehman Brothers Holdings Inc. pursuant to which we will receive $767 million to resolve our claims related to Lehman’s bankruptcy. Consequently, we adjusted our December 31, 2013 estimate of the expected recoveries of our short-term lending receivable by $350 million, which reduced other expenses by the same amount. For more information, see “NOTE 17: LEGAL CONTINGENCIES."
Reducing Our Mortgage-Related Investments Portfolio
During 2013, we continued to reduce the size of our mortgage-related investments portfolio, as required under the terms of the Purchase Agreement and FHFA regulation. Our mortgage-related investments portfolio declined 17%, or $96.5 billion, from $557.5 billion as of December 31, 2012 to $461.0 billion as of December 31, 2013 and was below the required limit. Our less liquid assets accounted for $70.9 billion of this decline primarily due to: (a) liquidations; and (b) consistent with our 2013 Conservatorship Scorecard goal, sales of $16.8 billion which exceeded our scorecard goal.
While our on-going focus remains on reducing our less liquid assets, we continue to purchase certain of these assets as part of our business strategies. In 2014, we plan to continue to reduce our mortgage-related investments portfolio, consistent with the Purchase Agreement and FHFA regulation, through liquidations and sales, subject to a variety of constraints, including market conditions.
Supporting U.S. Homeowners and Renters by Providing Lenders with a Constant Source of Liquidity for Mortgage Products even when Other Sources of Financing are Scarce
We maintain a consistent market presence by providing lenders with a constant source of liquidity for mortgage products even when other sources of financing are scarce. This liquidity provides our customers with confidence to continue lending even in difficult environments. During 2013 and 2012, we purchased or issued other guarantee commitments for $422.7 billion and $426.8 billion in UPB of single-family conforming mortgage loans, representing approximately 2.1 million and 2.0 million homes, respectively. We estimate that we, Fannie Mae, and Ginnie Mae collectively guaranteed more than 90% of the single-family conforming mortgages originated since 2008. During 2013, our multifamily new business activity (i.e., loan purchases and issuances of Other Structured Securities and other guarantee commitments), totaled $25.9 billion, and provided financing for nearly 1,600 properties amounting to nearly 388,000 apartment units. The vast majority of these apartments were affordable to low and moderate income families.
Building a Commercially Strong and Efficient Business Enterprise
Single-Family Guarantee Segment Strategies
Our single-family business is our core business line. We continue to take steps to build a stronger, profitable business model for our ongoing business. Our goal is to strengthen the business model in order to run the business efficiently and effectively in support of homeowners and taxpayers and, if required as part of a future state for the enterprise, to be able to promptly return to private sector ownership.
Our Single-family Guarantee segment is focused on strengthening our business model by:
Leveraging the fundamentals: We are leveraging our existing product offerings to better meet the needs of an evolving mortgage market. This includes working to reduce repurchase requests and penalties, in the form of fees, by providing greater certainty for seller/servicers that the loans they sell to us or service for us meet our requirements. We are doing this by enhancing the tools we make available to our customers (including Loan Prospector, Loan Quality Advisor, and Home Value Estimator), and expanding and leveraging the data standards of the Uniform Mortgage Data Program. We intend to continue to simplify, streamline, and strengthen our operations, while keeping pace with regulatory requirements, such as those implemented under the Dodd-Frank Act.
Better serving our customers: Our customers are our sellers, servicers, and investor/dealers. Based on feedback we have received directly from our customers through our Customer Advisory Boards, surveys, and ongoing conversations, we are enhancing our processes and programs to improve our customers’ experience when doing business with us.
Managing the credit risk of the single-family credit guarantee portfolio: We are managing our credit risk by setting our underwriting standards at a level commensurate with the long-term credit risk appetite of the company. 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 eligibility and underwriting standards, and the seller/servicers represent and warrant to us that the mortgages sold to us meet these standards. Beginning in 2009, we have made various changes to our credit policies, including changes to improve our underwriting standards, purchased fewer
loans with higher risk characteristics, and assisted in improving our mortgage insurers’ and lenders’ underwriting practices. As a result, the credit quality of the New single-family book is significantly better than that of the 2005-2008 Legacy single-family book, as measured by original LTV ratios, FICO scores, and the proportion of loans underwritten with full documentation, as well as delinquency rates and credit losses.
Transferring the credit risk of the single-family credit guarantee portfolio: We consider risk transfer transactions to be a prudent way to manage risk in our business. We executed three transactions during 2013 that transfer a mezzanine credit loss position on certain groups of loans in the New single-family book. These transactions are intended to shift mortgage credit risk from us to private investors and are consistent with our 2013 Scorecard goal. While these transactions have been relatively small compared to our overall mortgage credit risk, we believe they have attracted broad interest in the market. We will seek to expand and refine our offerings of credit risk transfer transactions in the future.
Optimizing the economics of the single-family credit guarantee portfolio: We strive to achieve the highest economic returns on our portfolio while considering and balancing our: (a) customer diversification; and (b) housing mission and goals. We also align our mortgage-related securities offerings and disclosures with customer needs and investor demand to balance the achievement of the above objectives while considering the relative performance of our securities in the market.
Investments Segment Strategies
Our Investments segment is a key business operation, which has certain objectives in 2014, including:
Maintaining a presence in the agency mortgage-related securities market. Our activities in this market may include outright purchases and sales, dollar roll transactions, and structuring existing agency securities into REMICs and selling some or all of the tranches.
Maintaining a portfolio of liquid securities consistent with our liquidity management guidelines. In managing the reduction of our mortgage-related investments, we evaluate the liquidity of these investments based on two categories: (a) single-class and multiclass agency securities; and (b) assets that are less liquid than agency securities. We are focusing our efforts on reducing the balance of less liquid assets in the mortgage-related investments portfolio. Our liquid assets collectively represented approximately 40% of UPB of the portfolio at December 31, 2013, compared to 38% at December 31, 2012.
Managing the single-family performing loans obtained through our cash purchase program. We purchase loans from lenders for cash and, in conjunction with the single-family business, securitize the majority of these loans into Freddie Mac agency securities that may be sold to dealers or investors, or retained in our mortgage investments portfolio as agency securities.
Managing single-family re-performing loans and performing modified loans. This includes securitizing loans, and could include selling loans or other disposition strategies in the future.
Managing single-family delinquent loans along with the single-family business. This includes removing seriously delinquent loans from PC pools and could include selling loans, securitizing loans, or other disposition strategies in the future.
Reducing the overall balance of our holdings of non-agency mortgage-related securities through liquidations and sales, subject to a variety of constraints, including market conditions.
Managing the treasury function, including funding and liquidity, for the overall company, through the issuance of short-term and long-term unsecured debt. We maintain a liquidity and contingency portfolio of cash and non-mortgage investments for short-term liquidity management.
Managing the interest-rate risk for the overall company through the use of derivatives and unsecured debt.
Multifamily Segment Strategies
Our Multifamily business is also a key business operation, and provides a consistent source of liquidity to the multifamily mortgage market while maintaining a strong credit and capital management discipline. We accomplish this primarily by focusing on our business model of aggregating and securitizing mortgage loans in order to transfer the expected credit risk associated with the loans to third-party investors who hold the subordinated securities. The nature of our Multifamily business is in line with the general concept that private investors should absorb the first and predominant losses before any taxpayer exposure; we believe this positions the business well for the future. Additionally, we plan to continue to execute our mission to provide and support a consistent supply of affordable rental housing.
As a result of our prudent underwriting standards and practices, and the continued positive multifamily market fundamentals, the credit quality of the multifamily mortgage portfolio remains strong, and multifamily credit losses during 2013 were less than 0.01% (or less than one basis point) as a percentage of the combined average balance of our multifamily loan and guarantee portfolios.
We continued to expand our K Certificate issuances in the multifamily market with a 32% increase in this activity in 2013, based on UPB, compared to 2012. We were able to increase our securitization volumes in 2013 despite our 10% reduction in new loan purchase volume. During 2013, we reduced the UPB of loans we held in our portfolio for securitization as we were able to reduce the time between loan purchase and securitization. Our K Certificate transactions allow us to sell a portion of mortgage credit risk to private investors who purchase subordinated tranches at the time of transaction execution. As a result of repayments, K Certificate issuances, and sales of loans in our multifamily mortgage portfolio, the non-credit enhanced portion of this portfolio declined by 21% during 2013. In addition, our CMBS portfolio (backed by multifamily loans) declined by 37% during 2013, principally from our sales of these securities. These actions significantly reduced our exposure to credit risk in our Multifamily business.
Positioning the Company, in Particular Our People and Infrastructure, to Succeed in a to-be-determined “future state”
Development of a New Secondary Mortgage Market
Under the direction of FHFA and in accordance with the 2013 Conservatorship Scorecard, we continue various efforts to build the infrastructure for a future housing finance system, including the following:
Common Securitization Platform: On October 7, 2013, FHFA announced the formation of Common Securitization Solutions, LLCSM ("CSS"), which will build and operate the future new common securitization platform. In addition, FHFA announced that: (a) office space has been leased for CSS; and (b) an executive recruitment firm has been retained to identify candidates for the positions of Chief Executive Officer and Chairman of the Board of Managers of CSS. CSS is equally-owned by Freddie Mac and Fannie Mae. In connection with the formation of CSS, we entered into a limited liability company agreement with Fannie Mae and anticipate entering into additional agreements with Fannie Mae relating to CSS in the future.
Contractual and Disclosure Framework: FHFA directed us to work with Fannie Mae to implement a set of uniform contractual terms and standards for transparency that can inform the single-family mortgage securitization market in the future. During 2013, a team from Freddie Mac and Fannie Mae performed analysis and developed preliminary recommendations for: (a) fully-guaranteed (GSE) mortgage-related securities; (b) non- or partially guaranteed (GSE) mortgage-related securities; and (c) new master trust agreements for these types of securities.
Uniform Mortgage Data Program: We and Fannie Mae are collaborating with the industry to develop and implement uniform data standards for single-family mortgages. We have already made significant progress by completing initial phases of this program, including: (a) standard appraisal data elements; (b) the Uniform Collateral Data Portal, which allows us to aggregate this data from sellers; and (c) the Uniform Loan Delivery Dataset, which defines common data elements for each loan we acquire or guarantee. During 2013, we expanded the data elements in the Uniform Loan Delivery Dataset and aligned the dataset with recent changes required by the Consumer Financial Protection Bureau, or CFPB.
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. Under it, lenders are relieved of certain repurchase obligations for loans that meet specific payment requirements three years after purchase (and one year for HARP and other relief refinance mortgages).
Lender placed insurance standards: As part of the servicing alignment initiative, we announced changes in our servicing standards for situations in which our servicers obtain property hazard insurance on properties securing single-family loans we own or guarantee. As a result, effective June 1, 2014, our seller/servicers may not receive compensation or other payment from insurance carriers nor may they use their own or affiliated entities to insure or reinsure a property.
In addition, we also worked to help our seller/servicers improve their underwriting processes for loans that they sell to us. As part of these efforts and in accordance with the 2013 Conservatorship Scorecard, we made progress in the following areas during 2013:
Began an initiative for enhanced early-risk assessment by seller/servicers, including implementation of Loan Quality Advisor, a new automated tool for use in evaluating the credit eligibility of loans and identifying non-compliance issues;
Announced requirements for our seller/servicers in response to certain final rules from the CFPB, including rules concerning the requirements for borrowers' ability to repay and high-cost mortgages, that were implemented beginning in January 2014. See “BUSINESS — Legislative and Regulatory Developments — Dodd-Frank Act” for further information on the final rules;
Implemented standard timelines, appeal requirements, and alternative remedies for resolution of repurchase obligations as part of our efforts to enhance post-delivery quality control practices and transparency associated with our new representation and warranty framework; and
Expanded our loan review sampling strategy, specifically focusing on newly purchased mortgage loans, to evaluate compliance with our standards.
Investing in Human, Technology and Other Resources
We continue to make strategic investments to maintain and improve our ability to operate the company for the foreseeable future in conservatorship and potentially afterwards. Our human capital risks have abated considerably in recent periods, as evidenced by low voluntary turnover and vacancy rates. In 2011, we experienced increased levels of voluntary turnover while the Administration and Congress publicly debated our future business model and compensation structure, and the possibility remains that we may experience increased turnover again in the future. However, during 2013 we continued to attract well-qualified candidates, as evidenced by our hiring of five new senior officers.
Our information technology risk also continues to decline. For example, in 2013, we completed a three-year multimillion dollar project to move our key legacy applications and infrastructure to current, supported technology. We are investing each year to maintain our technology and are focused on standardizing and simplifying the technology portfolio. We continue to focus on emerging information security risks and hired a new Chief Information Security Officer in 2013.
Streamlining, Simplifying and Strengthening Operations
We continue to strengthen our operations. Beginning in mid-2012 and continuing through 2013, we took steps to enhance management’s focus on control issues by elevating awareness of those issues across the company and stressing timely remediation. As a result, the number of outstanding control issues reached its lowest level since conservatorship. We also continue to work to improve our operating efficiency. In 2013, we began a multi-year project focused on simplifying our control structure and eliminating redundant control activities. We updated our risk and control framework to increase our emphasis on risk management and are conducting detailed operational controls design reviews to identify ways to simplify our controls structure.
We are reviewing our information technology architecture design with a focus on simplifying our information technology environment. We are also building our out-of-region disaster recovery capabilities.
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, our own preference for credit risk reflected in our purchase standards and the mortgage purchase and securitization activity of other financial institutions. We operate our business solely in the United States and its territories, and accordingly, we generate no revenue from and have no long-lived assets other than financial instruments in geographic locations outside the United States and its territories.
In addition to the directives given to 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 nation’s 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. We use mortgage securitization as an integral part of our activities. In certain circumstances, we also provide our guarantee without securitization of the related assets (we refer to these transactions as other guarantee commitments).
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 FHFA’s 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. For more
information, see “Regulation and Supervision — Legislative and Regulatory Developments — FHFA Request for Public Input on Proposed Gradual Decrease of Loan Limits.”
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 on the portion of the UPB of the mortgage that exceeds 80%;
a seller’s 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.
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 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%.
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.
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-related 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.
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 lender customers.
In general, for single-family loans, 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) to those who invest in the security; (e) the borrower’s 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.
We issue mortgage-related securities in the form of PCs, REMICs and Other Structured Securities, and Other Guarantee Transactions. Each of these types of mortgage-related securities is discussed below.
Our PCs are single-class pass-through securities that represent undivided beneficial interests in trusts that hold pools of mortgages we have purchased. For our fixed-rate PCs, we guarantee the timely payment of principal and interest. For our 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 PCs in transactions in which our customers provide us with mortgage loans in exchange for PCs. We refer to these transactions as guarantor swaps.
We guarantee our PCs 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 upfront payments 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. The following diagram illustrates a guarantor swap transaction.
We also issue PCs in transactions in which we purchase mortgage loans for cash and securitize them for sale to third parties. We often sell PCs in a “cash auction", as illustrated in the following diagram.
Cash Purchase Process and Securitization of PCs
Institutional and other fixed-income investors, including pension funds, insurance companies, securities dealers, money managers, REITs, and commercial banks, purchase our PCs. In recent 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 and the demand for and values of our PCs. The Federal Reserve began to taper these purchases in January 2014, but no assurance can be given that the Federal Reserve will continue its current practices.
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 price performance of our PCs relative 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 — Market Presence and 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. The profitability of our multifamily business could be adversely affected by a significant decrease in demand for K Certificates.” for additional information about our efforts to support the liquidity and relative price performance of our PCs.
REMICs and Other Structured Securities
Our REMICs and Other Structured Securities represent beneficial interests in pools of PCs and certain other types of mortgage-related assets. We create these securities (which can be single-class or multiclass types) primarily by using PCs or previously issued REMICs and Other Structured Securities as the underlying collateral.
Single-class securities 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.
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 exchange our own mortgage-related assets (e.g., PCs and REMICs and Other Structured Securities) 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.
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.
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 issue or 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 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 receive a management and guarantee fee and/or other delivery fees.
Our primary Other Guarantee Transactions are multifamily K Certificates. In substantially all of these transactions, we guarantee only the most senior tranches of the securities, and as a result, the expected credit risk associated with these loans is sold in subordinated tranches to third-party investors. We do not issue or guarantee the subordinate tranches, which are considered CMBS. However, we may purchase a portion of either the guaranteed certificates or the unguaranteed CMBS, based on market conditions.
The following diagram provides an example of our K Certificate transactions.
K Certificate Transaction
In 2009 and 2010, we entered into transactions under Treasury’s 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. 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.
For information about the amount of mortgage-related securities we have issued, see “Table 33 — Freddie Mac Mortgage-Related Securities.” For information about the relative performance of mortgages underlying these securities, see “MD&A — RISK MANAGEMENT — Credit Risk.”
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
In our Single-family Guarantee segment, we purchase and guarantee 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 securities in exchange for management and guarantee fees.
Single-Family Mortgage Market
The U.S. residential mortgage market consists of a primary mortgage market that links homebuyers and lenders (i.e., our sellers) and a secondary mortgage market that links lenders and investors. We participate in the secondary mortgage market primarily by purchasing mortgage loans and mortgage-related securities 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.
The terms of single-family mortgage loans 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 mortgage loans, borrowers with these mortgage loans are protected against rising interest rates, but are able to take advantage of declining rates through refinancing. When a borrower prepays a mortgage loan 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 primarily the risk that the investor will receive an unscheduled early return of the principal, and therefore may not earn the rate of return originally expected on the investment.
Our customers in the Single-family Guarantee segment are predominantly lenders and loan servicers in the primary mortgage market that originate mortgages for homeowners and service these loans for us. These companies include mortgage banking companies, commercial banks, community banks, credit unions, HFAs, and thrift institutions. Many of these companies perform both roles for us as seller/servicers. In addition, we view investors and dealers in our guaranteed mortgage-related securities and STACR debt notes as customers.
We acquire a significant portion of our mortgages from several lenders that are among the largest mortgage loan originators in the U.S. During 2013, two mortgage lenders, Wells Fargo Bank, N.A and JPMorgan Chase Bank, N.A., each accounted for 10% or more of our single-family mortgage purchase volume and together accounted for approximately 30% of our single-family mortgage purchase volume. Our top ten lenders accounted for approximately 64% and 73% of our single-family mortgage purchase volume during 2013 and 2012, respectively.
We do not have our own mortgage loan servicing operation. Instead, our customers perform the primary servicing function on our loans on our behalf. A significant portion of our single-family mortgage loans is serviced by several of our large customers. For additional information about our relationships with our customers, see “MD&A — RISK MANAGEMENT — Credit Risk — Institutional Credit Risk — Single-Family Mortgage Seller/Servicers.”
Historically, the principal competitors of our Single-family Guarantee segment have been Fannie Mae, Ginnie Mae (with 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 non-GSE competitors have ceased their securitization business or severely curtailed these activities relative to their previous levels. However, in recent periods, many of our non-GSE competitors that ceased securitization activity have continued to originate or purchase single-family loans and began to hold them on their balance sheets as investments rather than securitize them with the GSEs. 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.
The conservatorship, including direction provided to us by our Conservator, may affect our ability to compete. FHFA has required that we and Fannie Mae adopt uniform approaches in a number of areas. For more information, see “RISK FACTORS — Conservatorship and Related Matters — Competition from banking and non-banking companies, as well as efforts by FHFA to reduce the GSEs' dominance in the marketplace, may harm our business."
Guarantee Fees and Contractual Arrangements
We enter into mortgage loan purchase volume agreements with many of our single-family customers that outline the terms under which we agree to purchase loans from them. Some of these agreements, however, require the lenders to deliver to us a minimum percentage of their total sales of conforming loans. These agreements include specified pricing schedules for our management and guarantee fees that are negotiated at the outset of the contract. For the majority of the mortgages we purchase, however, the management and guarantee fees are not specified contractually. Instead, we bid for some or all of the lender's mortgage loan volume on a monthly basis at a management and guarantee fee rate that we specify.
Our mortgage loan 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 loan 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. For agreements that include specified management and guarantee fees, we can change such fees at our discretion, with notice. However, the lenders generally have the option to terminate these agreements when changes to our fees occur, unless the fee changes are broad-based as defined in the agreements.
We seek to issue guarantees with fee terms that we believe are commensurate with the risks assumed and that will, over the long-term: (a) provide management and guarantee fee income that exceeds our anticipated credit-related and administrative expenses on the underlying loans; and (b) provide a return on the capital that would be needed to support the related credit risk. 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, as well as other factors.
We implemented several increases in delivery fees in recent years that are applicable to single-family mortgage loans 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 FHFA’s direction, a further increase in guarantee fees on single-family mortgages of an average of 10 basis points.
In December 2013, FHFA announced a number of additional changes to our (and Fannie Mae's) guarantee fee rates that were scheduled to become effective in March and April of 2014. In January 2014, FHFA announced that it was delaying the implementation of these changes.
We primarily issue and guarantee PCs, and REMICs and Other Structured Securities. Except for our participation in the NIBP, we have not completed an Other Guarantee Transaction in our Single-family Guarantee segment in several years. See "Our Business — Overview of the Mortgage Securitization Process” for additional information about our securitization activities.
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 loan, 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.
Underwriting Requirements and Quality Control Standards
We use a process of delegated underwriting for the single-family mortgage loans we purchase or securitize. In this process, our contracts with seller/servicers describe mortgage eligibility and underwriting standards, and the seller/servicers represent and warrant to us that the mortgage loans 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 borrower’s credit score and credit history, the borrower’s 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.
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.
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 Mae’s proprietary software. The percentage of our single-family mortgage purchase volume (acquired under purchase volume agreements and excluding HARP and other relief refinance loans) evaluated by the loan originator using Loan Prospector prior to being purchased by us was 45% and 55% during 2013 and 2012, 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. In addition, we monitor the performance of loans delivered to us that were underwritten using underwriting software other than Loan Prospector to determine whether the performance is in line with our risk tolerance.
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. We give our seller/servicers an opportunity to appeal ineligible loan determinations in response to our request for the repurchase of the loan. For the last two years, we have required certain of our larger seller/servicers to maintain ineligible loan rates below a stated threshold (generally 5%), with financial consequences for non-compliance. In addition, for all of our largest seller/servicers, we actively manage the current quality of loan originations by providing monthly communications regarding loan defect rates and the causes 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 at a later date. Depending on our evaluation of counterparty financial strength, certain sellers are eligible for repurchase alternatives, including recourse and indemnification. In 2013, we entered into a number of agreements with our sellers to release certain pools of loans from certain repurchase obligations associated with underwriting deficiencies in exchange for a one-time cash payment.
At the direction of FHFA, we and Fannie Mae revised our representation and warranty framework for conventional loans purchased by the GSEs on or after January 1, 2013. Under this new framework, lenders are relieved of certain seller's repurchase obligations for loans that meet specific payment requirements. This includes, subject to certain exclusions, loans with 36 months (12 months for relief refinance mortgages) of consecutive, on-time payments after we purchase them.
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 use tools and available data to help us identify potentially defective loans prior to purchasing them. The changes to the representation and warranty process are key elements of the seller/servicer contract harmonization project that supported FHFA’s strategic plan for the Freddie Mac and Fannie Mae conservatorships announced in 2012.
In addition to representations and warranties for underwriting, our seller/servicers are required to service loans in accordance with our guidelines. Similar to seller violations, we can require servicers to repurchase loans or provide alternative remedies in the case of servicing violations. For certain servicing violations, we typically first issue a notice of defect and allow the servicer a period of time to correct the problem. If the servicing violation is not corrected, we then may issue a repurchase request. For breaches of servicing violations related to loans that have proceeded through foreclosure and REO sale or other workouts (e.g. short sales), we will accept reimbursement for realized credit losses in lieu of repurchase.
For more information, see “MD&A — RISK MANAGEMENT — Credit Risk — Institutional Credit Risk — Single-Family Mortgage Seller/Servicers.”
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. 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 borrower’s 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 executed three transactions during 2013 that provide us with partial credit protection on certain groups of loans in our New single-family book. These transactions are intended to shift mortgage credit risk from us to private investors. The transactions include two structured agency credit risk (STACR) debt note transactions in which we issued unsecured debt securities that reduced our exposure to credit risk, as illustrated below:
Risk Transfer - STACR® (Debt Issuance)
STACR debt notes allow us to transfer a mezzanine loss position on recently acquired single-family mortgage loans to third parties that invest in the issued notes. In a STACR debt note transaction, we create a reference pool consisting of recently acquired single-family mortgage loans. We then create a hypothetical securitization structure with notional credit risk positions, or tranches (e.g., first loss, mezzanine, and senior). We issue STACR debt notes (which relate to the mezzanine loss position) to investors. We are obligated to make payments of principal and interest on the STACR debt notes. The principal balance of the STACR debt notes is reduced when certain specified credit events (such as a loan becoming 180 days delinquent) occur on the loans in the reference pool. In turn, this may reduce the total amount of payments we ultimately make on the STACR debt notes. However, principal reductions will first occur on the first loss position (which is retained by us) until it is fully reduced before the STACR debt notes begin participating in reductions to the principal balances. The interest rate on STACR debt is generally higher than on our other unsecured debt securities due to the potential for reductions to its principal balance.
In 2013, we also executed a second type of risk transfer transaction in which we purchased an insurance policy on a portion of the mezzanine loss position that was not issued in the first STACR debt transaction. Under this insurance policy, we pay monthly premiums that are determined based on the outstanding balance of the STACR debt reference pool and we receive compensation upon the occurrence of specified credit events (such as a loan becoming 180 days delinquent) up to an aggregate limit determined in the contract.
Our use of certain types of credit enhancements to reduce our exposure to mortgage credit risk generally 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 our mortgage loan insurers.
Single-Family Loan Workouts and the MHA Program
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 programs designed to help them manage non-performing loans more 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 2013, 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 2013, 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. During 2013, we granted principal forbearance but did not utilize principal forgiveness for our loan modifications. Principal forbearance is a change to a loan’s 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 generally be modified twice (although only once during a 12 month period) under our standard loan modification program or once under our streamlined modification program. However, we reserve the right to approve additional non-HAMP loan modifications to the same borrower, based on the borrower’s individual facts and circumstances.
Short sale and deed in lieu of foreclosure transactions.
We 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. 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 our loan workout activities, as well as HARP and our relief refinance mortgage initiative.
Home Affordable Modification Program
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 the servicer will enter into the modification. HAMP is available for loans originated on or before January 1, 2009. The program is scheduled to end with trial period plan effective dates on or before March 1, 2016 and modification effective dates on or before September 1, 2016.
The guidelines for HAMP were revised effective June 1, 2010 to address certain underwriting issues experienced in the beginning of the program. Since that date, we have experienced a significantly better modification completion rate under the program. When a borrower’s trial period is canceled, the loan is considered for our other workout activities.
HAMP includes the following features:
Under HAMP, the goal is to reduce the borrower’s 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 allows the 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 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. We bear the costs of borrower incentive payments and servicer incentive fees for our HAMP loans, without reimbursement of such costs from Treasury.
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.
Similar to HAMP, our non-HAMP standard loan modification initiative also requires a three-month trial period. The standard modification offers eligible borrowers an extension of the loan’s term to 480 months and a fixed interest rate. Similar to HAMP modifications, servicers are paid incentive fees for each completed non-HAMP modification. Unlike with HAMP modifications, our non-HAMP standard modification does not provide for borrower incentive payments.
In March 2013, as part of the servicing alignment initiative, we announced a new streamlined modification initiative, which provides an additional modification opportunity to certain borrowers who are at least 90 (but not more than 720) days delinquent. Borrowers are not required to apply for assistance or provide income or hardship documentation. This modification requires a three-month trial period and offers eligible borrowers the same mortgage terms as the non-HAMP standard
modification. This initiative was implemented in July 2013 (with earlier adoption permitted), and is scheduled to end in December 2015.
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. Our relief refinance initiative began in 2009 and is designed to provide eligible homeowners 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 by employing one or more of the following changes: (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.
The relief refinance mortgage initiative, including HARP, originally permitted eligible borrowers with Freddie Mac mortgages (that were originated on or before May 31, 2009) and LTVs up to 125% to refinance their mortgages. We implemented a number of changes to HARP and the relief refinance mortgage initiative in late 2011 and during 2012. These changes included: (a) removing the 125% LTV ratio ceiling for fixed-rate mortgages; and (b) relieving the lenders of certain representations and warranties on the original mortgage being refinanced. In addition, in April 2013, we extended HARP to December 31, 2015, at the direction of FHFA.
Relief refinance mortgages (including HARP loans) generally present higher risk to us than other refinance loans we have purchased since 2009. However, relief refinance mortgages (including HARP loans) generally have performed better than loans with similar characteristics remaining in our single-family credit guarantee portfolio that were originated prior to 2009. For more information, see “MD&A — RISK MANAGEMENT — Credit Risk — Mortgage Credit Risk — Single-Family Loan Workouts and the MHA Program — Relief Refinance Mortgage Initiative and Home Affordable Refinance Program.”
Servicing Alignment Initiative
Under the servicing alignment initiative, we made a number of changes to our single-family loan workout activities to align with Fannie Mae, including the non-HAMP standard loan modification and the streamlined modification initiatives, a new standard short sale process (implemented in late 2012) and a new deed in lieu of foreclosure process (implemented in early 2013). During 2013, we and Fannie Mae further aligned certain standards for servicing non-performing loans owned or guaranteed by the companies pursuant to the FHFA-directed servicing alignment initiative. 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.
Under these new servicing standards, we pay various incentives to servicers for completing workouts of problem loans. We also assess compensatory fees if servicers do not achieve certain benchmarks 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.
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.”
The Investments segment reflects results from three primary activities: (a) managing the company’s mortgage-related investments portfolio, excluding Multifamily segment investments; (b) managing the treasury function, including funding and liquidity, for the overall company; and (c) managing interest-rate risk for the overall company.
Management of the company’s mortgage-related investments portfolio, excluding investments held by the Multifamily segment, primarily consists of:
Managing agency mortgage-related securities, including PCs and REMICs, issued by Freddie Mac, Fannie Mae, and Ginnie Mae. Our activities may include outright purchases and sales, dollar roll transactions, and structuring existing agency securities into REMICs and selling some or all of the tranches.
Managing single-family performing loans obtained through our cash purchase program. We purchase loans from lenders for cash and, in conjunction with the single-family business, securitize the majority of these loans into Freddie Mac agency securities that may be sold to dealers or investors or retained in our mortgage investments portfolio as agency securities.
Managing single-family re-performing loans and performing modified loans. This includes securitizing loans, and could include selling loans or other disposition strategies in the future.
Managing single-family delinquent loans along with the single-family business. This includes removing seriously delinquent loans from PC pools and could include selling loans, securitizing loans, or other disposition strategies in the future.
Reducing the overall balance of our holdings of non-agency mortgage-related securities through liquidations and sales, subject to a variety of constraints, including market conditions.
Managing the treasury function, including funding and liquidity, for the overall company primarily consists of funding the company’s investments in mortgage loans, mortgage-related securities and other assets and its business activities, primarily through the issuance of short-term and long-term unsecured debt. We maintain a liquidity and contingency portfolio of cash and non-mortgage investments for short-term liquidity management.
Managing interest-rate risk for the overall company primarily consists of using derivatives, primarily interest-rate swaps and options, and unsecured debt to manage the interest rate exposure of the company’s mortgage-related investments portfolio, including investments held by the Multifamily segment. In addition to hedging the interest-rate risk of this portfolio, the Investments segment manages the buy-ups and float that are generated from the Single-family Guarantee segment after initial loan acquisition.
Within our core business, our unsecured debt securities are initially purchased by dealers and redistributed to their customers, including insurance companies, money managers, central banks, depository institutions, and pension funds. Our customers under our mortgage loan cash purchase program are a variety of lenders, as discussed in “Single-Family Guarantee Segment — Our Customers.”
Our competitors are firms that invest in mortgage-related assets, purchase mortgage loans, and issue corporate debt. As a result, we have a variety of principal competitors, including Fannie Mae, REITs, supranationals (international institutions that provide development financing for member countries), commercial and investment banks, dealers, thrift institutions, insurance companies, and the FHLBs.
Market Presence and PC Support Activities
From time to time, we may undertake various activities in an effort to support: (a) our presence in the agency securities market; or (b) the liquidity and price performance of our PCs relative to comparable Fannie Mae securities. These activities may include the purchase and sale of agency securities, purchases of loans, and dollar roll transactions, as well as the issuance of REMICs and Other Structured Securities. Depending upon market conditions, there may be substantial variability in any period in the total amount of securities we purchase or sell. In some cases, purchasing or selling agency securities could adversely impact our security performance. 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. For more information about our efforts to support the liquidity and relative price performance for PCs, see “Our Business — Overview of the Mortgage Securitization Process.”
We incur costs in connection with our efforts to support our presence in the agency securities market or 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 our market presence or 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. The profitability of our multifamily business could be adversely affected by a significant decrease in demand for K Certificates.”
Our Multifamily segment provides liquidity to the multifamily market and supports a consistent supply of affordable rental housing by purchasing and securitizing mortgage loans secured by properties with five or more units. The Multifamily segment reflects results from our investment (both purchases and sales), securitization, and guarantee activities in multifamily mortgage loans and securities. Our primary business model is to purchase multifamily mortgage loans for aggregation and then securitization through issuance of multifamily K Certificates. With this model, we utilize securitization to substantially reduce our credit risk while providing liquidity to the multifamily market. Historically, we were primarily a buy and hold investor in multifamily mortgage assets (both loans held for investment and investment securities, primarily CMBS), but while these legacy investments continue to be significant, we have not focused on this investment strategy since 2009.
The multifamily property market is affected by local and regional economic factors, such as employment rates, construction cycles, preferences for homeownership versus renting, 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.
Our underwriting decisions are largely based on the assessment of the property’s 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 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.
We acquire our multifamily mortgage loans from a network of approved seller/servicers. For 2013, our top two multifamily sellers, CBRE Capital Markets, Inc. and Berkadia Commercial Mortgage, LLC, each accounted for more than 10%, and together accounted for approximately 36%, of our multifamily new business volume. Our top 10 multifamily lenders represented an aggregate of approximately 77% of our multifamily purchase volume for 2013.
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.
In the Multifamily segment, we compete on the basis of: (a) price; (b) products, including our use of certain securitization structures; and (c) service. Our principal competitors are Fannie Mae, FHA, commercial and investment banks, CMBS conduits, dealers, thrift institutions, and life insurance companies.
Underwriting Requirements and Quality Control Standards
Our process and standards for underwriting multifamily mortgages differ from those used for single-family mortgages as we use a prior approval underwriting approach on loans we purchase or guarantee. With this approach, we maintain our credit discipline by completing our own underwriting and credit review for each newly-originated multifamily loan prior to purchasing it. 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 borrower’s ability to service its mortgage obligation using the secured property’s 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 addition to DSCR and LTV ratio, we consider other qualitative factors, such as borrower experience and the strength of the local market, in the credit decision we make on each loan.
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 are the master servicer for loans in our multifamily mortgage portfolio, except those we securitize (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 unsecuritized loans over $1 million in our portfolio, servicers must generally submit an annual assessment of the mortgaged property to us based on the servicer’s analysis of the property as well as the borrower’s 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.
Loss Mitigation Activities
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 (e.g., providing a short-term loan extension of up to 12
months), 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.
We primarily securitize mortgage loans through Other Guarantee Transactions (i.e., K Certificates) in our multifamily business. 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. We refer to these transactions as Other Structured Securities. See “Our Business — Overview of the Mortgage Securitization Process” for additional information about our securitization activities.
From time to time, we may undertake various activities in an effort to support the liquidity of our K Certificates. These activities are similar to those described above in “Investments Segment — Market Presence and PC Support Activities.”
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 guarantee the payment of principal and interest on certain tax-exempt multifamily housing revenue bonds secured by low- and moderate-income multifamily mortgage loans. In addition, during 2010 and 2009, we issued guarantees under the TCLFP on securities backed by HFA bonds as part of the HFA Initiative (certain of which are still outstanding). See “NOTE 2: CONSERVATORSHIP AND RELATED MATTERS — Housing Finance Agency Initiative” for further information.
Conservatorship and Related Matters
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 management, business, financial condition and results of operations.
In connection with our entry into conservatorship, we entered into the Purchase Agreement with Treasury, pursuant to which we issued to Treasury both senior preferred stock and a warrant to purchase common stock. We refer to the Purchase Agreement and the warrant as the “Treasury Agreements.” 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 certain risks to our business relating to the conservatorship and Treasury Agreements, see “RISK FACTORS — Conservatorship and Related Matters.”
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 outlined how FHFA, as Conservator, intends to guide us and Fannie Mae over the next few years, and identified the strategic goals of (a) building a new infrastructure for the secondary mortgage market; (b) gradually contracting Freddie Mac and Fannie Mae’s 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 began instituting annual Conservatorship Scorecards that establish objectives, performance targets and measures, and provide the implementation roadmap for FHFA’s 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. In recent years, the Federal Reserve has purchased significant amounts of mortgage-related securities issued by us, Fannie Mae, and Ginnie Mae.
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.”
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. 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 business operations so that the company can continue to operate in the ordinary course. 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 Board’s 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 have not held stockholders’ meetings (or prepared or provided proxy statements for the solicitation of proxies) since we entered into conservatorship, nor do we expect to do so while we are under conservatorship.
We describe the powers of our Conservator in further 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 imposed by Treasury due to the terms of, and Treasury’s 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 business 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 2013 Conservatorship Scorecard). 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. 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. In 2013, the Conservator required us to contract our presence in specific ways in the mortgage market and simplify our operations. 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.
For more information on the impact of conservatorship and our current business objectives, see "Executive Summary — Our Primary Business Objectives," "RISK FACTORS — Conservatorship and Related Matters — We are under the control of FHFA, and our business activities are subject to significant restrictions. We may be required to take actions that materially adversely affect our business and financial results," and "NOTE 2: CONSERVATORSHIP AND RELATED MATTERS."
Limits on Investment Activity and Our Mortgage-Related Investments Portfolio
Our mortgage-related investments portfolio consists of agency securities, single-family non-agency mortgage-related securities, CMBS, housing revenue bonds, and single-family and multifamily unsecuritized mortgage loans. Our ability to acquire and sell mortgage assets is significantly constrained by limitations under the Purchase Agreement and those imposed by FHFA. Under the Purchase Agreement and FHFA regulation, the UPB of our mortgage-related investments portfolio is subject to a cap that decreases by 15% each year until the portfolio reaches $250 billion. As a result, the UPB of our mortgage-related investments portfolio could not exceed $553 billion as of December 31, 2013 and may not exceed $470 billion as of December 31, 2014. 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.
In addition, the 2013 Conservatorship Scorecard included a goal to reduce the December 31, 2012 mortgage-related investments portfolio balance by selling 5%, or $15.7 billion in UPB, of mortgage-related assets (exclusive of agency securities, multifamily loans classified as held-for-sale, and single-family loans purchased for cash). We sold $16.8 billion of these assets and FHFA has stated that we met this scorecard goal for 2013. The reduction in the mortgage-related investments portfolio will result in a decline in income from this portfolio over time.
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 2 — Mortgage-Related Investments Portfolio(1)
December 31, 2013
December 31, 2012
Investments segment — Mortgage investments portfolio
Single-family Guarantee segment — Single-family unsecuritized mortgage loans(2)
Multifamily segment — Mortgage investments portfolio
Total mortgage-related investments portfolio
Based on UPB and excludes mortgage loans and mortgage-related securities traded, but not yet settled.
Represents unsecuritized seriously delinquent single-family loans.
The UPB of our mortgage-related investments portfolio at December 31, 2013 was $461.0 billion, a decline of 17% compared to $557.5 billion at December 31, 2012. The reduction in UPB resulted primarily from liquidations (i.e., principal repayments) and is consistent with our efforts to reduce the size of our mortgage-related investments portfolio as described above.
We evaluate the liquidity of the assets in our mortgage-related investments portfolio based on two categories: (a) single-class and multiclass agency securities; and (b) assets that are less liquid than agency securities. Assets that we consider to be less liquid than agency securities include unsecuritized performing single-family mortgage loans, multifamily mortgage loans, CMBS, housing revenue bonds, 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 less liquid assets collectively represented approximately 60% of the UPB of the portfolio at December 31, 2013, compared to 62% at December 31, 2012.
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 to put us in a safe and solvent condition and appropriate to carry on our business and preserve and conserve our assets and property. The Conservator’s powers include the ability to transfer or sell any of our assets or liabilities (subject to certain limitations and post-transfer notice provisions) without any approval, assignment of 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 by the Conservator for the beneficial owners of the trust and cannot be used to satisfy our general creditors.
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.
Security Interests Protected; Exercise of Rights Under Qualified Financial Contracts
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 receiver’s 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.
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.
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.
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
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 Treasury’s 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, 2013. 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. As of December 31, 2013, the amount of available funding remaining under the Purchase Agreement was $140.5 billion. This amount will be reduced by any future draws.
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 Treasury’s funding commitment as then in effect. However, as long as the net worth sweep dividend provisions described below under "Senior Preferred Stock" 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 previously waived the fee for all prior quarters.
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 Treasury’s 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 Treasury’s funding commitment will terminate under any of the following circumstances: (a) the completion of our liquidation and fulfillment of Treasury’s 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 Conservator’s 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 Treasury’s aggregate funding commitment or add conditions to Treasury’s 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 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 cumulative 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. Under the net worth sweep dividend, our dividend obligation each quarter is the amount, if any, by which our Net Worth Amount at the end of the immediately preceding fiscal quarter, less the applicable Capital Reserve Amount, exceeds zero. 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 Treasury’s 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 Treasury’s funding commitment. Following the termination of Treasury’s 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 Treasury’s 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.
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.
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 arm’s 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 generally also apply to our subsidiaries.
The Purchase Agreement also requires us to reduce the amount of mortgage assets we own, as described in "Limits on Investment Activity and our Mortgage-Related Investments Portfolio." 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.
The warrant we issued to Treasury includes, among others, the covenant that we may not, without the prior written consent of Treasury, 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 to any person other than Freddie Mac or its wholly-owned subsidiaries.
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. In the discussion below, we refer to Freddie Mac and Fannie Mae as the “enterprises.”
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.
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.
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 critical undercapitalization.
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.
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. These capital standards are described in "NOTE 18: REGULATORY CAPITAL." Under the GSE Act, FHFA has the authority to increase our minimum capital levels or to establish additional capital and reserve requirements for particular purposes.
In September 2013, FHFA released a final rule that will require FHFA-regulated entities to conduct annual stress tests to determine whether such companies have sufficient capital to absorb losses as a result of adverse economic conditions. Under the rule, Freddie Mac is required to: (a) conduct annual stress tests using scenarios specified by FHFA that reflect a minimum of three sets of economic and financial conditions (baseline, adverse, and severely adverse); and (b) beginning in 2014, publicly disclose the results of the stress test under the “severely adverse” scenario.
For additional information, see “MD&A — LIQUIDITY AND CAPITAL RESOURCES — Capital Resources, the Purchase Agreement, and the Dividend Obligation on the Senior Preferred Stock” and “RISK FACTORS — Legal and Regulatory Risks.”
The GSE Act requires the enterprises to obtain the approval of FHFA before initially offering any product (including new mortgage products), subject to certain exceptions. The GSE Act also requires us to provide FHFA with written notice of any new activity that we consider not to be a product. While FHFA has published an interim final rule on prior approval of new products, it has 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.
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 believed were more likely to serve the borrowers targeted by the goals, but have not done so to a significant extent since we entered into conservatorship. In February 2010, the then 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 2013 and 2014
FHFA’s affordable housing goals for Freddie Mac for 2013 and 2014 are set forth below. FHFA has not yet issued the affordable housing goals for 2015.
Table 3 — Affordable Housing Goals for 2013 and 2014
Goals for 2013
Goals for 2014
Single-family purchase money goals (benchmark levels):
Low-income areas subgoal
Single-family refinance low-income goal (benchmark level)
Multifamily low-income goal (in units)
Multifamily low-income subgoal (in units)
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 2013, FHFA set the benchmark level at 21%.
We expect to report our performance with respect to the 2013 affordable housing goals in March 2014. At this time, based on preliminary information, we believe we met the single-family purchase money low-income areas subgoal, the single-family refinance low-income goal and both multifamily goals for 2013, but believe we failed to meet the FHFA benchmark level for the other single-family goals. In such cases, FHFA regulations allow us to achieve a goal if our qualifying share matches that of the market, as measured by the Home Mortgage Disclosure Act. Because the Home Mortgage Disclosure Act data for 2013 will not be released until September 2014, FHFA will not be able to make a final determination on our performance until that time. If we fail to meet both the FHFA benchmark level and the market level, we may enter into discussions with FHFA concerning whether these goals were infeasible under the terms of the GSE Act, due to market and economic conditions and our financial condition. We view the purchase of mortgage loans that are eligible to count toward our affordable housing goals to be a principal part 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 process 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 2011 and 2012
In October 2013, FHFA informed us that it had reviewed our performance with respect to the affordable housing goals for 2012, and determined that we achieved all of our housing goals.
Our housing goals and results for 2011 and 2012 are set forth in the table below.
Table 4 — Affordable Housing Goals and Results for 2011 and 2012
Goals for 2011
Market Level for 2011 (1)
Results for 2011 (2)
Goals for 2012
Market Level for 2012 (1)
Results for 2012
Single -family purchase money goals (benchmark levels):
Low-income areas subgoal
Single -family refinance low-income goal (benchmark level)
Multifamily low-income goal (in units)
Multifamily low-income subgoal (in units)
Determined by FHFA based on its analysis of market data.
We failed to achieve any of the four single-family purchase money goals for 2011. FHFA did not require us to submit a housing plan for the goals that we did not achieve in 2011.
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 2011 and 2012, FHFA set the benchmark level for the low-income areas goal at 24% and 20%, respectively.
Affordable Housing Allocations
The GSE Act requires us to set aside in each fiscal year an amount equal to 4.2 basis points (or 0.042%) of 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. For more information, see "LEGAL PROCEEDINGS."
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 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.
The GSE Act provides FHFA with power to regulate the size and content of our mortgage-related investments portfolio. 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.
Predatory lending practices are in direct opposition to our mission, goals, and 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.
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 18: 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 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.”
Legislation Related to Freddie Mac and its Future Status
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 continues to hold hearings and consider legislation on the future state of Freddie Mac, Fannie Mae and the housing finance system. Recent developments are discussed below.
In June 2013, the “Let the GSEs Pay Us Back Act of 2013” was introduced in the House of Representatives. The bill would amend Freddie Mac and Fannie Mae’s Purchase Agreements with Treasury to:
terminate the dividends on the senior preferred stock;
treat the funds received by a GSE from Treasury under the Purchase Agreement (including funds received prior to the amendment) as a fully amortizing loan from Treasury to the GSE with a maturity of 30 years and an annual interest rate of 5%; and
credit the dividends previously paid by a GSE on the senior preferred stock as payments of principal and interest under such loan.
In June 2013, the “Housing Finance Reform and Taxpayer Protection Act of 2013” was introduced in the Senate with bi-partisan co-sponsors. The bill would substantially alter the current housing finance system. Among other things, the bill would:
require the wind down of Freddie Mac and Fannie Mae. The companies’ charters would be repealed within five years of enactment (except for charter provisions relating to the rights of holders of the companies’ outstanding debt and mortgage-backed security obligations), and the companies would then not have authority to conduct new business. A full faith and credit U.S. government guarantee would be extended to the then outstanding debt obligations of the companies and mortgage-backed securities guaranteed by the companies;
require that any proceeds from the wind down go first to the holders of Freddie Mac's and Fannie Mae’s senior preferred stock, then preferred shareholders and then common shareholders, with the amount of proceeds to be paid to these shareholders to be determined by the U.S. government;
set certain requirements relating to the disposition of the functions, activities, infrastructure and property of Freddie Mac and Fannie Mae; and
decrease conforming loan limits in high cost areas and require the gradual reduction of Freddie Mac's and Fannie Mae’s retained mortgage portfolios.
In July 2013, the “Protect American Taxpayers and Homeowners Act of 2013” was approved by the House Financial Services Committee. The bill would also substantially alter the current housing finance system. Among other things, the bill would:
require FHFA to place Freddie Mac and Fannie Mae into receivership within five years of enactment (or potentially longer, in certain circumstances). The companies’ charters would be repealed at that time (except for charter provisions relating to the rights of holders of the companies’ outstanding debt and mortgage-backed security obligations), and the companies would then not have authority to conduct new business. A full faith and credit U.S. government guarantee would be extended to the then outstanding debt obligations of the companies and mortgage-backed securities guaranteed by the companies; and
place certain restrictions on Freddie Mac's and Fannie Mae’s activities prior to being placed into receivership, including decreasing conforming loan limits in high cost areas, gradually reducing the size of Freddie Mac's and Fannie Mae’s retained mortgage portfolios to $250 billion each, and requiring the companies to enter into additional risk sharing transactions to cover at least 10% of their new single-family business each year. Under the bill, the companies would likely be required to increase their guarantee fees.
In addition, bills were introduced in the Senate in 2013 that focus on preventing the use of Freddie Mac and Fannie Mae guarantee fees to offset government spending. For example, the Jumpstart GSE Reform Act would bar any increase in guarantee fees charged by Freddie Mac and Fannie Mae to offset government spending, and would prohibit the sale of the senior preferred stock by Treasury without Congressional approval and other structural reform. In addition, the Senate passed a 2014 budget resolution that established certain procedural requirements designed to make it more difficult to use Freddie Mac and Fannie Mae guarantee fees to offset other government spending.
We anticipate that other bills related to Freddie Mac, Fannie Mae and the future of the mortgage finance system will be introduced. We cannot predict whether any of such bills will be enacted.
For more information, see “RISK FACTORS — Conservatorship and Related Matters — The future status and role of Freddie Mac are uncertain.”
FHFA’s 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 set forth objectives and steps FHFA is taking or will take to meet FHFA’s obligations as Conservator. In March 2012, FHFA began instituting annual Conservatorship Scorecards for us and Fannie Mae that establish objectives, performance targets and measures, and provide the implementation roadmap for the strategic plan.
FHFA’s 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's and Fannie Mae’s dominant presence in the marketplace while simplifying and shrinking their operations.
Maintain. Maintain foreclosure prevention activities and credit availability for new and refinanced mortgages.
For information about the 2013 Conservatorship Scorecard, and our performance with respect to it, see “EXECUTIVE COMPENSATION — Compensation Discussion and Analysis.”
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 Administration’s plan to reform the U.S. housing finance market, including options for structuring the government’s 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 Administration’s 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 Administration’s plan.
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, some of which are still in process, and some of which only recently became effective. 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 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 origination, finance, and servicing practices. The rules generally went into effect in January 2014. The rules include an ability-to-repay rule, which 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. In May 2013, FHFA directed Freddie Mac and Fannie Mae to limit future single-family acquisitions to loans that are qualified mortgages under applicable CFPB regulations, including those mortgages meeting the special or temporary qualified mortgage definition for us and Fannie Mae, as the case may be. The directive generally restricts us and Fannie Mae from acquiring loans that are: (a) not fully amortizing; (b) have a term greater than 30 years; or (c) have points and fees in excess of 3% of the total loan amount.
Other rules address consumer protection and high cost mortgages, mortgage servicing, escrow accounts, loan origination compensation, and appraisals. These rules will, individually and in combination, significantly change many aspects of the mortgage industry and may affect us both directly and indirectly. Examples of indirect effects include possible changes in pricing and other practices by customers and counterparties, 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 and result in significant changes to mortgage servicing and foreclosure practices that could adversely affect our business. In addition, 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.
Credit risk retention proposed rule: In August 2013, six agencies, including FHFA, jointly proposed a rule concerning credit risk retention. This rule revises a 2011 proposal that would implement the credit risk retention requirements of the Dodd-Frank Act. The rule generally would require a securitizer of asset-backed securities to retain no less than five percent of the credit risk of the assets underlying such securities. The rule would provide an exemption from this requirement for asset-backed securities collateralized exclusively by qualified residential mortgages (or “QRMs”), and would define a QRM by reference to the definition of a “qualified mortgage” under the Truth in Lending Act. The proposal also requests comment on an alternative definition of QRM that would significantly reduce the number of
loans that would qualify as QRM. As in the 2011 proposal, Freddie Mac’s fully guaranteed securitizations generally would satisfy the risk retention requirements for so long as we are in conservatorship or receivership and receiving federal financial support. This exemption would not apply to securitization structures that are not fully guaranteed. Under the proposal, the effective date of any final risk retention rule with respect to residential mortgage securitizations will be one year after such rule is finalized.
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 — Legislative or regulatory actions could adversely affect our business activities and financial results.”
Financial Crimes Enforcement Network's Anti-money Laundering Final Rule
On February 20, 2014, the Financial Crimes Enforcement Network finalized its regulations that will require Freddie Mac to establish a written anti-money laundering program, file suspicious activity reports with the Network, and comply with certain statutory and regulatory information sharing procedures. These regulations may require operational changes, as they differ in certain respects from the regulations we are currently subject to concerning the reporting of fraudulent financial instruments.
FHFA Advisory Bulletin
In April 2012, FHFA issued Advisory Bulletin AB 2012-02, “Framework for Adversely Classifying Loans, Other Real Estate Owned, and Other Assets and Listing Assets for Special Mention” (the “Advisory Bulletin”), which is applicable to Fannie Mae, Freddie Mac and the Federal Home Loan Banks. The Advisory Bulletin establishes guidelines for adverse classification and identification of specified single-family and multifamily 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 requirements, this Advisory Bulletin requires that we classify the portion of an outstanding single-family loan balance in excess of the fair value of the underlying property, less costs to sell and adjusted for any credit enhancements, as a “loss” no later than when the loan becomes 180 days delinquent, except in certain specified circumstances (such as those involving properly secured loans with an LTV ratio equal to or less than 60%). For multifamily loans, the Advisory Bulletin requires that any portion of a loan balance that exceeds the amount secured by the fair value of the collateral, less costs to sell, for which there is no available and reliable source of repayment other than the sale of the underlying real estate collateral, to be classified as a “loss.” The Advisory Bulletin also requires us to charge off the portion of the loan classified as a “loss.” The Advisory Bulletin 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 loss reserves or as a reduction in our foreclosed property expenses. In May 2013, FHFA issued an additional Advisory Bulletin clarifying the implementation timeline for AB 2012-02, requiring that: (a) the asset classification provisions of AB 2012-02 should be implemented by January 1, 2014; and (b) the charge-off provisions of AB 2012-02 should be implemented no later than January 1, 2015.
We establish an allowance for loan losses against our loans either through our collective loss reserve or our loss reserve for individually impaired loans. Thus, at the time single-family loans become 180 days delinquent, we have already established an allowance for loan losses against them. The Advisory Bulletin requires us to change our practice for determining when a loan is deemed uncollectible to the date the loan is classified as a “loss” as described above. This is a change from our current practice for determining when a loan is deemed to be uncollectible, which is based on historical data and results in a loan being deemed to be uncollectible at the date of foreclosure or other liquidation event (such as a deed-in-lieu of foreclosure or a short sale).
In the period in which we adopt the Advisory Bulletin, our allowance for loan losses on the impacted loans will be eliminated and the corresponding recorded investment in the loan will be reduced by the amounts that are charged off. Under our existing accounting practices and upon adoption of the Advisory Bulletin, the ultimate amount of losses we realize on our loan portfolio will be the same over time; however, the timing of when we recognize the losses in our financial statements will differ.
We are working with FHFA to consider how the Advisory Bulletin may impact our credit risk management practices. A significant percentage of our modifications are initiated after loans become 180 days delinquent. This is a result of a number of factors, including servicer backlogs, lack of borrower responsiveness to loss mitigation efforts, and extended foreclosure timelines, which affect the willingness of borrowers to engage regarding loss mitigation options. Given the current rate of modification activity after loans become 180 days delinquent, the benefit we expect from borrower re-performance is significant in estimating the losses for this population of loans. In July, we introduced a streamlined modification program, which may accelerate the timing of our modifications; however, we still expect a meaningful amount of modifications to be initiated after our loans become 180 days delinquent. As we obtain incremental information on the performance of this program, we will enhance our loss estimates, as necessary, to reflect the change in the expected timing and volume of modifications.
We are working with FHFA to resolve certain implementation issues related to our adoption of the Advisory Bulletin. However, we do not expect that the Advisory Bulletin will have a material impact on our financial position or results of operations.
FHFA Request for Public Input on Proposed Gradual Decrease of Loan Limits
On December 16, 2013, FHFA announced that it is requesting public input on the implementation of a plan to gradually reduce the maximum size of single-family mortgage loans that we and Fannie Mae may purchase. In areas where the statutory maximum loan limit for one-unit properties is currently $417,000, FHFA’s plan would set the loan purchase limit at $400,000, which represents a reduction of approximately four percent. The loan purchase limit would be reduced by the same percentage in "higher cost" areas, where current limits can be as high as $625,500. The loan purchase limits in such areas would be no greater than $600,000. Implementation of a decrease in loan limits would, over time, reduce the income we earn from our single-family credit guarantee activities. FHFA has indicated that the contemplated plan is not a final decision.
FHFA Request for Public Input on Reducing Freddie Mac and Fannie Mae Multifamily Businesses
On August 9, 2013, FHFA announced that it is evaluating alternatives for reducing Freddie Mac and Fannie Mae’s presence in the multifamily housing finance market in 2014 and is seeking public input on the potential market impact of various strategies. FHFA stated that the strategies may include:
Restrictions on available loan terms;
Simplification and standardization of loan products;
Limits on property financing;
Limits on business activities; and,
Other options that FHFA should consider to contract the enterprises’ multifamily businesses.
Input from the public was due October 8, 2013 in order for FHFA to consider the responses for potential inclusion in our 2014 Conservatorship Scorecard and provide for continued gradual contraction of the GSEs' multifamily business.
At February 14, 2014, we had 5,053 full-time and 59 part-time employees. Our principal offices are located in McLean, Virginia.
We file reports and other information with the SEC. In view of the Conservator’s 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 SEC’s 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 SEC’s 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 Mac’s 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 Mac’s global debt facility,
including pricing supplements for individual issuances of debt securities. Similar information about our STACR debt securities is available at www.freddiemac.com/creditsecurities.
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.
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.” Examples of forward-looking statements include, but are not limited to, statements pertaining to the conservatorship, our current expectations and objectives for our single-family, multifamily, and investment businesses, our loan workout initiatives and other efforts to assist the housing market, liquidity, capital management, economic and market conditions and trends, market share, the effect of legislative and regulatory developments and new accounting guidance, credit quality of loans we own or guarantee, 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 control. Forward-looking statements are often accompanied by, and identified with, terms such as “objective,” “expect,” “possible,” “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 the U.S. government (including FHFA, Treasury, and Congress) may take, or require us to take, including to further support the housing recovery or to implement FHFA’s strategic plan for us and Fannie Mae;
the effect of the restrictions on our business due to the conservatorship and the Purchase Agreement, including 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 any changes in our credit ratings or those of the U.S. government;
changes in our charter or in applicable legislative or regulatory requirements (including any legislation on the future status of our company), or in the regulation of the housing finance and financial services industries;
changes in the fiscal and monetary policies of the Federal Reserve, including the effect of the tapering of its program of purchasing mortgage-related securities and any future sales of such securities;
the extent of our success in our efforts to mitigate our losses on our Legacy single-family books and our investments in non-agency mortgage-related securities;
the adequacy of our operating systems and infrastructure, and our ability to maintain the security of such systems and infrastructure;
changes in accounting standards, or in our accounting policies or estimates;
changes in economic and market conditions, including changes in employment rates, interest rates, yield curves, mortgage and debt spreads, and home prices;
changes in the U.S. residential mortgage market, including changes in the supply and type of mortgage products (e.g., refinance versus purchase, and fixed-rate versus ARM);
our ability to effectively execute our business strategies, implement new initiatives, and improve efficiency;
our ability to recruit and retain executive officers and other key employees;
the adequacy of our risk management framework, internal control over financial reporting, and disclosure controls and procedures;
the failure of our customers, vendors, service providers, and counterparties to fulfill their obligations to us;
our ability to manage mortgage credit risks, including the effect of changes in underwriting and servicing practices;
our ability to manage interest-rate and other market risks, including the availability of derivative financial instruments needed for risk management purposes;
changes or errors in the methodologies, models, assumptions and estimates we use to prepare our financial statements, make business decisions, and manage risks;
changes in investor demand for our debt or mortgage-related securities (e.g., single-family PCs and multifamily K Certificates);
adverse judgments or settlements in connection with judicial or regulatory proceedings;
changes in the practices of loan originators, investors and other participants in the secondary mortgage market;
the occurrence of a major natural or other disaster in areas in which our offices or portions of our total mortgage portfolio are concentrated; and
other factors and assumptions described in this Form 10-K, including in the “MD&A” section.
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.
ITEM 1A. RISK FACTORS
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.
Conservatorship and Related Matters
The future status and role of Freddie Mac are uncertain.
There is significant uncertainty about our future status and role and we could be materially adversely affected by legislative and regulatory action that alters the ownership, structure, and mission of the company. The then 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.
Several bills were introduced in Congress in 2013 concerning the future status of Freddie Mac, Fannie Mae, and the mortgage finance system, including bills which provide for the wind down of Freddie Mac and Fannie Mae. The Administration (as discussed in its February 2011 report to Congress) has recommended reducing the role of Freddie Mac and Fannie Mae and ultimately winding down both companies.
The conservatorship is indefinite in duration and the timing, conditions, and likelihood of our emerging from conservatorship are uncertain. Termination of the conservatorship (other than in connection with receivership) also requires Treasury’s consent under the Purchase Agreement. There can be no assurance as to when, and under what circumstances, Treasury would give such consent. It is possible that the conservatorship will end with us being placed into receivership. Even if the conservatorship is terminated, we would remain subject to the Purchase Agreement and the senior preferred stock. In addition, because Treasury holds a warrant to acquire almost 80% of our common stock for nominal consideration, the company could effectively remain under the control of the U.S. government even if the conservatorship is ended and the voting rights of common stockholders restored.
During 2013 and 2014, a number of lawsuits were filed against the U.S. government challenging certain government actions related to the conservatorship (including actions taken in connection with the imposition of conservatorship) and the Purchase Agreement. This may add to the uncertainty surrounding our company’s future.
For more information, see “BUSINESS — Regulation and Supervision — Legislative and Regulatory Developments.”
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:
the success of our foreclosure prevention and loss mitigation efforts;
adverse changes in interest rates, yield curves, implied volatility or mortgage spreads, which could increase realized and unrealized fair value losses recorded in earnings or AOCI;
reductions in the size of our mortgage-related investments portfolio or required sales of higher yielding assets, and other limitations on our investment activities that reduce our earnings capacity;
reductions in the maximum UPB of single-family loans we are permitted to purchase or other restrictions on our single-family guarantee activities that could reduce our income from these activities;
restrictions on the volume of multifamily business we may conduct or other limits on multifamily business activities that could reduce our income from these activities;
adverse changes in our liquidity or funding costs, or limitations in our access to public debt markets;
changes in accounting practices or guidance (e.g., implementation of FHFA's April 2012 Advisory Bulletin);
effects of the MHA Program and other government initiatives, including any future requirements to reduce the principal amount of loans, which could increase the likelihood of prepayment of mortgages and potentially reduce our net interest income;
changes in housing or economic conditions, legislation, or other factors that affect our assessment of our ability to realize our net deferred tax asset, and cause us to establish a valuation allowance against our net deferred tax asset; or
changes in business practices resulting from legislative and regulatory developments or direction from our Conservator.
We do not have the authority over the long term to build and retain capital from the earnings generated by our business operations, as a result of the net worth sweep dividend. This increases the likelihood of draws in future periods, particularly as the permitted Capital Reserve Amount (which is $2.4 billion for 2014) declines over time. Additional draws under the Purchase Agreement will increase the liquidation preference of the senior preferred stock, which was $72.3 billion as of December 31, 2013. In addition, draws we take for deficits in our net worth will reduce the amount of available funding remaining under the Purchase Agreement, which was $140.5 billion as of December 31, 2013. 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.
We are under the control of FHFA, and our business activities are subject to significant restrictions. We may be required to take actions that materially adversely affect our business and financial results.
We may be required to undertake activities that are unprofitable, costly to implement, expose us to additional credit and other risks, or that otherwise adversely affect our business over the short- or long-term. We are under the control of FHFA, as our Conservator, and are not managed to maximize stockholder returns. FHFA determines the strategic direction of our company. FHFA has changed our business objectives significantly since we entered into conservatorship, and could make additional changes at any time. We are also subject to significant restrictions under the Purchase Agreement and senior preferred stock. Other agencies of the U.S. government, as well as Congress, also could require us to take actions that adversely affect our business and financial results.
FHFA has required us to make changes to our business that have adversely affected our financial results, and may require us to make additional changes in the future. For example, FHFA is requiring us to contract our presence in the mortgage market and simplify our operations. These actions will adversely affect our profitability over the long term. FHFA also may require us to provide additional support for the mortgage market in a manner that serves our public mission, but that adversely affects our financial results, such as by engaging in more expensive loss mitigation efforts. From time to time, FHFA and Treasury have prevented us from engaging in business activities or transactions that we believe would benefit our business and financial results, and may do so in the future. FHFA may require us to engage in activities that are operationally difficult to implement. FHFA, as our Conservator, could also take a number of actions that could materially adversely affect our company, such as reducing the maximum UPB of single-family loans we are permitted to purchase or limiting the amount of securities we could sell for liquidity management purposes. Significant strategy changes, either from FHFA or Treasury, could have an adverse impact on the earnings of our business.
We currently face a variety of different, and potentially competing, business objectives and new FHFA-mandated activities (e.g., the initiatives we are pursuing under the 2013 Conservatorship Scorecard). It may be difficult for us to devote sufficient resources and management attention to these multiple priorities, some of which present significant operational challenges to us. See “BUSINESS — Executive Summary — Our Primary Business Objectives” for more information.
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. These limitations could have a material adverse effect on our future results of operations and financial condition. Over the long-term, as a result of the net worth sweep dividend provisions of the senior preferred stock, we do not have the authority to build and retain capital from the earnings 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 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 warrant held by Treasury, the restrictions on our business contained in the Purchase Agreement, and the senior status and net worth dividend provisions of the senior preferred stock issued to Treasury under the Purchase Agreement 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.
Our regulator may, and in some cases must, place us into receivership, which would result in the liquidation of our assets; if this occurs, there may not be sufficient funds to pay the claims of the company, repay the liquidation preference 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 critical undercapitalization. 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. Treasury might not be able to provide the requested funding if, for example, the U.S. government were shut down or if the U.S. government reached its borrowing limit and, as a result, Treasury was unable to obtain funds sufficient to cover the request. For more information, see "BUSINESS — Regulation and Supervision — Federal Housing Finance Agency — 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. Bills pending in Congress provide for Freddie Mac to eventually be placed into receivership.
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.
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.
The conservatorship and investment by Treasury has had, and will continue to have, a material adverse effect on our common and preferred stockholders.
The market price for our common stock and publicly traded classes of preferred stock declined substantially after we entered into conservatorship. As a result, the investments of our common and preferred stockholders lost substantial value, which they may never recover. Our shares could further diminish in value, and they are not likely to have any value in the longer-term. In November 2011, the then Acting Director of FHFA stated that "[Freddie Mac and Fannie Mae’s] 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 have 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 that decreases over time. Accordingly, over the long-term, 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.
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 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. 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 level of earnings in recent periods is not sustainable over the long term.
The level of earnings we have experienced in recent periods is not sustainable over the long term. While our recent financial results, particularly our benefit (provision) for credit losses, benefited significantly from strong home price appreciation we are beginning to see moderation in home price growth. In addition, our recent financial results include large benefits related to the release of our deferred tax asset valuation allowance and settlements of residential non-agency mortgage-related securities litigation and claims for breaches of representations and warranties by our sellers. These trends are not expected to continue over the long term. Our settlements with sellers for claims for breaches of representations and warranties primarily related to pre-conservatorship loan activity are largely complete. Our residential non-agency mortgage-related securities litigation is ongoing with many large institutions and we expect additional settlements in 2014. In addition, declines in the size of our mortgage-related investments portfolio, as required by FHFA and the Purchase Agreement, will reduce earnings over time. Our financial results will also continue to be positively or negatively affected by changes in interest rates, yield curves, and mortgage spreads, which can cause significant earnings and net worth variability.
We are subject to significant limitations on our investment activity, including a requirement to reduce the size of our mortgage-related investments portfolio, and significant constraints on our ability to purchase or sell mortgage assets. As it is likely that the overall volume of our business will decline, our debt funding needs will likely also decline. It may become probable that our previously forecasted debt issuances will not occur, resulting in the deferred gain or loss associated with these forecasted transactions being reclassified from AOCI into earnings immediately. In addition, many of our mortgage 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 assets, 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 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 or that our current strategies will not have an adverse impact on our business or financial results. For more information, 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 for a number of reasons, including that 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. In addition, the overall volume of our guarantee business will likely decline over time, as one of FHFA’s goals is to contract our presence in the mortgage market. We generally must obtain FHFA’s approval to implement across-the-board price increases in our guarantee business, and there can be no assurance FHFA will approve any such increase requests in the future. The combination of the restrictions on our business activities and 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.
Our single-family credit guarantee and multifamily mortgage portfolios are subject to mortgage credit risks, including mortgage credit risk relating to off-balance sheet arrangements; 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 and securities 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 (e.g., K Certificates we guarantee); (b) certain single-family Other Guarantee Transactions; and (c) other guarantee commitments, including long-term standby commitments and liquidity guarantees.
We expect our credit losses to remain elevated for the near term due to the large number of single-family non-performing loans that will likely be resolved. We also continue to have significant amounts of mortgage loans in our single-family credit guarantee portfolio with certain characteristics, such as Alt-A loans, interest-only loans, option ARM loans, 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. See “Table 43 — Certain Higher-Risk Categories in the Single-Family Credit Guarantee Portfolio” for more information.
Our loan loss reserves do not reflect the total of all future credit losses we will ultimately incur with respect to the single-family and multifamily mortgage loans we currently own or guarantee. 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.
We use certain credit enhancements to mitigate some of our potential credit losses. However, such credit enhancements may provide less protection than we expect, or otherwise fail to prevent us from incurring credit losses on the related loans. For more information, see "NOTE 4: MORTGAGE LOANS AND LOAN LOSS RESERVES — Credit Protection and Other Forms of Credit Enhancement."
For more information on our mortgage credit risk with respect to single-family and multifamily loans, see “MD&A — RISK MANAGEMENT — Credit Risk — Mortgage Credit Risk.”
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 in our mortgage-related investments portfolio.
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, 2013, we held $59.3 billion in UPB of such securities, which represented approximately 13% of our total mortgage-related investments portfolio. We also hold non-agency mortgage-related securities backed by manufactured housing loans and home equity lines of credit. The credit performance of the loans underlying these non-agency mortgage-related securities has declined since 2007, and although it has stabilized in recent periods, it remains weak. 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. The population of non-agency mortgage-related securities that management intends to sell may increase, which would cause us to immediately recognize in earnings any unrealized losses on these securities.
Since 2007, the fair value of these investments has declined significantly, and we have recorded substantial other-than-temporary impairments, both of which have adversely affected our net worth. We may experience additional fair value declines and losses in the future due to a number of factors, including if delinquency and loss rates on the underlying loans increase. The quality of the servicing performed on the underlying loans can significantly affect the performance of these securities, including the timing and amount of losses incurred on the underlying loans and thus the timing and amount of losses we recognize on our securities. Our ability to influence servicing performance is limited. In addition, there is a general lack of transparency in the market for the non-agency mortgage-related securities we hold, and the information disclosed by the trustees of the trusts that issued these securities is not sufficient to allow us to adequately analyze decisions made by servicers that may directly impact the cash flows on such securities. The servicing of the loans is significantly concentrated among several companies, which may increase this risk. Any credit enhancements covering these securities may not prevent us from incurring losses. See “MD&A — CONSOLIDATED BALANCE SHEETS ANALYSIS — Investments in Securities” for information about these securities and related credit enhancements.
Future declines in U.S. home prices or other adverse changes in the U.S. housing market could negatively impact our business and adversely affect our earnings and equity.
Our financial results and business volumes can be negatively affected by declines in home prices and other adverse changes in the housing market. Although the single-family housing market improved in 2013, our credit losses remained high compared to levels before 2009, in part because home prices have experienced significant cumulative declines in many geographic areas since 2006. While we expect home prices to increase moderately in 2014, there can be no assurance that this will occur.
We prepare internal forecasts of future home prices, which we use for certain business activities, including: (a) hedging prepayment risk; (b) estimating expected costs of new guarantee business; and (c) portfolio activities. If future home prices are lower than our forecasts, this could cause the return we earn on new single-family guarantee business to be less than expected or cause us to incorrectly hedge prepayment and other market risks associated with our mortgage-related investments. 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). For more information, see “MD&A — RISK MANAGEMENT — Credit Risk.”
Our business volumes (i.e., mortgage loan purchases and guarantee issuances) are closely tied to the rate of growth in total outstanding U.S. residential mortgage debt, the size of the U.S. residential mortgage market, and the amount of new mortgage originations. Total residential mortgage debt declined approximately 0.7% in the first nine months of 2013 (the most recent data available) compared to a decline of approximately 2.5% in 2012.
While the multifamily market has experienced strong rent growth and occupancy trends in the past four years, these trends are not likely to continue at their current pace as apartment fundamentals are already very favorable, with vacancy rates at their lowest level since 2001. New supply of multifamily housing has been increasing in recent periods and could potentially outpace demand, which could result in excess supply and rising vacancy rates. Any softening of multifamily markets could cause delinquencies and credit losses relating to our multifamily activities to increase beyond our current expectations.
We could incur significant losses in the event of a major natural disaster or other catastrophic event.
We own or guarantee mortgage loans and own REO properties throughout the United States. The occurrence of a major natural or environmental disaster 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. A catastrophic event that either damages or destroys residential real estate underlying mortgage loans we own or guarantee, or negatively affects the ability of homeowners to continue to make 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 and financial results. Such an event could also damage or destroy REO properties we own. We may not have insurance coverage for some of these catastrophic events.
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 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. Our important institutional counterparties include seller/servicers, mortgage insurers, and bond insurers, and counterparties to derivatives and short-term lending and other funding transactions.
A significant failure by a major institutional counterparty could harm our business and financial results in a variety of ways, as many of our major counterparties provide several types of services to us. The concentration of our exposure to our counterparties remains high and we continue to face challenges in reducing our risk concentrations with counterparties. Efforts we take to reduce exposure to financially weakened counterparties could concentrate our exposure to other individual counterparties, and increase our costs and reduce our revenue. In recent years, challenging market conditions have, at times, adversely affected the liquidity and financial condition of our counterparties, and some of our major counterparties have failed. Similar events may occur in future periods.
Our business could be adversely affected if counterparties to derivatives and short-term lending and other transactions fail to meet their obligations to us.
We have significant exposure to institutions in the financial services industry relating to derivatives, funding, short-term lending, securities and other transactions. These transactions are critical to our business, including our ability to: (a) manage interest rate and other risks related to our investments in mortgage-related assets; and (b) fund our business operations. In addition to these institutions, we face the risk of operational failure of any of the clearing members, exchanges, clearinghouses, or other financial intermediaries we use to facilitate these transactions. If a clearing member or clearinghouse were to fail, we could experience losses related to any collateral we had posted with such clearing member or clearinghouse to cover initial or variation margin. Similarly, if our counterparties in short-term lending transactions fail, we have exposure to losses if the transaction was unsecured or to the extent the value of the collateral posted to us is insufficient. A failure of any of these various parties could adversely affect our ability to engage in derivatives and other transactions, service our customers, and manage our exposure to interest rate and other risks. 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 Eurozone could significantly affect such counterparties. In turn, this could adversely affect their ability to meet their obligations to us.
For more information, see “MD&A — RISK MANAGEMENT — Credit Risk — Institutional Credit Risk — Cash and Other Investments Counterparties,” “— Derivative Counterparties” and “— Selected European Sovereign and Non-Sovereign Exposures.”
Our financial condition or results of operations may be adversely affected if mortgage seller/servicers fail to perform their repurchase and other obligations to us.
Our seller/servicers have a significant role in servicing loans in our single-family credit guarantee portfolio, as they perform the primary servicing function for us. Therefore, we could be adversely affected if they lack appropriate process controls, experience a failure in their controls, or experience an operating disruption in their ability to service mortgage loans. Our servicers have an active role in our loss mitigation efforts, and 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 effect on our ability to mitigate credit losses. The risk of such a decline in performance remains high due to a number of factors, including the continued high volume of seriously delinquent loans and the fact that the servicing function has become significantly more complex in recent years. Any efforts we take to attempt to improve our servicers’ performance (such as requiring that they pay us compensatory fees for underperformance) could adversely affect our relationships with such servicers, many of which also sell loans to us.
In recent periods, servicers that specialize in servicing troubled loans have experienced rapid growth in their servicing portfolios, and they now service a large share of our loans. 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 to recover 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. However, we face the risk that we might not receive a sufficient price for the mortgage servicing rights or that we may be unable to find buyers who are willing to assume the representations and warranties of the former servicer and have sufficient capacity to service the affected mortgages. 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 property’s financial performance and physical condition.
We require seller/servicers to make certain representations and warranties regarding the loans they sell to us and/or service for 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. We also may have other contractual remedies, including the right to be indemnified against losses on the loans. We have similar rights and remedies with respect to loans they service on our behalf. If a seller/servicer does not satisfy its contractual obligations to us 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. It may be difficult, expensive, and time-consuming to enforce (through the exercise of contractual remedies, including legal proceedings) a seller/servicer's repurchase obligations, in the event a seller/servicer fails to perform such obligations. As of December 31, 2013, the UPB of loans subject to repurchase requests based on breaches of representations and warranties (related to loans sold to us and/or serviced for us) issued to our single-family seller/servicers was approximately $2.2 billion.
During 2013, we entered into a number of agreements with sellers to resolve certain existing and future repurchase obligations, and we may enter into additional agreements with sellers or servicers in the future. The amounts we receive under any such agreements may be less than the losses we ultimately incur.
If, as we expect, there is a decline in origination volume and a change in the mix of originations (refinance vs. purchase) in 2014, the competitive and financial pressures on single-family originators and servicers could increase, and thereby increase our counterparty risk with respect to these entities.
For more information, see “MD&A — RISK MANAGEMENT — Credit Risk — Institutional Credit Risk — Single-family Mortgage Seller/Servicers” and “— Multifamily Mortgage Seller/Servicers.”
Our losses 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.
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 fails to fulfill its obligations, 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 affect the timing and amount of claim payments made to us. A regulator could also restrict an insurer's ability to write new business.
The majority of our mortgage insurance exposure is concentrated in four insurers, certain of which have been under financial stress during the last several years. Our ability to reduce our exposure to individual mortgage insurers is limited, and we continue to acquire significant amounts of new loans with mortgage insurance from mortgage insurers that have credit ratings that are below investment grade. In addition, we expect to receive substantially less than full payment of our mortgage insurance claims from three of our mortgage insurers: Triad Guaranty Insurance Corporation, Republic Mortgage Insurance Company, and PMI Mortgage Insurance Co.
In the event a mortgage insurer falls out of compliance with regulatory capital requirements, it may attempt various strategies (such as a corporate restructuring or raising additional capital) designed to enable it to continue to write new business. There can be no assurance that any such restructuring or recapitalization will enable payment in full of all of our claims in the future.
With respect to bond insurers, if a bond insurer was to become insolvent, it is likely that we would not collect our claims from it. This would affect 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 insurer’s 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. 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, see “MD&A — RISK MANAGEMENT — Credit Risk — Institutional Credit Risk — Mortgage Insurers” and “— Bond Insurers.”
The loss of business volume 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 2013, approximately 64% of our single-family mortgage purchase volume was associated with our ten largest customers. Similarly, we acquire a significant portion of our multifamily mortgage loans from several large lenders.
We enter into mortgage purchase commitments with many of our single-family customers that are typically less than one year in duration. 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.
We are engaged in various loss mitigation and recovery efforts concerning: (a) representation and warranty claims on single-family loans we own or guarantee; and (b) certain of our investments in non-agency mortgage-related securities. Some of these efforts involve litigation against some of our largest single-family customers. These and other loss mitigation and recovery efforts could adversely affect our relationship with any such customer and could, for example, result in the loss of some or all of our business with the customer.
Our charter requires that single-family mortgages with LTV ratios above 80% at the time of purchase be covered by mortgage insurance or other credit enhancements. 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 higher LTV ratios. If the availability of mortgage insurance for loans with LTV ratios above 80% is reduced, we may be restricted in our ability to purchase or securitize such loans. This could reduce our overall volume of new business.
Competition from banking and non-banking companies, as well as efforts by FHFA to reduce the GSEs' dominance in the marketplace, 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 affect our financial results. Increased competition from Fannie Mae, Ginnie Mae, FHA/VA, and new entrants may alter our product mix, lower our volumes, and reduce our revenues on new business.
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 securitization activities since 2008. However, in recent periods, a number of our non-GSE competitors increased their retention of loans on their balance sheets. In addition, one of FHFA’s 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.
FHFA is also Conservator of Fannie Mae, our primary competitor, and FHFA’s actions as Conservator of both 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.
Actions we may take or may be directed to take to reduce the GSEs' dominance of new single-family guarantee business, such as by tightening credit standards or raising guarantee fees, could cause our share of the total mortgage market to decrease and the volume of our single-family guarantee business to decline.
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.
As multifamily market fundamentals have improved over recent years, more life insurers, banks, CMBS conduits, and other market participants have re-entered or increased their activities in the multifamily market, and as a result we have faced
increased competition. In addition, FHFA's efforts to decrease our presence in this market (e.g., the requirement to reduce our new multifamily business volume by at least 10% in 2013) could encourage further competition.
Our investment activities may be adversely affected by limited availability of financing and increased funding costs.
The amount, type and cost of our unsecured funding, including financing from other financial institutions and the capital markets, directly affects 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 unsecured debt markets or by pledging mortgage-related securities as collateral to other institutions could cease or change rapidly, and the cost of available funding could increase significantly, due to changes in market confidence and other factors. We may incur costs, including potentially higher funding costs, for our liquidity management practices and procedures and there can be no assurance that such practices and procedures would provide us with sufficient liquidity to meet our ongoing cash obligations under all circumstances. In particular, we believe that our liquidity contingency plans may be difficult or impossible to execute during a liquidity crisis or period of significant market turmoil. If we cannot access the unsecured debt markets, our ability to repay maturing indebtedness and fund our operations could be eliminated or significantly impaired, as our alternative sources of liquidity (e.g., cash and other investments) may not be sufficient to meet our liquidity needs.
Wider spreads could cause a reduction in long-term debt issuances and an increased reliance on short-term debt issuances. Significant issuances of short-term debt could lead to a funding gap between short- and long-term debt and could increase rollover risk (i.e., the risk that we may be unable to refinance our debt when it becomes due), and could increase the use of derivatives and the volatility of reported net income.
Our mortgage-related investments portfolio has contracted significantly since we entered into conservatorship. A significant portion of the assets remaining in the portfolio are those we consider to be less liquid, and our ability to use these assets as a significant source of liquidity (for example, through sales or use as collateral in secured lending transactions) is limited.
We pay cash dividends (known as the net worth sweep dividend) to Treasury on the senior preferred stock on a quarterly basis. 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 increases 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.
Changes in Government Support
Treasury supports us through the Purchase Agreement and Treasury’s ability to purchase up to $2.25 billion of our obligations under its permanent statutory authority. Unlike certain of our competitors, we do not have access to the Federal Reserve's discount window. Changes or perceived changes in the government’s support of us could have a severe negative effect on our access to the unsecured debt markets and our debt funding costs. As of December 31, 2013, the amount of available funding remaining under the Purchase Agreement was $140.5 billion. This amount will be reduced by any future draws. While we believe that the support provided by Treasury pursuant to the Purchase Agreement currently enables us to maintain our access to the unsecured debt markets and to have adequate liquidity to conduct our normal business activities, our access to the unsecured debt markets and the costs of our debt funding could be adversely affected by a number of factors, including (a) uncertainty about the future of the GSEs; (b) if debt investors believe that the risk that we could be placed into receivership is increasing; and (c) if we were to make significant draws in the future, and thereby significantly reduce the amount of available funding remaining under the Purchase Agreement. For more information, see “MD&A — LIQUIDITY AND CAPITAL RESOURCES — Liquidity — Capital Resources, the Purchase Agreement, and the Dividend Obligation on the Senior Preferred Stock.”
Demand for Debt Funding
If investor demand for our debt securities were to decrease, our liquidity, business, and results of operations could be materially adversely affected. 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. The market for our debt securities may become less liquid as our mortgage-related investments portfolio winds down. This could lead to a decrease in demand for our debt securities and an increase in our funding costs.
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 and liquidity contingency plans 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 the institution providing the line of credit. 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, Moody’s, 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.
Our senior long-term debt credit rating was downgraded in 2011 by S&P, following S&P’s downgrade of the credit rating of the U.S. government, and it is possible we could experience further downgrades. S&P, Moody’s, and Fitch have recently indicated that they could take actions on the U.S. government’s ratings if steps toward a credible deficit reduction plan are not taken or if the U.S. experiences a weaker than expected economic recovery. For more information, see “MD&A — LIQUIDITY AND CAPITAL RESOURCES — Liquidity — Credit Ratings.”
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 and financial markets 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.
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. The profitability of our multifamily business could be adversely affected by a significant decrease in demand for K Certificates.
Security performance is one of Freddie Mac’s 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 price performance of our PCs relative to 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 monthly 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.
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 believe the strategies currently available to us may not reduce or eliminate these price differences over the long-term. A curtailment of mortgage-related investments portfolio purchases, sales, or retention activities 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.
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 — Market Presence and PC Support Activities.”
The current Multifamily segment business model is highly dependent on the ability of Freddie Mac to finance purchased loans through securitization into K Certificates. A significant decrease in demand for K Certificates over a long period of time could have an adverse impact on the profitability of the Multifamily segment business. We employ a variety of strategies in an effort to support the liquidity of our K Certificates, and may consider additional strategies if deemed appropriate. From time to time, we purchase and sell both guaranteed K Certificates and related unguaranteed CMBS through our mortgage-related investments portfolio.
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 will 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.
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, including prepayment risk. Changes in interest rates could adversely affect our net interest yield, the value of our mortgage assets, and the prepayment rate on mortgage loans we own or guarantee. We incur costs in connection with our efforts to manage these risks.
Our financial results can be significantly affected by changes in interest rates and changes in yield curves, especially results driven by financial instruments that are measured at fair value for accounting purposes either through earnings or in AOCI. These instruments include derivatives, trading securities, available-for-sale securities, and loans with the fair value option elected. 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 projections, thus potentially affecting the fair value of our assets, including our investments in mortgage-related assets. When interest rates fall, borrowers are more likely to prepay 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 affect the value of these securities.
When interest rates increase, our credit losses from loans with adjustable payment terms (e.g., ARM loans) may increase as borrower payments increase at their reset dates, which increases the borrower’s risk of default. Rising interest rates may also reduce the opportunity for these borrowers to refinance into a fixed-rate loan. Similarly, many borrowers may have additional debt obligations (such as home equity lines of credit and second liens) that also have adjustable payment terms. If a borrower's payment on his or her other debt obligations increases (due to rising interest rates or change in amortization), it may increase the risk that the borrower may default on a loan we own or guarantee.
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 results of operations, net worth, and fair value of net assets.
OAS is a model-based estimate of the incremental yield spread between a particular financial instrument and a benchmark yield curve. This includes consideration of potential variability in the instrument’s 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.
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. Our financial results can be significantly affected by changes in OAS, especially results driven by financial instruments that are measured at fair value for accounting purposes either through earnings or in AOCI. These instruments include trading securities, available-for-sale securities, and loans with the fair value option elected. A widening of the OAS on a given asset, which is typically associated with a decline in the current fair value of that asset, may cause significant fair value losses, and may adversely affect our near-term financial results and net worth. Conversely, a narrowing or tightening of the OAS is typically associated with 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, and could increase the cost of our activities to support our market presence and the price performance of our PCs. Consequently, a tightening of the OAS may adversely affect our future financial results and net worth. See “MD&A — FAIR VALUE BALANCE SHEETS 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.”
Negative publicity causing damage to our reputation could adversely affect our business, 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 to our business structure during or following conservatorship, including whether we will continue to exist.
Our efforts to reduce foreclosures, modify loan terms and refinance mortgages may adversely affect our financial results.
The servicing alignment initiative, MHA Program (which includes HAMP and HARP), 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. For example, with respect to HAMP loan modifications, 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, and are not reimbursed for these costs by Treasury.
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 costs, 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 loan modification programs. 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.
Certain of our modified loans (primarily HAMP loans) have provisions whereby the interest rates on such loans, which initially were set at a below-market rate, will increase gradually until they reach the market rate that was in effect at the time of the modification. This increase in payments may increase the risk that these borrowers will default.
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 continued high volumes of 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.
Our current loss mitigation activities may lead to faster prepayments, which could have an impact on the earnings from mortgage-related assets we hold in our Investments segment mortgage investments portfolio. In addition, loss mitigation
activities may adversely affect our ability to securitize and sell the loans subject to those activities (e.g., modified single-family mortgage loans).
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. For example, 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. In addition, 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. Furthermore, HARP and similar programs make it harder to estimate prepayments, which could adversely affect our ability to hedge our mortgage-related investments.
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.
For more 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 may experience further write-downs and losses relating to our assets that could materially adversely affect our financial results, liquidity and net worth.
We experienced significant losses and write-downs relating to certain of our assets in recent years, particularly between 2008 and 2012, 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. 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 financial results, liquidity, and net worth. We may decide to pursue certain mortgage-related investments portfolio strategies for economic reasons that could result in the immediate recognition of losses, such as paying a premium to repurchase debt or engaging in certain asset structuring activities that result in the write-off of premiums.
We have a significant deferred tax asset ($22.7 billion as of December 31, 2013), primarily resulting from our decision to release the valuation allowance on our deferred tax assets in the third quarter of 2013. In future periods we will continue to evaluate our ability to realize the net deferred tax asset. If future events significantly alter our current outlook, we may need to reestablish the valuation allowance. If this occurs, we would incur additional income tax expense and might require additional draws under the Purchase Agreement, which could be significant. For more information, see "MD&A — CONSOLIDATED BALANCE SHEETS ANALYSIS — Deferred Tax Assets and Liabilities."
There may not be an active, liquid trading market for our equity securities.
Our common stock and the publicly traded classes of our preferred stock trade exclusively on the OTCQB Marketplace. Trading volumes on the OTCQB Marketplace can fluctuate significantly, and may not be stable, which could make it difficult for investors to execute transactions in our securities and could make the prices of our securities decline or be volatile.
Our business may be adversely affected if we are unable to hire and retain qualified employees.
Our performance is largely dependent on the talents and efforts of highly skilled individuals. Our ability to recruit and retain executives and other employees with the necessary skills to conduct our business has at times in the past been, and may in the future be, adversely affected by the actions taken by Congress, Treasury, and the Conservator (e.g., significant restrictions on compensation), 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 negative publicity concerning the GSEs. We face competition from inside and outside of the financial services industry for qualified employees. Additionally, an improving economy may put additional pressures on turnover, as more attractive opportunities become available to our employees. 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.
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. Delays in the foreclosure process could cause our expenses 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 or denied if servicers do not follow proper procedures in addressing seriously delinquent borrowers, including if servicers do not complete foreclosures within required timelines.
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.
Issues related to the MERS System could delay or disrupt foreclosure activities and could have an adverse effect on our business.
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 and operated by MERSCORP Holdings, Inc., a privately held company, the shareholders of which include a number of organizations in the mortgage industry (including Freddie Mac).
Numerous lawsuits have been filed challenging foreclosures conducted using the MERS System. It is possible that adverse judicial decisions, regulatory proceedings or action, or legislative action could delay or disrupt foreclosure of mortgages that are registered on 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 could increase our costs or otherwise adversely affect our business. For example, we could be required to transfer mortgages out of the MERS System. Approximately 45% of the loans Freddie Mac owns or guarantees were registered in MERS’ name as of December 31, 2013.
Failures by MERSCORP Holdings and its subsidiaries to apply prudent and effective process controls and to comply with legal and other requirements in the foreclosure process could pose legal, reputational, and operational risks for us.
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.
Our business could be adversely affected by control deficiencies or failures. Control deficiencies could result in errors in our financial statements, 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 our 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) data quality; and (e) servicing-related issues.
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.
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 face risk associated with our use of models for financial accounting and reporting purposes, and to manage business risks. 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, financial and risk-related disclosures, and our ability to manage risks.
We use market-based information to construct 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 our models are not representative of current market conditions. For example, models may not fully capture the effect of certain economic events or government policies, which makes it more difficult to assess model performance and requires a higher degree of 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. In recent years, it has been more difficult to predict the behaviors of the housing and credit capital markets and market participants.
We face the risk that we could fail to implement, operate, 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 model’s 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.
We have increased our use of third-party models. While the use of such models may reduce risk (e.g., where no internal model is available), it may expose us to additional risk as third-parties typically do not provide us with proprietary information regarding their models. We also may have little control over the process by which the models are adjusted or changed. As a result, we may not fully account for 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.
We also face risk that we could make poor business decisions in areas where model results are an important factor, including loan purchases, securitizations and sales of loans, purchases and sales of securities, funding strategy, management and guarantee fee pricing, interest-rate risk management, market risk management, credit risk management, quality-control sampling strategies for loans in our single-family credit guarantee portfolio, and representation and warranty and other settlements with our counterparties. 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 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. 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 a significant effect on our provision for credit losses in the future. The accounting methods outlined in FHFA’s 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.”
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.
We face significant levels of operational risk, due to a variety of factors, including the complexity of our business operations and the amount of change to our core systems required to keep pace with regulatory and other requirements.
Shortcomings or failures in our internal processes, people, or systems could lead to impairment of our liquidity, financial and economic loss, errors in our financial statements, disruption of our business, liability to customers, further legislative or
regulatory intervention, or reputational damage. Our application portfolio contains certain legacy systems that require manual support and intervention, which may lead to heightened risk of system failures.
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. Our systems may contain design flaws. 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.
We also face increased operational risk due to the magnitude and complexity of the new initiatives we are undertaking, including our effort to help build a new housing finance system. Some of these initiatives require significant changes to our operational systems. In some cases, the changes must be implemented within a short period of time. Our legacy systems may also create increased operational risk for these new initiatives.
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.
Most of our key business activities are conducted in our offices in Virginia and represent a concentrated risk of people, technology, and facilities. As a result, a power outage or other infrastructure disruption in the area near our offices could significantly adversely affect our ability to conduct normal business operations. A terrorist event or natural disaster in the area near our offices could have a similar impact. Any measures we take to mitigate this risk may not be sufficient to respond to the full range of events that may occur.
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 protecting its various systems and processes, there is no assurance that Freddie Mac’s 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 or steal 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 borrowers, 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, negatively impact our competitive position, 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. In addition, there can be no assurance that our business partners and counterparties are adequately protecting the confidential and other information that we share with them. As a result, a cyber attack on their systems and networks, or breach of their security measures, may result in harm to our business and business relationships.
We rely on third parties for certain important functions. Any failures by those vendors could disrupt our business operations.
At times, we outsource certain key functions to external parties, including some that are critical to financial reporting, our mortgage-related investment activity, and mortgage loan underwriting. 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 affected. 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.
Legal and Regulatory Risks
Legislative or regulatory actions could adversely affect our business activities and financial results.
In addition to possible GSE reform discussed in “Conservatorship and Related Matters — The future status and role of Freddie Mac are uncertain,” our business may be directly adversely affected by other legislative and regulatory actions at the federal, state, and local levels. Legislative or regulatory actions could affect us in a number of ways, including by imposing
significant additional costs on us and diverting management attention or other resources. Judicial actions at the federal, state, or local level could have a similar effect. 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. 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 lawsuits challenging our statutory exemption from certain real estate transfer taxes. If we were to lose this exemption, our financial results could be adversely affected.
The Dodd-Frank Act, which was signed into law on July 21, 2010, significantly changed the regulation of the mortgage and financial services industries and could affect us in substantial and unforeseeable ways. For example, the Dodd-Frank Act and related current and future regulatory changes could require us to change our business practices, such as practices related to mortgage underwriting and servicing. 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. For more information on the Dodd-Frank Act, see “BUSINESS — Regulation and Supervision — Legislative and Regulatory Developments.”
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 Dodd-Frank Act and related current and future regulatory changes may significantly change the business practices of our customers and counterparties, and it is possible that any such changes will adversely affect our business and financial results. For example, the Dodd-Frank Act and related 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.
U.S. banking regulators have substantially revised the capital and liquidity requirements applicable to banking organizations, based on the Basel III standards developed by the Basel Committee on Banking Supervision. Phase-in of the new bank capital and liquidity requirements (some of which have not been finalized) will take several years and there is significant uncertainty about the extent to which implementation of the new requirements by banking organizations may affect us. For example, the emerging regulatory framework could affect demand for our securities and/or competition in the market for mortgage originations and servicing, with possible adverse consequences for 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 that could result in the payment of substantial damages or otherwise harm our business.
We are a party to various claims and other legal proceedings. We also have been, and in the future may be, involved in government investigations and IRS examinations. In addition, certain of our former officers are involved in legal proceedings for which they may be entitled to reimbursement by us for costs and expenses of the proceedings. 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 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. The defense of, or other involvement in, these various matters could divert management’s attention and other resources from the needs of the business. In addition, a number of lawsuits have been filed against the U.S. government relating to conservatorship and the Purchase Agreement that could adversely affect us. See “LEGAL PROCEEDINGS” and “NOTE 17: LEGAL CONTINGENCIES” for information about these various pending legal proceedings.
ITEM 1B. UNRESOLVED STAFF COMMENTS
ITEM 2. PROPERTIES
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.
ITEM 3. LEGAL PROCEEDINGS
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.
Litigation Against the U.S. Government Concerning Conservatorship and the Purchase Agreement
Between June and September 2013, a number of lawsuits were filed against the U.S. government and, in some cases, the Secretary of the Treasury and the then Acting Director of FHFA challenging certain government actions related to the conservatorship (including actions taken in connection with the imposition of conservatorship) and the Purchase Agreement. Several of the lawsuits seek to invalidate the net worth sweep dividend provisions of the senior preferred stock, which were implemented pursuant to the August 2012 amendment to the Purchase Agreement. Another lawsuit challenging the Purchase Agreement was filed in February 2014, and it is possible that additional similar lawsuits will be filed in the future. Freddie Mac is not a party to any of these lawsuits. However, a number of other lawsuits have been filed against Freddie Mac concerning the August 2012 amendment to the Purchase Agreement. See “NOTE 17: LEGAL CONTINGENCIES— Litigation Concerning the Purchase Agreement” for more information on the lawsuits filed against Freddie Mac.
It is not possible for us to predict the outcome of these lawsuits, or the actions the U.S. government (including Treasury and FHFA) might take in response to any ruling or finding in any of these lawsuits or any future lawsuits. However, it is possible that we could be adversely affected by these events, including, for example, by changes to the Purchase Agreement, or any resulting actual or perceived changes in the level of U.S. government support for our business.
Litigation Concerning Housing Trust Fund
On July 9, 2013, plaintiffs filed a lawsuit in the U.S. District Court for the Southern District of Florida styled Samuels et al. vs. FHFA and DeMarco. Freddie Mac is not a party to this lawsuit. In the lawsuit, plaintiffs challenge FHFA’s decision to suspend Freddie Mac's and Fannie Mae’s payments to an affordable housing trust fund managed by HUD. In November 2008, FHFA advised us that it has suspended the requirement to set aside or allocate funds for this trust fund until further notice. See “BUSINESS — Regulation and Supervision — Federal Housing Finance Agency — Affordable Housing Allocations” for more information. In October 2013, FHFA moved to dismiss the complaint and shortly thereafter plaintiffs filed an amended complaint. Plaintiffs’ amended complaint alleges that FHFA’s actions in ordering Freddie Mac and Fannie Mae to suspend payments to the trust fund, and FHFA’s failure to review its decision to suspend payments once Freddie Mac and Fannie Mae’s financial circumstances changed, violated the Administrative Procedure Act. The plaintiffs ask that the Court, among other items, vacate and set aside FHFA’s decision to indefinitely suspend payments by Fannie Mae and Freddie Mac to the trust fund, and order FHFA to instruct Freddie Mac and Fannie Mae to proceed as if FHFA’s suspension of payments to the trust fund had never taken place. Plaintiffs also seek reasonable attorneys’ fees and costs. On December 6, 2013, FHFA filed a motion to dismiss the amended complaint, which plaintiffs have opposed.
It is not possible for us to predict the outcome of this lawsuit, or the actions FHFA might take in response to any ruling or finding in this lawsuit. If we are required to contribute some or all of the amounts we would have contributed to the trust fund in past years had FHFA not suspended these allocations or to begin contributing these amounts in the future, it could have an adverse impact on our financial results.
ITEM 4. MINE SAFETY DISCLOSURES
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED
STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
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 14, 2014, there were 650,039,533 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.
Table 5 — Quarterly Common Stock Information
2013 Quarter Ended
2012 Quarter Ended
As of February 14, 2014, we had 1,904 common stockholders of record.
Dividends and Dividend Restrictions
We did not pay any cash dividends on our common stock during 2013 or 2012. 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 Mac’s common stock or on any series of Freddie Mac’s 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 capital distribution; 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, 2013. 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 2013 at the direction of the Conservator, as discussed in “MD&A — LIQUIDITY AND CAPITAL RESOURCES — Capital Resources, the Purchase Agreement, and the Dividend Obligation on the Senior Preferred Stock” and “NOTE 11: STOCKHOLDERS’ EQUITY (DEFICIT) — Dividends Declared.” We did not declare or pay dividends on any other series of preferred stock outstanding in 2013.
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 Treasury’s 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, 2013. 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 2013. 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 Treasury’s prior consent, and we may only purchase or redeem the senior preferred stock in certain limited circumstances set forth in the certificate of designation of the senior preferred stock.
Transfer Agent and Registrar
Computershare Trust Company, N.A.
P.O. Box 43078
Providence, RI 02940-3078
ITEM 6. SELECTED FINANCIAL DATA
The selected financial data presented below should be reviewed in conjunction with MD&A and our consolidated financial statements and related notes.
Table 6 — Selected Financial Data(1)
At or For The Year Ended December 31,
(dollars in millions, except share-related amounts)
Statements of Comprehensive Income Data
Net interest income
Benefit (provision) for credit losses
Non-interest income (loss)
Income tax benefit
Net income (loss) attributable to Freddie Mac
Total comprehensive income (loss) attributable to Freddie Mac
Loss attributable to common stockholders(2)
Loss per common share – basic and diluted
Cash dividends per common share
Weighted average common shares outstanding (in thousands) – basic and diluted(3)
Balance Sheets Data
Mortgage loans held-for-investment, at amortized cost by consolidated trusts (net of allowances for loan losses)
Debt securities of consolidated trusts held by third parties
All other liabilities
Total Freddie Mac stockholders’ equity (deficit)
Mortgage-related investments portfolio
Total Freddie Mac mortgage-related securities(5)
Total mortgage portfolio(6)
Return on average assets(9)
Non-performing assets ratio(10)
Equity to assets ratio(11)
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 2009 are not comparable with those of more recent years.
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.”
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.
Represents the UPB and excludes mortgage loans and mortgage-related securities traded, but not yet settled.
See ‘‘Table 33 — Freddie Mac Mortgage-Related Securities’’ for the composition of this line item.
See ‘‘Table 15 — Composition of Segment Mortgage Portfolios and Credit Risk Portfolios’’ for the composition of our total mortgage portfolio.
See ‘‘Table 53 — Non-Performing Assets’’ for a description of our non-performing assets.
The dividend payout ratio on common stock is not presented because the amount of cash dividends per common share is zero for all periods presented. 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.
Ratio computed as net income (loss) attributable to Freddie Mac divided by the simple average of the beginning and ending balances of total assets.
Ratio computed as non-performing assets divided by the ending UPB of our total mortgage portfolio, excluding non-Freddie Mac mortgage-related securities.
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.
ITEM 7. MANAGEMENT’S 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
The U.S. real gross domestic product rose by 2.7% during 2013, measured on a fourth quarter to fourth quarter basis, compared to 2.0% in 2012, according to the Bureau of Economic Analysis. The national unemployment rate was 6.7% in December 2013, compared to 7.9% in December 2012, based on data from the U.S. Bureau of Labor Statistics. In the data underlying the unemployment rate, an average of approximately 194,000 monthly net new jobs (non-farm) were added to the economy during 2013, which shows evidence of a slow, but steady positive trend for the economy and the labor market. Long-term interest rates, such as those of 30-year fixed-rate mortgages, generally increased during 2013. For example, based on our weekly Primary Mortgage Market Survey, the rate on 30-year fixed-rate conforming mortgages with an average LTV ratio of 80% averaged 4.5% in December 2013 compared to 3.4% in December 2012. This increase led to a significant reduction of single-family refinance mortgage activity in 2013.
Table 7 — Mortgage Market Indicators
Year Ended December 31,
Home sale units (in thousands)(1)
National home price change(2)
Single-family originations (in billions)(3)
U.S. single-family mortgage debt outstanding (in billions)(6)
U.S. multifamily mortgage debt outstanding (in billions)(6)
Consists of sales of new and existing homes in the U.S. Source: National Association of Realtors news release dated February 21, 2014 (sales of existing homes) and U.S. Census Bureau news release dated January 27, 2014 (sales of new homes).
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, 2013 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.
Source: Inside Mortgage Finance estimates of originations of single-family first-and second liens dated January 31, 2014.
ARM share of the dollar amount of total mortgage applications. Source: Mortgage Bankers Association’s Mortgage Applications Survey. Data reflect annual average of weekly figures.
Refinance share of the number of conventional mortgage applications. Source: Mortgage Bankers Association’s Mortgage Applications Survey. Data reflect annual average of weekly figures.
Source: Federal Financial Accounts of the United States dated December 9, 2013. The outstanding amounts for 2013 presented above reflect balances as of September 30, 2013.
Single-Family Housing Market
The single-family housing market improved significantly in 2013 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 2013 were 5.09 million, increasing 9% from 4.66 million in 2012. Based on data from the U.S. Census Bureau and HUD, sales of new homes in 2013 were 428,000, increasing 16% from 368,000 in 2012. Home prices increased during both 2013 and 2012, with our nationwide index registering approximately a 9.3% increase from December 2012 through December 2013 and a 5.9% increase from December 2011 to December 2012. Despite these increases, our national home price index reflects a cumulative decline of 15% since June 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 both 2013 and 2012 and was 2.39% as of December 31, 2013. The Mortgage Bankers Association reported in its National Delinquency Survey that serious delinquency rates on all single-family loans in the survey declined to 5.4% as of December 31, 2013, down from 6.8% at December 31,
2012. Borrower delinquency rates have been generally worse in areas with higher unemployment rates and where declines in property values have been more significant during recent years.
Based on the National Delinquency Survey’s data, we estimate that we owned or guaranteed approximately 23% of the single-family mortgages outstanding in the U.S. at December 31, 2013, based on number of loans. At December 31, 2013, we held or guaranteed approximately 255,000 seriously delinquent single-family loans, representing approximately 10% of the seriously delinquent single-family mortgages in the market as of that date.
Multifamily Housing Market
The multifamily market has experienced strong rent and occupancy trends over the last several years, although the pace slowed in 2013. These strong fundamentals, coupled with low interest rates, drove an increase in investor demand for multifamily properties. The most recent preliminary data reported by Reis, Inc. indicated that the national apartment vacancy rate declined by 50 basis points during 2013 to 4.1% in the fourth quarter, representing the lowest level since 2001. In addition, Reis, Inc. reported that effective rents grew by 3.2% during 2013, compared to 3.9% during 2012. 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. According to the latest information available from Moody's Analytics, Inc. and Real Capital Analytics, Inc., apartment prices rose approximately 12% nationally in 2013 and have returned to the peak values experienced in 2007 for most markets. As a result, the multifamily sector continued to experience strong investor interest and continued to outperform most other commercial real estate sectors in 2013.
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 cause the actual performance of the housing and mortgage markets and the U.S. economy in the near term to be significantly worse than we expect, including adverse changes in national or international economic conditions and changes in the federal government’s fiscal or monetary policies. See “FORWARD-LOOKING STATEMENTS” for additional information.
Although national home prices have increased for the last two years, home prices at December 31, 2013 remained significantly below their peak levels in many geographical areas. Declines in the market’s inventory of vacant housing have supported stabilization and increases in home prices in a number of metropolitan areas. However, we believe that home prices will not continue at the same growth rate experienced in 2013, but will gradually moderate in 2014 and will return towards growth rates that are consistent with long-term historical averages (approximately 2 to 5 percent growth on an annual basis). To the extent a large volume of loans completes the foreclosure process in a short period, the resulting increase in the market’s inventory of homes for sale could have a negative effect on home prices.
We continue to expect key macroeconomic drivers of the economy, such as income growth, employment, and inflation, will affect the performance of the housing and mortgage markets in 2014. Since we expect that economic growth will continue and mortgage interest rates will remain low in 2014, compared to historical levels (although higher than in 2013), we believe that housing affordability will remain relatively high in 2014 for potential home buyers. We also expect that the volume of home sales will likely increase in 2014, but not return to the historically high levels experienced in 2005 to 2007. 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 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 expect the UPB of our single-family credit guarantee portfolio will be relatively unchanged at the end of 2014 compared to 2013, as an expected decline in purchase volume is expected to be offset by a decline in prepayments. However, we believe that the recent increase and potential further increases in mortgage interest rates will result in a decline, which could be significant, in overall single-family mortgage originations in 2014 compared with 2013, driven by a decline in refinancings. During the second half of 2013, refinancings, including HARP, comprised approximately 61% of our single-family purchase and issuance volume, compared with 81% in the first half of 2013 and approximately 82% for all of 2012. As a result of the expected declines in overall originations, our purchase volumes will likely also decline, potentially significantly, during 2014. We expect HARP activity to decline in 2014, since the pool of borrowers eligible to participate in the program has declined and mortgage interest rates increased during 2013.
Our charge-offs remained elevated during 2013 compared to levels before 2009 and we expect they will continue to be elevated during 2014. 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 and short sale severity ratios to remain high. However, our recovery rates have been positively affected by recent improvements in home prices and home sales; and
The amount of non-performing assets and the volume of our loan workouts to remain high.
Our guarantee fee rate charged on new acquisitions increased in 2013 as a result of two across-the-board increases in guarantee fees implemented in 2012. In December 2013, FHFA directed us to make additional changes to our management and guarantee fee rates in 2014. In January 2014, FHFA announced it was delaying the implementation of these changes. FHFA may direct us to implement further increases in our guarantee fees in the future.
We expect that, at the national level, new supply of multifamily housing will not significantly exceed market demand in the near term due to constraints, such as rising construction costs and the availability of financing relative to other real estate sectors. We expect that demand growth, driven by a strengthening economy and positive demographics, will generally be sufficient for the increase in supply. However, there may be certain local markets where new supply may outpace demand, which would be evidenced by excess supply and rising vacancy rates. 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 2014. We believe the long-term outlook for the national multifamily market continues to be favorable as strong demand will support healthy cash flows and stable property values.
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.
Table 8 — Summary Consolidated Statements of Comprehensive Income
Year Ended December 31,
Net interest income
Benefit (provision) for credit losses
Net interest income after benefit (provision) for credit losses
Non-interest income (loss):
Gains (losses) on extinguishment of debt securities of consolidated trusts
Gains (losses) on retirement of other debt
Derivative gains (losses)
Impairment of available-for-sale securities:
Total other-than-temporary impairment of available-for-sale securities
Portion of other-than-temporary impairment recognized in AOCI
Net impairment of available-for-sale securities recognized in earnings
Other gains (losses) on investment securities recognized in earnings
Total non-interest income (loss)
REO operations income (expense)
Total non-interest expense
Income (loss) before income tax benefit
Income tax benefit
Net income (loss)
Other comprehensive income (loss), net of taxes and reclassification adjustments:
Changes in unrealized gains (losses) related to available-for-sale securities
Changes in unrealized gains (losses) related to cash flow hedge relationships
Changes in defined benefit plans
Total other comprehensive income (loss), net of taxes and reclassification adjustments
Comprehensive income (loss)
Net Interest Income
The table below summarizes our net interest income and net interest yield and provides an attribution of changes in annual results to changes in interest rates or changes in volumes of our interest-earning assets and interest-bearing liabilities. Average balance sheet information is presented because we believe end-of-period balances are not representative of activity throughout the periods presented. For most components of the average balances, a daily weighted average balance was calculated for the period. When daily average balance information was not available, a simple monthly average balance was calculated.
Table 9 — Net Interest Income/Yield, Average Balance, and Rate/Volume Analysis
Year Ended December 31,