Federal Home Loan Mortgage Corporation

Good morning, and thank you for joining us as we discuss Freddie Mac's Fourth Quarter and Full Year 2014 Financial Results. We're joined today by the company's Chief Executive Officer, Don Layton; and Chief Financial Officer, Jim MacKey.

Before we proceed, we'd like to point out that during this call, Freddie Mac's executives may make forward-looking statements. These statements are based upon a set of assumptions about the company's key business drivers and other factors.

Changes in these factors could cause the company's actual results to vary materially from its expectations. A description of these factors can be found in the company's 10-K report filed today.

As a company and conservatorship, Freddie Mac's commentary will be limited to business and market topics, which include financial results, summaries of current business activities and commentary on housing market conditions. As you know, we are not able to comment on the development of public policy or legislation concerning Freddie Mac.

As a reminder, this is a call for the media and only members of the media will have the ability to ask questions. [Operator Instruction].

This call will be recorded and a replay will be made available on Freddie Mac's website later today.

With that, I will now turn the call over to Don Layton, Chief Executive Officer of Freddie Mac.

Good morning, and thanks for being with us. As always, we want to spend most of our time taking your questions, but I'd like to cover 3 things with you first.

First, some key themes you will see buried in the numbers. Second, I'll hit some of the main highlights of our financial results; and third, I'll cover some 2014 business highlights, including our work to support the housing markets broadly.

So there are 3 key themes you will see in our financial and operating results, which you should keep in mind. First, the risks and earnings impact of the legacy business reflecting the great recession are declining at a fairly rapid pace now.

Some of it is just passage of time but we are also active in risk reduction to make it happen even more quickly. Second, we are building good, profitable and quality businesses going forward that enable us to continue our historic policy role to support the U.S.

housing markets by providing liquidity, stability and affordability to single-family and multifamily markets. And we are doing it in an increasingly taxpayer-friendly manner.

And third, when viewing any quarterly or yearly financial results for us, there is what I call a very high noise-to-signal ratio in our business, meaning we have lots of financial impacts that do not reflect the underlying core business.

Most are cyclical recovery items like lawsuit revenues, which we have long pointed out. These declined substantially in 2014 and are expected to continue to decline in the next few years.

Other impacts are just period-to-period volatility, some of which are simply that the accounting doesn't reflect the underlying economics in any one quarter or any one year.

Now let me jump to the financial results. As you've seen this morning, Freddie Mac reported full-year net income of $7.7 billion and comprehensive income of $9.4 billion.

We also reported fourth quarter net of $227 million and comprehensive income of $251 million. 2014 marks our third straight year of profitability and we returned nearly $20 billion to taxpayers during the year.

Our 2014 results were very solid, but much lower than 2013 for several reasons, most of which were cyclical and one-time in nature.

First, in 2013, there was the release of the DTA, deferred tax asset, in the third quarter. So we had that extremely large $23 billion income tax benefit then.

Second, national home price appreciation was very strong in 2013, 9% overall over the prior year. This growth and reduction in serious delinquencies as well as recoveries for representation in warranty settlements led to a $2.5 billion benefit for credit losses in 2013.

And by benefit, I mean not a cost as usual, but a source of profit. As home price appreciation slowed to a more sustainable 5% in 2014, we have now moved to credit losses being a provision for expense of $58 million.

Third, net interest income decreased $2.2 billion from 2013, primarily driven by a further reduction in our reinvestment portfolio. We expect this trend to continue over the long term, naturally, as we wind the portfolio down to meet Treasury and FHFA mandates on the topic.

And finally, our 2014 financial results were significantly impacted by $8.3 billion of derivative losses for the year with $3.4 billion in the fourth quarter alone as compared to a $2.6 billion gain in 2013. Most of the 2014 losses resulted from the decline in the value of the derivatives, which are mark-to-market each period as interest rates declined significantly during the year, especially near year end.

For example, the 10-year treasury rate fell by 83 basis points to 2.17% in 2014.

Now I want to take some time to address this last point, the mark-to-market volatility of our derivatives, because it is critical to understanding both our financial results and the underlying economics of the business. First, we use derivatives to reduce our interest rate risk.

On an economic basis, our models indicate that our duration gap between our assets and liabilities has consistently averaged near 0 months. This is in line with our conservatorship-appropriate goal to not take discretionary market risks given that the taxpayer supports us.

Second, we currently prefer a mix of derivatives and shorter-term debt to fund our business and hedge our interest rate risk versus match funding with longer-term debt for the average life of our assets. One primary reason for this strategy is that economically this is a -- has been less -- a less costly method of hedging our risk in funding our business.

In addition, this strategy provides us with much more flexibility in the future, especially to avoid the problem of a large cost of stranded term debt as we sell less liquid assets out of our retained portfolio in accordance with direction from the government. That would leave the asset being hedged gone and the liability still in our books.

The derivatives are mark-to-market each period while many hedged items, primarily the retained portfolio assets and debt, are generally carried at cost. Thus, the potential is there for GAAP accounting mismatch during any particular one period even with real economic risk having been properly hedged away.

In the long term, it should all work out.

It's important to remember that in a falling interest rate environment like you saw this year, all of our retained portfolio assets and debt change in value. However, since some of this is carried at cost, this is not reflected in the income statement.

The change in derivatives values, as I've mentioned, however, is so reflected, hence the timing problem.

We included a chart on Page 3 of the press release which illustrates the period-to-period volatility under our derivatives marks very carefully. The best way to look at the results and to look at the derivative expense excluding the interest carry component.

Interest carry has been relatively stable period-to-period and is the ongoing exchange of payments between us and our counterparties. Economically, it is the equivalent to additional interest expense.

Excluding this interest carry, we recorded $6.1 billion in gains in 2013 as interest rates increased and we recorded $5.7 billion losses in 2014 as rates declined. So over even just this 2-year time horizon, the cumu- GAAP effect was a nominal $400 million positive.

However, it proves quite volatile quarter-to-quarter.

One last comment on this before I move to my third topic. Given the lower economic cost and greater flexibility of using derivatives to hedge while in conservatorship, we believe it is smart for us and the U.S.

taxpayer to not be overly concerned with quarter-to-quarter GAAP earnings volatility, which as I've described, primarily non-economic.

Let me now turn to my third topic, Freddie Mac's strong improving business results and our support of the broader U.S. housing market, both today and for the future.

Our work to become more competitive and reduce taxpayer risk in our business model is clearly evident in our results. Let me share last year's highlights with you.

First, I'll start with our biggest business, single-family. We funded 1 out of every 4 home loans last year, that's $255 billion of much needed liquidity into the market.

Of the 1.2 million homes we funded, more than half this past year were home purchases, a marked shift from 2013 when almost 3/4 of the volume went towards helping borrowers refinance their homes. At the same time, we increased our portion of the market share between GSEs.

We achieved this by being a better competitor, improving customer service broadly and also adding more customers, especially amongst medium-sized and smaller firms. Simply put, we're doing a better job than we used to.

This business is coming on the books with higher guarantee fees. Last year, our average G-fee [ph] on new business was 47.4 basis points, up from 41.4 in 2013.

I note that this excludes the 10 basis points for the temporary payroll tax cut that we remit directly to Treasury and we're just a pass-through.

Our new book of business, loans acquired since 2009, grew to 60% of the single-family book at the year end of 2014 and this does not include HARP and other relief refinancings, which were another 20%. Our new book is strong and profitable.

This quality new business, coupled with our continued work to aid struggling borrowers -- we helped an additional 120,000 families avoid foreclosure in 2014 -- has driven our single-family delinquency rate down to 1.88%, the lowest level since January of 2009. And our business model is evolving to be more and more taxpayer friendly, reducing the taxpayers' exposure to mortgage risk.

In 2014, we transferred to the private capital markets a portion of the credit losses, the credit risk of credit losses, that could occur in an adverse house price scenario at almost $148 billion of single-family mortgages through 7 STACR debt note transactions as we call them, and 3 ACIS reinsurance transactions. The market generally refers to these as credit risk transfer transactions.

We substantially exceeded our 2014 scorecard target from the FHFA, which was $90 billion in UPB as against $148 billion we already did. Once again, we demonstrated leadership in credit risk transfer, doing more deals in 2014 than any other market participant.

And you can expect us to transfer credit risk on a minimum of $120 billion in 2015, which is our scorecard target, including for the first time a deal already completed in 2015, transferring a portion of the first-loss position as well.

Of course, in addition to our own business, we continue to work with the FHFA to improve the housing finance system broadly through our efforts to develop, as an example, the common securitization platform and the single security.

Now let me turn to our multifamily business. We had another very good year in multifamily.

We provided more than $28 billion in funding to the rental market in 2014, up 10% from the prior year, the second-largest year for multifamily purchases in the company's history. Our share of the multifamily GSE market was up over the level from 2013.

Importantly, approximately 90% of the rentals we funded were affordable to families earning up to the area median income.

We continue to grow this business, whose fundamentals are strong, with delinquency rate near 0 and a very capital- and thus taxpayer-efficient business model, which the vast majority of the expected credit losses for new loans is laid off to private capital markets. This is done through our well-known K-Deal structure.

We did 17 of them last year.

Last year also, after obtaining certain regulatory approvals, we expanded into several underserved market segments. Most noteworthy would be loans aimed at apartments with small numbers of units, which comprised almost 1/3 of the market and which are particularly intensive of affordable characteristics.

There's lots of momentum in multifamily and we expect to have another year of strong growth in 2015 if the market overall stays robust, which it, in fact, has so far this year.

Finally, a few words on the investment segment. We reduced the investments portfolio by nearly $53 billion last year, in line with the mandates to us from the government, with the majority of that reduction being a what we call less liquid assets, which tend to have the most risk.

$15.9 billion of the amount was sales of PLS and commercial mortgage-backed securities and part of the reduction was also through more accretive transactions. This included a pilot transaction of the sale of $600 million in nonperforming loans, which was well received by the market.

We also did $7 billion in securitizations of reperforming and modified loans, which we had taken onto our books. This work is paying dividends to the taxpayer and so we plan to continue to be smart in reducing both the size and legacy risk of the portfolios in ways that make economic sense for the taxpayer.

Let me conclude by saying that Freddie Mac had a very good year in 2014 and are proud of the progress we continue to make. We entered into 2015 with strong momentum and we're even better positioned to serve our customers, the market and millions of home buyers and renters in a taxpayer-friendly fashion.

I'll now open it up to your questions.

I was wondering if you could talk a little bit more about the significance of the volatility in your derivative investments, whether or not the results are due to an accounting mismatch. If that, that determines the amount of money that you pay to treasury or don't -- or take from treasury every quarter?

I'm wondering whether you're concerned that similar volatility could cause you all to need a draw in future quarters from treasury? And is this an argument for whether they should allow you guys to hold more capital or to rebuild capital?

Let me try to parse that out, Clea. It's Don Layton.

First, you referred to derivatives investments. I don't like that phrase.

We don't invest in derivatives to just make a profit or something like that. We use derivatives to hedge away the interest rate risk that comes from the business we're in, both the legacy assets and our ongoing businesses.

We could choose other ways to hedge, as I've mentioned, but the other ways have 2 negatives. One, they are more expensive, which is bad for taxpayer and profits; and #2, we have this real problem, a lot of the derivatives are used to help extend our liabilities to match the legacy investment assets in a retained portfolio, which we are selling in a regular way over the next several years in accordance with government mandates to do so.

If we sold the investments, we would then be left with the liability. If we issued long-term debt, we wouldn't have anything to do with that debt and that would be a problem.

So we like the flexibility that when it happens, we can just remove the derivatives and we're done with it. So the reasoning to do this is all very straight and straight-up business and perfectly reasonable [ph] .

The accounting problem is, as we state multiple times and I went through to describe, it's considered generally a "timing mismatch" because over the long run, the economics which we manage too, and the accountings generally converge. But in any one quarter, it can be quite volatile as we've shown.

Now we've seen probably some of the most volatile U.S. Treasury markets of late that we've experienced in quite a long time.

And interestingly enough, rates are very low these days and over the next few years, general expectation would be for them to rise. We actually have the accounting mismatch in our favor when rates go up.

It's against this when rates went down but as everyone knows, unexpectedly they went down a lot through the end, not just generally through 2014, but particularly concentrated in the fourth quarter. So it just is what it is.

I should note the large decline in the fourth quarter was such that we ended up with a small profit. So even the big decline did not wipe out our earnings.

Technically for us to have a draw, which is the last part of your question, we did -- would have to not only have lost money but to go through the reserve, the cushion that we have, before we would need a draw. The cushion going -- it now that we're in -- last year was $2.4 billion and you can see there's a long way between the small profit we had after a giant interest-rate decline and then losing so much more that you'd end up chewing up the $2.4 billion.

I would note the $2.4 billion declines. This year in 2015, it's now $1.8 billion.

So the odds of this being pierced to cause a draw are not 0 in theory, but are -- we consider it low. As we look forward, the amount of the reserve does decline so the issue of, would it be big enough to cause a draw does get concerning, ameliorating that is the amount of things we have to hedge will decline as we shrink the retained portfolio.

So we have a little bit of a footrace between a declining reserve and a declining usage of derivatives over the next few years. And that's where we stand.

We absolutely do not comment on topics such as you brought up about the lawsuits or things like that in line with what Sharon introduced earlier.

So on the -- just on the derivatives issue, how much more would -- I guess, one, what rates or rate exactly are you hedging against and to what would that have had to fall last year for you to actually trigger -- not trigger a draw but to have a loss?

Okay. First of all, the bulk of our hedging, to simplify it, core of the hedging is issuing shorter-term debt and extending its maturity by going short interest-rate derivatives, okay?

To create a synthetic long liability to match the long assets in the retained portfolio. That is the bulk of the hedging activity.

Because of the government support to us, our liabilities trade largely off of treasury rates, not totally but that's the easiest thing to look at. 5, 10-year treasury rates probably is the best thing for you to look at.

There's obviously some longer stuff, some shorter stuff. I'm looking at Jim MacKey here and figuring out if rates would have had declined how much more?

How much more would rates have had to decline?

Another, I want to say, 70 basis points.

On-the-fly, we're thinking about 70 basis points, but consider that an on-the-fly, seat-of-the-pants calculation.

Got it. And it sounds like -- and you said this already, but it sounds like that to calculate a treasury draw, the derivative issue is, I mean it is real, like if at some point when you're required to bring your capital down even further, I guess this derivative issue becomes a more and more of a problem that could trigger a draw?

In theory, it could trigger a draw. You would have to posit -- currently, you would have to posit say in 2015 very extreme rate moves and you can do the math at some point.

As the reserve cushion comes down, again I'll note, the need -- the usage of derivatives will also be declining because the assets we're hedging will be declining as they run off and we sell them off since we are required to shrink our investment portfolio in line with government mandates. If the portfolio this last year averaged about $450 billion or so, please remember we have to be under $250 billion about 4 years from now and the FHFA actually has targets to want us to have a cushion and be under the $250 billion even more.

Between 2's and 10's drop by 118 basis points during the year. I think the 30-year treasury ended the year roughly at near all-time lows.

So it's a pretty dramatic move. And you've seen equal moves the other way this year.

Right. That's why on Page 3 of the press release we showed you that even just over the 2 years, 2013 and '14, with the mark-to-market component of the interest rate derivatives, it was roughly 0.

That distinguishes the part of the derivatives losses which in fact, as I indicated, is really just the economic equivalent of extra interest expense.

I just wanted to quickly clarify one point on the derivatives and then ask about guarantee fees. The $3.4 billion hit you took on derivative losses, can we assume that in the coming quarters, some of that could come back in the form of earnings and then discussing guarantee fees, there's talk that your regulators are going to do something with those soon and I'm just wondering if they cut guarantee fees how will that affect your income going forward?

Okay, 2 separate topics. The answer is the derivatives, we will have that interest carry, that extra interest carry, that was the economic equivalent of an extra interest expense, that should be there, relatively stable and slightly declining amounts, over time as we use less derivatives, but the mark-to-market component is totally a reflection of interest rate moves.

If interest rates go down, we'll have losses. If interest rates go up, we will have gains.

It's just accounting entries. So yes, it is possible entirely that you will see gains coming in that number.

That's #1. And #2, in terms of the guarantee fees, the FHFA announced, I believe, the head of the -- Mel Watt, the Director of the FHFA, I believe, in congressional testimony indicated that they would make an announcement about guarantee fees probably by the end of the first quarter or somewhere pretty close to that.

So we will await that. How do guarantee fees work into our earnings is your real question.

Guarantee fees are established at the purchase of the loan and the sale -- put the loan into security. So guarantee fees are on new stuff only.

So it has a very slow increase or decrease effect on what we report as our average guarantee fees. In fact, if you kept guarantee fees where they are now with no change, our average we report would slowly climb as legacy and older assets run off the books.

So you're not going to see much change in the short run at all. Maybe we can do some math for you, but given how large the book is and such and that we are not in a giant refi boom, our license [ph] is being paid off and put on new guarantee fees, especially in a rising rate environment, if we get to that, you're going to see slow changes to the book.

Okay?

I wanted to ask, to what degree does the network calculation used to calculate the draws wash out some of the GAAP issues with the derivatives? And it looks like other comprehensive income where I would expect to see some amount of the offset for the GAAP derivative losses was basically flat during the quarter or 0 at the quarter.

Where are -- so if it's not flowing through there, where are the other places it's not flowing through, sort of the offset, economic offset?

The preferred stock purchase agreement, which is the legal document that controls draws and paying money back to the Treasury is keep 100% of comprehensive income lest [ph] -- it can't be allowed reserve or cushion, which we've talked about. That's why we tend to focus on comprehensive income, whereas the -- most companies tend to focus primarily on net income, okay?

I think your question -- we'll have Jim, who is a CPA, also answer it, is why is this item not part of AOCI, which is the difference between net income and comprehensive income. Is that what you're asking?

It's why -- well, why is there not a -- what's being hedged, why isn't that flowing through AOCI at least [indiscernible]

What you're seeing through OCI is the mark-to-market on the investment portfolio and during the fourth quarter, there was very little change in credit spreads from the beginning of the quarter to the end of the quarter. So you really didn't see any positive or negative movement in OCI.

During the third quarter, to contrast, there was a -- credit spreads improved dramatically and you saw gains. So you're seeing -- that's just the unrealized, think about it as the unrealized mark-to-market on those positions.

On spreads, not prices, essentially?

Well, it's all of the above. But if you think about it, if credit spreads improved, the prices improve.

Let me get it in a different way. We accept the credit spread risk on the assets.

We have it. These are legacy assets, we have it.

The assets did not change in value much. That's a combination of interest rates going down and the credit spreads technically went up a little bit so that the yield was roughly flat.

And [indiscernible] change the AOCI.

Anyway, expect over time spreads would be up and down, but obviously, yes.

No promises.

Also, it looks like in the last 10 months of the year or so, last year you guys kind of stabilized the agency MBS part of the portfolio. We've talked about some of this a little bit, Don, but I was curious how much of -- what was sort of the thinking behind that and how much of the derivative use is coming in that area and if you took that down faster, would it be less and lead to less volatility in earnings.

The derivative use is mainly related to the legacy retained investment portfolio where we have to cover the long-term interest rate of those PLS and CMBS and others and the long maturities of the modified or defaulted loans we own. That's our -- one of our biggest assets.

We currently have a portfolio, I'm trying to think about, $70 billion of the loans we have bought out of securitizations to honor our guarantee to the agency MBS investors. So you're not -- though this is not related to -- this is not primarily related to the liquid investment securities that your question was on.

In fact, one of -- just as a side -- an educational side, the modification programs being done for these loans make their maturities lengthen to be very long and create even more need for us to have long funding synthetically with derivatives to hedge them. It's one of our -- been our biggest issues of late.

Though it's not tied heavily to the liquid investment securities. Liquid investment securities are a combination -- we don't manage to quote the grand total of liquid securities.

We have various components. Some of them are, for example, where we resecuritize reperforming or modified loans and we often hold those for a while for example, until they have a history of performance and are more acceptable in the open markets.

Things like that. Generally just helping keeping inventory around of a small percentage of our liabilities, so we can help keep clean trading on the liabilities in our agency MBS, being a little bit of a bid when the market's weak and sail when the market's strong.

Things like that. And it comes out where it is.

Don Layton, I'll do it. Thank you for listening.

There's been obviously a lot of focus on the derivatives accounting. I wish accounting were more tied to economics, but in this case it's not.

We do run the company, especially as we're in conservatorship, not in your classic focus on share price and therefore net income. We focus more in the economics.

As we said, we think that's appropriate given the taxpayers orientation, not to be short-term earnings but long-term value in terms of their support of us being paid in -- for full value in the long run. But the business of the company is going extremely well.

We are executing well in single-family and doing much better than we've previously done. We're doing great in multifamily and we're setting the pace for how to take a complicated investment portfolio and get value for it as it's run down so the taxpayer gets full value.

So thank you for listening and have a nice day.