Federal Home Loan Mortgage Corporation

Thank you. Good morning, everyone, and thank you for joining us as we discuss Freddie Mac's first quarter 2015 financial results.

We're joined today by the company's Chief Executive Officer, Don Layton; Chief Financial Officer, Jim MacKey; and General Counsel, Bill McDavid. 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.

The description of these factors can be found in the company's 10-Q report filed today. As a company in conservatorship, Freddie Mac's commentary will be limited to business and market topics.

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 they will have the ability to ask questions. [Operator Instructions] This call is being recorded, and a replay will be made available on Freddie Mac's website later today.

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

Good morning, and thanks for being with us today. I'll keep my remarks relatively limited since I want to make sure we have adequate time to answer your questions.

I have 3 areas I want to cover with you this morning. First, I'm going to make 2 key observations on the quarter to provide context to my remarks; second, I'll give a quick summary of our financial results; and third, some first quarter business highlights, including our progress in building both a better company and a better mortgage industry.

So let me start with those 2 key observations. The first thing you probably noticed is that the first quarter of 2015 looks a lot like the fourth quarter of 2014.

We again had solid underlying earnings which were partially offset by mark-to-market volatility and timing-related items. As I said last quarter, much of this is simply accounting and does not reflect the underlying economics of our business.

The important things to take away are that we are continuing to be profitable on a GAAP basis despite the accounting noise, and the underlying economics are even better than the GAAP accounting numbers.

Second, my second observation is that the fundamentals of our business are strong and improving. Most of the cyclical recovery items of the past are behind us, things such as settlements, DTA, et cetera.

We are now seeing our hard work in the proposed crisis strategies of the company and of the FHFA, translating into a sustainable business model moving forward with an appropriate level of profitability. In fact, we have strong momentum across all 3 of our businesses.

I'll share those highlights with you in a moment.

With that backdrop, let me move right into my second topic, our financial results. We had another solid financial quarter, reporting net income of $524 million and comprehensive income, which is the more important measure for us while in conservatorship, of $746 million.

Our results were driven by net interest income, which includes the guarantee fees of the single-family business of $3.6 billion, which helped steady this quarter despite shrinking the retained portfolio to meet government requirements as well as the shared assets at economically attractive prices.

Importantly, we are seeing noticeable net interest income growth related to our single-family guarantee business as more recent and higher GC levels work their way into our total portfolio. This provides an offset in the quarter to the decline of the net interest income on the retained portfolio, which, of course, is shrinking by design as required.

But we continued to be materially impacted by noise as timing-related differences in our financial results, which are, of course, are reported on a GAAP basis, do not reflect the underlying economics of our business in any single quarter or year.

Let me point out 3 such notable items. First, during the quarter, we had derivative losses of $2.4 billion.

Of this amount, $1.8 billion represented mark-to-market, i.e. timing-related losses as interest rates declined another 26 basis points in the quarter and the yield curve flattened.

Second, we also had about $192 million of mark-to-market losses on STACR bonds, which are accounted for in a fair value basis versus a gain of $163 million last quarter. Just as with derivatives, the timing mismatch here is that the STACR bonds are mark-to-market, but the guarantee book those bonds hedge is not similarly mark-to-market.

And third, we reclassified $3.6 billion of nonperforming loans be held-for-sale as we now have the intent to sell part of the nonperforming loan portfolio. During the quarter, we executed 2 such transactions totaling approximately $1.4 billion.

While our strategy to sell nonperforming loans makes much sense from an economic that is cost-of-capital perspective, it does result in quite a bit of noise within the line items of our income statement that is where things appear. However, it had only a small net P&L impact.

Add it all up and our net worth was $2.5 billion at the end of the quarter. After allowing for the current $1.8 billion capital reserves specified in the preferred stock purchase agreement, we will therefore be returning an additional $746 million to the taxpayers in the second quarter, bringing our cumulative total dividend paid to the U.S.

Treasury to more than $92 billion or about $21 billion more than we received in draws earlier.

Now let me turn to our third topic, Freddie Mac's strong and improving business fundamentals. First up are the highlights from the single-family business, our largest.

First and foremost was our progress against our mission to bring liquidity to the housing market, which we did by helping more than 350,000 families buy or refinance their home in the first quarter. This means we funded approximately 1 out of every 4 home loans originated in the country.

I'd note that we saw an increase in refi or refinance volume in the first quarter. It was nearly 2/3 of our business.

This was not surprising given the attractiveness of the quarter's very low interest rates. We're also doing all we reasonably can to support our customers and to responsibly expand access to credit for homebuyers.

As I said last quarter, there is no silver bullet that will ensure the full use of our credit box; instead, it will be a variety of specific and targeted efforts.

First is greater certainty for our lenders. The rapid warranty relief framework that we introduced to the market in the second half of last year is part of that equation.

It provides our customers with greater clarity on several key risks and thus hopefully limits the use of credit overlays that is extra restrictions by lenders. We're taking further steps towards that on that front, utilizing technology as well.

We're providing our customers with new tools to aid them in evaluating collateral, capacity and credit.

Second, our renewed dedication to serving the entire range of lenders, from the largest to medium-size to smaller, is not only helping us to broaden and diversify our customer base. Just as important, it is helping a broader range of customers get access to our full credit box since many small lenders target specific types of clients in specific communities to meet their needs and circumstances.

Finally, new offerings will also play a role. Our 3% down mortgage, which we introduced to the market just in March, gives lenders another option for responsibly serving those who simply do not have the savings for a larger down payment, such as first-time homebuyers.

While it's too early to assess its performance, initial activity is in line with our expectations. That is, we don't expect large volume for this product, but it's an important option for those borrowers to whom it is suited.

Taken together, we believe such strategies, with more to come as we work with the FHFA on many conservatorship scorecard items, will help facilitate lenders responsibly utilizing our full credit box.

Turning now to credit risk. Our new book-of-business, loans acquired since 2009, grew to 61% of the single-family book in the first quarter, and this does not include HARP and other relief refinancings which were another 20%, so that's 81% in total.

So that leaves only 19% as being a fully owned book of business. The addition of quality loans since the financial crisis, our work to generate positive NPV, net present value, through foreclosure alternatives and modifications, plus the passing of time as the economy has healed have worked together to drive down our single-family serious delinquency rate to 1.73%.

This is the lowest since January of 2009 and a drop of 47 basis points from the same period last year. I'd note it peaked at 4.20% in 2010.

Also importantly, we continue to innovate to shift more and more credit risk away from taxpayers and towards private capital. This is, of course, in line with many policymaker proposals on the future of mortgage finance.

In April, we introduced a first-of-its-kind STACR transaction, where credit losses are based upon actual losses versus our previous fixed severity loss structure. This was a planned evolution of the product to better align the protection we are getting from the private capital markets with the actual losses we may incur regardless of whether they are higher or lower than the fixed severity calculation.

It has the added advantage of avoiding the requirement for mark-to-market accounting on our books, which I discussed earlier, and thus will minimize accounting volatility around these transactions going forward. This actual loss transaction was in fact our third STACR deal this year and was one that was upsized from about $720 million to just over $1 billion due to market demand.

In total, we've done more than $10 billion in STACR debt note and ACIS reinsurance transactions, laying off a portion of the credit losses on $282 billion UPB on single-family mortgages. That's a lot.

At the same time, we continue to work with the FHFA to strengthen the housing industry through such initiatives as the single security, the common securitization platform and the just announced eligibility standards for private mortgage insurers.

Now let me turn to our multifamily business. The strength of our multifamily business is continuing unabated.

We provided more than $10 billion in liquidity to the rental market during the first quarter, one of our best quarters ever for new volume. Importantly, approximately 90% of the rentals we funded were affordable to families earning up to the area of median income.

This reflects our emphasis on workforce rather than luxury housing.

We introduced a new small balance loan initiative in the fourth quarter of last year to responsibly serve such borrowings, and it is gaining traction. We now have 7 lenders participating in this new offering to fund department buildings with a relatively small number of units.

They comprise almost 1/3 of the market and are particularly intensive of affordable units. We also introduced a 55-day PC, backed by a $17 million multifamily mortgage loan.

This is a good outlet for the small amount of loans that are not includable in the K-Deal program and transforms an otherwise illiquid asset into a liquid one. We plan to do a few of these deals this year, subject to market conditions.

Overall, in the multifamily business, we continue to see solid demand, and the fundamentals of this business are extremely strong. And I want to emphasize and recall that the vast majority of our volume is financed via the industry-leading K-Deal structure, where the taxpayer is only exposed to catastrophic loss as the vast majority of the risk of credit losses is laid off to the private capital markets.

Such K-Deals are now a well-developed part of the multifamily financing market as we just passed a significant milestone and have now done more than $100 billion in K-Deal transactions since the program was launched in 2009.

Hereto, we continue to innovate, recently pricing our first 10-year floating rate K-Deal.

And finally, a few words on the investment segment. We did several important transactions in the investment business this quarter as we continued to reduce the retained portfolio in an economically sensible manner, including the less liquid asset classes which can be hard to dispose of at times.

For example, we executed our largest-ever nonperforming loan sale in the first quarter that had a UPB of $985 million. This came after working with FHFA to enhance the structure of such sales for improved outcomes for borrowers and communities.

To date, we've sold approximately $2 billion in nonperforming loans. In total, we reduced the portfolio in an economically sensible manner by almost $6 billion in the first quarter -- or $6 billion in less liquid assets during the quarter, which is very good news for taxpayers.

In closing, the strong momentum across our business is coupled with our work to run a more competitive company, has enabled us to do an even better job of serving our customers and the nation's homebuyers and renters. I continue to feel good about our progress and about our work to move the housing finance markets forward.

I will now open for questions.

I was curious how you're thinking about the -- with the GAAP volatility in the income. How are you thinking about maintaining positive GAAP earnings versus doing what's overall best for the company economically over time?

That is a very interesting question, something we grapple with. We start with the presumption that we will do what is best economically without regard to GAAP accounting.

So far, we've been able to run the company without trimming that to reflect GAAP accounting. We do sensitivity analysis on the volatility to give ourselves good confidence that we would still have positive earnings and even in very extreme circumstances, would not today, have a draw under the PSPA given the current $1.8 billion capital reserve.

Depending upon a lot of moving parts, the balance sheet shrinkage, prices of different things and the over time shrinkage of the capital reserve in the PSPA, we might actually begin to do things that would be GAAP-oriented rather than economically oriented, but -- and we study that constantly, but we have not gotten there yet.

Just actually, I had a multifamily question. You mentioned the business is pretty robust this quarter by a lot actually, and I was wondering if considering the, I mean, the rental crisis going on, do you think there is room to remove those caps that have been placed on you, considering that you're able to lay off so much risk?

The -- just as background, there is -- most of the business is considered to be under the cap. The cap is $30 billion for 2015 for both GSEs, and there are several categories of multifamily loans that are considered uncapped for various reasons.

We consider them target-affordable for underserved categories as defined by the FHFA. We're aware that the industry and others have gone to the FHFA and talked about the cap possibly being a problem because the market is so high.

And if the GSEs did not keep up with some sort of notion of attritional market share, it might be providing too much pressure in the market. The FHFA has heard that.

They've collected information from us and Fannie Mae, and they're taking it under consideration.

Do you know when they might make a decision on that?

That's up to them.

When we spoke about 6 months ago, or probably longer, you were talking...

Hey, Brian...

Brian...

Brian, we can hardly hear you. You'll have to get closer to the microphone.

Okay. Sorry.

We spoke about 2 quarters ago, about just trying to make the single-family more profitable than the multifamily. I was -- these numbers here don't look that good.

I was wondering if this is just an aberration? Or are we going to see improved profitability from the single-family back here?

I'll turn that over to Jim MacKey, our Chief Financial Officer.

Yes, I would say on an operating basis, the single-family business was roughly flat quarter-over-quarter. Don mentioned a couple of the accounting noise items during the quarter and those hit the single-family business particularly hard, in particular, the mark-to-market on the STACR risk transfer transactions.

And there were some noise related to the movements of our nonperforming loans from held-for-investment to held-for-sale. So if you back those out, the segment was flat.

Well, okay. Well, this is going to be continuing, right?

These transactions?

These transactions will continue, but as Don mentioned on the STACR debt, we move to a new structure for actual losses. So over time, there will be less volatility in that.

And while there is timing noise related to when we move nonperforming loans from held-for-investment to held-for-sale, the economics -- the true economics on those trades are very positive from a capital perspective. So over time, it's accretive to earnings and the capital.

All right. Thank you.

We -- again, we had what we consider a very good quarter in showing the business fundamentals of Freddie Mac being rebuilt, be a good sustainable business model in our guarantee businesses, and we continue to be, we think, a good steward of the taxpayer's money. So that, other than that, I'll talk to you next quarter.

Thank you.