Looking back, the housing industry is totally Scrooged

Looking back, the housing industry is totally Scrooged

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Investments

Freddie Mac income and revenue down

Decline driven by falling settlement income, derivative changes

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Freddie Mac reported net income of $1.4 billion for the second quarter of 2014, compared to $4 billion for the first quarter of 2014, with the sharp drop driven primarily by lower income from legal settlements related to private-label securities. Fannie Mae also reported second quarter earnings this morning.

The GSE also reported comprehensive income of $1.9 billion for the second quarter of 2014, compared to $4.5 billion for the first quarter of 2014.

The GSE’s net income was $1.4 billion for the second quarter of 2014, down $2.7 billion from the first quarter of 2014.

Today’s earnings report comes on the two-year anniversary of the “third amendment sweep” which obligated the GSEs – Freddie and Fannie Mae (which also reported 2Q earnings Thursday) pay all of their future profits to the Treasury as dividends.

At the time of the third amendment, the U.S. Treasury had purchased $187.5 billion in senior preferred stock to prevent the GSEs from becoming insolvent. The GSEs were paying a 10 percent per year dividend on this stock, with the payment of dividends through 2011 funded by additional Treasury purchases of senior preferred stock.

Federal Housing Finance Agency Director Mel Watt has the statutory power to end this arrangement, which is what retail investors shut out of their own investments want, but he has expressed no interest in that. (Read HousingWire’s exclusive, first interview with Watt and his plans at the FHFA here. Subscription required but worth it.)

Click to enlarge the graphic.

The impact of lower legal settlements in the second quarter of 2014 was partially offset by a shift to a benefit for credit losses primarily reflecting improved single-family loss severity and lower losses from derivatives driven by less yield curve flattening in the second quarter compared to the first quarter.

Freddie Mac’s comprehensive income was $1.9 billion for the second quarter of 2014, down $2.6 billion from the first quarter of 2014.

The decrease was primarily driven by lower quarterly net income.

Freddie Mac’s earnings may be volatile due to changes in the fair value of the company’s derivative portfolio, which is used to reduce Freddie Mac’s exposure to interest-rate risk.

Fair value changes on derivatives are included in earnings, while fair value changes associated with several of the types of assets and liabilities being hedged are not. Therefore, there can be timing mismatches affecting current period earnings, which may not be reflective of the economics of the company’s business. In addition,

Freddie Mac and the Federal Housing Finance Agency continued to reach agreements with a number of institutions to settle litigation related to Freddie Mac’s investment in certain PLS.

These settlements contributed $0.4 billion to Freddie Mac’s pre-tax income in the second quarter of 2014, compared to $4.5 billion in the first quarter of 2014. Additionally, Freddie Mac’s settlements of representation and warranty claims had minimal impact on the company’s pre-tax income in the second quarter of 2014, compared to a benefit of $0.3 billion in the first quarter of 2014.

Additionally, the company’s 2013 and 2014 financial results included legal settlements of both PLS litigation and representation and warranty claims. Freddie Mac’s financial results in these periods, particularly the level of loan loss provisioning, also benefited significantly from strong home price appreciation, which is moderating. In addition, declines in the size of the company’s mortgage-related investments portfolio, as required by FHFA and the Purchase Agreement with Treasury, will reduce earnings over time.

Freddie Mac has been operating under conservatorship, with FHFA as conservator, since September 6, 2008. The support provided by Treasury pursuant to the Purchase Agreement enables the company to maintain access to the debt markets and have adequate liquidity to conduct its normal business operations.

Based on Freddie Mac’s net worth of $4.3 billion at June 30, 2014, less the 2014 capital reserve amount of $2.4 billion, the company’s dividend obligation to Treasury in September 2014 will be $1.9 billion. Including the September 2014 dividend obligation, Freddie Mac’s aggregate cash dividends paid to Treasury will total $88.2 billion, $16.8 billion more than cumulative cash draws of $71.3 billion received from Treasury through June 30, 2014. Under the Purchase Agreement, the payment of dividends does not reduce the outstanding liquidation preference. Accordingly, Treasury still maintains a liquidation preference of $72.3 billion on the company’s senior preferred stock as of June 30, 2014.

In August 2012, the terms governing the company’s dividend obligations on the senior preferred stock were amended. The amended Purchase Agreement does not allow the company to build capital over the long term. Beginning in 2013, the required senior preferred stock dividends each quarter equal the amount, if any, by which the company’s net worth as of the end of the preceding quarter exceeds an applicable capital reserve amount. The applicable capital reserve amount is $2.4 billion for 2014, and will be reduced by $600 million each year thereafter until it reaches zero on January 1, 2018.

The amount of remaining funding available to Freddie Mac under the Purchase Agreement with Treasury is currently $140.5 billion, and will be reduced by any future draws.

Freddie Mac is not permitted to redeem the senior preferred stock prior to the termination of Treasury’s funding commitment under the Purchase Agreement, which as noted Watt has the power to do.

In September 2012, Freddie Mac began remitting proceeds to Treasury from the 10 basis point guarantee fee increase required by the Temporary Payroll Tax Cut Continuation Act of 2011. The cumulative expense related to this increase totals $1.0 billion, including $187 million in the second quarter of 2014.

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