CONSOLIDATED RESULTS OF OPERATIONS You should read this discussion of our consolidated results of operations in conjunction with our consolidated financial statements and accompanying notes. We have two primary sources of revenue: n Net interest income - primarily consists of the guarantee fees from our
single-family credit guarantee portfolio and the net interest income from our
investments portfolio.
n Guarantee fee income - primarily consists of the guarantee fees from our
multifamily guarantee portfolio.
We also earn revenue from (a) realized and unrealized gains (losses) on mortgage loans and investment securities and the debt and derivatives we use to fund and hedge them, which are primarily recognized in investment gains (losses), net, and may fluctuate significantly from period-to-period based on the volume and nature of our investment, funding, and hedging activities and changes in market conditions, such as interest rates and market spreads; and (b) fees that we charge to our single-family and multifamily sellers and servicers, which are recognized in other income. Our primary expense items consist of credit-related expenses and operating expenses. Credit-related expenses consist of (a) provision for credit losses, which primarily represents probable incurred losses on our mortgage loans held-for-investment; (b) REO operations expense, which represents expenses related to foreclosed properties; and (c) credit enhancement expense, which represents the costs we incur to transfer credit risk to third-party investors under freestanding credit enhancements. Operating expenses consist of administrative expenses, the 10 basis point fee related to the Temporary Payroll Tax Cut Continuation Act of 2011, and other expenses we incur to run the business. The table below compares our consolidated results of operations for the past three years. Certain amounts in prior periods have been reclassified to conform to the current presentation. See Note 1 for additional information about the prior period reclassifications. Table 2 - Summary of Consolidated Statements of Comprehensive Income (Loss)
Year Over Year Change
Year Ended December 31, 2019 vs. 2018 2018 vs. 2017 (Dollars in millions) 2019 2018 2017 $ % $ % Net interest income$11,848 $12,021 $14,164 ($173 ) (1 )% ($2,143 ) (15 )% Guarantee fee income 1,089 866 749 223 26 117 16 Investment gains (losses), (1,103 ) (57 ) 761 66 net 818 1,921 1,160 Other income (loss) 323 762 4,984 (439 ) (58 ) (4,222 ) (85 ) Net revenues 14,078 15,570 21,057 (1,492
) (10 ) (5,487 ) (26 )
Benefit (provision) for 746 736 84 10 1 652 776 credit losses Credit enhancement expense (708 ) (417 ) (280 ) (291 ) (70 ) (137 ) (49 ) REO operations expense (229 ) (169 ) (189 ) (60 ) (36 ) 20 11 Credit-related expense (191 ) 150 (385 ) (341 ) (227 ) 535 139 Administrative expense (2,564 ) (2,293 ) (2,106 ) (271 ) (12 ) (187 ) (9 ) Temporary Payroll Tax Cut Continuation Act of 2011 (1,617 ) (1,484 ) (1,340 ) (133 ) (9 ) (144 ) (11 ) expense Other expense (657 ) (469 ) (392 ) (188 ) (40 ) (77 ) (20 ) Operating expense (4,838 ) (4,246 ) (3,838 ) (592 ) (14 ) (408 ) (11 ) Income before income tax 9,049 11,474 16,834 (2,425 ) (21 ) (5,360 ) (32 ) (expense) benefit Income tax (expense) (1,835 ) (2,239 ) (11,209 ) 404 18 8,970 80 benefit Net income (loss) 7,214 9,235 5,625 (2,021 ) (22 ) 3,610 64 Total other comprehensive income (loss), net of taxes and 573 (613 ) (67 ) 1,186 193 (546 ) (815 ) reclassification adjustments Comprehensive income (loss)$7,787 $8,622 $5,558 ($835 ) (10 )%$3,064 55 % See Critical Accounting Policies and Estimates for information concerning certain significant accounting policies and estimates applied in determining our reported results of operations and Note 1 for information on our accounting policies and a summary of other significant accounting policies and the related notes in which information about them can be found.
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Management's Discussion and Analysis Consolidated Results of Operations
Net Revenues Net Interest Income -------------------------------------------------------------------------------- Net interest income consists of guarantee portfolio net interest income, investments portfolio net interest income, and income (expense) from hedge accounting. n Guarantee portfolio net interest income - consists of two components:
l Guarantee fees we receive for managing the credit risk associated with the
mortgage loans held by consolidated trusts, which primarily consist of the
loans in our single-family credit guarantee portfolio. We record interest
income on loans held by consolidated trusts and interest expense on the
debt securities issued by the trusts. The difference between these amounts
represents the guarantee fee income we receive as compensation for our guarantee of the principal and interest payments of the issued debt securities. This difference includes the legislated 10 basis point increase in guarantee fees that is remitted toTreasury as part of the Temporary Payroll Tax Cut Continuation Act of 2011.
l Amortization of cost basis adjustments, such as premiums and discounts on
securitized mortgage loans, including upfront fees we receive when we acquire a loan, and debt securities of consolidated trusts. These cost
basis adjustments are amortized into interest income or interest expense
based on the effective yield over the contractual life of the associated
financial instrument. The amortization of loans and debt securities of consolidated trusts may vary significantly from period to period and is
primarily driven by actual prepayments on the underlying loans. Increases
in actual prepayments result in a higher rate of amortization, while
decreases in actual prepayments result in a lower rate of amortization.
The timing of amortization of loans may differ from the timing of
amortization of the securities backed by the loans, as the proceeds from
the loans backing these securities are remitted to the security holders at
a date subsequent to the date these proceeds are received by us.
n Investments portfolio net interest income - consists of two components:
l The difference between the interest income earned on the assets in our
investments portfolio and the interest expense incurred on the liabilities
used to fund those assets, including interest expense related to CRT debt (STACR debt notes and SCR debt notes).
l Amortization of cost basis adjustments, such as premiums and discounts on
unsecuritized mortgage loans, investments securities, other assets, and
other debt, which are amortized into interest income or interest expense
based on the effective yield over the contractual life of the associated
financial instrument.
n Income (expense) from hedge accounting - consists of two components:
l Upon adoption of amended hedge accounting guidance in 4Q 2017, fair value
changes for the hedging instrument, including the accrual of periodic cash
settlements, fair value changes for the hedged item attributable to the risk being hedged for qualifying fair value hedge relationships, and amortization of hedge accounting related basis adjustments. See Note 9 for additional detail on hedge accounting.
l Deferred gains and losses on closed cash flow hedges related to forecasted
debt issuances that are reclassified from AOCI to net interest income when
the related forecasted transaction affects net interest income.
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Management's Discussion and Analysis Consolidated Results of Operations
The table below presents the components of net interest income. Table 3 - Components of Net Interest Income
Year Over Year Change
Year Ended December 31, 2019 vs. 2018 2018 vs. 2017 (Dollars in millions) 2019 2018 2017 $ % $ % Guarantee portfolio net interest income: Contractual net interest income$3,767 $3,457 $3,270 $310 9 %$187 6 % Net interest income related to the Temporary Payroll Tax Cut Continuation Act of 2011 1,590 1,438 1,314 152 11 124 9 Amortization 2,436 2,900 3,258 (464 ) (16 ) (358 ) (11 ) Total guarantee portfolio net interest income 7,793 7,795 7,842 (2 ) - (47 ) (1 ) Investments portfolio net interest income: Contractual net interest income 6,004 6,556 7,227 (552 ) (8 ) (671 ) (9 ) Amortization (593 ) (305 ) (78 ) (288 ) (94 ) (227 ) (291 ) Interest expense related to CRT debt (1,104 ) (1,094 ) (834 ) (10 ) (1 ) (260 ) (31 ) Total investments portfolio net interest income 4,307 5,157 6,315 (850 ) (16 ) (1,158 ) (18 ) Income (expense) from hedge accounting (252 ) (931 ) 7 679 73 (938 ) (13,400 ) Net interest income$11,848 $12,021 $14,164 ($173 ) (1 %) ($2,143 ) (15 %) Key Drivers: n Guarantee portfolio contractual net interest income
l 2019 vs. 2018 and 2018 vs. 2017 - Increased primarily due to the continued
growth of the core single-family loan portfolio.
n Guarantee portfolio amortization
l 2019 vs. 2018 and 2018 vs. 2017 - Decreased primarily due to the timing
differences in amortization related to prepayments between debt of
consolidated trusts and the underlying mortgage loans, partially offset by
increases in amortization of upfront fees.
n Investments portfolio contractual net interest income
l 2019 vs. 2018 - Decreased primarily due to the lower and flatter interest
rate environment, coupled with a change in our investment mix as the other
investments portfolio represented a larger percentage of our total investments portfolio.
l 2018 vs. 2017 - Decreased primarily due to the continued reduction in the
balance of our mortgage-related investments portfolio, pursuant to the portfolio limits established by the Purchase Agreement and FHFA. See Conservatorship and Related Matters - Limits on Our Mortgage-Related Investments Portfolio and Indebtedness for additional discussion of the limits on the mortgage-related investments portfolio.
n Investments portfolio amortization
l 2019 vs. 2018 and 2018 vs. 2017 - Decreased primarily due to lower amortization related to unsecuritized mortgage loans, as certain of those loans were reclassified from held-for-investment to held-for-sale and ceased amortizing, and lower accretion of previously recognized other-than-temporary impairments, due to a decline in the population of impaired securities.
n Interest expense related to CRT debt
l 2019 vs. 2018 - Remained relatively flat as higher short-term interest
rates were offset by a decline in volume as we no longer issue STACR debt notes on a regular basis. l 2018 vs. 2017 - Increased primarily due to higher STACR debt yield as short-term interest rates increased combined with a higher average balance.
n Income (expense) from hedge accounting
l 2019 vs. 2018 - Increased primarily due to a positive earnings mismatch
and lower expense related to accruals of periodic cash settlements on
derivatives in hedging relationships, partially offset by amortization of
hedge accounting-related basis adjustments. The earnings mismatch is the
amount by which the gain or loss on the designated derivative instrument
does not exactly offset the gain or loss on the hedged item attributable
to the hedged risk.
l 2018 vs. 2017 - Affected primarily by the inclusion of fair value hedge
accounting results within net interest income beginning in 4Q 2017, due to
the adoption of amended hedge accounting guidance. In prior periods, this activity was included in other income and derivative gains (losses).FREDDIE MAC | 2019 Form 10-K 19
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Management's Discussion and Analysis Consolidated Results of Operations
Net Interest Yield Analysis -------------------------------------------------------------------------------- The table below presents an analysis of interest-earning assets and interest-bearing liabilities. To calculate the average balances, we generally use a daily weighted average of amortized cost. When daily average balance information is not available, such as for mortgage loans, we use monthly averages. Mortgage loans on non-accrual status, where interest income is generally recognized when collected, are included in the average balances. Table 4 - Analysis of Net Interest Yield Year Ended December 31, 2019 2018 2017 Interest Interest Interest Average Income Average
Average Income Average Average Income Average (Dollars in millions)
Balance (Expense) Rate
Balance (Expense) Rate Balance (Expense) Rate
Interest-earning assets:
Cash and cash equivalents
45,360 880 1.94 57,883 588 1.02 agreements to resell Secured lending 2,933 104 3.55 1,350 35 2.58 859 21 2.42 Mortgage-related securities: Mortgage-related 132,735 5,761 4.34 143,424 6,026 4.20 164,663 6,402 3.89 securities Extinguishment of debt securities of consolidated (85,407 ) (3,524 ) (4.13 ) (88,757 ) (3,437 ) (3.87 ) (87,665 ) (3,264 ) (3.72 ) trusts held byFreddie Mac Total mortgage-related 47,328 2,237 4.73 54,667 2,589 4.74 76,998 3,138 4.08 securities, net Non-mortgage-related 22,776 500 2.19 18,955 446 2.35 17,558 277 1.58 securities Loans held by consolidated 1,882,802 64,927 3.45 1,799,122 61,883 3.44 1,730,000 58,746 3.40 trusts(1) Loans held by Freddie 86,973 3,656 4.20 98,005 4,154 4.24 117,043 4,989 4.26 Mac(1) Total interest-earning 2,108,202 72,895 3.46 2,024,648 70,054 3.46 2,011,306 67,807 3.37 assets Interest-bearing liabilities: Debt securities of consolidated trusts 1,907,818 (57,504 ) (3.01 ) 1,826,429 (54,966 ) (3.01 ) 1,753,983 (50,920 ) (2.90 ) including those held by Freddie Mac Extinguishment of debt securities of consolidated (85,407 ) 3,524 4.13 (88,757 ) 3,437 3.87 (87,665 ) 3,264 3.72 trusts held byFreddie Mac Total debt securities of consolidated trusts held 1,822,411 (53,980 ) (2.96 ) 1,737,672 (51,529 ) (2.97 ) 1,666,318 (47,656 ) (2.86 ) by third parties Other debt: Short-term debt 85,492 (1,910 ) (2.23 )
62,893 (1,193 ) (1.90 ) 72,071 (615 ) (0.85 ) Long-term debt
192,100 (5,157 ) (2.68 )
216,484 (5,311 ) (2.45 ) 264,354 (5,372 ) (2.03 ) Total other debt
277,592 (7,067 ) (2.55 ) 279,377 (6,504 ) (2.33 ) 336,425 (5,987 ) (1.78 ) Total interest-bearing 2,100,003 (61,047 ) (2.91 ) 2,017,049 (58,033 ) (2.88 ) 2,002,743 (53,643 ) (2.68 ) liabilities Impact of net non-interest-bearing 8,199 - 0.01 7,599 - 0.01 8,563 - 0.01 funding Total funding of$2,108,202 ($61,047 ) (2.90 )%$2,024,648 ($58,033 ) (2.87 )%$2,011,306 ($53,643 ) (2.67 )% interest-earning assets Net interest income/yield$11,848 0.56 %$12,021 0.59 %$14,164 0.70 %
(1) Loan fees, primarily consisting of amortization of upfront fees, included in
interest income were
held by consolidated trusts and
for loans held by
FREDDIE MAC | 2019 Form 10-K 20
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Management's Discussion and Analysis Consolidated Results of Operations
Net Interest Income Rate / Volume Analysis -------------------------------------------------------------------------------- The table below presents a rate and volume analysis of our net interest income. Our net interest income reflects the reversal of interest income accrued, net of interest received on a cash basis, related to mortgage loans that are on non-accrual status. Table 5 - Net Interest Income Rate / Volume Analysis Variance Analysis 2019 vs. 2018 2018 vs. 2017 (Dollars in millions) Rate Volume Total Change Rate Volume Total Change Interest-earning assets: Cash and cash equivalents$101 $19 $120 $45 ($26 )$19 Securities purchased under agreements to resell 170 234 404 443 (151 ) 292 Secured lending 17 52 69 1 13 14 Mortgage-related securities 194 (459 ) (265 ) 491 (867 ) (376 ) Extinguishment of debt securities of consolidated trusts held by Freddie Mac (220 ) 133 (87 ) (132 ) (41 ) (173 ) Total mortgage-related securities, net (26 ) (326 ) (352 ) 359 (908 ) (549 ) Non-mortgage-related securities (31 ) 85 54 146 23 169
Loans held by consolidated trusts 159 2,885 3,044
767 2,370 3,137 Loans held by Freddie Mac (34 ) (464 ) (498 ) (28 ) (807 ) (835 ) Total interest-earning assets 356 2,485 2,841 1,733 514 2,247 Interest-bearing liabilities: Debt securities of consolidated trusts including those held by (85 ) (2,453 ) (2,538 ) (1,902 ) (2,144 ) (4,046 ) Freddie Mac Extinguishment of debt securities of consolidated trusts held by Freddie Mac 220 (133 ) 87 132 41 173 Total debt securities of consolidated trusts held by third 135 (2,586 ) (2,451 ) (1,770 ) (2,103 ) (3,873 ) parties Other debt: Short-term debt (237 ) (480 ) (717 ) (665 ) 87 (578 ) Long-term debt (476 ) 630 154 (1,005 ) 1,066 61 Total other debt (713 ) 150 (563 ) (1,670 ) 1,153 (517 )
Total interest-bearing liabilities (578 ) (2,436 ) (3,014 )
(3,440 ) (950 ) (4,390 ) Net interest income ($222 )$49 ($173 ) ($1,707 ) ($436 ) ($2,143 ) Guarantee Fee Income
-------------------------------------------------------------------------------- Guarantee fee income relates primarily to multifamily securitizations. For additional details on our multifamily securitizations, see Our Business Segments - Multifamily - Products and Activities - Securitization and Guarantee Products. Guarantee fee income consists of the following: n Contractual guarantee fee - consists of the fees earned from guarantees
issued to third parties and securitization trusts that we do not consolidate.
n Guarantee obligation amortization - represents the amortization of our obligation to perform over the term of the guarantee.
n Guarantee asset fair value changes - represents the change in fair value of
our right to receive contractual guarantee fees. Because our multifamily
loans contain prepayment protection, decreasing interest rates generally
result in a higher guarantee asset fair value, with the opposite effect occurring when interest rates increase.FREDDIE MAC | 2019 Form 10-K 21
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Management's Discussion and Analysis Consolidated Results of Operations
The table below presents the components of guarantee fee income. Table 6 - Components of Guarantee Fee Income
Year Over Year Change
Year Ended December 31, 2019 vs. 2018 2018 vs. 2017 (Dollars in millions) 2019 2018 2017 $ % $ % Contractual guarantee fee$910 $810 $661 $100 12 %$149 23 % Guarantee obligation amortization 813 711 601 102 14 110 18 Guarantee asset fair value changes (634 ) (655 ) (513 ) 21 3 (142 ) (28 ) Guarantee fee income$1,089 $866 $749
Key Drivers : n 2019 vs. 2018 - Increased primarily due to the continued growth in our
multifamily guarantee portfolio, coupled with lower fair value losses on our
guarantee asset due to declining interest rates.
n 2018 vs. 2017 - Increased primarily due to the continued growth in our
multifamily guarantee portfolio, partially offset by increased fair value
losses on our guarantee asset due to rising interest rates.
Investment Gains (Losses), Net -------------------------------------------------------------------------------- The table below presents the components of investment gains (losses), net. Table 7 - Components of Investment Gains (Losses), Net
Year Over Year Change
Year Ended December 31, 2019 vs. 2018 2018 vs. 2017 (Dollars in millions) 2019 2018 2017 $ % $ % Mortgage loans gains (losses)$4,744 $746 $2,062 $3,998 536 % ($1,316 ) (64 %) Investment securities gains (losses) 389 (815 ) 935 1,204 148 (1,750 ) (187 ) Debt gains (losses) 201 720 151 (519 ) (72 ) 569 377 Derivative gains (losses) (4,516 ) 1,270 (1,988 ) (5,786 ) (456 ) 3,258 164 Investment gains (losses), net$818 $1,921 $1,160 ($1,103
) (57 %)
Mortgage Loans Gains (Losses) -------------------------------------------------------------------------------- Mortgage loans gains (losses) consists of the following: n Gains (losses) on certain mortgage loan purchase commitments - represents the
change in fair value between the commitment date and settlement date for
multifamily loan purchase commitments for which we have elected the fair
value option. n Gains (losses) on mortgage loans - includes changes in fair value on
held-for-sale loans, including loans for which we have elected the fair value
option, as well as any gains and losses on the sales of these loans.
Mortgage loans gains (losses) are affected by a number of factors, including: n Volume of held-for-sale single-family seasoned mortgage loans;
n Volume of multifamily loan purchase commitments and mortgage loans for which
we have elected the fair value option; and
n Changes in interest rates and market spreads.
FREDDIE MAC | 2019 Form 10-K 22
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Management's Discussion and Analysis Consolidated Results of Operations
The table below presents the components of mortgage loans gains (losses). Table 8 - Components of Mortgage Loans Gains (Losses)
Year Over Year Change
Year Ended December 31, 2019 vs. 2018 2018 vs. 2017 (Dollars in millions) 2019 2018 2017 $ % $ % Gains (losses) on certain loan purchase commitments$1,913 $777 $1,098 $1,136 146 % ($321 ) (29 )% Gains (losses) on mortgage loans 2,831 (31 ) 964 2,862 9,232 (995 ) (103 ) Mortgage loans gains (losses)$4,744 $746 $2,062 $3,998 536 % ($1,316 ) (64 )% Key Drivers: n 2019 vs. 2018 - Increased due to fair value gains on multifamily held-for-sale mortgage loans and commitments driven by a decrease in long-term interest rates and targeted price increases related to changing market conditions, coupled with a higher volume of sales of single-family seasoned loans. n 2018 vs. 2017 - Decreased due to fair value losses on multifamily mortgage loans and commitments as a result of spread widening and an increase in interest rates, coupled with higher fair value losses on single-family seasoned loans. Investment Securities Gains (Losses) -------------------------------------------------------------------------------- Investment securities gains (losses) primarily consists of fair value gains and losses recognized on trading securities and realized gains and losses on the sale of available-for-sale securities. Investment securities gains (losses) are affected by a number of factors, including changes in interest rates and market spreads and volume of sales of available-for-sale securities. Key Drivers: n 2019 vs. 2018 - Shifted to gains during 2019 primarily driven by higher gains on trading securities due to decreasing interest rates, partially offset by lower volume of sales at gains of non-agency mortgage-related securities. n 2018 vs. 2017 - Shifted to losses during 2018 primarily driven by higher losses on trading securities due to increasing interest rates and spread widening, combined with lower volume of sales at gains of non-agency mortgage-related securities. Debt Gains (Losses) -------------------------------------------------------------------------------- Debt gains (losses) consists of the following: n Fair value changes - includes the gains and losses on debt for which we have
elected the fair value option, primarily certain STACR debt notes.
n Gains (losses) on extinguishment of debt - represents the difference between
the consideration paid and the debt carrying value when we purchase debt
securities of consolidated trusts as investments in our mortgage-related
investments portfolio and when we repurchase or call other debt.
Debt gains (losses) are affected by a number of factors, including: n Changes in the market spreads between debt yields and benchmark interest
rates and
n Amount and type of debt selected for repurchase based on our investment and
funding strategies, including our efforts to support the liquidity and price
performance of our mortgage-related securities.
FREDDIE MAC | 2019 Form 10-K 23
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Management's Discussion and Analysis Consolidated Results of Operations
The table below presents the components of debt gains (losses). Table 9 - Components of Debt Gains (Losses)
Year Over Year Change
Year Ended December 31, 2019 vs. 2018 2018 vs. 2017 (Dollars in millions) 2019 2018 2017 $ % $ %
Fair value changes:
CRT-related debt$105 $140 ($212 ) ($35 )
(25 )%
Non-CRT-related debt 27 2 22 25 1,250 (20 ) (91 ) Total fair value changes 132 142 (190 ) (10 ) (7 ) 332 175 Gains (losses) on extinguishment of debt 69 578 341 (509 ) (88 ) 237 70 Debt gains (losses)$201 $720 $151 ($519 ) (72 )%$569 377 % Key Drivers: n 2019 vs. 2018 - Decreased primarily due to losses from the extinguishment of fixed-rate debt securities of consolidated trusts, as market interest rates declined between the time of issuance and repurchase, partially offset by an increase in gains on callable debt due to an increase in call volume. n 2018 vs. 2017 - Improved primarily due to higher gains from the extinguishment of fixed-rate debt securities of consolidated trusts, as market interest rates increased between the time of issuance and repurchase, coupled with fair value gains on STACR debt notes as a result of spread widening during 2018. Derivative Gains (Losses) -------------------------------------------------------------------------------- Derivative instruments are a key component of our interest-rate risk management strategy. We use derivatives to economically hedge our interest-rate risk exposure. We primarily use interest-rate swaps, futures, and option-based derivatives, such as swaptions, to manage our exposure to changes in interest-rates. We consider the cost of derivatives used in interest-rate risk management to be an inherent part of the cost of funding our mortgage-related investments portfolio. In addition, we routinely enter into commitments to purchase and sell loans and mortgage-related securities. The majority of these commitments are accounted for as derivative instruments. We continue to align our derivative portfolio with the changing duration of our assets and liabilities so as to economically hedge them. We manage our exposure to interest-rate risk on an economic basis to a low level as measured by our models. We believe the impact of derivatives on our GAAP financial results should be considered in the context of our overall interest-rate risk profile, including our PVS and duration gap results. For more information about our interest-rate risk management activities and the sensitivity of reported GAAP earnings to those activities, see Risk Management - Market Risk. Derivative gains (losses) consists of the following: n Fair value changes - represents changes in the fair value of our derivatives
while not designated in hedging relationships based on market conditions at
the end of the period or at the time the derivative instrument is terminated.
These amounts may or may not be realized over time, depending on future
changes in market conditions and the terms of our derivative instruments.
n Accrual of periodic cash settlements - consists of the net amount we accrue
during a period for interest-rate swap payments that we will make or receive
for derivatives while not designated in hedging relationships. This accrual
represents the ongoing cost of our hedging activities, and is economically
equivalent to interest expense.
We apply fair value hedge accounting to certain single-family mortgage loans and long-term debt to reduce our GAAP earnings volatility. For the first three quarters of 2017, we included gains and losses on derivatives designated in qualifying hedge relationships in other income and the accrual of periodic cash settlements on derivatives in qualifying hedge relationships in derivatives gains (losses). Beginning in 4Q 2017, due to the adoption of amended hedge accounting guidance, we include gains and losses and the accrual of periodic cash settlements on derivatives designated in qualifying hedge relationships in the same line used to present the earnings effect of the hedged item. See Note 9 for more information on hedge accounting and the adoption of amended hedge accounting guidance during 2017. Derivative gains (losses) are affected by a number of factors, including: n Changes in interest rates - Our primary derivative instruments are
interest-rate swaps, including pay-fixed and receive-fixed interest-rate
swaps. With a pay-fixed interest-rate swap, we pay a fixed rate of interest
and receive a variable rate of interest based on a specified notional balance
(the notional balance is for calculation purposes only). As interest rates
decline, we recognize derivative losses, as the amount of interest we pay
remains fixed, and the amount of interest we
FREDDIE MAC | 2019 Form 10-K 24
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Management's Discussion and Analysis Consolidated Results of Operations
receive declines. As rates rise, we recognize derivative gains, as the amount of interest we pay remains fixed, but the amount of interest we receive increases. With a receive-fixed interest-rate swap, the opposite results occur. n Implied volatility - Many of our assets and liabilities have embedded
prepayment options. We use option-based derivatives, including swaptions, to
economically hedge the prepayment options embedded in our mortgage assets and
callable debt. Fair value gains and losses on swaptions are sensitive to
changes in both interest rates and implied volatility, which reflects the
market's expectation of future changes in interest rates. Assuming all other
factors are unchanged, including interest rates, purchased swaptions
generally become more valuable as implied volatility increases and less
valuable as implied volatility decreases, with the opposite being true for
written swaptions.
n Changes in the shape of the yield curve - We own assets and have outstanding
debt with different cash flows along the yield curve. We use derivatives to
hedge the yield exposure of assets and debt, resulting in derivatives with
different maturities. As a result, changes in the shape of the yield curve
will affect our derivative gains (losses).
n Changes in the composition of our derivative portfolio - The mix and balance
of our derivative portfolio changes from period to period as we enter into or
terminate derivative instruments to respond to changes in interest rates and
changes in the balances and modeled characteristics of our assets and
liabilities. Changes in the composition of our derivative portfolio will
affect the derivative gains and losses we recognize in a given period,
thereby affecting the volatility of comprehensive income.
The table below presents the components of derivative gains (losses). Table 10 - Components of Derivative Gains (Losses)
Year Over Year Change
Year Ended December 31, 2019 vs. 2018 2018 vs. 2017 (Dollars in millions) 2019 2018 2017 $ % $ % Fair value changes: Interest-rate swaps ($3,085 )$1,422 $626 ($4,507 ) (317 )%$796 127 % Option-based derivatives 188 (630 ) (1,041 ) 818 130 411 39 Futures (946 ) 57 144 (1,003 ) (1,760 ) (87 ) (60 ) Commitments (452 ) 606 (91 ) (1,058 ) (175 ) 697 766 CRT-related derivatives (1 ) (38 ) (30 ) 37 97 (8 ) (27 ) Other 52 (6 ) (6 ) 58 967 - - Total fair value changes (4,244 ) 1,411 (398 ) (5,655 ) (401 ) 1,809 455 Accrual of periodic cash settlements (272 ) (141 ) (1,590 )
(131 ) (93 ) 1,449 91
Derivative gains (losses) (
Key Drivers : n 2019 vs. 2018 - Decreases in long-term rates during 2019 resulted in
derivative fair value losses compared to derivative fair value gains during
2018. The interest rate decreases during 2019 resulted in fair value losses
on our pay-fixed interest rate swaps, forward commitments to issue
mortgage-related securities, and futures, partially offset by fair value
gains on our receive-fixed swaps and certain of our option-based derivatives.
n 2018 vs. 2017 - Increases in long-term rates during 2018 resulted in
derivative fair value gains compared to derivative fair value losses during
2017. The interest rate increases during 2018 resulted in fair value gains on
our pay-fixed interest rate swaps, forward commitments to issue
mortgage-related securities, and futures, partially offset by fair value
losses on our receive-fixed swaps and certain of our option-based
derivatives. As a result of the adoption of amended hedge accounting guidance
in 4Q 2017, fair value changes on derivatives in qualifying hedge
relationships have been recorded within net interest income.
Other Income --------------------------------------------------------------------------------Key Drivers : n 2019 vs. 2018 and 2018 vs. 2017 - Primarily reflected the recognition of a
Holding America, Inc. (Nomura) and
2017 from a litigation settlement with the Royal Bank of Scotland Group plc
(RBS) related to certain of our non-agency mortgage related securities. See
Note 14 for additional information on the Nomura judgment and RBS settlement.
FREDDIE MAC | 2019 Form 10-K 25
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Management's Discussion and Analysis Consolidated Results of Operations
Credit-Related Expense Benefit (Provision) for Credit Losses --------------------------------------------------------------------------------Key Drivers : n 2019 vs. 2018 - Remained relatively flat due to the strong credit performance
of both our single-family and multifamily portfolios.
n 2018 vs. 2017 - Increased benefit for credit losses during 2018, primarily
driven by estimated hurricane-related losses recognized in 2017.
Credit Enhancement Expense -------------------------------------------------------------------------------- Credit enhancement expense includes the premiums paid to transfer credit risk to third parties under freestanding credit enhancements and transaction and other costs incurred to enter into freestanding credit enhancements. Credit enhancement expense does not include costs associated with CRT-related debt, which are primarily recognized in interest expense, or the costs associated with CRT-related derivatives, which are recognized in investment gains (losses), net.Key Drivers : n 2019 vs. 2018 and 2018 vs. 2017 - Increased primarily due to higher volumes
of CRT transactions.
See MD&A - Our Business Segments - Single-Family Guarantee - Products and Activities and MD&A - Our Business Segments - Multifamily - Products and Activities for additional information on our credit enhancements. Operating ExpenseKey Drivers : n 2019 vs. 2018 - Increased primarily due to higher salaries and employee
benefits driven by the VERP and higher technology costs.
n 2018 vs. 2017 - Increased primarily due to higher administrative expense.
Income Tax ExpenseKey Drivers : n 2019 vs. 2018 - Decreased primarily due to lower pre-tax income.
n 2018 vs. 2017 - Decreased due to the impact of the Tax Cuts and Jobs Act
enacted in
rate from 35% in 2017 to 21% in 2018 and required us to measure our net
deferred tax asset using the reduced rate and recognize a charge to income
tax expense of
Other Comprehensive Income (Loss) Our investments in securities classified as available-for-sale are measured at fair value on our consolidated balance sheets. The fair value of these securities is primarily affected by changes in interest rates, market spreads, and the movement of these securities towards maturity. All unrealized gains and losses on these securities are excluded from earnings and reported in other comprehensive income until realized. We reclassify our unrealized gains and losses from AOCI to earnings upon the sale of the securities or if the securities are determined to be other-than-temporarily impaired. If, subsequent to the recognition of other-than-temporary impairment, our expectation of the cash flows we will receive on a previously impaired security has significantly increased, we will accrete that increase in cash flows into earnings. The accretion into earnings will generally reduce the amount of unrealized gains that we would have otherwise recognized if not for the accretion.Key Drivers : n 2019 vs. 2018 - Increased primarily due to fair value gains as long-term
interest rates declined, partially offset by fair value losses due to spread
widening on our agency mortgage-related securities.
n 2018 vs. 2017 - Decreased primarily due to higher fair value losses due to
increasing long-term interest rates, coupled with smaller spread-related fair
value gains driven by lower balances of non-agency mortgage-related securities.
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Management's Discussion and Analysis Consolidated Balance Sheets Analysis
CONSOLIDATED BALANCE SHEETS ANALYSIS The table below compares our summarized consolidated balance sheets. Table 11 - Summarized Consolidated Balance Sheets
As of December 31, Year Over Year Change (Dollars in millions) 2019 2018 $ % Assets: Cash and cash equivalents$5,189 $7,273 ($2,084 ) (29 )% Securities purchased under agreements to resell 66,114 34,771 31,343 90 Subtotal 71,303 42,044 29,259 70 Investments in securities, at fair value 75,711 69,111 6,600 10 Mortgage loans, net 2,020,200 1,926,978 93,222 5 Accrued interest receivable 6,848 6,728 120 2 Derivative assets, net 844 335 509 152 Deferred tax assets, net 5,918 6,888 (970 ) (14 ) Other assets 22,799 10,976 11,823 108 Total assets$2,203,623 $2,063,060 $140,563 7 % Liabilities and Equity: Liabilities: Accrued interest payable$6,559 $6,652 ($93 ) (1 )% Debt, net 2,179,528 2,044,950 134,578 7 Derivative liabilities, net 372 583 (211 ) (36 ) Other liabilities 8,042 6,398 1,644 26 Total liabilities 2,194,501 2,058,583 135,918 7 Total equity 9,122 4,477 4,645 104 Total liabilities and equity$2,203,623 $2,063,060 $140,563 7 %
increased on a combined basis primarily due to higher loan prepayments,
coupled with higher near-term cash needs for upcoming debt maturities and
anticipated calls of other debt and a higher expected loan purchase forecast.
n Other assets increased primarily due to higher servicer receivables driven by
an increase in mortgage loan payoffs reported but not yet remitted at the end
of 4Q 2019 and a change in our servicing cycle in 2Q 2019 related to the
implementation of Release 2 of the CSP and the Single Security Initiative.
n Total equity increased primarily as a result of our ability to retain
earnings as a result of an increase in the applicable Capital Reserve Amount
from
Agreement.FREDDIE MAC | 2019 Form 10-K 27
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Management's Discussion and Analysis Our Business Segments | Segment Earnings
OUR BUSINESS SEGMENTS As shown in the table below, we have three reportable segments, which are based on the way we manage our business. Certain activities that are not part of a reportable segment are included in the All Other category.
Segment/Category Description
Reflects results from our purchase,
securitization, and
Single-family Guarantee guarantee of single-family loans and the management of single-family mortgage credit risk Reflects results from our purchase, sale, securitization, and guarantee of multifamily loans and securities, our Multifamily investments in those loans and securities, and the management of multifamily mortgage credit risk and market risk Reflects results from managing our mortgage-related investments portfolio (excluding Multifamily segment investments, single-family seriously delinquent loans, and Capital Markets the credit risk of single-family performing and reperforming loans), single-family securitization activities, and treasury function, which includes interest-rate risk management for the company Consists of material corporate-level activities that are All Other infrequent in nature and based on decisions outside the control of the management of our reportable segments Segment Earnings We evaluate segment performance and allocate resources based on a Segment Earnings approach: n We make significant reclassifications among certain line items in our GAAP
financial statements to reflect measures of guarantee fee income on
guarantees, net interest income on investments, and benefit (provision) for
credit losses on loans that are in line with how we manage our business.
n We allocate certain revenues and expenses, including certain returns on
assets, funding and hedging costs, and all administrative expenses to our
three reportable segments. n The sum of Segment Earnings for each segment and the All Other category
equals GAAP net income (loss). Likewise, the sum of comprehensive income
(loss) for each segment and the All Other category equals GAAP comprehensive
income (loss).
Segment Earnings differs significantly from, and should not be used as a substitute for, net income (loss) as determined in accordance with GAAP. Our definition of Segment Earnings may differ from similar measures used by other companies. We believe that Segment Earnings provides us with meaningful metrics to assess the financial performance of each segment and our company as a whole. See Note 1 3 for additional details on Segment Earnings, including additional financial information for our segments.
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Management's Discussion and Analysis Our Business Segments | Segment Earnings
Segment Comprehensive Income -------------------------------------------------------------------------------- The graph below shows our comprehensive income by segment.
[[Image Removed: chart-47f7eed8af135732987a01.jpg]]
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Management's Discussion and Analysis Our Business Segments | Single-Family Guarantee
Single-Family Guarantee Business Overview -------------------------------------------------------------------------------- Our Single-family Guarantee segment supports our strategic goals to exit conservatorship, create a world-class operating platform, and become the leader in housing by: n Maintaining strong financial and capital management and identifying growth
opportunities;
n Positioning our business model to produce attractive, sustainable returns
while preserving strong risk management discipline; n Utilizing efficient and resilient operations to run our business, serve our clients, and fulfill our mission; n Continuing to create innovative structures to cost-effectively transfer credit risk to third-party investors; n Leveraging technology, processes, policies, and data to ensure we have a stable, flexible ecosystem that can evolve as we evolve;
n Identifying and implementing new and creative ways to support fair access to
credit in a safe, sound, and responsible manner; and
n Maintaining a high performing, inclusive, and diverse workforce striving to
achieve our mission and realize our vision of becoming the leader in housing.
TheU.S. residential mortgage market consists of a primary mortgage market that links homebuyers and lenders, and a secondary mortgage market that links lenders and investors. The size of theU.S. residential mortgage market is affected by many factors, including changes in interest rates, unemployment rates, homeownership rates, housing prices, the supply of housing, lender preferences regarding credit risk, and borrower preferences regarding mortgage debt. In accordance with our Charter, we participate in the secondary mortgage market. The Single-family Guarantee segment provides liquidity and support to the single-family market through a variety of activities that include the purchase, securitization, and guarantee of single-family loans originated by sellers and servicers. The mix of loan products available for us to purchase is affected by several factors, including the volume of loans meeting the requirements of our Charter, our own preference for credit risk reflected in our purchase standards, and the loan purchase and securitization activity of other financial institutions. Our primary business model is to acquire loans that lenders originate and then pool those loans into mortgage-related securities that transfer interest rate, prepayment, and liquidity risk to investors and can be sold in the capital markets. To reduce our exposure under our guarantees, we transfer credit risk on a portion of our single-family credit guarantee portfolio to the private market when it is cost-effective to do so. The returns we generate from these activities are primarily derived from the ongoing guarantee fee we receive in exchange for providing our guarantee of the principal and interest payments of the issued mortgage-related securities. In order to issue mortgage-related securities, we establish trusts pursuant to our Master Trust Agreements and serve as the trustee of those trusts. The lender or servicer administers the collection of borrowers' payments on their loans and remits the collected funds to us. We administer the distribution of payments to the investors in the mortgage-related securities, net of any applicable guarantee fees. The diagram below illustrates our primary business model.[[Image Removed: sfprimarybusinessmodeljan02.jpg]] When a borrower prepays a loan that we have securitized, the outstanding balance of the security owned by investors is reduced by the amount of the prepayment. If the borrower becomes delinquent, we continue to make the applicable payments to the investors in the mortgage-related securities pursuant to our guarantee until we purchase the loan out of the consolidated
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Management's Discussion and Analysis Our Business Segments | Single-Family Guarantee
trust. We have the option to purchase specified loans, including certain delinquent loans, from consolidated trusts at a purchase price equal to the current UPB of the loan, less any outstanding advances of principal that have been previously distributed. However, in order to maintain alignment with Fannie Mae under the Single Security Initiative, FHFA requires us to purchase loans out of consolidated trusts if they are delinquent for 120 days, and we have the option to purchase sooner under certain circumstances (e.g., imminent default and seller breaches of representations and warranties). If borrowers become delinquent, we work with the borrowers through our servicers to mitigate our losses through our loan workout programs, which are discussed in more detail in Risk Management. If we are unable to achieve a successful loan workout, we will pursue foreclosure of the underlying property, which will result in a third-party sale or our acquisition of the property as REO. The purchase and sale of delinquent loans are done in conjunction with the Capital Markets segment. Guarantee Fees -------------------------------------------------------------------------------- We enter into loan purchase agreements with many of our single-family customers that outline the terms under which we agree to purchase loans from them over a period of time. For most of the loans we purchase, the guarantee fees are not specified contractually. Instead, we bid for some or all of the lender's loan volume on a monthly basis at a guarantee fee that we specify. As a result, our loan purchase volumes from individual customers can fluctuate significantly. We seek to issue guarantees with fee terms that are commensurate with the aggregate risks assumed and that will, over the long-term, provide guarantee fee income that exceeds the credit-related and administrative expenses on the underlying loans and also provide a return on the capital that would be needed to support the related credit risk. The guarantee fees charged on new acquisitions generally consist of: n A contractual monthly fee paid as a percentage of the UPB of the underlying
loan;
n Upfront fees, which primarily include delivery fees that are calculated based
on credit risk factors such as the loan product type, loan purpose, LTV
ratio, and credit score. These delivery fees are charged to compensate us for
higher levels of risk in some loan products;
n Upfront payments made or received to buy up or buy down, respectively, the
monthly contractual guarantee fee ("buy-up fees" or "buy-down fees"). These
fees are paid in conjunction with the formation of a security to provide for
a uniform coupon rate for the mortgage pool underlying the security. The
payments made to buy-up the monthly contractual guarantee fee are allocated
to the Capital Markets segment;
n Market adjusted pricing costs based on the market pricing of our securities
relative to the market pricing of comparable Fannie Mae securities primarily
for loans acquired prior to implementation of the Single Security Initiative
in
acquisitions following implementation, as the Single Security Initiative is
designed to enhance the overall liquidity of
securities in the TBA market by supporting their fungibility without regard
to which company is the issuer; and
n The legislated 10 basis point increase in guarantee fees under the Temporary
Payroll Tax Cut Continuation Act of 2011.
We operate in a competitive market by varying our pricing for different customers, loan products, and underwriting characteristics. We seek to maintain a broad-ranging mix of loan quality for the loans we purchase. However, sellers may elect to retain loans with better credit characteristics. A seller's decision to retain these loans could result in our purchases having a more adverse credit profile. We must obtain FHFA's approval to implement across-the-board changes to our guarantee fees. In addition, from time to time, FHFA issues directives or guidance to us affecting the levels of guarantee fees that we may charge. Common Securitization Platform and the UMBS -------------------------------------------------------------------------------- We continue to work with FHFA, Fannie Mae, and CSS to support the CSP and the UMBS market. We have been using the CSP for data acceptance, issuance support, and bond administration activities related toFreddie Mac single-class fixed-rate mortgage-related securities since 2016. InJune 2019 ,Freddie Mac , Fannie Mae, and FHFA announced the implementation of Release 2 of the CSP and the Single Security Initiative forFreddie Mac and Fannie Mae, under which we and Fannie Mae began issuing UMBS. Upon implementation of Release 2, we transitioned additional securities administration activities to the CSP. Release 2 also added to the functionality of the CSP by, among other things, enabling commingling ofFreddie Mac and Fannie Mae UMBS and other TBA-eligible mortgage securities in resecuritization transactions. As a result, implementation of Release 2 of the CSP and the Single Security Initiative increased our counterparty risk exposure to Fannie Mae and our operational risk exposure to CSS. For additional information, see Risk Management - Counterparty Credit Risk and Risk Management - Operational Risk. In connection with these developments, we extended the payment delay for newly issued fixed-rate mortgage securities from 45 days to 55 days, and inJune 2019 , we ceased issuing Gold PCs (which have a 45-day payment delay). We also updated our servicer reporting cycle to align with an industry standard monthly calendar cycle and adopted a single common remittance due date for principal and interest payments, excluding payoffs.FREDDIE MAC | 2019 Form 10-K 31
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Management's Discussion and Analysis Our Business Segments | Single-Family Guarantee
We are offering an optional exchange program for security holders to exchange certain existing 45-day payment delay fixed-rate Gold PCs and Giant PCs for the corresponding new UMBS and other applicable 55-day payment delayFreddie Mac mortgage securities. As part of this program, we make a one-time payment to exchanging security holders for the value of the 10 additional days of payment delay, based on "float compensation" rates we calculate. We do not expect the return from this additional float to fully offset our payments to the security holders. During 2019, we exchanged$282.6 billion in UPB of 45-day payment delay securities, including securities owned byFreddie Mac , for 55-day payment delay securities, and paid$0.1 billion in float compensation in connection with these exchanges. Products and Activities -------------------------------------------------------------------------------- Securitization and Guarantee Products We offer various types of guarantee and securitization products, primarily Level 1 Securitization Products and Resecuritization Products. In these securitization products,Freddie Mac functions in its capacity as depositor, guarantor, administrator, and trustee. We retain the credit risk and transfer the interest-rate, prepayment, and liquidity risks to the investors. While the Single-family Guarantee segment is responsible for the guarantee of our securities, the Capital Markets segment manages the securitization and resecuritization processes. Level 1 Securitization Products We offer a variety of Level 1 Securitization Products to our customers. Our Level 1 Securitization Products are pass-through securities that represent undivided beneficial interests in trusts that hold pools of loans. For our fixed-rate Level 1 Securitization Products, 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 loans. We also guarantee the full and final payment of principal, but not the timely payment of principal, on ARM PCs. In exchange for our guarantee, we receive fees as described in the Guarantee Fees section above. We issue the following types of Level 1 Securitization Products: n UMBS - Single-class pass-through securities with a 55-day payment delay for TBA-eligible fixed-rate mortgage loans. We began issuing UMBS for all TBA-eligible fixed-rate mortgage loans onJune 3, 2019 .
n 55-day MBS - Single-class pass-through securities with a 55-day payment delay
for non-TBA-eligible fixed-rate mortgage loans. We began issuing 55-day MBS
for all non-TBA-eligible fixed-rate mortgage loans on
n PCs
l Gold PCs - Single-class pass-through securities with a 45-day payment
delay that we issued for fixed-rate mortgage loans prior to
With the implementation of Release 2 of the CSP and the Single Security
Initiative, we no longer issue Gold PCs. Existing Gold PCs that are not
entirely resecuritized are eligible for exchange into UMBS (for
TBA-eligible securities) or 55-day MBS (for non-TBA-eligible securities).
l ARM PCs - Single-class pass-through securities with a 75-day payment delay
for ARM products. Implementation of Release 2 of the CSP and the Single
Security Initiative did not affect our ARM PC offerings.
All Level 1 Securitization Products are backed only by mortgage loans that we have acquired. We offer (or previously offered) all of the above products through both guarantor swap and cash loan purchase programs. In a guarantor swap execution, we offer transactions in which our customers, primarily large mortgage banking companies and commercial banks, provide us with loans in exchange for a security backed by those same loans, as shown in the diagram below:FREDDIE MAC | 2019 Form 10-K 32
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Management's Discussion and Analysis Our Business Segments | Single-Family Guarantee
[[Image Removed: guarantorswapa06.jpg]] In a cash loan purchase execution, we offer to pay cash to our customers, primarily community and regional banks. In these transactions, we purchase loans for cash and securitize them for retention in our mortgage-related investments portfolio or for sale to third parties. For the period of time between loan purchase and securitization, we refer to the loan as being in our securitization pipeline. The purchase of loans and sale of securities are managed by the Capital Markets segment. The diagram below illustrates a cash loan purchase execution. [[Image Removed: cashpurchaseprocess01.jpg]]FREDDIE MAC | 2019 Form 10-K 33
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Management's Discussion and Analysis Our Business Segments | Single-Family Guarantee
Resecuritization Products We offer resecuritization products to our customers. Our resecuritization products represent beneficial interests in pools of Level 1 Securitization Products and certain other types of mortgage assets. We create these securities by using Level 1 Securitization Products or our previously issued resecuritization products as the underlying collateral. We leverage the issuance of these securities to expand the range of investors in our mortgage-related securities to include those seeking specific security attributes. Similar to our Level 1 Securitization Products, we guarantee the payment of principal and interest to the investors in our resecuritization products. We do not charge a guarantee fee for these securities if the underlying collateral is already guaranteed by us since no additional credit risk is introduced, although we typically receive a transaction fee as compensation for creating the security and future administrative responsibilities. Upon implementation of Release 2 of the CSP and the Single Security Initiative, we have the ability to commingle TBA-eligible Fannie Mae collateral in certain of our resecuritization products. When we resecuritize Fannie Mae securities, which are separately guaranteed by Fannie Mae, in our commingled resecuritization products, our guarantee covers timely payment of principal and interest on such products from underlying Fannie Mae securities. If Fannie Mae were to fail to make a payment on a Fannie Mae security that we resecuritized, we would be responsible for making the payment. We do not charge an incremental guarantee fee to commingle Fannie Mae collateral in resecuritization transactions. All the cash flows from the collateral underlying our resecuritization products are generally passed through to investors in these securities. We do not issue resecuritization products that have concentrations of credit risk beyond those embedded in the underlying assets. In many of our resecuritization transactions, securities dealers or investors deliver mortgage assets in exchange for the resecuritization product. In certain cases, we may also transfer our own mortgage assets in exchange for the resecuritization product. The resecuritization activities are managed by the Capital Markets segment. The following diagram provides a general example of how we create resecuritization products: [[Image Removed: resecuritizationproductsa02.jpg]] We offer the following types of resecuritization products: n Single-class resecuritization products - Involve the direct pass-through of all cash flows of the underlying collateral to the beneficial interest holders and include:
l Supers - Resecuritizations of UMBS and certain other mortgage securities.
This structure allows commingling of
collateral, where newly issued or exchanged UMBS and Supers issued by us
or Fannie Mae may be commingled to back Supers issued by us or Fannie
Mae. Supers can be backed by:
- UMBS and/or other Supers issued by us or Fannie Mae;
- Existing TBA-eligible Fannie Mae "MBS" and/or "Megas"; and/or
- UMBS and Supers that we have issued in exchange for TBA-eligible PCs and Giant PCs that have been delivered to us in response to our exchange offer.FREDDIE MAC | 2019 Form 10-K 34
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Management's Discussion and Analysis Our Business Segments | Single-Family Guarantee
l Giant MBS - Resecuritizations of:
- Newly issued 55-day MBS and/or Giant MBS; and/or
- 55-day MBS and/or Giant MBS that we have issued in exchange for non-TBA-eligible PCs and non-TBA-eligible Giant PCs that have been delivered to us in response to our exchange offer. l Giant PCs - Resecuritizations of previously issued PCs or Giant PCs. Although we no longer issue Gold PCs, existing Gold PCs may continue to be resecuritized into Giant PCs. In addition, ARM PCs may continue to be resecuritized into ARM Giant PCs. Fixed-rate Giant PCs are eligible for exchange into Supers (for TBA-eligible securities) or Giant MBS (for non-TBA-eligible securities).
n Multiclass resecuritization products
l REMICs - Resecuritizations of previously issued mortgage securities that divide all cash flows of the underlying collateral into two or more classes of varying maturities, payment priorities, and coupons. This structure allows commingling of TBA-eligibleFreddie Mac and Fannie Mae collateral.
l Strips - Resecuritizations of previously issued Level 1 Securitization
Products or single-class resecuritization products and issuance of
stripped securities, including principal-only and interest-only securities
or floating rate and inverse floating rate securities, backed by the cash
flows from the underlying collateral. This structure allows commingling of
TBA-eligible
Other Securitization Products n Senior subordinate securitization structures backed by recently originated loans (consolidated) - In prior years, we created senior subordinate securitization structures in which we issued guaranteed senior securities and unguaranteed subordinated securities backed by recently originated single-family loans. The unguaranteed subordinated securities absorb first losses on the related loans and the loans are serviced in accordance with our Guide. We discontinued regular offerings of these transactions in 2019. n Other securitization products - Guaranteed mortgage-related securities collateralized by non-Freddie Mac mortgage-related securities. However, we have not entered into these types of transactions as part of our Single-family Guarantee business in several years. Long-Term Standby Commitments We also offer a guarantee on mortgage assets held by third parties, in exchange for guarantee fees, without securitizing those assets. These long-term standby commitments obligate us to purchase seriously delinquent loans that are covered by those commitments. From time to time, we have consented to the termination of our long-term standby commitments and simultaneously entered into guarantor swap transactions with the same counterparty, issuing securities backed by many of the same loans. The primary impacts of the aforementioned products and transactions to Segment Earnings are:
• Guarantee fee income earned on our guarantee of principal and interest
payments on our mortgage-related securities and
• Benefit (provision) for credit losses, which is affected by changes in
estimated probabilities of default and estimated loss severities, the actual
level of loan defaults, the effect of loss mitigation efforts, and payment
performance of our individually impaired mortgage portfolio.
CRT Transactions To reduce our credit risk exposure, we engage in various types of credit enhancements, including CRT transactions and other credit enhancements. We define CRT transactions as those arrangements where we actively transfer the credit risk exposure on mortgages that we own or guarantee. We define other credit enhancements as those arrangements, such as traditional primary mortgage insurance, where we do not actively take part in the transfer of the credit risk exposure. Our CRT transactions are designed to reduce the amount of conservatorship capital needed under the CCF, to transfer portions of credit losses on groups of previously acquired loans to third-party investors, and to reduce the risk of future losses to us and taxpayers if borrowers go into default. The payments we make in exchange for this credit protection effectively reduce our guarantee fee income from the associated mortgages. The following strategic considerations were incorporated into the design of our CRT transactions: n Offer repeatable and scalable execution with a broad appeal to diversified investors; n Execute at a cost that is economically sensible; n Result in no or minimal effect on the TBA market; n Minimize changes required of, and effects on, sellers and servicers by having
n Avoid or very substantially mitigate the risk that our losses are not reimbursed timely and in full.
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Management's Discussion and Analysis Our Business Segments | Single-Family Guarantee
Each CRT transaction is designed to transfer a certain portion of the credit risk that we assume for loans with certain targeted characteristics. Risk positions may be transferred to third-party investors through one or more CRT transactions where economically sensible. The risk transfer could occur prior to, or simultaneously with, our purchase of the loan (i.e., front-end coverage) or after the purchase of the loan (i.e., back-end coverage). As CRT has become part of our normal business activities, we have established the following programs to regularly transfer portions of credit risk to diversified investors: STACR and ACIS Offerings Our two primary CRT programs are STACR and ACIS. n STACR - Our primary single-family securities-based credit risk sharing vehicle.STACR Trust note transactions transfer risk to the private capital markets through the issuance of unguaranteed notes using a third-party trust. In a STACR transaction, we create a reference pool of loans from our single-family loan portfolio and an associated securitization-like structure with notional credit risk positions (e.g., first loss, mezzanine, and senior positions). The trust issues notes linked to certain of the notional credit risk positions to third-party investors and makes periodic payments of principal and interest on the notes, but is not required to repay principal to the extent that the notional credit risk position is reduced as a result of specified credit events. We make payments to the trust to support payment of the interest due on the notes. The amount of risk transferred in each transaction affects the amounts we are required to pay. We receive payments from the trust that otherwise would have been made to the noteholders to the extent there are certain defined credit events on the mortgages in the related reference pool. The note balances are reduced by the amount of the payments to us, thereby transferring the related credit risk of the loans in the reference pool to the note investors. Generally, the notional amounts of the credit risk positions are also reduced based on principal payments that occur on the loans in the reference pool. We enhanced theSTACR Trust note structure in 4Q 2019 to qualify the notes issued as interests in a REMIC that allow favorable tax treatment for certain types of investors. The following diagram illustrates a typical STACR transaction: [[Image Removed: stacrtrustnotetransactionsfe.jpg]] n ACIS - Our primary insurance-based credit risk sharing vehicle. ACIS transactions are insurance policies we enter into with global insurance and reinsurance companies to cover a portion of credit risk on the STACR or standalone reference pools. We pay monthly premiums to the insurers or reinsurers in exchange for claim coverage on their portion of the reference pool. We require our ACIS counterparties to partially collateralize their exposure to reduce the risk that we will not be reimbursed for our claims under the policies. We have established programmatic offerings of STACR and ACIS transactions to regularly transfer credit risk on a targeted population of recently acquired mortgage loans ("on-the-run transactions"). STACR and ACIS are complementary programs issued from the same reference pool for on-the-run transactions. The targeted loan population for on-the-run transactions is recently acquired 30-year fixed-rate mortgage loans with LTV ratios between 60% and 97%, excluding loans acquired under our relief refinance programs, government guaranteed loans, and loans that do not meet certain eligibility criteria. Our typical on-the-run transactions are issued on a quarterly basis and provide back-end coverage for loans that we guaranteed 2 to 3 quarters prior to issuance (e.g., a transaction in 4Q 2019 would typically cover loans acquired in 1Q or 2Q 2019). Starting with our issuances in 3Q 2018, in a typical on-the-run transaction, we transfer to third-party investors a portion of the credit risk between an initial first loss position and a specified detachment point which may vary based on numerous factors, such as the type of collateral and market conditions. We retain the initial first loss position and at least 5% of the credit risk of all the positions sold to align our interests with those of the investors. We also retain all of the senior credit risk position. On-the-run STACR transactions typically have a 30-year maturity and on-the-run ACIS transactions typically have a 12.5-year maturity. The diagram below illustrates a typical on-the-run STACR and ACIS structure:FREDDIE MAC | 2019 Form 10-K 36
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Management's Discussion and Analysis Our Business Segments | Single-Family Guarantee
[[Image Removed: stacrandacisstructurejan2020.jpg]] In addition to our regularly issued on-the-run transactions, we also periodically execute "off-the-run" STACR and ACIS transactions that provide back-end coverage on certain loans that are not in the on-the-run transaction targeted loan population. For example, we offer STACR and ACIS transactions that provide coverage on HARP and other relief refinance loans, STACR and ACIS transactions that provide coverage on unissued portions of the reference pools related to previous STACR and ACIS transactions, and ACIS transactions that provide coverage on loans with 15-year maturities not related to any STACR offering. Prior to 2018, the majority of our STACR transactions were structured as unsecured debt issued directly by us (STACR debt notes) rather than as debt issued by a trust. These transactions operate similarly toSTACR Trust notes, except that we make payments of principal and interest on the issued STACR debt notes and are not required to repay principal to the extent that the notional credit risk position is reduced as a result of a specified credit event on a loan in the reference pool. In certain of these transactions, we transferred risk in both first loss and mezzanine notional credit risk positions, while in other transactions we only transferred risk in the mezzanine notional credit risk position. For certain STACR debt notes issued in prior years (generally STACR debt notes issued prior to 2015), losses are allocated to the notional amounts of the credit risk positions based on calculated losses using a predefined formula when the loans experience a credit event, which predominantly occurs when a loan becomes 180 days delinquent. As a result, in these transactions, we receive reimbursement of losses based on these calculated loss amounts rather than based on actual losses. While we may issue STACR debt notes in the future, we expect to predominantly issueSTACR Trust notes. Additional Offerings In addition to our primary offerings, we also offer the following CRT products: n ACIS Forward Risk Mitigation (AFRM) - An additional offering in the ACIS program that provides front-end credit risk transfer as loans come into the portfolio. Under each of these insurance policies, we pay monthly premiums that are determined based on the outstanding balance of the reference pool. When specific credit events occur, we generally receive compensation from the insurance policy up to an aggregate limit based on actual losses. nIntegrated Mortgage Insurance (IMAGINSM) - An insurance-based offering that provides loan-level front-end protection for loans with 80% and higher LTV ratios. IMAGIN is designed to expand and diversify sources of private capital supporting low down payment lending, while enabling better management of taxpayer exposure to our mortgage and counterparty risks. Mortgage insurance provided to each loan is generally underwritten by a group of insurers and reinsurers. IMAGIN is offered to a broad range ofFreddie Mac sellers, who can choose IMAGIN or traditional primary mortgage insurance at their discretion. n Lender risk-sharing - We offer a variety of transactions in which lenders may retain a portion of the credit risk on loans they originate and/or service. These transactions are generally collateralized so that our exposure to counterparty credit risk is not increased.
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Management's Discussion and Analysis Our Business Segments | Single-Family Guarantee
For additional information on single-family mortgage loan credit enhancements, see Risk Management - Single-Family Mortgage Credit Risk - Transferring Credit Risk toThird-Party Investors . The primary impacts of our credit risk transfer transactions to Segment Earnings are:
• Interest expense on our STACR debt notes, net of reinvestment income;
• Fair value gains and losses recognized on certain CRT transactions;
• Expenses to transfer credit risk for certain CRT transactions; and
• Benefits recognized from recoveries under certain CRT transactions.
Securitization and Sales of Seasoned Loans We continually manage the balance of our less liquid single-family mortgage loans, many of which we acquired by purchasing delinquent or modified loans from guaranteed securities. We offer to sell select seasoned single-family mortgage loans through a variety of methods. In these transactions, we reduce or eliminate our credit risk, in addition to our interest-rate and prepayment risk, associated with the underlying mortgage loans. The sales of these mortgage loans are managed by the Capital Markets segment. Our seasoned loan transactions include the following: n Senior subordinate securitization structures backed by seasoned loans
(non-consolidated) - Transactions where we issue guaranteed senior securities
and unguaranteed subordinated securities. The collateral for these structures
primarily consists of reperforming loans. The unguaranteed subordinated securities absorb first losses on the related loans. Unlike senior subordinate securitization transactions backed by recently originated mortgage loans, in these transactions the loans are not serviced in accordance with our Guide and we do not control the servicing.
n Level 1 Securitization Products - We securitize reperforming loans using
Level 1 Securitization Products through a similar process to that discussed
above. We may subsequently resecuritize a portion of the guaranteed
securities, with some of the resulting interests being sold to third parties.
Our use of this strategy has declined over time, with our primary strategy
now utilizing our senior subordinate securitization structures.
n Whole loan sales - Sales of seriously delinquent loans for cash.
The primary impacts of the aforementioned products and transactions to Segment Earnings are:
• Gains and losses recognized on the reclassification of loans
held-for-investment to held-for-sale and subsequent sale of these loans.
Customers
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Our customers in the Single-family Guarantee segment are predominantly financial institutions that originate, sell, and perform the ongoing servicing of loans for new or existing homeowners. These companies include mortgage banking companies, commercial banks, regional banks, community banks, credit unions, HFAs, savings institutions, and non-depository financial institutions. Many of these companies are both sellers and servicers for us. In addition, we maintain relationships with investors and dealers in our guaranteed mortgage-related securities. We acquire a significant portion of our loans from several lenders that are among the largest originators in theU.S. In addition, a significant portion of our single-family loans is serviced by several large servicers. The following charts show the concentration of our 2019 single-family purchase volume by our largest sellers and our loan servicing by our largest servicers as ofDecember 31, 2019 . Any seller or servicer with a 10% or greater share is listed separately.
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Management's Discussion and Analysis Our Business Segments | Single-Family Guarantee Percentage of Single-Family Purchase Volume [[Image Removed: chart-2c59681247a95f8b98aa01.jpg]] Percentage of Single-Family Servicing Volume(1) [[Image Removed: chart-ed2c501fef8c5eeeb2ca01.jpg]] (1) Percentage of servicing volume is based on the total single-family credit guarantee portfolio, which includes loans where we do not exercise servicing control. However, loans where we do not exercise servicing control are not included for purposes of determining the concentration of servicers who serviced more than 10% of our single-family credit guarantee portfolio because we do not know which entity serves as the primary servicer for such loans. For additional information about seller and servicer concentration risk and our relationships with our seller and servicer customers, see Risk Management - Counterparty Credit Risk - Sellers and Servicers and Note 14. Competition -------------------------------------------------------------------------------- Our principal competitors in the Single-family Guarantee segment are Fannie Mae, FHA/VA (withGinnie Mae securitization), and other financial institutions that retain or securitize loans, such as commercial and investment banks, dealers, and savings institutions. We compete on the basis of price, products, securities structure, and service. Competition to acquire single-family loans 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. The areas in which we and Fannie Mae compete have been limited by the Single Security Initiative as we have been required by FHFA to align certain of our single-family mortgage purchase offerings, servicing, and securitization practices with Fannie Mae to achieve market acceptance of the UMBS. InFebruary 2019 , FHFA issued a final rule that limits our and Fannie Mae's ability to compete with each other in areas that affect prepayment speeds of single-family mortgage-related securities. For more information, see Risk Factors - Other Risks - Competition from banking and non-banking institutions (including Fannie Mae and FHA/VA withGinnie Mae securitization) may harm our business. FHFA's actions, as Conservator of both companies, could affect competition between us and Fannie Mae.FREDDIE MAC | 2019 Form 10-K 39
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Management's Discussion and Analysis Our Business Segments | Single-Family Guarantee
Business Results -------------------------------------------------------------------------------- The following graphs and related discussion present the business results of our Single-family Guarantee segment. New Business Activity --------------------------------------------------------------------------------
UPB of Single-Family Loan Purchases and Guarantees by Loan Purpose and Average
GuaranteeFee Rate (1) Charged on New Acquisitions [[Image Removed: chart-8a063aaa75828e5ce96.jpg]]
(1) Guarantee fee excludes legislated 10 basis point increase.
Number of Families Helped to Own a Home [[Image Removed: chart-93243d2b77f40b15195.jpg]]
n We maintain a consistent market presence by providing lenders with a constant
source of liquidity for conforming loan products. We have funded
approximately 18.8 million single-family homes since
purchased approximately 1.4 million HARP loans since the initiative began in
2009. HARP was replaced by the Enhanced Relief Refinance program in 2019. Our
loan purchase and guarantee activity increased in 2019 compared to 2018 primarily due to an increase in refinance activity as a result of lower average mortgage interest rates.
n The average guarantee fee rate charged on new acquisitions recognizes upfront
fee income, including the expected gains (losses) from buy-up fees, over the
estimated life of the related loans using our expectations of prepayments and
other liquidations. See Single-Family Guarantee - Business Overview -
Guarantee Fees for more information on our guarantee fees. The average
guarantee fee rate charged on new acquisitions increased in 2019 compared to
2018 primarily due to an enhancement in our estimation methodology related to
recognition of buy-up fees in 2Q 2019. n We continued working to improve access to affordable housing, including through our Home Possible® loan initiatives. Our Home Possible loan
initiatives offer down payment options as low as 3% and are designed to help
qualified borrowers with limited savings buy a home. We purchased over
157,000 loans under these initiatives in 2019. We also continue to implement
programs that support responsibly broadening access to affordable housing by:
l Improving the effectiveness of pre-purchase and early delinquency counseling for borrowers;
l Expanding our ability to support borrowers who do not have a credit score;
l Implementing the Duty to Serve Underserved Markets plan; and
l Increasing support for first-time home buyers and mortgage industry professionals. While we are responsibly expanding our programs and outreach capabilities to better serve low- and moderate-income borrowers and underserved markets, these loans result in increased credit risk. Expanding access to affordable housingFREDDIE MAC | 2019 Form 10-K 40
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Management's Discussion and Analysis Our Business Segments | Single-Family Guarantee
will continue to be a top priority in 2020. See Regulation and Supervision -Federal Housing Finance Agency - Duty to Serve Underserved Markets Plan for more information. Single-Family Credit Guarantee Portfolio --------------------------------------------------------------------------------
Single-Family Credit Guarantee Portfolio as of December 31,[[Image Removed: chart-e3f6561bc034509bbeda01.jpg]] Single-Family Loans as of December 31,[[Image Removed: chart-401cddba230a5f8fbaaa01.jpg]] n The single-family credit guarantee portfolio increased during 2019 by
approximately 5%, driven by an increase in
outstanding as a result of continued home price appreciation. New business
acquisitions had a higher average loan size compared to older vintages that
continued to run off.
n The core single-family loan portfolio grew to 85% of the single-family credit
guarantee portfolio at
2018.
n The legacy and relief refinance single-family loan portfolio declined to 15%
of the single-family credit guarantee portfolio at
to 18% at
n The average portfolio Segment Earnings guarantee fee rate recognizes upfront
fee income over the contractual life of the related loans (usually 30 years).
If the related loans prepay, the remaining upfront fee is recognized
immediately. The effect of prepayments may be offset by our upfront fee
hedging activities. See Single-Family Guarantee - Business Overview -
Guarantee Fees for more information on our guarantee fees and Note 13 for
more information on the effect of our upfront fee hedging activities on
Segment Earnings.
n The average portfolio Segment Earnings guarantee fee rate was 40 bps, 35 bps,
and 36 bps at
respectively, excluding the legislated 10 basis point increase in guarantee
fees. The rate increased in 2019 compared to 2018 due to an increase in the
recognition of upfront fees, net of hedging, driven by a higher prepayment
rate and an increase in contractual guarantee fees as older vintages were
replaced by acquisitions of new loans with higher contractual guarantee fees.
FREDDIE MAC | 2019 Form 10-K 41
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Management's Discussion and Analysis Our Business Segments | Single-Family Guarantee
CRT Activities -------------------------------------------------------------------------------- The table below provides the issuance amounts during 2019 on the protected UPB and maximum coverage by loss position associated with CRT transactions for loans in our single-family credit guarantee portfolio. Table 12 - Single-Family Credit Guarantee Portfolio CRT Issuance Issuance for the Year Ended Issuance for the Year Ended December 31, 2019 December 31, 2018 Protected Protected UPB(1) Maximum Coverage(2) UPB(1) Maximum Coverage(2) First First (In millions) Total Loss(3) Mezzanine Total Total Loss(3) Mezzanine Total STACR$203,239 $2,106 $4,565 $6,671 $243,007 $1,893 $5,042 $6,935 Insurance/reinsurance 210,650 864 1,823 2,687 270,084 834 2,306 3,140 Subordination 11,197 719 947 1,666 30,911 746 1,238 1,984 Lender risk-sharing 19,328 911 580 1,491 10,940 - 345 345 Less: UPB with more than one type of CRT activity (181,738 ) - - - (219,072 ) - - - Total CRT Activities$262,676 $4,600 $7,915 $12,515 $335,870 $3,473 $8,931 $12,404
(1) For STACR and certain insurance/reinsurance transactions (e.g., ACIS),
represents the UPB of the assets included in the reference pool. For other
insurance/reinsurance transactions, represents the UPB of the assets covered
by the insurance policy. For subordination, represents the UPB of the
guaranteed securities, which represents the UPB of the assets included in
the trust net of the protection provided by the subordinated securities.
(2) For STACR transactions, represents the balance held by third parties at
issuance. For insurance/reinsurance transactions, represents the aggregate
limit of insurance purchased from third parties at issuance. For
subordination, represents the UPB of the securities that are subordinate to
Freddie Mac guaranteed securities and held by third parties. (3) First loss includes the most subordinate securities (i.e., B tranches) in ourSTACR Trust notes and their equivalent in ACIS and other CRT transactions. We obtained maximum coverage of$12.5 billion on protected UPB of$262.7 billion through CRT transactions during 2019. We are continually evaluating our CRT strategy and make changes depending on market conditions and our business strategy. The aggregate cost of our CRT activity, as well as the amount of risk transferred, will continue to increase as we continue to do new transactions. See Risk Management - Single-Family Mortgage Credit Risk - Transferring Credit Risk toThird-Party Investors for more information on CRT transactions and credit enhancements on our single-family guarantee portfolio. Loss Mitigation Activities -------------------------------------------------------------------------------- Number of Families Helped to Avoid Foreclosure
[[Image Removed: chart-becd8f83f756599dbaca01.jpg]]
Loan Workout Activity
[[Image Removed: chart-78de365583ae5979b21.jpg]] n We continue to help struggling families retain their homes or otherwise avoid
foreclosure through loan workouts. The reduced level of loan workout activity
in 2019 compared to 2018 was primarily driven by elevated loan workout
activity in 2018 as a result of the hurricanes that occurred in late 2017.
FREDDIE MAC | 2019 Form 10-K 42
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Management's Discussion and Analysis Our Business Segments | Single-Family Guarantee
n As part of our strategy to mitigate losses and reduce our holdings of less
liquid assets, we pursue sales of seriously delinquent and reperforming loans
when we believe the sale of these loans provides better economic returns than
continuing to hold them. See Risk Management - Single-Family Mortgage Credit
Risk - Engaging in Loss Mitigation Activities for more information on our
loss mitigation activities. n The relief refinance program has been replaced with the Enhanced Relief Refinance program, which became available inJanuary 2019 for loans
originated on or after
borrowers who are current on their mortgages but are unable to refinance
because their LTV ratios exceed our standard refinance limits. While the HARP
program ended in
application received dates on or prior to
30, 2019.
See Risk Management for additional information on our loan workout activities. Financial Results -------------------------------------------------------------------------------- The table below presents the components of the Segment Earnings and comprehensive income for our Single-family Guarantee segment. Table 13 - Single-Family Guarantee Segment Financial Results
Year Over Year Change
Year Ended December 31, 2019 vs. 2018 2018 vs. 2017 (Dollars in millions) 2019 2018 2017 $ % $ % Guarantee fee income$7,773 $6,581 $6,363 $1,192
18 %
Investment gains (losses), net 964 307 116 657 214 191 165 Other income (loss) 391 841 896 (450 ) (54 ) (55 ) (6 ) Net revenues 9,128 7,729 7,375 1,399 18 354 5 Benefit (provision) for credit losses 418 448 (177 ) (30 ) (7 ) 625 353
Credit enhancement expense (1,393 ) (1,077 ) (891 ) (316 ) (29 ) (186 ) (21 )
REO operations expense (245 ) (189 ) (203 ) (56 ) (30 ) 14 7 Credit-related expense (1,220 ) (818 ) (1,271 ) (402
) (49 ) 453 36
Administrative expense (1,647 ) (1,491 ) (1,381 ) (156 ) (10 ) (110 ) (8 )
Other expense (786 ) (568 ) (516 ) (218 ) (38 ) (52 ) (10 ) Operating expense (2,433 ) (2,059 ) (1,897 ) (374 ) (18 ) (162 ) (9 ) Segment Earnings before income tax expense 5,475 4,852 4,207 623 13 645 15 Income tax expense (1,110 ) (944 ) (1,448 ) (166 ) (18 ) 504 35 Segment Earnings, net of taxes 4,365 3,908 2,759 457 12 1,149 42 Total other comprehensive income (loss), net of tax (22 ) (3 ) 40 (19 ) (633 ) (43 ) (108 ) Total comprehensive income (loss)$4,343 $3,905 $2,799 $438 11 %$1,106 40 % Key Drivers: n 2019 vs. 2018
l Higher guarantee fee income primarily due to increased upfront fee
amortization income driven by higher prepayments and continued growth in
our single-family credit guarantee portfolio.
l Higher investment gains primarily due to higher realized gains on a higher
volume of sales of, and lower unrealized lower-of-cost-or-fair-value losses related to, single-family held-for-sale loans. l Lower other income primarily due to higher non-cash premium/discount
amortization expense driven by timing differences between liquidations of
the loans and liquidations of the securities backed by these loans.
l Higher credit enhancement expense primarily due to higher outstanding
cumulative volumes of CRT transactions.
n 2018 vs. 2017
l Higher guarantee fee income due to continued growth in our single-family
credit guarantee portfolio and increased credit fee/buy-down short-term
returns.
l Higher investment gains primarily driven by fair value gains on STACR debt
notes as a result of spread widening.
l Increased benefit for credit losses primarily driven by estimated losses
from the hurricanes in 2017.
l Higher credit enhancement expense primarily due to higher outstanding
cumulative volumes of CRT transactions.FREDDIE MAC | 2019 Form 10-K 43
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Management's Discussion and Analysis Our Business Segments | Multifamily
Multifamily
Business Overview -------------------------------------------------------------------------------- The Multifamily segment supports our strategic goals to exit conservatorship, create a world-class operating platform, and become the leader in housing by: n Improving our risk-adjusted returns by leveraging private capital in our risk transfer transactions; n Identifying new opportunities beyond our existing K Certificate and SB
Certificate transactions to cost-effectively transfer risk to third parties
and reduce taxpayer exposure;
n Maintaining strong credit and capital management discipline;
n Operating in a customer focused manner to build business value and support
the creation of a strong, long-lasting rental housing system;
n Leveraging technology to make the multifamily loan process more efficient
industry-wide;
n Fostering innovation through the development of products that expand the
availability of workforce housing in the marketplace; and n Continuing to provide financing to the multifamily mortgage market and
expanding our market presence for workforce housing in line with our mission.
The Multifamily segment provides liquidity and support to the multifamily mortgage market through a variety of activities that include the purchase, guarantee, sale, and/or securitization of multifamily loans and mortgage-related securities. The overall market demand for multifamily loans is generally affected by local and regional economic factors, such as unemployment rates, construction cycles, property prices, preferences for homeownership versus renting, and the relative affordability of single-family homes, as well as certain macroeconomic factors, such as interest rates. Our primary business model is to acquire multifamily loans for aggregation and then securitization. The returns we generate from these activities are primarily derived from (i) the net interest income we earn on the loans prior to their securitization, (ii) the price received upon securitization of the loans versus the price we paid to acquire the loans, and (iii) the ongoing guarantee fee we receive in exchange for providing our guarantee primarily on the issued senior securities. We evaluate these factors collectively to assess the profitability of any given transaction and to maximize our returns. Our securitization activities generally (i) provide us with a mechanism to finance our loan product offerings, (ii) reduce our credit risk, interest-rate risk, and liquidity risk exposure on the loans that we purchase, and (iii) reduce our conservatorship capital required under CCF. For multifamily loans that we do not intend to securitize, we may pursue other strategies, including the execution of other CRT products designed to transfer to third parties all or a portion of the loans' credit risk, thereby reducing taxpayer exposure. Our support of the multifamily market generally begins with our underwriting of the loans that we commit to purchase from our Optigo® network of approved lenders and typically ends with the disposition of those loans, generally through a borrower payoff. Through our support of the multifamily mortgage market, borrowers can obtain lower financing costs, which can benefit renters through lower rental rates and/or improved services or amenities. Products and Activities -------------------------------------------------------------------------------- Loan Products Through our Optigo network of approved lenders, we offer borrowers a variety of loan products for the acquisition, refinance, and/or rehabilitation of multifamily properties. While our Optigo lenders originate the loans that we purchase, we use a prior-approval underwriting approach, in contrast to the delegated underwriting approach used in our Single-family Guarantee segment and Fannie Mae's Delegated Underwriting and Servicing (DUS) program. Under this approach, we maintain credit discipline by completing our own underwriting, credit review, and legal review for each loan prior to issuing a loan purchase commitment, including reviewing third-party appraisals and performing cash flow analysis. We also price every loan or transaction based on the specific terms, structure, and type of execution. Multifamily loans are typically originated by our Optigo lenders without recourse to the borrower, making repayment dependent on the cash flows generated by the underlying property. Cash flows generated by a property are significantly influenced by vacancy and rental rates, as well as conditions in the local rental market, the physical condition of the property, the quality of property management, and the level of operating expenses.
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Management's Discussion and Analysis Our Business Segments | Multifamily
Our primary multifamily loan products include the following: n Conventional loans - Financing that includes fixed-rate and floating-rate
loans, loans in lease-up and with moderate property upgrades, manufactured
housing community loans, senior housing loans, student housing loans,
supplemental loans, and certain Green Advantage loans.
n Small balance loans - Financing provided to small rental property borrowers for
the acquisition or refinance of multifamily properties. Financing ranges from
properties from 5 to 50 units.
n Targeted affordable housing - Financing provided to borrowers in underserved
areas that have restricted units affordable to households with low income
(earning up to 80% of AMI) and very-low income (earning up to 50% of AMI) and
that typically receive government subsidies.
The amount and type of multifamily loans that we purchase is significantly influenced by the multifamily loan purchase cap that is established by FHFA. In 3Q 2019, FHFA announced a revised multifamily loan purchase cap of$100.0 billion for the five-quarter period from 4Q 2019 through 4Q 2020. This cap applies to all multifamily business activity, with no exclusions. To ensure a strong focus on affordable housing and traditionally underserved markets, at least 37.5% of the multifamily business must be mission-driven, affordable housing over the same five-quarter period. Examples of multifamily loans that qualify as mission-driven, affordable housing include certain senior housing loans, small balance loans, manufactured housing loans, and targeted affordable housing loans. In addition, the amount and type of multifamily loans that we purchase is influenced by our current business strategy and overall market demand for multifamily loan products. Index Lock Commitments We offer borrowers an option to lock theTreasury index component of their fixed interest-rate loans at any time after the loan is under application with an Optigo lender. This option enables borrowers to lock the most volatile part of their coupon, thereby providing an enhanced level of risk mitigation against interest-rate volatility. The index lock commitment period for most loans is 45 days and is generally followed by a loan purchase commitment. We economically hedge our interest-rate exposure from these commitments primarily by entering into pay-fixed, receive-float interest rate swaps. These commitments do not qualify for accounting recognition and therefore temporarily introduce volatility through our hedges in our financial results until they proceed to a loan purchase commitment. The primary impact to Segment Earnings is:
• Fair value gains or losses recognized on interest-rate derivatives. These
gains or losses are generally offset once an index lock commitment becomes a
loan purchase commitment and is accounted for at fair value.
Loan Purchase Commitments Prior to issuing an unconditional commitment to purchase a multifamily loan, we negotiate with the lender and borrower the specific economic terms and conditions of our commitment, including the loan's purchase price, index, and mortgage spread. Targeted pricing decisions related to the commitment price and/or mortgage spread may affect our profitability and are generally influenced by our current business strategy, the type of loan that we acquire (i.e., whether it qualifies as mission-driven, affordable housing), the amount available under the loan purchase cap, and changing market conditions. At the time we commit to purchase a multifamily loan, we preliminarily determine our intent with respect to that loan. For commitments to purchase loans that we intend to sell or securitize (i.e., held-for-sale commitments), we may elect the fair value option and therefore recognize and measure these commitments at fair value on our consolidated financial statements. No such election is made for commitments to purchase loans that we intend to hold for the foreseeable future (i.e., held-for-investment commitments), and therefore these commitments are not recognized on our consolidated financial statements. Our multifamily held-for-sale commitments and held-for-sale loans that are measured at fair value are subject to changes in fair value due to two main risks: (i) interest-rate risk and (ii) spread risk. While we use derivatives to hedge the interest rate-related fair value changes of these assets measured at fair value, we continue to be exposed to spread-related fair value changes. We partially reduce our spread-related fair value exposure by purchasing or entering into certain spread-related derivatives, thereby obtaining some protection against significant adverse movements in market spreads. We refer to the fair value adjustments resulting from changes in these risks, net of any offsetting fair value adjustments from our derivatives, as our holding period fair value gains and losses.FREDDIE MAC | 2019 Form 10-K 45
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Management's Discussion and Analysis Our Business Segments | Multifamily
The primary impacts to Segment Earnings are:
• At the commitment date, we recognize the estimated fair value of the
held-for-sale commitments where we elected the fair value option;
• After the commitment date, but prior to purchase, we recognize changes in the
fair value of commitments where we elected the fair value option. These fair
value adjustments result from changes in the expected pricing of our
securitizations due to changes in interest rates and securitization market
spreads;
• Fair value gains or losses recognized on interest-rate derivatives. These
changes generally offset interest-rate related fair value changes on the loan
purchase commitments; and
• Fair value gains or losses recognized on spread-related derivatives. These
changes may offset spread-related fair value changes on the loan purchase commitments. Loan Purchases When we purchase a loan, we finalize our intent with respect to that loan. Multifamily loans that we intend to hold for the foreseeable future are classified as held-for-investment and measured at amortized cost, while multifamily loans that we intend to sell or securitize are classified as held-for-sale and typically measured at fair value through a separate fair value option election. The vast majority of all new multifamily loan purchases are initially classified as held-for-sale and included in our securitization pipeline. The holding period for loans in our securitization pipeline generally ranges between two and five months, as we aggregate sufficient loans with similar terms and risk characteristics to securitize. For example, loans purchased during the first quarter will generally be used as collateral for securitizations that settle in the second and third quarters of that same year. The primary impacts to Segment Earnings are:
• During the holding period, we generally recognize changes in the fair value of
loans classified as held-for-sale. These fair value adjustments result from
changes in the expected pricing of our securitizations due to changes in
interest rates and securitization market spreads;
• Fair value gains or losses recognized on interest-rate derivatives. These
changes generally offset interest-rate related fair value changes on the
loans;
• Fair value gains or losses recognized on spread-related derivatives. These
changes may offset spread-related fair value changes on the loans; and
• Interest income on loans while held in our mortgage-related investments
portfolio.
Securitization and Guarantee Products We enter into various types of securitizations that generally result in the transfer of all or a portion of the underlying collateral's interest-rate risk, liquidity risk, and/or credit risk to third parties. These products make up substantially all of our guarantee portfolio. The collateral used in our securitization activities can vary and generally includes loans underwritten and purchased by us at loan origination. In our typical securitizations, we guarantee the issued senior securities. In exchange for providing this guarantee, we receive an ongoing guarantee fee that is commensurate with the risks assumed and that will, over the long-term, provide us with guarantee fee income that is expected to exceed the credit-related and administrative expenses of the underlying loans. Structural deal features, such as term, type of underlying loan product, and subordination levels, generally influence the deal's risk profile, which ultimately affects the guarantee fee rate we set at the time of securitization. Our typical securitization structure and level of subordination are designed to maximize the return we earn when we sell loans for securitization. Depending on the securitization product and subordination levels selected, we may realize a higher (lower) gain on sale, but recognize lower (higher) ongoing guarantee fee income. We continue to seek new and innovative risk transfer opportunities beyond our current product offerings so that we can provide further liquidity to the multifamily market and reduce taxpayer exposure. Primary Securitization Products Our primary securitization products are K Certificates and SB Certificates, which transfer substantially all of the interest-rate risk, liquidity risk, and credit risk of the underlying collateral. The structures of these transactions typically involve the issuance of senior, mezzanine, and subordinated securities that represent undivided beneficial interests in trusts that hold pools of multifamily loans that we previously purchased. The volume of our primary securitizations is generally influenced by the product mix and size of our securitization pipeline, along with market demand for multifamily securities. As shown in the diagram below, in a typical K Certificate transaction, we sell multifamily loans to a non-Freddie Mac securitization trust that issues senior, mezzanine, and subordinated securities, and simultaneously purchase and place the senior securities into aFreddie Mac securitization trust that issues guaranteed K Certificates. In these transactions, we guarantee the senior securities, but do not
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Management's Discussion and Analysis Our Business Segments | Multifamily
issue or guarantee the mezzanine or subordinated securities. As a result, the interest-rate risk, liquidity risk, and a large majority of expected and stress credit risk is sold to third-party investors through securitization, thereby reducing our risk exposure. [[Image Removed: a10kdiagrams2018kcertificate.jpg]] n K Certificates - Regularly issued structured pass-through securities backed
by recently originated multifamily loans. This product offers investors a
wide range of structural and collateral options that provide for stable cash
flows and a structured credit enhancement. While the amount of guarantee fee
we receive may vary by collateral type, it is generally fixed for those K
Certificate series that we issue with regular frequency (e.g., 5, 7, and
10-year fixed-rate K Certificates and our Floating Rate K Certificates). The
guarantee fee received on these standard K Certificates currently ranges
between 20 basis points and 45 basis points.
The guarantee fee on K Certificates that we do not issue on a regular basis, such as our single-sponsor K Certificates, is determined based on the specific risks associated with the underlying collateral and the structure of the securitization, including tranche sizes and risk distribution. n SB Certificates - Regularly issued securities typically backed by multifamily
small balance loans that we underwrite at loan origination and purchase prior
to securitization. Similar to our K Certificate transactions, a non-Freddie
Mac trust will issue the senior classes of securities, which we guarantee, as
well as the unguaranteed subordinated securities. However, unlike our K
Certificate transactions, while we may purchase a portion of the senior
securities, we generally do not place those securities into a
trust. The guarantee fee we receive in these transactions is generally 35
basis points.
From time to time, we may undertake certain activities to support the liquidity of K Certificates and SB Certificates. For more information, see Risk Factors - Other Risks - The profitability of our multifamily business could be adversely affected by a significant decrease in demand for our K Certificates and SB Certificates. Other Securitization Products Our other securitization products involve the issuance of pass-through securities that represent beneficial interests in trusts that hold pools of multifamily loans. The collateral for these securitizations may include loans underwritten and purchased by us at loan origination and loans we do not own prior to securitization and that we underwrite after (rather than at) origination.FREDDIE MAC | 2019 Form 10-K 47
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Management's Discussion and Analysis Our Business Segments | Multifamily
Summary of Our Primary Business Model and Its Impacts to Segment Earnings The following diagram summarizes the activities included in our primary business model and the corresponding impacts to our Segment Earnings. [[Image Removed: mfprimarybusinessmodeljan202.jpg]] Other Guarantee Products n Other mortgage-related guarantees - We guarantee mortgage-related assets held
by third parties in exchange for guarantee fee income, without securitizing
those assets. For example, we provide guarantees on certain tax-exempt multifamily housing revenue bonds secured by low- and moderate-income multifamily loans. Other CRT Products For the multifamily assets for which we have not transferred credit risk through securitization, we may pursue other strategies to reduce our risk exposure. Our other CRT products include the following: n MCIP - We purchase insurance coverage underwritten by a group of insurers
and/or reinsurers that generally provide first loss and/or mezzanine loss
credit protection. These transactions are similar in structure to the ACIS
contracts purchased by the Single-family Guarantee segment, except the
reference pool, in addition to loans, may include bonds underlying our other
mortgage-related guarantees. When specific credit events occur, we receive
compensation from the insurance policy up to an aggregate limit based on
actual losses. We require our counterparties to partially collateralize their
exposure to reduce the risk that we will not be reimbursed for our claims
under the policies.
n SCR notes - Through the issuance of our SCR notes, which are unsecured and
unguaranteed corporate debt obligations, we transfer to third parties a
portion of the credit risk of the loans underlying certain of our
consolidated other securitizations and certain of our other mortgage-related
guarantees. The interest we pay on our SCR notes effectively reduces the
guarantee fee income we would otherwise earn on the other mortgage-related
guarantees. SCR notes are generally similar in structure to our Single-family
Guarantee segment's STACR debt notes.
In addition to our other CRT products, we engage in whole loan sales, including sales of loans to funds to which we may also provide secured financing, to eliminate our interest-rate risk, liquidity risk, and credit risk exposure to certain loans. For additional information on multifamily credit enhancements, see Risk Management - Multifamily Mortgage Credit Risk - Transferring Credit Risk toThird-Party Investors . Investing Activities n Mortgage loans - We hold a portfolio of multifamily loans as part of a
buy-and-hold investment strategy. However, this strategy is not part of our
primary business model.
n Mortgage-related securities - Depending on market conditions and our business
strategy, we may purchase or sell guaranteed K Certificates or SB Certificates at issuance or in the secondary market.
n Other investments - We invest in certain non-mortgage investments, including
LIHTC partnerships and other secured lending activities. These LIHTC
partnerships invest directly in limited partnerships that own and operate
affordable multifamily rental properties that generate federal income tax
credits and deductible operating losses.
FREDDIE MAC | 2019 Form 10-K 48
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Management's Discussion and Analysis Our Business Segments | Multifamily
Customers
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Our multifamily loan activity is generally sourced through our Optigo network of approved lenders, who are primarily non-bank real estate finance companies and banks. We generally provide post-construction financing to apartment project operators with established performance records. The following charts show the concentration of our 2019 multifamily new business activity by our largest sellers and loan servicing by our largest servicers as ofDecember 31, 2019 . Any seller or servicer with a 10% or greater share is listed separately. Percentage of New Business
Activity(1) [[Image Removed: chart-a8dd3c8a87be5b35920a01.jpg]] (1) Excludes LIHTC new business activity.
Percentage of Servicing Volume(2) [[Image Removed: chart-30ad16e275915f56ac0a01.jpg]] (2) Percentage of servicing volume is based on the total multifamily mortgage portfolio, which includes loans where we do not exercise servicing control. Competition -------------------------------------------------------------------------------- We compete on the basis of price, service and products, including our use of certain securitization structures. Our principal competitors in the multifamily market are Fannie Mae, FHA, commercial and investment banks, CMBS conduits, savings institutions, and life insurance companies.
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Management's Discussion and Analysis Our Business Segments | Multifamily
Business Results -------------------------------------------------------------------------------- The graphs, tables, and related discussion below present the business results of our Multifamily segment. New Business Activity -------------------------------------------------------------------------------- New Business Activity for the Year EndedDecember 31 ,
[[Image Removed: chart-ca85cdcc9c05d0cdfc1.jpg]]
Acquisition of Units by AMI for the Year Ended
n In 3Q 2019, FHFA announced a revised loan purchase cap structure for the
multifamily business. The loan purchase cap will be
five-quarter period from 4Q 2019 through 4Q 2020 and applies to all
multifamily business activity, with no exclusions. To ensure a strong focus
on affordable housing and traditionally underserved markets, at least 37.5%
of the new multifamily business must be mission-driven, affordable housing
over the same five-quarter period.
n During 4Q 2019, our total new business activity subject to the new cap was
affordable housing. Furthermore, during 2019, we continued our support of
workforce housing through our continued purchases of manufactured housing
community loans and small balance loans.
n Outstanding commitments, including index lock commitments and commitments to
purchase or guarantee multifamily assets, were$14.6 billion and$18.7 billion as ofDecember 31, 2019 andDecember 31, 2018 , respectively. n Our new business activity was slightly higher for 2019 than 2018 due to
continued strong demand for multifamily financing and healthy multifamily
market fundamentals driving continued growth in overall multifamily mortgage
debt outstanding.
n The portion of our new mortgage loan purchase activity that was classified as
held-for-sale and intended for our securitization pipeline decreased to 87%
in 2019 from 93% in 2018 due to an increase in the issuance of fully
guaranteed and consolidated other securitizations as we continued to refine
the disposition path for certain loan products. The purchase activity that
remained in our securitization pipeline as of
with market demand for our securities, will be a driver for our primary securitizations in the first two quarters of 2020.FREDDIE MAC | 2019 Form 10-K 50
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Management's Discussion and Analysis Our Business Segments | Multifamily
Securitization, Guarantee, and Risk Transfer Activity --------------------------------------------------------------------------------
Securitization and Guarantee Activities for the Year EndedDecember 31 , [[Image Removed: chart-12a408a15b742b0f636.jpg]]
n Total securitization UPB increased during 2019 compared to 2018, primarily
due to a higher volume of fully guaranteed other securitizations.
n Approximately 90% and 91% of total securitization UPB related to our primary
securitizations during 2019 and 2018, respectively.
n The average guarantee fee rate on new guarantee contracts increased slightly
during 2019 compared to 2018, primarily driven by a higher volume of fully
guaranteed other securitizations that have higher negotiated guarantee fee
rates due to the lack of structural subordination.
n In addition to the credit risk we transferred to third parties through our
securitizations, we obtained credit protection up to
billion on
products and loss sharing arrangements during 2019 and 2018, respectively.
n We further reduced our risk exposure through loan sales to whole loan funds
of
FREDDIE MAC | 2019 Form 10-K 51
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Management's Discussion and Analysis Our Business Segments | Multifamily
Multifamily Portfolio and Market Support -------------------------------------------------------------------------------- The following table summarizes our multifamily portfolio and our support of the multifamily market. Table 14 - Multifamily Portfolio and Market Support (In millions) December 31, 2019 December 31, 2018 Guarantee portfolio: Primary securitizations$240,134 $210,419 Other securitizations 20,205 16,499 Other mortgage-related guarantees 10,514 10,405 Total guarantee portfolio 270,853 237,323 Mortgage-related investments portfolio: Unsecuritized mortgage loans held-for-sale 18,954 23,959 Unsecuritized mortgage loans held-for-investment 10,831 10,828 Mortgage-related securities(1) 5,889 7,385 Total mortgage-related investments portfolio 35,674 42,172 Other investments(2) 2,945 708 Total multifamily portfolio 309,472 280,203 Add: Unguaranteed securities(3) 40,666 35,835 Less: Acquired mortgage-related securities(4) (5,709 ) (7,160 ) Total multifamily market support$344,429 $308,878 (1) Includes mortgage-related securities acquired by us from our securitizations.
(2) Includes the carrying value of LIHTC investments and the UPB of non-mortgage
loans, including financing provided to whole loan funds.
(3) Reflects the UPB of unguaranteed securities issued as part of our
securitizations and amounts related to loans sold to whole loan funds that
were not financed by
(4) Reflects the UPB of mortgage-related securities that were both issued as
part of our securitizations and acquired by us. This UPB must be removed
from the mortgage-related securities balance to avoid double-counting the
exposure, as it is already reflected within the guarantee portfolio or unguaranteed securities.
n Our total multifamily portfolio increased during 2019, primarily due to our
strong loan purchase and securitization activity. We expect continued growth
in our total portfolio in 2020 as purchase and securitization activities
should outpace run off. n AtDecember 31, 2019 , approximately 75% of our held-for-sale loans were fixed-rate, while the remaining 25% were floating-rate.
n As of
of expected and stress credit risk on the multifamily guarantee portfolio
primarily through subordination in our securitizations. In addition, nearly
all of our securitization activities shifted substantially all of the
interest-rate and liquidity risk associated with the underlying collateral
away from
n We earn guarantee fees in exchange for providing our guarantee of some or all
of the securities we issue as part of our securitizations. The average
guarantee fee rate that we earn on our guarantee portfolio was 37 bps, and
the average remaining guarantee term was eight years, as of both
2019 and
the average guarantee fee rate over the average remaining guarantee term, the
actual amount earned will depend on the performance of the underlying collateral subject to our financial guarantee.
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Management's Discussion and Analysis Our Business Segments | Multifamily
Net Interest Yield -------------------------------------------------------------------------------- Net Interest Yield & Average Investment Portfolio Balance [[Image Removed: chart-4b82b3232e595f99a7ea01.jpg]]
n 2019 vs. 2018
l Net interest yield increased primarily due to a higher yield and higher
prepayment income received from mortgage-related securities, coupled with
lower funding costs on our held-for-sale mortgage loans driven by lower
interest rates.
l The weighted average investment portfolio balance of interest-earning
assets decreased due to a reduction of our unsecuritized
held-for-investment loans as we securitized more of these loans into fully
guaranteed and consolidated other securitizations.
n 2018 vs. 2017
l Net interest yield increased primarily due to higher prepayment income
received from mortgage-related securities, coupled with an increase in our
interest-only security holdings which generally have higher yields
relative to our non-interest-only securities and loans, partially offset
by higher average funding costs on our held-for-sale mortgage loans driven
by higher interest rates.
FREDDIE MAC | 2019 Form 10-K 53
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Management's Discussion and Analysis Our Business Segments | Multifamily
K Certificate Benchmark Spreads -------------------------------------------------------------------------------- K Certificate Benchmark Spreads as ofDecember 31 , [[Image Removed: chart-8a5a1838686555f3934a01.jpg]]
Source: Independent Dealers n The valuation of our securitization pipeline and held-for-sale commitments
for which we have elected the fair value option, along with the profitability
of our primary securitization product, the K Certificate, are affected by
both changes in K Certificate benchmark spreads and deal-specific attributes,
such as tranche size, risk distribution, and collateral characteristics (loan
term, coupon type, prepayment restrictions, and underlying property type).
These market spread movements and deal-specific attributes contribute to our
earnings volatility, which we manage by controlling the size of our
securitization pipeline and by entering into certain spread-related
derivatives. Spread tightening generally results in fair value gains, while
spread widening generally results in fair value losses.
n K Certificate benchmark spreads generally tightened during 2019, primarily
resulting in spread-related fair value gains on our held-for-sale mortgage
loans and commitments.FREDDIE MAC | 2019 Form 10-K 54
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Management's Discussion and Analysis Our Business Segments | Multifamily
Financial Results -------------------------------------------------------------------------------- The table below presents the components of the Segment Earnings and comprehensive income for our Multifamily segment. Table 15 - Multifamily Segment Financial Results
Year Over Year Change
Year Ended December 31, 2019 vs. 2018 2018 vs. 2017 (Dollars in millions) 2019 2018 2017 $ % $ % Net interest income$1,069 $1,096 $1,206 ($27 ) (2 )% ($110 ) (9 )% Guarantee fee income 1,101 861 750 240 28 111 15 Investment gains (losses), net 576 16 1,516 560
3,500 (1,500 ) (99 )
Other income (loss) 108 129 75 (21 ) (16 ) 54 72 Net revenues 2,854 2,102 3,547 752 36 (1,445 ) (41 ) Credit-related expense (18 ) 9 (30 ) (27 )
(300 ) 39 130
Administrative expense (503 ) (437 ) (395 ) (66 )
(15 ) (42 ) (11 )
Other expense (41 ) (36 ) (48 ) (5 ) (14 ) 12 25 Operating expense (544 ) (473 ) (443 ) (71 ) (15 ) (30 ) (7 ) Segment Earnings before income tax expense 2,292 1,638 3,074 654 40 (1,436 ) (47 ) Income tax expense (465 ) (319 ) (1,060 ) (146 ) (46 ) 741 70 Segment Earnings, net of taxes 1,827 1,319 2,014 508 39 (695 ) (35 ) Total other comprehensive income (loss), net of tax 101 (83 ) (77 ) 184 222 (6 ) (8 ) Total comprehensive income (loss)$1,928 $1,236 $1,937 $692 56 % ($701 ) (36 )% Key Drivers: n 2019 vs. 2018
l Net interest income remained relatively flat.
l Increase in guarantee fee income primarily driven by continued growth in
our multifamily guarantee portfolio, coupled with lower fair value losses
on our guarantee asset due to declining interest rates.
l Higher investment gains (net of other comprehensive income) primarily
driven by higher fair value gains on held-for-sale commitments due to
targeted price increases related to changing market conditions and spread
tightening. n 2018 vs. 2017
l Lower net interest income due to a decline in our weighted average
portfolio balance of interest-earning assets, partially offset by higher
net interest yields on an increased balance of interest-only securities.
l Higher guarantee fee income due to continued growth in our multifamily
guarantee portfolio, partially offset by lower average guarantee fee rates on new guarantee business volume and increased fair value losses on our guarantee asset due to rising interest rates. l Shift to investment losses (net of other comprehensive income) due to
spread widening on mortgage loans and commitments and mortgage-related
securities, coupled with lower fair value gains on held-for-sale commitments due to targeted price decreases related to our business strategy.FREDDIE MAC | 2019 Form 10-K 55
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Management's Discussion and Analysis Our Business Segments | Capital Markets
Capital Markets Business Overview --------------------------------------------------------------------------------The Capital Markets segment supports our strategic goals to exit conservatorship, create a world-class operating platform, and become the leader in housing by: n Managing the mortgage-related investments portfolio's risk-versus-return
profile using our internal economic framework;
n Distributing a portion of securitized loans from our cash purchase program
through the investment portfolio;
n Engaging in economically sensible transactions to reduce our less liquid
assets;
n Responding to market opportunities in funding our business activities;
n Managing our economic interest-rate risk through the use of derivatives and
various debt instruments;
n Attempting to align prepayment profiles for Freddie Mac TBA programs with
Fannie Mae's TBA characteristics; and n Delivering mortgage capital markets services, including our cash loan
purchase program, in conjunction with the Single-family Guarantee segment.
The Capital Markets segment is responsible for managing the majority of our mortgage-related investments portfolio, and providing company-wide treasury and interest-rate risk management functions. In addition, we are responsible for managing our securitization and resecuritization activities related to single-family loans, and supporting multifamily securitizations. Our mortgage portfolio management activities primarily include single-family unsecuritized loans and purchases and sales of agency mortgage-related securities. In addition, we actively engage in the structuring of our agency mortgage-related securities. Our portfolio management activities also include responsibility for maintaining the other investments portfolio, which is primarily used for short-term liquidity management. However, certain portions of the mortgage-related investments portfolio are not managed by us, including the portions of the portfolio related to multifamily assets, single-family seriously delinquent loans, and the credit risk on single-family performing and reperforming loans. We provide a company-wide treasury function, primarily managing our funding and liquidity needs on both a short- and long-term basis. The primary activities of the treasury function include issuing, calling and repurchasing other debt and maintaining a portfolio of non-mortgage investments. Our interest-rate risk management function consolidates and manages the overall interest-rate risk of the company. We actively monitor and economically hedge this risk, primarily through the use of derivative instruments. In addition, we further reduce these interest-rate exposures through active management of our debt funding mix and through the structuring of our investments in mortgage-related securities. We use fair value hedge accounting to reduce the variability in our GAAP earnings due to changes in interest rates. Finally, the Capital Markets segment is responsible for management of our securitization and resecuritization activities related to single-family loans, which are discussed in more detail in Our Business Segments - Single-Family Guarantee. We may forgo certain investment opportunities for a variety of reasons, including the limit on the size of our mortgage-related investments portfolio or the risk that an accounting treatment may create earnings variability. For additional information on the limits on the mortgage-related investments portfolio established by the Purchase Agreement and by FHFA, see Conservatorship and Related Matters - Limits on Our Mortgage-Related Investments Portfolio and Indebtedness. Products and Activities -------------------------------------------------------------------------------- Investing, Liquidity Management, and Related Activities In our Capital Markets segment, our objectives are to make appropriate risk and capital management decisions, effectively execute our strategy and be responsive to market conditions. We manage the following types of products: n Agency mortgage-related securities - We primarily invest inFreddie Mac
mortgage-related securities and may also invest in Fannie Mae and
mortgage-related securities from time to time. Our activities with respect to
these products may include purchases and sales, dollar roll transactions, and
structuring activities (e.g., resecuritizing existing agency securities into
REMICs and selling some or all of the resulting REMIC tranches).
n Single-family unsecuritized loans - We acquire single-family unsecuritized
loans in two primary ways:
l Loans acquired through our cash loan purchase program that are awaiting
securitization - We securitize most of the loans acquired through our cash
loan purchase program into
may be sold to investors or retained in our mortgage-related investments
portfolio; and l Seriously delinquent or modified loans that we have removed from our consolidated trusts - Certain of these loans may reperform, either on their own or through modification. Reperforming loans are managed by both
the Capital Markets and Single-family Guarantee segments, but are included
in the Capital Markets segment's financial
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Management's Discussion and Analysis Our Business Segments | Capital Markets
results. Loans that remain seriously delinquent are also managed by both the Capital Markets and Single-family Guarantee segments, but are included in the Single-family Guarantee segment's financial results. We continue to reduce the balance of our seriously delinquent and reperforming loans through a variety of methods, including loss mitigation and foreclosure activities and securitizations and sales. For more information on securitization and sales of seasoned loans, see Our Business Segments - Single-Family Guarantee - Business Overview - Products and Activities - Securitization and Sales of Seasoned Loans. n Other investments portfolio - We invest in other investments, including: (i)
the Liquidity and Contingency Operating Portfolio, primarily used for
short-term liquidity management, (ii) cash and other investments held by
consolidated trusts, (iii) investments used to pledge as collateral, and (iv)
secured lending activities.
In our secured lending activities: (i) we provide funds to lenders for mortgage loans that they will subsequently either sell through our cash purchase program or securitize into securities that they will deliver to us, (ii) we enter into securities purchased under agreements to resell as a mechanism to provide financing to investors inFreddie Mac securities to increase liquidity and expand the investor base for those securities, and (iii) we provide secured term financing through revolving lines of credit collateralized by the value of contractual mortgage servicing rights on certain mortgages that we own. However, we no longer extend such lines of credit to new customers. n Non-agency mortgage-related securities - We generally no longer purchase
non-agency mortgage-related securities, and have minimal investments in such
securities from our acquisitions in prior years. Our activities with respect
to this product are primarily sales. However, we may acquire such securities
in connection with our senior subordinate securitization structures backed by
seasoned loans. In recent years, we and FHFA reached settlements with a
number of institutions to mitigate or recover losses we recognized in prior
years.
The primary impacts to Segment Earnings are:
• Interest income on agency and non-agency mortgage-related securities,
unsecuritized loans, and our other investments portfolio;
• Fair value gains and losses due to changes in interest rate and market spreads
on our agency and non-agency mortgage-related securities and on certain
securities held within our other investments portfolio that are accounted for
as investment securities. These amounts are recognized in Segment Earnings or
total other comprehensive income(loss) depending upon their classification
(trading or available-for-sale, respectively);
• Amortization of cost basis adjustments, such as net amortization of loans from
our cash purchase program and related debt securities in consolidated trusts
and hedge accounting related basis adjustments; and
• Gains and losses on the sale of unsecuritized loans.
We evaluate the liquidity of our mortgage-related assets based on three categories (in order of liquidity): n Liquid - single-class and multi-class agency securities, excluding certain
structured agency securities collateralized by non-agency mortgage-related
securities;
n Securitization pipeline - performing single-family loans purchased for cash
and primarily held for a short period until securitized, with the resulting
n Less liquid - assets that are less liquid than both agency securities and
loans in the securitization pipeline (e.g., reperforming loans and non-agency
mortgage-related securities).
We may undertake various activities to support our presence in the agency securities market or to support the liquidity of our securities, including their price performance relative to comparable Fannie Mae securities. These activities may include the purchase and sale of agency securities, dollar roll transactions, and structuring activities, such as resecuritization of existing agency securities and the sale of some or all of the resulting securities. Depending upon market conditions, there may be substantial variability in any period in the total amount of securities we purchase or sell. The purchase or sale of agency securities could, at times, adversely affect the price performance of our securities relative to comparable Fannie Mae securities. We may incur costs to support our presence in the agency securities market and to support the liquidity and price performance of our securities. For more information, see Risk Factors - Other Risks - A significant decline in the price performance of or demand for our UMBS could have an adverse effect on the volume and/or profitability of our new single-family guarantee business.
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Management's Discussion and Analysis Our Business Segments | Capital Markets
Funding and Liquidity Management Activities Our treasury function manages the funding needs of the company, including the Capital Markets segment, primarily through the issuance of unsecured other debt. The type and term of debt issued is based on a variety of factors and is designed to meet our ongoing cash needs and to comply with our Liquidity Management Framework. This Framework provides a mechanism for us to sustain periods of market illiquidity, while being able to maintain certain business activities and remain current on our obligations. See Liquidity and Capital Resources - Liquidity Management Framework for additional discussion of our Liquidity Management Framework. We primarily use the following types of products as part of our funding and liquidity management activities: n Discount notes and Reference Bills® - We issue short-term instruments with
maturities of one year or less. These products are generally sold on a
discounted basis, paying principal only at maturity. Reference Bills are
auctioned to dealers on a regular schedule, while discount notes are issued in
response to investor demand and our cash needs.
n Medium-term notes - We issue a variety of fixed-rate and variable-rate
medium-term notes, including callable and non-callable securities, and
zero-coupon securities, with various maturities.
n Reference Notes® securities - Reference Notes securities are non-callable
fixed-rate securities, which we generally issue with original maturities
greater than or equal to two years.
n Securities sold under agreements to repurchase - Collateralized short-term
borrowings where we sell securities to a counterparty with an agreement to
repurchase those securities at a future date.
In addition, proceeds from STACR debt notes, SCR debt notes, upfront fees and net worth are used to meet the funding needs of the company. We expect the volume of our STACR debt issuance to continue to decline as STACR debt note transactions will be replaced withSTACR Trust note transactions. We consider the issuance of these debt notes when managing the treasury function for the company. For a description of STACR debt notes, see Our Business Segments - Single-Family Guarantee - Business Overview - Products and Activities, and for a description of SCR notes, see Our Business Segments - Multifamily - Business Overview - Products and Activities. The average life of our assets is longer than the average life of our liabilities, which creates liquidity risk. To manage short-term liquidity risk, we may hold a combination of cash, cash-equivalent, and non-mortgage-related investments in our Liquidity and Contingency Operating Portfolio. These instruments are limited to those we expect to be liquid or mature in the short term. We also lend available cash on a short-term basis through transactions where we purchase securities under agreements to resell. This portfolio is designed to allow us to meet all of our obligations in the event that we lose access to the unsecured debt markets for a period of time. See Liquidity and Capital Resources for a further discussion of our funding and liquidity management activities. The primary impacts to Segment Earnings are:
• Interest expense on our various funding products and
• Gains and losses on the early termination (call or repurchase) of our funding
products. Interest-Rate Risk Management Activities We manage the economic interest-rate risk for the company and have management-approved limits for interest-rate risk, as measured by our models. See Risk Management - Market Risk for additional information, including the measurement of the interest-rate sensitivity of our financial assets and liabilities. There is a cash flow mismatch between the company's assets and liabilities that we use to fund those assets. This mismatch in cash flows not only leads to liquidity risk, but also results in interest-rate risk. We typically use interest-rate derivatives to reduce the economic risk exposure due to this mismatch. Using our risk management practices described in the Risk Management - Market Risk section, we seek to reduce this impact to low levels. Additionally, assets that are likely to be sold prior to their final maturity may have a different debt and derivative mix than assets that we plan to hold for a longer period. As a result, interest-rate risk measurements for those assets may include additional assumptions (such as a view on expected changes in market spreads) concerning their price sensitivity rather than just a longer-term view of cash flows. To manage our interest-rate risk, we primarily use interest rate swaps, options, swaptions, and futures. When we use derivatives to mitigate our risk exposures, we consider a number of factors, including cost, exposure to counterparty credit risk, and our overall risk management strategy. While our interest-rate risk management activities are primarily focused on reducing our economic interest-rate risk, we also use hedge accounting strategies to reduce our GAAP earnings variability. We use hedge accounting to better align our earnings with the economics of our business, but hedge accounting is not intended to change the investment and portfolio management
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Management's Discussion and Analysis Our Business Segments | Capital Markets
decisions that our segment would otherwise make. For more information on our use of hedge accounting see Risk Management - Market Risk - GAAP Earnings Variability and Note 9. We have participated in transactions that support the development of the Secured Overnight Financing Rate (SOFR) as an alternative rate to LIBOR and expect to continue to do so for the foreseeable future. These transactions include investment in and issuance of SOFR indexed floating-rate debt securities and execution of SOFR indexed derivatives. For additional details on SOFR see Risk Factors - Market Risk - The discontinuance of LIBOR after 2021 could negatively affect the fair value of our financial assets and liabilities, results of operations, and net worth. A transition to an alternative reference interest rate could present operational problems and result in market disruption, including inconsistent approaches for different financial products, as well as disagreements with counterparties. The primary impacts to Segment Earnings are:
• Fair value gains and losses on derivatives not designated in qualifying hedge
relationships;
• Interest income/expense on derivatives; and
• Differences between changes in the fair value of the hedged item attributable
to the risk being hedged and changes in the fair value of the hedging instrument for derivatives designated in qualifying fair value hedge accounting relationships. Summary of our Primary Business Model and Its Impacts to Segment Earnings [[Image Removed: cmbusinessmodelfeb2020.jpg]] Securitization Activities We manage the company's securitization and resecuritization activities related to single-family loans. See Our Business Segments - Single-Family Guarantee for a discussion of our single-family securitization and guarantee products. Customers -------------------------------------------------------------------------------- Our customers include banks and other depository institutions, insurance companies, money managers, central banks, pension funds, state and local governments, REITs, brokers and dealers, and a variety of lenders as discussed in Our Business Segments - Single-Family Guarantee - Business Overview - Customers. Our unsecured other debt securities and structured mortgage-related securities are initially purchased by dealers and redistributed to their customers.FREDDIE MAC | 2019 Form 10-K 59
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Management's Discussion and Analysis Our Business Segments | Capital Markets
Competition
--------------------------------------------------------------------------------
Our competitors in the Capital Markets segment are firms that invest in loans and mortgage-related assets and issue corporate debt, including Fannie Mae, REITs, supranationals (international institutions that provide development financing for member countries), commercial and investment banks, dealers, savings institutions, insurance companies, the Federal Farm Credit Banks, the FHLBs, and non-bank loan aggregators, who are both our customers and competitors. Business Results -------------------------------------------------------------------------------- The graphs and related discussion below present the business results of our Capital Markets segment. Investing Activity -------------------------------------------------------------------------------- The following graphs present the Capital Markets segment's total investments portfolio and the composition of its mortgage investments portfolio by liquidity category. Investments Portfolio as ofDecember 31 ,
[[Image Removed: chart-2b805e56f6f25115be5a01.jpg]]
Mortgage Investments Portfolio as ofDecember 31 ,
[[Image Removed: chart-26a234c04f655c35be3a01.jpg]] n The balance of our mortgage investments portfolio remained relatively flat
from
Matters - Managing Our Mortgage-Related Investments Portfolio Over Time for
additional details.
n The balance of our other investments portfolio increased 61.5% primarily due
to a higher consolidated trusts account balance driven by higher loan
prepayments, coupled with higher near-term cash needs for upcoming maturities
and anticipated calls of other debt, and a higher expected loan purchase
forecast. n The overall liquidity of our mortgage investments portfolio continued to improve as our less liquid assets decreased during 2019. The percentage of less liquid assets relative to our total mortgage investments portfolio declined from 26.6% atDecember 31, 2018 to 17.9% atDecember 31, 2019 , primarily due to repayments, securitizations, and sales. n We continue to participate in transactions that support the development of
SOFR as an alternate rate to LIBOR. These transactions include investment in
and issuance of SOFR indexed floating-rate debt securities and execution of SOFR indexed derivatives.FREDDIE MAC | 2019 Form 10-K 60
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Management's Discussion and Analysis Our Business Segments | Capital Markets
Reduction in Less Liquid Assets --------------------------------------------------------------------------------
Less Liquid Assets as of December 31,[[Image Removed: chart-13b06089bbfe52a99a7a01.jpg]] Sales of Less Liquid Assets for the Year EndedDecember 31 , [[Image Removed: chart-d42ef5115cf756cf9caa01.jpg]]
n Since 2013, we have focused on reducing, in an economically sensible manner,
our holdings of certain less liquid assets, including single-family
reperforming loans and non-agency mortgage-related securities. Our
disposition strategies for our less liquid assets include securitizations and
sales.
n During 2019, our sales of less liquid assets included
reperforming loans using our senior subordinate securitization structures. As
part of these transactions, we retained certain of the guaranteed senior
securities for our mortgage-related investments portfolio. We also sold
billion of non-agency mortgage-related securities.
n In 2018 and 2017, we securitized
of reperforming loans into Level 1 Securitization Products. We did not
execute any such transactions in 2019, as our use of this strategy has
declined over time with our primary strategy now utilizing senior subordinate
securitization structures.FREDDIE MAC | 2019 Form 10-K 61
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Management's Discussion and Analysis Our Business Segments | Capital Markets
Net Interest Yield and Average Balances -------------------------------------------------------------------------------- Net Interest Yield & Average Investments Portfolio Balances (Weighted average balance in billions) [[Image Removed: chart-75051cea3ae65f00b8ba01.jpg]]
n 2019 vs. 2018 - Net interest yield decreased by 28 basis points primarily due
to the lower and flatter interest rate environment, coupled with a change in
our investment mix, as the other investments portfolio represented a larger
percentage of our total investments portfolio, and an increase in amortization expense resulting from higher loan liquidation rates.
n 2018 vs. 2017 - Net interest yield increased by 15 basis points primarily due
to higher yields on our newly acquired mortgage-related assets and other
investments as a result of increases in interest rates, coupled with a change
in our investment mix due to reductions in both our less liquid assets and
the percentage of our other investments portfolio relative to our total
investments portfolio and larger benefit provided by non-interest bearing
funding due to increases in both short-term interest rates and the percentage
of non-interest bearing funding relative to our total liabilities.
n Net interest yield for the Capital Markets segment is not affected by our
hedge accounting programs due to reclassifications made for Segment Earnings.
See Note 13 for more information.
FREDDIE MAC | 2019 Form 10-K 62
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Management's Discussion and Analysis Our Business Segments | Capital Markets
Financial Results -------------------------------------------------------------------------------- The table below presents the components of the Segment Earnings and comprehensive income for our Capital Markets segment. Table 16 - Capital Markets Segment Financial Results
Year Over Year Change
Year Ended December 31, 2019 vs. 2018 2018 vs. 2017 (Dollars in millions) 2019 2018 2017 $ % $ % Net interest income$2,486 $3,217 $3,279 ($731
) (23 )% (
Investment gains (losses), net (36 ) 1,803 1,772 (1,839 ) (102 ) 31 2 Other income (loss) (700 ) 340 4,913 (1,040 ) (306 ) (4,573 ) (93 ) Net revenues 1,750 5,360 9,964 (3,610
) (67 ) (4,604 ) (46 )
Administrative expense (414 ) (365 ) (330 ) (49 ) (13 ) (35 ) (11 ) Other expense (54 ) (11 ) (81 ) (43 ) (391 ) 70 86 Operating expense (468 ) (376 ) (411 ) (92 ) (24 ) 35 9 Segment Earnings before income tax expense 1,282 4,984 9,553 (3,702 ) (74 ) (4,569 ) (48 ) Income tax expense (260 ) (976 ) (3,296 ) 716 73 2,320 70 Segment Earnings, net of taxes 1,022 4,008 6,257 (2,986 ) (75 ) (2,249 ) (36 ) Total other comprehensive income (loss), net of tax 494 (527 ) (30 ) 1,021 194 (497 ) (1,657 ) Total comprehensive income (loss)$1,516 $3,481 $6,227 ($1,965 ) (56 )% ($2,746 ) (44 )% The portion of total comprehensive income (loss) driven by interest rate-related and market spread-related fair value changes, after-tax, is presented in the table below. These amounts affect various line items in the table above, including investment gains (losses), net, income tax expense, and total other comprehensive income (loss), net of tax. Table 17 - Capital Markets Segment Interest Rate-Related and Market Spread-Related Fair Value Changes, Net of Tax Year Over Year Change Year Ended December 31, 2019 vs. 2018 2018 vs. 2017 (Dollars in millions) 2019 2018 2017 $ % $ % Interest rate-related ($0.4 ) ($0.3 ) ($0.3 ) ($0.1 ) (33 )% $- - % Market spread-related 0.2 0.4 0.8 (0.2 ) (50 ) (0.4 ) (50 ) Key Drivers: n 2019 vs. 2018
l Net interest income decreased primarily due to the lower and flatter
interest rate environment, which also resulted in an increase in
amortization expense due to higher loan liquidation rates and a change in
our investment mix, as the other investments portfolio represented a larger percentage of our total investments portfolio.
l Decrease in investment gains (losses), net of
offset by an increase of$1.0 billion in other comprehensive income. The remaining decline in investment gains (losses) was primarily due to a decline of approximately$0.5 billion in gains from debt repurchase
activity and the
spread-related fair value losses shown in the table above. Both of these
declines were primarily attributable to the decrease in long-term interest
rates. Our derivative volume increased beginning in 2Q 2019 as we updated
our interest-rate risk measures to include upfront fees (including
buy-downs) related to single-family credit guarantee activity recorded in
the single-family segment. This increase in derivative volume introduced
additional volatility in our financial results that primarily drove our
interest rate-related fair value losses. See Risk Management - Market Risk
for additional information on the effect of market-related items on our comprehensive income.
l Decrease in other income primarily due to lower net amortization income
driven by the timing differences in amortization related to prepayment
between debt of consolidated trusts and the underlying loans from our cash
purchase program. For further discussion on timing differences in
amortization, see MD&A - Consolidated Results of Operations.
n 2018 vs. 2017
l Net interest income decreased primarily due to the continued reduction in
the balance of our mortgage-related investments portfolio. This decrease
was partially offset by higher yields on our newly acquired
mortgage-related assets and other investments as interest rates increased,
coupled with changes in our investment mix due to
FREDDIE MAC | 2019 Form 10-K 63
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Management's Discussion and Analysis Our Business Segments | Capital Markets
reductions in both our less liquid assets and the percentage of our other investments portfolio relative to our total investments portfolio, and larger benefit provided by non-interest bearing funding due to increases in both short-term interest rates and the percentage of non-interest bearing funding relative to our total liabilities. l Decrease in investment gains (losses), net (net of other comprehensive
income (loss)) primarily due to lower spread-related gains driven by lower
non-agency mortgage-related securities balances and relatively flat
interest rate-related fair value losses. These interest rate-related fair
value losses were mostly offset by the change in fair value of the hedged
items attributable to interest-rate risk in our hedge accounting programs.
See Risk Management - Market Risk for additional information on the effect
of market-related items on our comprehensive income.
l Decrease in other income primarily due to recognition of
proceeds received during 2017 from the RBS settlement compared to a
billion gain recognized from the Nomura judgment during 2018 related to
certain of our non-agency mortgage related securities, coupled with lower
amortization of debt securities of consolidated trusts during 2018 driven
by a decrease in prepayments as a result of higher interest rates. For more information on these settlements, see Note 14.FREDDIE MAC | 2019 Form 10-K 64
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Management's Discussion and Analysis Our Business Segments | All Other
All Other Comprehensive Income
-------------------------------------------------------------------------------- The table below shows our comprehensive income (loss) for the All Other category. Table 18 - All Other Category Comprehensive Income
Year Over Year Change
Year Ended December 31, 2019 vs. 2018 2018 vs. 2017 (Dollars in millions) 2019 2018 2017 $ % $ % Comprehensive income (loss) - All Other $- $- ($5,405 ) $- -%$5,405 100% Key Drivers: n 2018 vs. 2017 - Changes in comprehensive income (loss) driven by:
l Higher income tax expense in 2017 due to the revaluation of our net
deferred tax asset driven by the Tax Cuts and Jobs Act, which reduced the
statutory corporate income tax rate from 35% to 21% for tax years after
2017. For more information on the statutory tax rate change, see Note 12.
FREDDIE MAC | 2019 Form 10-K 65
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Management's Discussion and Analysis Risk Management | Overview
RISK MANAGEMENT Overview To achieve our mission of providing liquidity, stability, and affordability to theU.S. housing market, we take risks as an integral part of our business activities. Risk is the possibility that events will adversely affect the achievement of our mission, strategy, and business objectives. Risk can manifest itself in many ways and the responsibility for risk management resides at all levels of the company. We seek to take risks in a safe and sound, well-controlled manner to earn acceptable risk-adjusted returns on both a corporate-wide and, where applicable, transaction basis. Our goal is to maintain a strong risk culture where employees are risk aware, collaborative, and transparent, individually accountable for their decisions, and conduct business in an effective, legal, and ethical manner. We utilize a risk taxonomy to define and classify risks that we face in operating our business. These risks have the potential to adversely affect our current or projected financial and operational resilience. The risk taxonomy is also the basis for aligning corporate risk policies and standards. The key types of risks are: n Credit Risk; n Operational Risk; n Market Risk; n Liquidity Risk; n Strategic Risk; and n Reputation Risk. Strategic and reputation risks are factored into business decisions and are a shared responsibility of senior management. For more discussion of these and other risks facing our business, see Risk Factors. See Liquidity and Capital Resources for a discussion of liquidity risk. Enterprise Risk Framework -------------------------------------------------------------------------------- The enterprise risk framework establishes the foundation for how we manage risk to achieve our objectives and strategies. The enterprise risk framework: n Serves as the basis for managing risk in a consistent manner and across a
range of stressful conditions;
n Defines risk roles and responsibilities across the three lines of defense;
n Provides for independent risk assessment and oversight; and
n Promotes accountability and transparency in risk management decisions and
execution.
The framework includes the following components: n Three Lines of Defense - The business lines, with support from the enterprise
divisions, ERM, and internal audit, make up the three lines of defense.
n Risk Culture - The Board and all levels of management support an effective
risk culture by establishing and exercising accountability, promoting risk
awareness, and by encouraging proactive risk discussions. A strong risk
culture reinforces the importance of our risk management strategy, and
promotes collaboration and transparency among the three lines of defense.
n Risk Governance - Risk governance comprises the risk responsibilities of the
three lines of defense, the risk committee structure at the division,
enterprise, and Board levels, and reporting and escalation requirements.
n Risk Appetite - The risk appetite is the aggregate level and types of risk
that the Board and management are willing to assume to achieve the company's
strategic objectives. The risk appetite is integrated and aligned with the
strategic plans for the company and each business segment.
n Risk Authority - The Board delegates authority to the CEO. The CEO delegates
authority to members of executive management. Authority delegated from the
CEO is subject to limitations set forth in corporate risk policies or standards approved by the CRO or his/her delegate. n Corporate Risk Policies and Standards - Corporate risk policies provide
clarity on roles and responsibilities, establish approval requirements for
risk decisions, and define escalation and reporting requirements. Corporate
risk standards provide the minimum requirements to implement corporate risk
policies and may also establish approval requirements for risk decisions.
n Capital Framework - We use both FHFA's CCF and internal capital methodologies
to measure risk for making economically effective decisions. See Liquidity
and Capital Resources - Capital Resources -Conservatorship Capital Framework.FREDDIE MAC | 2019 Form 10-K 66
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Management's Discussion and Analysis Risk Management | Overview
n Risk-Adjusted Return - We use risk-adjusted return, based on the CCF, to measure ROCC of business lines, transactions, and initiatives. We seek to
achieve acceptable risk-adjusted returns consistent with pre-set targets.
n Risk Profile - The risk profile is a point-in-time assessment and measurement
of inherent and/or residual risk for a specific risk type, measured at a
divisional or enterprise level for the relevant risk types. The risk profile
considers risk trends, the impact of emerging, escalated, and top risks,
control performance, and risk indicators. The risk profile also incorporates
results from stress testing or scenario analysis, judgmental evaluation of
external and internal factors, or any development that may affect performance
relative to the strategy and business objectives.
Enterprise Risk Governance Structure -------------------------------------------------------------------------------- We manage risk using a three-lines-of-defense risk management model and governance structure that includes enterprise-wide oversight by the Board and its committees, the CRO, the CCO, and our corporate ERC. The information and diagram below present the responsibilities associated with our three-lines-of-defense risk management model and our risk governance structure. The risk governance structure also includes division risk committees to actively discuss and monitor business-specific risk profiles, risk decisions, and risk appetite metrics, limits and thresholds, and risk type committees to oversee specific risk types that are present in and span across business lines. For more information on the role of the Board and its committees, see Directors, Corporate Governance, and Executive Officers - Corporate Governance - Board and Committee Information.FREDDIE MAC | 2019 Form 10-K 67
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Management's Discussion and Analysis Risk Management | Overview
[[Image Removed: riskmanagementdiagramjan2020.jpg]]
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Management's Discussion and Analysis Risk Management | Credit Risk
Credit Risk Overview -------------------------------------------------------------------------------- Credit risk is the risk associated with the inability or failure of a borrower, issuer, or counterparty to meet its financial and/or contractual obligations. We are exposed to both mortgage credit risk and counterparty credit risk. Mortgage credit risk is the risk associated with the inability or failure of a borrower to meet its financial and/or contractual obligations. We are exposed to two types of mortgage credit risk: n Single-family mortgage credit risk, through our ownership or guarantee of
loans in the single-family credit guarantee portfolio and
n Multifamily mortgage credit risk, through our ownership or guarantee of loans
in the multifamily mortgage portfolio.
Counterparty credit risk is the risk associated with the inability or failure of a counterparty to meet its contractual obligations. In the sections below, we provide a general discussion of our enterprise risk framework and current risk environment for mortgage credit risk and for counterparty credit risk. Single-Family Mortgage Credit Risk -------------------------------------------------------------------------------- We manage our exposure to single-family mortgage credit risk, which is a type of consumer credit risk, using the following principal strategies: n Maintaining prudent underwriting standards and quality control practices and
managing seller/servicer performance;
n Transferring credit risk to third-party investors;
n Monitoring loan performance and characteristics;
n Engaging in loss mitigation activities; and
n Managing foreclosure and REO activities.
Maintaining Prudent Underwriting Standards and Quality Control Practices and Managing Seller/Servicer Performance -------------------------------------------------------------------------------- We employ multiple strategies to maintain loan quality and data transparency: n Underwriting standards, as published in our Guide and incorporated in Freddie Mac Loan AdvisorSM, establish the requirements for eligibility, documentation, and representations and warranties;
n Loan quality control practices, including post-close credit review and the
underwriting defects repurchase process, help to ensure that the loan
origination process is in compliance with our Guide and that loans perform at
or above expected levels; and
n Robust seller/servicer management, including in-house quality control and
performance monitoring, provides that quality control is maintained for loans
sold and/or serviced by third-parties.
Underwriting Standards We use a delegated underwriting process in connection with our acquisition of single-family loans whereby we set eligibility and underwriting standards, and sellers represent and warrant to us that loans they sell to us meet these standards. Our eligibility and underwriting standards are used to assess loans based on a number of characteristics. Limits are established on the purchase of loans with certain higher risk characteristics. These limits are designed to balance our credit risk exposure while supporting affordable housing in a responsible manner. Our purchase guidelines generally provide for a maximum original LTV ratio of 97% for creditworthy first-time homebuyers and for a targeted segment of creditworthy borrowers meeting certain AMI requirements under our affordable housing initiatives, a maximum original LTV ratio of 95% for all other home purchase and no cash out refinance loans, a maximum original LTV ratio of 80% for cash-out refinance loans, and no maximum LTV ratio for fixed-rate HARP loans and fixed-rate Enhanced Relief Refinance program loans. InJuly 2019 , we lowered the AMI requirements under our Home Possible loan initiative which will reduce the amount of 97% LTV loans we buy under the initiative. Loan Advisor is our main tool for assessing loan eligibility and documentation. Loan Advisor is a set of integrated software applications and services designed to give lenders access to our view of risk, loan quality, and eligibility during the origination process, which promotes efficient commerce between lenders andFreddie Mac . As a key component of Loan Advisor, Loan Product Advisor® takes advantage of proprietary data models and intelligent automation to ensure all loans meet our
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Management's Discussion and Analysis Risk Management | Single-Family Mortgage Credit Risk
underwriting standards. Loan Product Advisor features innovative tools and offerings leveraging algorithms to enhance the origination process and generates an assessment of a loan's credit risk and overall quality. Historically, the majority of our purchase volume was assessed using either Loan Product Advisor, Fannie Mae's comparable software Desktop Underwriter (DU), or the seller's proprietary automated underwriting system. During 2019, we initiated steps to require the loans we purchase to be assessed by one ofFreddie Mac's proprietary underwriting software tools, Loan Product Advisor or Loan Quality Advisor®, prior to purchase. We have made significant progress in this initiative such that by the end of 2019, the majority of loans we purchase are now assessed byFreddie Mac proprietary software ensuring their compatibility with our risk appetite and reducing the volume of loans we acquire with layered risk. With Loan Advisor, lenders can actively monitor representation and warranty relief earlier in the mortgage loan production process. Loan Advisor offers limited representation and warranty relief for certain loan components that satisfy automated data analytics related to appraisal quality, valuation, borrower assets, and borrower income. In general, limited representation and warranty relief is only offered when information provided by lenders is validated through the use of independent data sources. If we discover that the representations or warranties related to a loan 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 contractual remedies include the ability to require the seller or servicer to repurchase the loan at its current UPB, reimburse us for losses realized with respect to the loan after consideration of any other recoveries, and/or indemnify us. Our current remedies framework provides for the categorization of loan origination defects for loans with settlement dates on or afterJanuary 1, 2016 . Among other items, the framework provides that "significant defects" will result in a repurchase request or a repurchase alternative, such as recourse or indemnification. Under our current selling and servicing representation and warranty framework for our mortgage loans, we relieve sellers of repurchase obligations for breaches of certain selling representations and warranties for certain types of loans, including: n Loans that have established an acceptable payment history for 36 months (12
months for relief refinance loans) of consecutive, on-time payments after
purchase, subject to certain exclusions and
n Loans that have satisfactorily completed a quality control review.
An independent dispute resolution process for alleged breaches of selling or servicing representations and warranties on our loans allows for a neutral third party to render a decision on demands that remain unresolved after the existing appeal and escalation processes have been exhausted. Quality Control Practices We employ a quality control process to review loan underwriting documentation for compliance with our standards using both random and targeted samples. We also perform quality control reviews of many delinquent loans and review all loans that have resulted in credit losses before the representations and warranties are relieved. Sellers may appeal our ineligible loan determinations prior to repurchase of the loan. We use a standard quality control process that facilitates more timely reviews and is designed to identify breaches of representations and warranties early in the life of the loan. Proprietary tools, such as Quality Control Advisor®, provide greater transparency into our customer quality control reviews. Managing Seller/Servicer Performance We actively monitor seller and servicer performance, including compliance with our standards. We maintain approval standards for our seller/servicers, which include requiring our sellers to maintain an in-house quality control program with written procedures that operates independently of the seller's underwriting and origination functions. We monitor servicer performance using our Servicer Success Scorecard and periodically review our seller/servicers' operational processes. We also periodically change seller/servicer guidelines based on the results of our mortgage portfolio monitoring, if warranted. Loan Purchase Credit Characteristics The credit quality of our single-family loan purchases remains strong by historical standards. Risk decreased during 2019 as our refinance volume increased due to declining interest rates and the reduction in the volume of higher risk loans we acquire, including loans with layered risk. The graphs below show the credit profile of the single-family loans we purchased or guaranteed in each of the last three years.
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Management's Discussion and Analysis Risk Management | Single-Family Mortgage Credit Risk
Weighted Average Original LTV Ratio [[Image Removed: chart-5e92b650d0c454699d3a01.jpg]] Weighted Average Original Credit Score (1)
[[Image Removed: chart-c52da2a957635f83b2aa01.jpg]]
(1) Original credit score is based on three credit bureaus (Equifax, Experian,
and
The table below contains additional information about the single-family loans we purchased or guaranteed in the last three years. Table 19 - Single-Family New Business Activity Year Ended December 31, 2019 2018 2017 (Dollars in millions) Amount % of Total Amount % of Total Amount % of Total 30-year or more amortizing fixed-rate$389,515 86 %$266,995 87 %$275,677 80 % 20-year amortizing fixed-rate 15,381 3 8,373 3 12,338 4 15-year amortizing fixed-rate 43,164 10 28,878 9 45,597 13 Adjustable-rate 5,257 1 3,848 1 9,841 3 FHA/VA and other governmental 164 - 103 - 113 - Total$453,481 100 %$308,197 100 %$343,566 100 % Percentage of purchases DTI ratio > 45% 14 % 18 % 13 % Detached/townhome property type 92 92 91 Primary residence 90 90 89 Loan purpose Purchase 55 69 58 Cash-out refinance 18 19 22 Other refinance 27 12 20 FREDDIE MAC | 2019 Form 10-K 71
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Management's Discussion and Analysis Risk Management | Single-Family Mortgage Credit Risk
Transferring Credit Risk toThird-Party Investors -------------------------------------------------------------------------------- Types of Credit Enhancements Our Charter requires coverage by specified credit enhancements or participation interests on single-family loans with LTV ratios above 80% at the time of purchase. Most of our loans with LTV ratios above 80% are protected by primary mortgage insurance, which provides loan-level protection against loss up to a specified amount, the premium for which is typically paid by the borrower. Generally, an 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 sale, before a claim can be filed under a primary mortgage insurance policy. 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. In addition to obtaining credit enhancements required by our Charter, we also enter into various CRT transactions in which we transfer mortgage credit risk to third parties. The table below contains a summary of the types of credit enhancements we use to transfer credit risk on our single-family loans. See Single-Family Guarantee - Business Overview - Products and Activities for more information on our CRT transactions. Category Products
Accounting
CRT Coverage type
treatment
Primary mortgage insurance Primary mortgage insurance No Front-end
Attached STACR STACR Trust notes Yes Back-end Freestanding STACR debt notes Yes Back-end Debt ACIS Yes Back-end Freestanding Insurance/reinsurance AFRM Yes Front-end Freestanding IMAGIN Yes Front-End Freestanding Senior subordinate securitization structures Yes Back-end Attached backed by seasoned loans (non-consolidated) Subordination Senior subordinate securitization structures backed by recently Yes Back-end Debt originated loans (consolidated) Lender risk-sharing Lender risk sharing Yes Front-end Freestanding Credit Enhancement Coverage for Single-Family Credit Guarantee Portfolio The tables below provide information on the total protected UPB and maximum coverage associated with credit enhanced loans in our single-family credit guarantee portfolio as ofDecember 31, 2019 andDecember 31, 2018 , respectively. Table 20 - Details of Credit Enhanced Loans in Our Single-Family Credit Guarantee Portfolio Outstanding as of December 31, 2019 Percentage of Single-Family Credit Guarantee Protected UPB(1) Portfolio Maximum Coverage(2) (Dollars in millions) Total Total First Loss(3) Mezzanine Total Primary mortgage insurance$421,870 21 %$107,690 $-$107,690 STACR 824,359 41 5,874 19,238 25,112 Insurance/reinsurance 863,149 43 2,483 7,674 10,157 Subordination 44,941 2 2,608 2,791 5,399 Lender risk-sharing 24,078 1 5,077 580 5,657 Other 1,056 - 1,051 - 1,051 Less: UPB with multiple CRT and/or other credit enhancements (1,058,402 ) (52 ) - - - Single-family credit guarantee portfolio with credit enhancement 1,121,051 56 124,783 30,283 155,066 Single-family credit guarantee portfolio without credit enhancement 873,398 44 - - - Total$1,994,449 100 %$124,783 $30,283 $155,066 FREDDIE MAC | 2019 Form 10-K 72
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Management's Discussion and Analysis Risk Management | Single-Family Mortgage Credit Risk Outstanding as of December 31, 2018 Percentage of Single-Family Credit Guarantee Protected UPB(1) Portfolio Maximum Coverage(2) (Dollars in millions) Total Total First Loss(3) Mezzanine Total Primary mortgage insurance$378,594 20 %$96,996 $-$96,996 STACR 766,415 40 3,777 18,845 22,622 Insurance/reinsurance 808,484 43 1,706 7,572 9,278 Subordination 41,277 2 1,923 2,046 3,969 Lender risk-sharing 17,458 1 4,830 340 5,170 Other 1,305 - 1,290 - 1,290 Less: UPB with multiple CRT and/or other credit enhancements (991,109 ) (52 ) - - - Single-family credit guarantee portfolio with credit enhancement 1,022,424 54 110,522 28,803 139,325 Single-family credit guarantee portfolio without credit enhancement 873,762 46 - - - Total$1,896,186 100 %$110,522 $28,803 $139,325
(1) For STACR and certain insurance/reinsurance transactions (e.g., ACIS),
represents the UPB of the assets included in the reference pool. For other
insurance/reinsurance transactions, represents the UPB of the assets covered
by the insurance policy. For subordination, represents the UPB of the
guaranteed securities, which represents the UPB of the assets included in
the trust net of the protection provided by the subordinated securities.
(2) For STACR transactions, represents the outstanding balance held by third
parties. For insurance/reinsurance transactions, represents the remaining
aggregate limit of insurance purchased from third parties. For
subordination, represents the outstanding UPB of the securities that are
subordinate to
(3) First loss includes the most subordinate securities (i.e., B tranches) in our STACR transactions and their equivalent in ACIS and other CRT transactions. We had coverage remaining of$155.1 billion and$139.3 billion on our single-family credit guarantee portfolio as ofDecember 31, 2019 andDecember 31, 2018 , respectively. CRT transactions provided 29.8% and 29.4% of the coverage remaining at those dates. The table below provides information on the credit-enhanced and non-credit-enhanced loans in our single-family credit guarantee portfolio. The credit enhanced categories are not mutually exclusive as a single loan may be covered by both primary mortgage insurance and other credit protection. Table 21 - Credit-Enhanced and Non-Credit-Enhanced Loans in Our Single-Family Credit Guarantee Portfolio As of December 31, 2019 2018 2017 (Percentage of portfolio based on UPB) % of Portfolio SDQ Rate % of Portfolio SDQ Rate % of Portfolio SDQ Rate Credit-enhanced Primary mortgage insurance 21 % 0.79 % 20 % 0.86 % 18 % 1.43 % Other 55 0.40 48 0.31 37 0.53 Non-credit-enhanced 45 0.70 47 0.83 56 1.16 Total N/A 0.63 % N/A 0.69 % N/A 1.08 % Credit Enhancement Expenses and Recoveries The recognition of expenses and estimated probable recoveries associated with credit enhancements in our consolidated financial statements depends on the type of credit enhancement as follows: n Attached credit enhancements - Attached credit enhancements are obtained
contemporaneously with, and in contemplation of, the origination of a
financial instrument, and effectively travel with the financial instrument
upon sale. Attached credit enhancements are accounted for on a net basis with
the associated financial instrument. As a result, we do not explicitly
recognize a separate expense in our consolidated statements of comprehensive
income for attached credit enhancements. Rather, the cost of attached credit
enhancements is reflected as lower revenue. For example, we charge a lower
guarantee fee for a loan with primary mortgage insurance than we otherwise
would for the same loan without primary mortgage insurance. Similarly, credit
losses on loans with attached credit enhancements are accounted for on a net
basis. We do not recognize a provision for credit losses on loans with
attached credit enhancements unless the estimated incurred loss exceeds the
amount of credit protection provided by the attached credit enhancement and
do not separately recognize a recovery asset. For additional information on
the effect of attached credit enhancements on our credit losses, see the
Monitoring Loan Performance and Characteristics - Credit Losses and Recoveries section below.FREDDIE MAC | 2019 Form 10-K 73
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Management's Discussion and Analysis Risk Management | Single-Family Mortgage Credit Risk
n Freestanding credit enhancements - Freestanding credit enhancements are
contracts that are entered into separately and apart from any other financial
instruments or entered into in conjunction with some other transaction and
are legally detachable and separately exercisable. Freestanding credit enhancements are accounted for on a gross basis separately from the associated financial instrument. We recognize the payments we make to transfer credit risk under freestanding credit enhancements as credit enhancement expense. We recognize expected recoveries from freestanding
credit enhancements as separate assets when the claim for recovery is deemed
probable, which typically occurs at the same time we recognize a provision
for credit losses on the associated loan. n Debt with embedded credit enhancements - Credit enhancements that are
structured as debt issuances are accounted for on a gross basis separately
from the associated mortgage loan. We primarily recognize expenses associated
with debt with embedded credit enhancements as interest expense. We recognize
recoveries from debt with embedded credit enhancements as debt extinguishment
gains within investment gains (losses) when the loss confirming event occurs
and we are legally released from our debt obligation, which typically occurs
after we recognize a provision for credit losses on the associated loan. Such
recoveries have not been significant. We no longer issue debt with embedded
credit enhancements as part of our primary CRT strategy and therefore expect
the effect of these transactions on our financial results to become less
significant over time.
Certain of our credit enhancements are accounted for at fair value, with changes in fair value recognized in earnings as a component of investment gains (losses), net. See Note 6 for additional information on our credit enhancements. The table below contains details on the costs associated with our single-family credit enhancements. Table 22 - Details of Single-Family Credit Enhancement Expense Year Ended December 31, (In millions) 2019 2018 2017 Credit enhancement costs: (1) Credit enhancement expense ($693 ) ($402 ) ($263 ) Interest expense related to CRT debt (1,060 ) (1,047 )
(808 )
Total costs (1,753 ) (1,449 )
(1,071 )
Estimated reinvestment income from proceeds of CRT debt issuance 360 372
180
Single-family credit enhancement expense ($1,393 ) ($1,077 ) ($891 ) (1) Excludes fair value gains and losses on CRT derivatives and CRT debt recorded at fair value. See MD&A - Consolidated Results of Operations for additional information on these items. Impact of CRT Transactions onConservatorship Capital We use FHFA's risk-based CCF guidelines to determine the amount of total conservatorship capital needed for our single-family credit guarantee portfolio. We reduce the amount of conservatorship capital needed for credit risk by shifting the risk of credit losses fromFreddie Mac to third-party investors through our CRT transactions, primarily our STACR and ACIS transactions. The table below presents information on the impact of certain CRT transactions on the amount of capital needed for credit risk (conservatorship credit capital) pursuant to the CCF. For more information on the CCF, see Liquidity and Capital Resources - Capital Resources - Conservatorship Capital Framework. Table 23 - Reduction inConservatorship Credit Capital (1) as a Result of Certain CRT Transactions As of December 31, 2019 As of December 31, 2018 Single-Family Single-Family Credit Guarantee Credit Guarantee Single-Family Portfolio - Single-Family Single-Family Portfolio - Single-Family Credit Guarantee covered by certain
Credit Guarantee Credit Guarantee covered by certain Credit Guarantee (Dollars in billions)
Portfolio CRT transactions Portfolio - Other Portfolio CRT transactions Portfolio - Other Conservatorship credit capital prior to CRT (2)$31.9 $16.1 $15.8 $29.8 $14.6 $15.2 Conservatorship credit capital reduced by CRT (3) (11.8 ) (11.8 ) - (9.3 ) (9.3 ) - Conservatorship credit capital needed after CRT$20.1 $4.3 $15.8 $20.5 $5.3 $15.2 Reduction in conservatorship credit capital (%) (4) 37.0 % 73.3 % - % 31.2 % 63.7 % - % UPB$1,994 $945 $1,049 $1,896 $875 $1,021 % of portfolio 100 % 47 % 53 % 100 % 46 % 54 %
(1) Conservatorship credit capital figures for each period are based on the CCF
in effect during the period. The CCF in effect as of
largely unchanged from the CCF as of
credit capital figures for 2019 are preliminary and subject to change until
official submission to FHFA.
FREDDIE MAC | 2019 Form 10-K 74
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Management's Discussion and Analysis Risk Management | Single-Family Mortgage Credit Risk
(2) Represents the total conservatorship credit capital prior to CRT on the outstanding balance of our single-family credit guarantee portfolio as of
(3) Represents the amount of conservatorship credit capital released from
certain CRT transactions, including STACR, ACIS/AFRM, certain senior
subordination securitization structures, and certain lender risk-sharing
transactions, based on prescribed CCF guidelines. (4) Calculated as conservatorship credit capital reduced by CRT divided by conservatorship credit capital prior to CRT. Monitoring Loan Performance and Characteristics -------------------------------------------------------------------------------- We review loan performance, including delinquency statistics and related loan characteristics in conjunction with housing market and economic conditions, to determine if our pricing and eligibility standards reflect the risk associated with the loans we purchase and guarantee. We review the payment performance of our loans to facilitate early identification of potential problem loans, which could inform our loss mitigation strategies. We also review performance metrics for additional loan characteristics that may expose us to concentrations of credit risk, including: n Higher risk loan attributes and attribute combinations;
n Higher risk loan product types; and
n Geographic concentrations. Delinquency Rates Our single-family serious delinquency rate declined in 2019 compared to 2018 due to the continued shift in the single-family credit guarantee portfolio mix, as the legacy and relief refinance loan portfolio runs off and we add higher credit quality loans to our core single-family loan portfolio. This decline is also attributable to our continued loss mitigation efforts and sales of certain seriously delinquent loans, as well as home price appreciation and a low unemployment rate. The charts below show the credit losses and serious delinquency rates for each of our single-family loan portfolios. Our core single-family loan portfolio continues to perform well and account for a small percentage of our credit losses, as shown below. Our legacy and relief refinance single-family loan portfolio continues to decline as a percentage of our overall portfolio, but continues to account for the majority of our credit losses. Portfolio Composition and Credit Losses
[[Image Removed: chart-76ed90fa24d95a068a6a01.jpg]]
Serious Delinquency Rates as ofDecember 31 ,
[[Image Removed: chart-1039b40455745780930a01.jpg]]
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Management's Discussion and Analysis Risk Management | Single-Family Mortgage Credit Risk
Loan Characteristics The table below contains a description of some of the loan characteristics we monitor in our single-family credit guarantee portfolio. Characteristic Description Impact on Credit Quality • Measures ability of the Ratio of the UPB of the loan to underlying property to cover our the value of the underlying exposure on the loan property collateralizing the loan. Original LTV ratio is • Higher LTV ratios
indicate higher
LTV ratio measured at loan origination, risk, as proceeds from sale of while current LTV (CLTV) ratio the property may not cover our is defined as the ratio of the exposure on the loan current loan UPB to the • Lower LTV ratios indicate estimated current property borrowers are more likely to value repay Statistically-derived number • Borrowers with higher credit used by lenders to assess a scores are generally more likely borrower's likelihood to repay to repay or have the ability to debt. We use FICO scores, which refinance their loans than those are currently the most commonly with lower scores used credit scores for mortgages. Original credit score represents each Credit score borrower's FICO score at the time of origination or our purchase, while current credit score represents each borrower's most recent FICO score, which is obtained by Freddie Mac as of the first month of the most recent quarter Indicates how the borrower • Cash-out refinancings, which intends to use the proceeds increase the LTV ratios,
Loan purpose from a loan (i.e., purchase, generally have a higher risk of
cash-out refinance, or other default than loans originated in refinance) purchase or other refinance transactions • Detached single-family houses and townhouses are the predominant Indicates whether the property type of single-family property
Property type is a detached single-family • Condominiums historically have
house, townhouse, condominium, experienced greater volatility in or co-op home prices than detached single-family houses, which may expose us to more risk Indicates whether the borrower • Loans on primary residence Occupancy type intends to use the property as properties tend to have lower a primary residence, second credit risk than loans on second home, or investment property homes or investment properties Indicates the type of loan • Loan products that contain terms based on key loan terms, such which result in
scheduled changes
as the contractual maturity, in monthly payments may result in Product type type of interest rate, and higher risk payment characteristics of the • Shorter loan terms result in loan faster repayment of principal and may indicate lower risk • Second liens can increase the Indicates whether the risk of default underlying property is covered • Borrowers are free to obtain Second liens by more than one loan at the second-lien financing after time of origination origination, and we are not entitled to receive notification when a borrower does so Ratio of the borrower's total • Borrowers with lower DTI ratios monthly debt payments to gross are generally more likely to monthly income. One indicator repay their loans than those with of the creditworthiness of higher DTI ratios, holding all DTI ratio borrowers, as it measures other factors equal borrowers' ability to manage • DTI ratios are at the time of monthly payments and repay origination and may not be debts indicative of the borrowers' current credit worthiness FREDDIE MAC | 2019 Form 10-K 76
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Management's Discussion and Analysis Risk Management | Single-Family Mortgage Credit Risk
The tables below contain details on characteristics of the loans in our single-family credit guarantee portfolio. Table 24 - Credit Quality Characteristics of Our Single-Family Credit Guarantee Portfolio As of December 31, 2019 Original Current Current Current Credit Credit Original LTV LTV Ratio (Dollars in billions) UPB Score (1) Score (1) LTV Ratio Ratio >100% Alt-A % Core single-family loan portfolio$1,701 750 752 75 % 60 % - % - % Legacy and relief refinance single-family loan portfolio 293 712 692 83 52 2 7 Total$1,994 745 749 76 % 59 % - % 1 % As of December 31, 2018 Original Current Current Current Credit Credit Original LTV LTV Ratio (Dollars in billions) UPB Score (1) Score (1) LTV Ratio Ratio >100% Alt-A % Core single-family loan portfolio$1,550 750 753 74 % 59 % - % - % Legacy and relief refinance single-family loan portfolio 346 705 690 78 45 2 7 Total$1,896 743 748 76 % 58 % 1 % 1 %
(1) Original credit score is based on three credit bureaus (Equifax, Experian,
and
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Management's Discussion and Analysis Risk Management | Single-Family Mortgage Credit Risk
Table 25 - Characteristics of the Loans in Our Single-Family Credit Guarantee Portfolio
As of December 31, (Percentage of portfolio based on UPB) 2019 2018 2017 Original LTV ratio range 60% and below 18 % 19 % 20 % Above 60% to 80% 52 % 52 % 52 % Above 80% to 100% 28 % 26 % 24 % Above 100% 2 % 3 % 4 %
Portfolio weighted average original LTV ratio 76 % 76 % 75 %
Current LTV ratio range 60% and below 51 % 51 % 49 % Above 60% to 80% 35 % 36 % 37 % Above 80% to 100% 14 % 12 % 13 % Above 100% - % 1 % 1 %
Portfolio weighted average current LTV ratio 59 % 58 % 59 %
Original credit score (1) 740 and above 61 % 60 % 60 % 700 to 739 21 % 22 % 21 % 660 to 699 12 % 12 % 12 % 620 to 659 4 % 4 % 5 % Less than 620 2 % 2 % 2 %
Portfolio weighted average original credit score 745 743 743
Current credit score (1) 740 and above 66 % 66 % 65 % 700 to 739 16 % 16 % 16 % 660 to 699 9 % 9 % 10 % 620 to 659 4 % 4 % 4 % Less than 620 5 % 5 % 5 %
Portfolio weighted average current credit score 749 748 747
Loan purpose Purchase 46 % 45 % 39 % Cash-out refinance 20 % 20 % 21 % Other refinance 34 % 35 % 40 %
(1) Original credit score is based on three credit bureaus (Equifax, Experian,
and
In addition, at
n Approximately 90% of our loans were secured by properties used as the borrower's primary residence at origination; and
n More than 90% of our loans were fixed-rate.
AtDecember 31, 2019 , approximately 7% of our loans had second-lien financing by the originator or other third party at origination, and these loans comprised approximately 13% of our seriously delinquent loan population. It is likely that additional borrowers have post-origination second-lien financing. Higher Risk Loan Attributes and Attribute Combinations Certain of the loan attributes shown above may indicate a higher risk of default. For example, loans with original LTV ratios over 90% and/or credit scores below 620 at origination may be higher risk. The tables below provide information on loans in our portfolio with these characteristics. The tables include a presentation of each higher risk category in isolation. A single loan may fall within more than one category.
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Management's Discussion and Analysis Risk Management | Single-Family Mortgage Credit Risk
Table 26 - Single-Family Credit Guarantee Portfolio Higher Risk Loan Data
As of December 31, 2019 (Dollars in billions) UPB CLTV % Modified SDQ Rate Original LTV ratio greater than 90%, HARP loans$71.5 65 % 2.7 % 0.89 % Original LTV ratio greater than 90%, all other loans 286.0 79 3.2 0.98 Loans with credit scores below 620 at origination 33.1 60 15.4 4.52 As of December 31, 2018 (Dollars in billions) UPB CLTV % Modified SDQ Rate Original LTV ratio greater than 90%, HARP loans$85.1 70 % 2.9 % 0.90 % Original LTV ratio greater than 90%, all other loans 248.3 79 4.4 1.10 Loans with credit scores below 620 at origination 33.6
62 20.0 4.59
In addition, certain combinations of loan attributes can indicate an even higher degree of credit risk, such as loans with both higher LTV ratios and lower credit scores. The following tables show the combination of credit score and CLTV ratio attributes of loans in our single-family credit guarantee portfolio. Table 27 - Single-Family Credit Guarantee Portfolio Attribute Combinations for Higher Risk Loans As of December 31, 2019 CLTV ? 80 CLTV > 80 to 100 CLTV > 100 All Loans (Original Credit score) % Portfolio SDQ Rate % Portfolio SDQ Rate(1) % Portfolio SDQ Rate(1) % Portfolio SDQ Rate % Modified Core single-family loan portfolio: < 620 0.3 % 2.68 % - % NM - % NM 0.3 % 2.87 % 3.5 % 620 to 659 2.1 1.26 0.4 1.59 % - NM 2.5 1.30 1.9 ? 660 69.8 0.20 12.6 0.26 - NM 82.4 0.20 0.3 Not available 0.1 1.23 - NM - NM 0.1 1.96 3.6 Total 72.3 % 0.24 % 13.0 % 0.33 % - % NM 85.3 % 0.26 % 0.4 % Legacy and relief refinance single-family loan portfolio: < 620 1.1 % 4.16 % 0.2 % 9.33 % 0.1 % 15.03 % 1.4 % 4.83 % 17.7 % 620 to 659 1.5 3.01 0.2 7.91 0.1 12.84 1.8 3.52 16.3 ? 660 10.5 1.06 0.7 3.91 0.2 6.32 11.4 1.23 5.9 Not available 0.1 4.39 - NM - NM 0.1 4.68 19.6 Total 13.2 % 1.58 % 1.1 % 5.39 % 0.4 % 8.96 % 14.7 % 1.84 % 8.3 % FREDDIE MAC | 2019 Form 10-K 79
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Management's Discussion and Analysis Risk Management | Single-Family Mortgage Credit Risk As of December 31, 2018 CLTV ? 80 CLTV > 80 to 100 CLTV > 100 All Loans (Original Credit score) % Portfolio SDQ Rate % Portfolio SDQ Rate(1) % Portfolio SDQ Rate(1) % Portfolio SDQ Rate % Modified Core single-family loan portfolio: < 620 0.3 % 2.18 % - % NM - % NM 0.3 % 2.34 % 3.7 % 620 to 659 2.0 1.13 0.3 1.27 - NM 2.3 1.15 1.9 ? 660 69.0 0.17 10.0 0.25 - NM 79.0 0.18 0.3 Not available 0.1 1.52 - NM - NM 0.1 2.60 3.6 Total 71.4 % 0.21 % 10.3 % 0.30 % - % NM 81.7 % 0.22 % 0.4 % Legacy and relief refinance single-family loan portfolio: < 620 1.2 % 4.16 % 0.2 % 8.76 % 0.1 % 14.34 % 1.5 % 4.94 % 22.6 % 620 to 659 1.7 3.13 0.3 6.78 0.1 11.69 2.1 3.68 19.8 ? 660 13.0 1.12 1.2 3.60 0.4 5.81 14.6 1.33 7.1 Not available 0.1 4.62 - NM - NM 0.1 4.98 19.5 Total 16.0 % 1.62 % 1.7 % 4.78 % 0.6 % 8.18 % 18.3 % 1.93 % 10.0 %
(1) NM - not meaningful due to the percentage of the portfolio rounding to zero.
Higher Risk Loan Product Types There are several types of loan products that contain terms which result in scheduled changes in the borrower's monthly payments after specified initial periods, such as interest-only and option ARM loans. These products may result in higher credit risk because the payment changes may increase the borrower's monthly payment, resulting in a higher risk of default. The majority of these loans are in our legacy and relief refinance single-family loan portfolio. Only a small percentage of our core single-family loan portfolio consists of ARM loans. We fully discontinued purchases of option ARM loans in 2007, Alt-A loans in 2009, and interest-only loans in 2010. The balance of our interest-only and option ARM loans has continued to decline in recent years as many of these borrowers have repaid or refinanced their loans, received loan modifications, or completed foreclosure alternatives or foreclosure sales. While we have not categorized option ARM loans as either subprime or Alt-A for presentation in this Form 10-K and elsewhere in our reporting, they could exhibit similar credit performance to collateral sometimes referred to as subprime or Alt-A by market participants. For reporting purposes, loans within the option ARM category continue to be presented in that category following a modification of the loan, even though the modified loan no longer provides for optional payment provisions. The tables below provide credit characteristic information on higher risk loan product types. Table 28 - Higher Risk Single-Family Loan Credit Characteristics As of December 31, 2019 (Dollars in billions) UPB CLTV % Modified SDQ
Rate
Amortizing ARM and option ARM (1)$40.1 49 % 2.2 % 0.84 % Interest-only 10.9 64 - 2.72 Step-rate modified 8.7 59 100 6.27 As of December 31, 2018 (Dollars in billions) UPB CLTV % Modified SDQ Rate Amortizing ARM and option ARM (1)$47.7 50 % 1.9 % 0.88 % Interest-only 11.0 64 0.1 3.43 Step-rate modified 14.5 64 100 6.12
(1) Includes
2019 and
of 51% and 54%, (b) loan modification percentages of 20.4% and 17.9%, and
(c) serious delinquency rates of 2.94% and 3.40%, respectively.
The table below shows the timing of scheduled payment changes for certain types of loans within our single-family credit guarantee portfolio. The amounts in the table below are aggregated by product type and categorized by the year in which the loan will experience a payment change. The timing of the actual payment change may differ from that presented in the table due to a number of factors, including if the borrower refinances the loan. Loans where the year of first payment change is 2019FREDDIE MAC | 2019 Form 10-K 80
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Management's Discussion and Analysis Risk Management | Single-Family Mortgage Credit Risk
or prior have already had one or more payment changes as ofDecember 31, 2019 ; loans where the year of first payment change is 2020 or later have not had a payment change as ofDecember 31, 2019 and will not experience a payment change until a future period. Step-rate modified loans are shown in each year that the borrower will experience a scheduled interest-rate increase; therefore, a single loan may be included in multiple periods. However, the total of step-rate loans in the table reflects the ending UPB of such loans as ofDecember 31, 2019 . Table 29 - Timing of Scheduled Payment Changes for Certain Single-Family Loan Types As of December 31, 2019 (In millions) 2019 and Prior 2020 2021 2022 2023 2024 Thereafter Total(1) ARM/amortizing$9,097 $3,860 $3,647 $4,967 $3,930 $4,552 $7,281 $37,334 ARM/interest-only 4,692 80 - - - - - 4,772 Fixed/interest-only 513 1 10 28 2 - - 554 Step-rate modified 8,179 1,225 900 201 52 26 - 8,657 Total$22,481 $5,166 $4,557 $5,196 $3,984 $4,578 $7,281 $51,317
(1) Excludes loans underlying certain other securitization products since the
payment change information is not available to us for these loans.
We believe that the performance of these types of loans has been affected by prior adverse macroeconomic conditions, such as unemployment rates and home price declines in many geographic areas, in addition to the increase in the borrower's monthly payment. However, we continue to monitor the performance of these loans as many have experienced a payment change or are scheduled to have a payment change in 2020 or thereafter, which is likely to subject the borrowers to higher monthly payments. Since a substantial portion of these loans were originated in 2005 through 2008 and are located in geographic areas that were most affected by declines in home prices that began in 2006, we believe that the serious delinquency rate for these types of loans will remain high in 2020. Other Higher Risk Loans - Alt-A and Subprime Loans While we have referred to certain loans as subprime or Alt-A for purposes of the discussion below and elsewhere in this Form 10-K, there is no universally accepted definition of subprime or Alt-A, and the classification of such loans may differ from company to company. We do not rely on these loan classifications to evaluate the credit risk exposure relating to such loans in our single-family credit guarantee portfolio. Participants in the mortgage market have characterized single-family loans based upon their overall credit quality at the time of origination, including as prime or subprime. While we have not historically characterized the loans in our single-family credit guarantee portfolio as either prime or subprime, we monitor the amount of loans we have guaranteed with characteristics that indicate a higher degree of credit risk. In addition, we estimate that approximately$0.8 billion and$0.9 billion of security collateral underlying our other securitization products atDecember 31, 2019 andDecember 31, 2018 , respectively, were identified as subprime based on information provided to us when we entered into these transactions. Mortgage market participants have classified single-family loans as Alt-A if these loans have credit characteristics that range between their prime and subprime categories, if they are underwritten with lower or alternative income or asset documentation requirements compared to a full documentation loan, or both. Although we have discontinued new purchases of loans with lower documentation standards, we continue to purchase certain amounts of such loans in cases where the loan was either purchased pursuant to a previously issued guarantee, part of our relief refinance initiative or part of another refinance loan initiative and the pre-existing loan was originated under less than full documentation standards. In the event we purchase a refinance loan and the original loan had been previously identified as Alt-A, such refinance loan may no longer be categorized or reported as an Alt-A loan in this Form 10-K and our other financial reports because the new refinance loan replacing the original loan would not be identified by the seller or servicer as an Alt-A loan. As a result, our reported Alt-A balances may be lower than would otherwise be the case had such refinancing not occurred. From the time the relief refinance initiative began in 2009 toDecember 31, 2019 , we have purchased approximately$36.4 billion of relief refinance loans that were previously categorized as Alt-A loans in our portfolio. The table below contains information on Alt-A loans in our single-family credit guarantee portfolio. Table 30 - Alt-A Loans in Our Single-Family Credit Guarantee Portfolio As of December 31, 2019 As of December 31, 2018 (Dollars in billions) UPB CLTV % Modified SDQ Rate UPB CLTV % Modified SDQ Rate Alt-A $21.1 61 % 18.4 % 3.75 %
$23.9 63 % 23.2 % 4.13 %
The UPB of Alt-A loans in our single-family credit guarantee portfolio is continuing to decline due to borrowers refinancing into other mortgage products, foreclosure sales, and other liquidation events.
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Management's Discussion and Analysis Risk Management | Single-Family Mortgage Credit Risk
Geographic Concentrations We purchase mortgage loans from across theU.S. and maintain a geographically diverse portfolio. However, local economic conditions can affect borrowers' ability to repay and the value of the underlying collateral, leading to concentrations of credit risk in certain geographic areas. The following table presents certain geographic concentrations in our single-family credit guarantee portfolio. The states presented below had the largest number of seriously delinquent loans as of December 31, 2019. See Note 14 for additional information on the concentration of credit risk in our single-family credit guarantee portfolio. Table 31 - Geographic Concentration in Our Single-Family Credit Guarantee Portfolio As of December 31, 2019 Full Year As of December 31, 2018 Full Year As of December 31, 2017 Full Year (Dollars 2019 2018 2017 in SDQ % of SDQ Credit SDQ % of SDQ Credit SDQ % of SDQ Credit
millions) Loan Count Loans SDQ Rate Losses Loan Count Loans SDQ Rate Losses Loan Count Loans SDQ Rate Losses New York 5,741 8 % 1.21 % $109 6,312
8 % 1.37 % $289 8,117 7 % 1.74 % $415 Florida 5,430 8 0.77 208 6,888
9 1.01 263 22,253 19 3.33 614
6 0.86 244 6,228 5 1.13 445
6 0.35 275 5,514 5 0.41 884 Texas 3,950 6 0.54 49 4,081 5 0.59 55 8,908 8 1.36 44 All Others 45,269 64 0.61 881 48,499 66 0.67 1,454 64,669 56 0.90 2,413 Total 69,721 100 % 0.63 % $1,514 75,140 100 % 0.69 % $2,580 115,689 100 % 1.08 % $4,815 The following table presents our single-family charge-offs and recoveries in each geographic region. See Single-Family Credit Guarantee Portfolio in Note 14 for a description of these regions. Table 32 - Single-Family Charge-Offs and Recoveries by Region Year Ended December 31, 2019 2018 2017 Charge-offs, Recoveries Charge-offs, Charge-offs, Recoveries Charge-offs, Charge-offs, Recoveries Charge-offs, (In millions) gross (1) net gross (1) net gross (1) net Northeast $619 ($157 ) $462 $1,105 ($175 ) $930 $1,690 ($155 ) $1,535 Southeast 414 (105 ) 309 515 (98 ) 417 1,001 (95 ) 906 North Central 307 (76 ) 231 544 (88 ) 456 774 (81 ) 693 West 252 (73 ) 179 522 (72 ) 450 1,382 (62 ) 1,320 Southwest 145 (41 ) 104 199 (42 ) 157 204 (32 ) 172 Total $1,737 ($452 ) $1,285 $2,885 ($475 ) $2,410 $5,051 ($425 ) $4,626 (1) 2019, 2018, and 2017 include charge-offs of $1.3 billion, $2.1 billion and $3.8 billion, respectively, related to the transfer of loans from held-for-investment to held-for-sale. FREDDIE MAC | 2019 Form 10-K 82
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Management's Discussion and Analysis Risk Management | Single-Family Mortgage Credit Risk
The tables below present the concentration of loans in each geographic region by CLTV ratio. Table 33 - Concentration of Single-Family Loans in Each Region by CLTV Ratio As of December 31, 2019 CLTV <= 80% CLTV > 80% to 100% CLTV > 100% All Loans % of Portfolio SDQ Rate % of Portfolio SDQ Rate % of Portfolio SDQ Rate(1) % of Portfolio SDQ Rate North Central 13 % 0.55 % 3 % 0.80 % - % NM 16 % 0.61 % Northeast 20 0.75 4 1.28 - NM 24 0.87 Southeast 14 0.68 2 0.91 - NM 16 0.73 Southwest 12 0.54 2 0.46 - NM 14 0.54 West 27 0.34 3 0.54 - NM 30 0.36 Total 86 % 0.57 % 14 % 0.83 % - % NM 100 % 0.63 % As of December 31, 2018 CLTV <= 80% CLTV > 80% to 100% CLTV > 100% All Loans % of Portfolio SDQ Rate % of Portfolio SDQ Rate % of Portfolio SDQ Rate(1) % of Portfolio SDQ Rate North Central 14 % 0.55 % 2 % 0.93 % - % NM 16 % 0.63 % Northeast 21 0.79 3 1.62 - NM 24 0.96 Southeast 14 0.79 2 1.37 - NM 16 0.90 Southwest 12 0.56 2 0.58 - NM 14 0.57 West 27 0.35 2 0.76 1 3.81 30 0.38 Total 88 % 0.60 % 11 % 1.09 % 1 % 7.98 % 100 % 0.69 %
(1) NM - not meaningful due to the percentage of the portfolio rounding to zero.
Credit Losses and Recoveries The table below contains certain credit performance metrics of our single-family credit guarantee portfolio. Table 34 - Single-Family Credit Guarantee Portfolio Credit Performance Metrics Year Ended December 31, (Dollars in millions) 2019 2018 2017 Charge-offs, gross(1) $1,737 $2,885 $5,051 Recoveries (452 ) (475 ) (425 ) Charge-offs, net 1,285 2,410 4,626 REO operations expense 229 170 189 Total credit losses $1,514 $2,580 $4,815
Total credit losses(1) (in bps) 7.7 13.7 27.0
(1) 2019, 2018, and 2017 include charge-offs of $1.3 billion, $2.1 billion, and
$3.8 billion, respectively, related to the transfer of loans from
held-for-investment to held-for-sale.
We recognized recoveries from primary mortgage insurance (excluding recoveries that represent reimbursements for our expenses, such as REO operations expenses) of $117 million, $151 million, and $263 million that reduced our charge-offs of single-family loans during 2019, 2018, and 2017, respectively. We also recognized recoveries from primary mortgage insurance of $52 million, $47 million, and $50 million during 2019, 2018, and 2017, respectively, as part of REO operations (expense) income. Our credit losses and seriously delinquent loan population are concentrated in the legacy and relief refinance single-family loan portfolio. In addition, our credit losses and seriously delinquent loan population are also concentrated within loans having certain characteristics, as shown in the table below. These categories are not mutually exclusive; for example, an Alt-A loan can be associated with a property located in a judicial foreclosure state and/or have a CLTV ratio of greater than 100%. Additional detail on loans in judicial foreclosure states is presented in the Managing Foreclosure and REO Activities section below.FREDDIE MAC | 2019 Form 10-K 83
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Management's Discussion and Analysis Risk Management | Single-Family Mortgage Credit Risk
Table 35 - Credit Characteristics of Certain Single-Family Loan Categories
2019 2018 As of December 31 Year Ended As of December 31 Year Ended December 31 December 31 SDQ Rate % of Credit SDQ Rate % of Credit % of Portfolio Losses % of Portfolio Losses CLTV > 100% 0.4 % 8.22 % 16 % 1 % 7.98 % 16 % Alt-A loans 1 3.75 12 1 4.13 16 Judicial foreclosure states 38 0.81 61 38 0.92 59 Allowance for Credit Losses Our allowance for credit losses continued to decline in 2019, primarily driven by charge-offs as a result of our transfer of loans from held-for-investment to held-for-sale. On January 1, 2017, we elected a new accounting policy for loan reclassifications from held-for-investment to held-for-sale. Under the new policy, when we reclassify (transfer) a loan from held-for-investment to held-for-sale, we charge off the entire difference between the loan's recorded investment and its fair value if the loan has a history of credit-related issues. See Note 4 for further information about this change. The table below summarizes our single-family allowance for credit losses activity. Table 36 - Single-Family Allowance for Credit Losses Activity Year Ended December 31, (Dollars in millions) 2019 2018 2017 2016 2015 Beginning balance $6,176 $8,979 $13,463 $15,348 $21,793 Provision (benefit) for credit losses (749 ) (712 ) (97 ) (781 ) (2,639 ) Charge-offs, gross(1) (1,737 ) (2,885 ) (5,051 ) (1,938 ) (5,071 ) Recoveries 452 475 425 497 717 Other(2) 126 319 239 337 548 Ending balance $4,268 $6,176 $8,979 $13,463 $15,348 As a percentage of our single-family credit guarantee portfolio 0.21 % 0.33 % 0.49 % 0.77 % 0.90 % (1) 2016 and 2015 do not include lower-of-cost-or-fair-value adjustments
recognized when we transfer loans from held-for-investment to held-for-sale,
which totaled $1.2 billion and $3.4 billion, respectively. 2019, 2018, and
2017 include charge-offs of $1.3 billion, $2.1 billion, and $3.8 billion,
respectively, related to the transfer of loans from held-for-investment to
held-for-sale.
(2) Primarily includes capitalization of past due interest on modified loans.
TDRs and Individually Impaired Loans Single-family loans that have been individually evaluated for impairment, such as modified loans, generally have a higher associated allowance for loan losses than loans that have been collectively evaluated for impairment. Due to the large number of loan modifications completed in recent years, a significant portion of our allowance for loan losses is attributable to individually impaired single-family loans. As of December 31, 2019, 43% of the allowance for loan losses for single-family loans related to interest rate concessions provided to borrowers as part of loan modifications. Most of our modified single-family loans, including TDRs, were current and performing at December 31, 2019. We expect our allowance for loan losses associated with existing single-family TDRs to decline over time as we continue to sell reperforming loans. In addition, these allowances for loan losses will decline as borrowers continue to make monthly payments under the modified terms and interest rate concessions are amortized into earnings.
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Management's Discussion and Analysis Risk Management | Single-Family Mortgage Credit Risk
The table below summarizes the carrying value on our consolidated balance sheets for individually impaired single-family loans for which we have recorded an allowance determined on an individual basis. Table 37 - Single-Family Individually Impaired Loans with an Allowance Recorded 2019 2018 (Dollars in millions) Loan Count Amount Loan Count Amount TDRs, at January 1 290,255 $42,254 364,704 $54,415 New additions 30,568 4,871 52,300 8,115 Repayments and reclassifications to (85,181 ) (14,016 ) (119,366 ) (19,285 ) held-for-sale Foreclosure sales and foreclosure (4,502 ) (605 ) (7,383 ) (991 ) alternatives TDRs, at December 31 231,140 32,504 290,255 42,254 Loans impaired upon purchase 1,600 102 2,555 170 Total impaired loans with an 232,740 32,606 292,810 42,424 allowance recorded Allowance for loan losses (2,872 ) (4,369 ) Net investment, at December 31 $29,734
$38,055
The tables below present information about the UPB of single-family TDRs and non-accrual loans on our consolidated balance sheets. Table 38 - Single-Family TDR and Non-Accrual Loans
As of December 31, (In millions) 2019 2018 2017 2016 2015 TDRs on accrual status $32,188 $41,839 $51,644 $77,122 $82,026 Non-accrual loans 11,183 11,197 17,748 16,164 22,460 Total TDRs and non-accrual $43,371 $53,036 $69,392 $93,286 $104,486 loans Allowance for loan losses associated with: TDRs on accrual status $2,452 $3,612 $5,257 $10,295 $12,105 Non-accrual loans 597 1,003 1,883 2,290 2,677 Total $3,049 $4,615 $7,140 $12,585 $14,782 Year Ended December 31, (In millions) 2019 2018 2017 2016 2015 Foregone interest income on $790 $1,122 $1,604 $2,109 $2,690 TDRs and non-accrual loans(1)
(1) Represents the amount of interest income that we did not recognize but would
have recognized during the period for loans outstanding at the end of each
period, had the loans performed according to their original contractual
terms.
Engaging in Loss Mitigation Activities -------------------------------------------------------------------------------- Servicers perform loss mitigation activities as well as foreclosures on loans that they service for us. Our loss mitigation strategy emphasizes early intervention by servicers in delinquent loans and offers alternatives to foreclosure by providing servicers with default management programs designed to manage non-performing loans more effectively and to assist borrowers in maintaining home ownership or to facilitate foreclosure alternatives. We offer a variety of borrower assistance programs, including refinance programs for certain eligible loans and loan workout activities for struggling borrowers. Our loan workouts include both home retention options and foreclosure alternatives. We also engage in transfers of servicing for and sales of certain seriously delinquent and reperforming loans. Relief Refinance Program Our relief refinance initiative allows eligible homeowners whose loans we already own or guarantee to refinance with more favorable terms (such as reduction in payment, reduction in interest rate or movement to a more stable loan product) and without the need to obtain additional mortgage insurance. Prior to January 2019, our relief refinance program included HARP, the portion of our relief refinance initiative for loans with LTV ratios above 80%. The HARP program ended on December 31, 2018, although we continued to purchase HARP loans with application received dates on or prior to December 31, 2018 through September 30, 2019.FREDDIE MAC | 2019 Form 10-K 85
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Management's Discussion and Analysis Risk Management | Single-Family Mortgage Credit Risk
The relief refinance program has been replaced with the Enhanced Relief Refinance program, which became available in January 2019 for loans originated on or after October 1, 2017. This program provides liquidity for borrowers who are current on their mortgages but are unable to refinance because their LTV ratios exceed our standard refinance limits. The following table includes information about the performance of our relief refinance mortgage portfolio. Table 39 - Single-Family Relief Refinance Loans As of December 31, 2019 2018 (Dollars in millions) UPB Loan Count SDQ Rate UPB Loan Count SDQ Rate Above 125% Original LTV $15,906 103,401 0.93 % $18,847 117,410 0.97 % Above 100% to 125% Original LTV 31,072 200,227 0.96 37,084 228,419 0.93 Above 80% to 100% Original LTV 52,020 362,647 0.76 61,843 410,027 0.77 80% and below Original LTV 70,752 681,232 0.43 83,647 762,477 0.42 Total $169,750 1,347,507 0.64 % $201,421 1,518,333 0.64 % Loan Workout Activities When refinancing is not practicable, we require our servicers first to evaluate the loan for a forbearance agreement, repayment plan, or loan modification, because our level of recovery on a loan that reperforms is often much higher than for a loan that proceeds to a foreclosure alternative or foreclosure. We offer the following types of home retention options: n Forbearance agreements - Arrangements that require reduced or no payments
during a defined period, generally less than one year, to allow borrowers to
return to compliance with the original mortgage terms or to implement another
loan workout. For agreements completed in 2019, the average time period for
reduced or suspended payments was between four and five months.
n Repayment plans - Contractual plans designed to repay past due amounts to
allow borrowers to return to compliance with the original mortgage terms. For
plans completed in 2019, the average time period to repay past due amounts
was approximately four months. Servicers are paid incentive fees for
repayment plans that are paid in full and loans brought to current status.
n Loan modifications - Contractual plans that may involve changing the terms of
the loan, adding outstanding indebtedness, such as delinquent interest, to the UPB of the loan, or a combination of both, including principal forbearance. Our modification programs generally require completion of a
trial period of at least three months prior to receiving the modification. If
a borrower fails to complete the trial period, the loan is considered for our
other workout activities. These modification programs offer eligible
borrowers extension of the loan's term up to 480 months and a fixed interest
rate. Servicers are paid incentive fees for each completed modification, and
there are limits on the number of times a loan may be modified.
The reduced level of loan workout activity in 2019 compared to 2018 was primarily driven by elevated loan workout activity in 2018 as a result of the hurricanes that occurred in late 2017. When a seriously delinquent single-family loan cannot be resolved through an economically sensible home retention option, we typically seek to pursue a foreclosure alternative or sale of the seriously delinquent loan. We pay servicers incentive fees for each completed foreclosure alternative. In some cases, we provide cash relocation assistance to the borrower, while allowing the borrower to exit the home in an orderly manner. We offer the following types of foreclosure alternatives: n Short sale - The borrower sells the property for less than the total amount
owed under the terms of the loan. A short sale is preferable to a borrower
because we provide limited relief to the borrower from repaying the entire
amount owed on the loan. A short sale allows
we would otherwise incur to complete the foreclosure and subsequently sell
the property.
n Deed in lieu of foreclosure - The borrower voluntarily agrees to transfer
title of the property to us without going through formal foreclosure
proceedings.
The volume of foreclosures moderated in recent periods, primarily due to generally declining volumes of seriously delinquent loans, the success of our loan workout programs, and our sales of certain seriously delinquent loans. The volume of our short sale transactions declined in 2019 compared to 2018, continuing the trend in recent periods. Similarly, the volume of short sales in the overall market also declined in recent periods as home prices have continued to increase. The following graphs provide details about our single-family loan workout activities and foreclosure sales.
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Management's Discussion and Analysis Risk Management | Single-Family Mortgage Credit Risk
Home Retention Actions [[Image Removed: chart-46991572ba8a54778f1a01.jpg]] Foreclosure Alternatives and Foreclosure Sales[[Image Removed: chart-4a368737b8165097a49.jpg]]
The tables below contain credit characteristic data on our single-family modified loans. Table 40 - Credit Characteristics of Single-Family Modified Loans
As of December 31, 2019 (Dollars in billions) UPB % of Portfolio CLTV Ratio SDQ Rate Loan Modifications $40.8 2 % 64 % 10.59 % As of December 31, 2018 (Dollars in billions) UPB % of Portfolio CLTV Ratio SDQ Rate Loan Modifications $55.4 3 % 68 % 9.16 % The table below contains information about the payment performance of modified loans in our single-family credit guarantee portfolio, based on the number of loans that were current or paid off one year and, if applicable, two years after modification. Table 41 - Payment Performance of Single-Family Modified Loans Quarter of Loan Modification Completion 4Q 2018 3Q 2018 2Q 2018 1Q 2018 4Q 2017 3Q 2017 2Q 2017 1Q 2017 Current or paid off one year after 68 % 76 % 75 % 66 % 63 % 60 % 62 % 62 % modification: Current or paid off two years after N/A N/A N/A N/A 68 67 64 64 modification: Servicing Transfers and Sales and Securitization of Certain Seasoned Loans From time to time, we facilitate the transfer of servicing for certain groups of loans that are delinquent or are deemed at risk of default to servicers that we believe have capabilities and resources necessary to improve the loss mitigation associated with the loans. See Sellers and Servicers in Counterparty Credit Risk for additional information on these activities.
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Management's Discussion and Analysis Risk Management | Single-Family Mortgage Credit Risk
We pursue sales of seriously delinquent loans when we believe the sale of these loans provides better economic returns than continuing to hold them. During 2019 and 2018, we completed sales of $0.2 billion and $0.7 billion, respectively, in UPB of seriously delinquent single-family loans. Of the $18.5 billion in UPB of single-family loans classified as held-for-sale at December 31, 2019, $4.1 billion related to loans that were seriously delinquent. The FHFA requirements guiding these transactions, including bidder qualifications, loan modifications, and performance reporting, are designed to improve borrower outcomes. Certain seriously delinquent loans may reperform, either on their own or through modification. In addition to sales of seriously delinquent loans, we sell certain reperforming loans. Our sales of reperforming loans typically involve securitization of the loans using our senior subordinate securitization structures. During 2019 and 2018, we sold $12.9 billion and $9.5 billion, respectively, in UPB of reperforming loans through these structures. In prior years, we have securitized reperforming loans using Level 1 Securitization Products, which may be resecuritized and sold to third parties subsequently. During 2018, we securitized $1.6 billion in UPB of reperforming loans using this strategy. We did not execute any such transactions in 2019. Our use of this strategy has declined over time with our primary strategy now utilizing senior subordinate securitization structures. Managing Foreclosure and REO Activities -------------------------------------------------------------------------------- In a foreclosure, we may acquire the underlying property and later sell it, using the proceeds of the sale to reduce our losses. We typically acquire properties as a result of borrower defaults and subsequent foreclosures on loans that we own or guarantee. We evaluate the condition of, and market for, newly acquired REO properties, determine if repairs will be performed, determine occupancy status and whether there are legal or other issues to be addressed, and determine our sale or disposition strategy. When we sell REO properties, we typically provide an initial period where we consider offers by owner occupants and entities engaged in community stabilization activities before offers by investors. We also consider disposition strategies, such as auctions, as appropriate to improve collateral recoveries and/or when traditional sales strategies (i.e., marketing viaMultiple Listing Service and a real estate agent) may not be as effective. The pace and volume of REO acquisitions are affected by the length of the foreclosure process, which extends the time it takes for loans to be foreclosed upon and the underlying properties to transition to REO. Delays in Foreclosure Process and Average Length of Foreclosure Process Our serious delinquency rates and credit losses may be adversely affected by delays in the foreclosure process in states where a judicial foreclosure is required. Foreclosures generally take longer to complete in such states, resulting in concentrations of delinquent loans in those states, as shown in the table below. At December 31, 2019, loans in states with a judicial foreclosure process comprised 38% of our single-family credit guarantee portfolio. The table below presents the length of time our loans have been seriously delinquent, by jurisdiction type. Table 42 - Seriously Delinquent Single-Family Loans by Jurisdiction As of December 31, 2019 2018 2017 Aging, by locality Loan Count Percent Loan Count Percent Loan Count Percent Judicial states <= 1 year 26,063 37 % 27,811 37 % 50,554 44 % > 1 year and <= 2 years 7,416 11 8,268 11 10,649 9 > 2 years 5,336 8 6,871 9 10,863 9 Non-judicial states <= 1 year 24,997 36 25,675 34 34,850 30 > 1 year and <= 2 years 3,928 5 4,133 6 5,406 5 > 2 years 1,981 3 2,382 3 3,367 3 Combined <= 1 year 51,060 73 53,486 71 85,404 74 > 1 year and <= 2 years 11,344 16 12,401 17 16,055 14 > 2 years 7,317 11 9,253 12 14,230 12 Total 69,721 100 % 75,140 100 % 115,689 100 % FREDDIE MAC | 2019 Form 10-K 88
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Management's Discussion and Analysis Risk Management | Single-Family Mortgage Credit Risk
The longer a loan remains delinquent, the greater the associated costs we incur. Loans that remain delinquent for more than one year are more challenging to resolve as many of these borrowers may not be in contact with the servicer, may not be eligible for loan modifications or may determine that it is not economically beneficial for them to enter into a loan modification due to the amount of costs incurred on their behalf while the loan was delinquent. We expect the portion of our credit losses related to loans in states with judicial foreclosure processes will remain high as loans awaiting court proceedings in those states transition to REO or other loss events. The number of our single-family loans delinquent for more than one year declined 14% during 2019. Our servicing guidelines do not allow initiation of the foreclosure process on a primary residence until a loan is at least 121 days delinquent, regardless of where the property is located. However, we evaluate the timeliness of foreclosure completion by our servicers based on the state where the property is located. Our servicing guide provides for instances of allowable foreclosure delays in excess of the expected timelines for specific situations involving delinquent loans, such as when the borrower files for bankruptcy or appeals a denial of a loan modification. The table below presents average completion times for foreclosures of our single-family loans. Table 43 - Average Length of Foreclosure Process for Single-Family Loans Year Ended December 31, (Average days) 2019 2018 2017 Judicial states Florida 1,143 1,173 1,069 New Jersey 1,089 1,343 1,497 New York 1,765 1,790 1,658 All other judicial states 692 710 704 Judicial states, in aggregate 872 926 907 Non-judicial states, in aggregate 520 530 545 Total 730 766 751 As indicated in the table above, the average length of the foreclosure process for our single-family loans has been trending downward in recent years for some jurisdictions, particularly in states with a non-judicial foreclosure process, but it has remained elevated in others, particularly in states with a judicial foreclosure process, such asFlorida andNew York . Our REO inventory continued to decline in 2019 primarily due to a decrease in REO acquisitions driven by the improved credit quality of our portfolio, effective loss mitigation strategies, effective and innovative REO disposition strategies, and a large proportion of property sales to third parties at foreclosure. Third-party sales at foreclosure auction allow us to avoid the REO property expenses that we would have otherwise incurred if we held the property in our REO inventory until disposition. We expect the rate of decline in our REO inventory may slow as a large portion of newly acquired REO properties are older, lower value, and more geographically disbursed, thus creating additional challenges in marketing and selling them. In addition, legal-related delays (i.e., redemption periods, litigations, and eviction procedures) continue to result in extended holding periods. The table below shows our single-family REO activity. Table 44 - Single-Family REO Activity Year Ended December 31, 2019 2018 2017 Number of Number of Number of (Dollars in millions) Properties Amount Properties Amount Properties Amount Beginning balance - REO 7,100 $780 8,299 $900 11,418 $1,215 Additions 7,910 786 10,442 1,012 12,240 1,191 Dispositions (10,021 ) (1,001 ) (11,641 ) (1,132 ) (15,359 ) (1,506 ) Ending balance - REO 4,989 565 7,100 780 8,299 900 Beginning balance, valuation allowance (11 ) (14 ) (17 ) Change in valuation allowance 1 3 3 Ending balance, valuation allowance (10 ) (11 ) (14 ) Ending balance - REO, net $555 $769 $886 FREDDIE MAC | 2019 Form 10-K 89
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Management's Discussion and Analysis Risk Management | Single-Family Mortgage Credit Risk
Severity Ratios Severity ratios are the percentages of our realized losses when loans are resolved by the completion of REO dispositions and third-party foreclosure sales or short sales. Severity ratios are calculated as the amount of our recognized losses divided by the aggregate UPB of the related loans. The amount of recognized losses is equal to the amount by which the UPB of the loans exceeds the amount of sales proceeds from disposition of the properties, net of capitalized repair and selling expenses, if applicable. Loss severity excludes the cost of funding the loans after they are repurchased from the associated security pool. The table below presents single-family severity ratios. Table 45 - Single-Family Severity Ratios Year Ended December
31,
2019 2018
2017
REO dispositions and third-party foreclosure sales 21.7 % 24.2 % 27.2 % Short sales
24.5 26.6 27.7 Our severity ratios declined during 2019 compared to 2018, primarily driven by home price appreciation as well as effective cost control and disposition strategies. REO Property Status A significant portion of our REO portfolio is unable to be marketed at any given time because the properties are occupied, involved in legal matters (e.g., bankruptcy, litigation, etc.), or subject to a redemption period, which is a post-foreclosure period during which borrowers may reclaim a foreclosed property. Redemption periods increase the average holding period of our inventory by as much as 10% or more. As of December 31, 2019, approximately 27% of our REO properties were unable to be marketed because the properties were occupied, located in states with a redemption period or subject to other legal matters. Another 23% of the properties were being prepared for sale (i.e., valued, marketing strategies determined, and repaired). As of December 31, 2019, approximately 30% of our REO properties were listed and available for sale, and 20% of our inventory was pending the settlement of sales. Though it varied significantly in different states, the average holding period of our single-family REO properties, excluding any redemption period, was 234 days and 244 days for our REO dispositions during 2019 and 2018, respectively.
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Risk Management |
Multifamily
Management's Discussion and Analysis Mortgage Credit Risk Multifamily Mortgage Credit Risk -------------------------------------------------------------------------------- We manage our exposure to multifamily mortgage credit risk, which is a type of commercial real estate credit risk, using the following principal strategies: n Maintaining policies and procedures for new business activity, including
prudent underwriting standards;
n Transferring credit risk to third-party investors; and
n Managing our portfolio, including loss mitigation activities.
Maintaining Policies and Procedures for New Business Activity, Including Prudent Underwriting Standards -------------------------------------------------------------------------------- We use a prior approval underwriting approach for multifamily loans, in contrast to the delegated underwriting approach used for single-family loans and Fannie Mae's DUS program. Under this approach, we maintain credit discipline by completing our own underwriting and credit review for each new loan prior to issuing a loan purchase commitment, including reviewing third-party appraisals and performing cash flow analysis. Our underwriting standards focus on the LTV ratio and DSCR, which estimates a borrower's ability to repay the loan using the secured property's cash flows, after expenses. A higher DSCR indicates lower credit risk. Our standards require maximum LTV ratios and minimum DSCRs that vary based on the characteristics and features of the loan. Loans are generally underwritten with a maximum original LTV ratio of 80% and a DSCR of greater than 1.25, assuming monthly payments that reflect amortization of principal. However, certain loans may have a higher LTV ratio and/or a lower DSCR, typically where this will serve our mission and contribute to achieving our affordable housing goals. Consideration is also given to other qualitative factors, such as borrower experience, the type of loan, location of the property, and the strength of the local market. Sellers provide certain representations and warranties regarding the loans they sell to us, and are required to repurchase loans for which there has been a breach of representation or warranty. However, repurchases of multifamily loans have been rare due to our underwriting approach, which is completed prior to issuance of a loan purchase commitment. Multifamily loans may be amortizing or interest-only (for the full term or a portion thereof) and have a fixed or variable rate of interest. Multifamily loans generally amortize over a thirty-year period, but have shorter contractual maturity terms than single-family loans, typically ranging from five to ten years. As a result, most multifamily loans require a balloon payment at maturity, making a borrower's ability to refinance or pay off the loan at maturity a key attribute. Some borrowers may be unable to refinance during periods of rising interest rates or adverse market conditions, increasing the likelihood of borrower default. Occasionally, we may take on additional credit risk through the issuance of certain other securitizations when the loans or bonds underlying the issued securities are contributed by third parties and are underwritten by us after (rather than at) origination. Prior to securitization, we are not exposed to the credit risk of these underlying loans or bonds. However, as we may guarantee some or all of the securities issued by the trusts used in these transactions, we effectively assume credit risk equal to the guaranteed UPB. Similar to our primary securitizations, these other securitizations generally provide for structural credit enhancements (e.g., subordination or other loss sharing arrangements) that allocate first loss exposure to third parties. The table below presents the key risk characteristics of our multifamily new business activity. Table 46 - Multifamily New Business Activity Key Risk Characteristics Year Ended December 31, 2019 2018 2017 Weighted average original LTV ratio 68 % 67 % 68 % Original LTV ratio greater than 80%(1) 2 1 2
Original DSCR less than or equal to 1.10(1) 1 1 1
(1) Shown as a percentage of multifamily new business activity.
FREDDIE MAC | 2019 Form 10-K 91
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Risk Management |
Multifamily
Management's Discussion and Analysis Mortgage Credit Risk Transferring Credit Risk to Third-Party Investors -------------------------------------------------------------------------------- Types of Credit Enhancements In connection with the acquisition or securitization of a loan or group of loans, we may obtain various forms of credit protection that reduce our credit risk exposure to the underlying mortgage borrower and reduce our required conservatorship capital. For example, at the time of loan acquisition, we may obtain recourse and/or indemnification protection from our lenders or sellers. After acquisition, we primarily reduce our credit risk exposure to the underlying borrower by using one or more of our securitization products. The following table summarizes our principal types of credit enhancements. See Our Business Segments - Multifamily - Business Overview - Products and Activities for additional information on our securitization and credit risk transfer products. Category Products CRT
Coverage Type Accounting
Treatment Primary securitization products Yes Back-end Attached Other securitization products:
Subordination • Securitizations of purchased collateral Yes
Back-end Attached/Debt • Securitizations of collateral No Front-end Attached contributed by third parties Securitizations in which we issue fully Yes Front-end Freestanding Lender risk-sharing guaranteed securities and simultaneously enter into a separate loss sharing agreement. Insurance/reinsurance MCIP Yes Back-end Freestanding SCR SCR notes Yes Back-end Debt Credit Enhancement Coverage for Multifamily Mortgage Portfolio We report multifamily delinquency rates based on the UPB of loans in our multifamily mortgage portfolio that are two monthly payments or more past due or in the process of foreclosure, as reported by our servicers. Loans that have been modified (or are subject to forbearance agreements) are not counted as delinquent as long as the borrower is less than two monthly payments past due under the modified (or forbearance) terms. The table below shows the delinquency rates for both credit-enhanced and non-credit-enhanced loans in our multifamily mortgage portfolio. Table 47 - Credit-Enhanced and Non-Credit-Enhanced Loans Underlying Our Multifamily Mortgage Portfolio As of December 31, 2019 2018 2017 (Dollars in billions) UPB % of Portfolio Delinquency Rate UPB % of Portfolio Delinquency Rate UPB % of Portfolio Delinquency Rate Credit-enhanced $267.0 89 % 0.09 % $234.9 87 % 0.01 % $198.1 82 % 0.01 % Non-credit-enhanced 33.1 11 - 36.6 13 - 42.6 18 0.06 Total $300.1 100 % 0.08 % $271.5 100 % 0.01 % $240.7 100 % 0.02 % Our securitizations remain our principal risk transfer mechanism. Through securitizations, we have transferred a large majority of the expected and stress credit risk on the multifamily guarantee portfolio, thereby reducing our overall credit risk exposure and required conservatorship capital. Since 2009, we have transferred a portion of the credit risk related to $389.6 billion in UPB of multifamily loans through our securitizations, primarily K Certificates and SB Certificates, and other credit risk transfer products. The following table provides information on the level of subordination on our securitizations. Table 48 - Level of Subordination on Our Securitizations As of December 31, 2019 2018 (Dollars in billions) UPB Delinquency Rate UPB Delinquency Rate Subordination level at issuance No subordination $9.3 - % $7.7 - % Less than 10% 1.2 - 3.1 - Greater than 10% 249.8 0.09 216.1 0.01 Total $260.3 0.09 % $226.9 0.01 % FREDDIE MAC | 2019 Form 10-K 92
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Risk Management |
Multifamily
Management's Discussion and Analysis Mortgage Credit Risk The average remaining level of subordination on our outstanding primary securitizations was 14% at both December 31, 2019 and December 31, 2018, respectively. Since we began issuing our primary securitizations, we have not experienced credit losses associated with our guarantees on these securities. In addition to the credit enhancements listed above, we have various other credit enhancements related to our multifamily unsecuritized loans, securitizations, and other mortgage-related guarantees, in the form of collateral posting requirements, pool insurance, bond insurance, loss sharing agreements, and other similar arrangements, that along with the proceeds received from the sale of the underlying mortgage collateral, are designed to enable us to recover all or a portion of our losses on our mortgage loans or the amounts paid under our financial guarantee contracts. Our historical losses paid under our guarantee contracts and related recoveries pursuant to these agreements have not been significant. See Note 6 for more information on the total current and protected UPB of our multifamily mortgage portfolio that is credit-enhanced and the associated maximum coverage. We continue to develop other strategies to reduce our credit risk exposure to multifamily loans and securities. See Our Business Segments - Multifamily - Business Overview - Products and Activities - Securitization and Guarantee Products for additional information. Managing Our Portfolio, Including Loss Mitigation Activities -------------------------------------------------------------------------------- To help mitigate our potential losses, we generally require sellers to act as the primary servicer for loans they have sold to us, including property monitoring tasks beyond those typically performed by single-family servicers. We typically transfer the role of master servicer in our K Certificate transactions to third parties, while retaining that role in our SB Certificate transactions. Servicers for unsecuritized loans over $1 million must generally provide us with an assessment of the mortgaged property at least annually based on the servicer's analysis of the property as well as the borrower's financial statements. In situations where a borrower or property is in distress, the frequency of communications with the borrower may be increased. We rate servicing performance on a regular basis, and we may conduct on-site reviews to confirm compliance with our standards. Our primary credit risk exposure results from our unsecuritized loans. By their nature, loans awaiting securitization that we hold for sale remain on our balance sheet for a shorter period than loans we hold for investment and are generally covered by general seller representations and warranties. For unsecuritized loans, we may offer a workout option to give the borrower an opportunity to bring the loan current and retain ownership of the property, such as providing a short-term extension of up to 12 months. These arrangements are entered into 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. Our multifamily loan modification and other workout activities have been minimal in the last three years.
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Risk Management |
Multifamily
Management's Discussion and Analysis Mortgage Credit Risk The table below presents information about the composition and delinquency rates of the multifamily mortgage portfolio. Table 49 - Multifamily Mortgage Portfolio Attributes As of December 31, 2019 2018 (Dollars in billions) UPB Delinquency Rate UPB Delinquency Rate Unsecuritized loans $29.8 0.01 % $34.8 0.01 % Securitization-related products 260.3 0.09 226.9 0.01 Other mortgage-related guarantees 10.0 0.09 9.8 - Total $300.1 0.08 % $271.5 0.01 % Unsecuritized HFI loans Original LTV ratio Below 75% $7.7 - % $7.1 - % 75% to 80% 2.5 - 3.0 - Above 80% 0.6 - 0.7 - Total $10.8 - % $10.8 - % Weighted average LTV ratio at 68 % 69 % origination Maturity dates 2019 N/A N/A $1.7 - % 2020 $1.2 - % 1.5 - 2021 1.1 - 1.8 - 2022 1.0 - 1.4 - 2023 0.8 - 1.1 - Thereafter 6.7 - 3.3 - Total $10.8 - % $10.8 - % REO Activity Our REO activity has remained low in the past several years as a result of the strong property performance of our multifamily mortgage portfolio. As of December 31, 2019, we had no REO properties. Credit Losses and Allowance for Credit Losses Our multifamily credit losses remain low due to the strong property performance of our multifamily mortgage portfolio. See Note 4 for additional information regarding multifamily credit losses and allowance for credit losses.
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Management's Discussion and Analysis Risk Management | Counterparty Credit Risk
Counterparty Credit Risk -------------------------------------------------------------------------------- We are exposed to counterparty credit risk, which is a type of institutional credit risk, as a result of our contracts with sellers and servicers, credit enhancement providers (mortgage insurers, investors, etc.), financial intermediaries, clearinghouses, and other counterparties. We manage our exposure to counterparty credit risk using the following principal strategies: n Maintaining eligibility standards;
n Evaluating creditworthiness and monitoring performance; and
n Working with underperforming counterparties and limiting our losses from
their nonperformance of obligations, when possible.
In the sections below, we discuss our management of counterparty credit risk for each type of counterparty to which we have significant exposure. Sellers and Servicers -------------------------------------------------------------------------------- Overview In our single-family guarantee business, we do not originate loans or have our own loan servicing operation. Instead, our sellers and servicers perform the primary loan origination and loan servicing functions on our behalf. We establish underwriting and servicing standards for our sellers and servicers to follow and have contractual arrangements with them under which they represent and warrant that the loans they sell to us meet our standards and that they will service loans in accordance with our standards. If we discover that the representations or warranties related to a loan were breached (i.e., that contractual standards were not followed), we can exercise certain contractual remedies to mitigate our actual or potential credit losses. If our sellers or servicers lack appropriate controls, experience a failure in their controls, or experience an operating disruption, including as a result of financial pressure, legal or regulatory actions or ratings downgrades, we could experience a decline in mortgage servicing quality and/or be less likely to recover losses through lender repurchases, recourse agreements, or other credit enhancements, where applicable. In our multifamily business, we are exposed to the risk that multifamily sellers and 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. This could also, in certain cases, reduce the likelihood that we could recover losses through lender repurchases, recourse agreements, or other credit enhancements, where applicable. This risk primarily relates to multifamily loans that we hold on our consolidated balance sheets where we retain all of the related credit risk. In addition, our single-family guarantee and multifamily businesses are exposed to settlement risk on the non-performance of sellers and servicers as a result of our forward settlement loan purchase programs. For additional details, see the Financial Intermediaries, Clearinghouses, and Other Counterparties - Other Counterparties - Forward Settlement Counterparties section below. Maintaining Eligibility Standards Our eligibility standards for sellers and servicers require the following: a demonstrated operating history in residential mortgage origination and servicing, or an eligible agent acceptable to us; adequate insurance coverage; a quality control program that meets our standards; and sufficient net worth, capital, liquidity, and funding sources. Evaluating Counterparty Creditworthiness and Monitoring Performance We perform ongoing monitoring and review of our exposure to individual sellers or servicers in accordance with our institutional credit risk management framework, including requiring our counterparties to provide regular financial reporting to us. We also monitor and rate our sellers and servicers' compliance with our standards and periodically review their operational processes. We may disqualify or suspend a seller or servicer with or without cause at any time. Once a seller or servicer is disqualified or suspended, we no longer purchase loans originated by that counterparty and generally no longer allow that counterparty to service loans for us, while seeking to transfer servicing of existing portfolios. As discussed in more detail in Our Business Segments, we acquire a significant portion of both our single-family and multifamily loan purchase volume from several large lenders, and a large percentage of our loans are also serviced by several large servicers. We have significant exposure to non-depository and smaller depository financial institutions in our single-family business. These institutions may not have the same financial strength or operational capacity, or be subject to the same level of regulatory oversight, as large depository institutions. Although our business with our single-family loan sellers is concentrated, a number of our largest single-family loan seller counterparties reduced or eliminated their purchases of loans from mortgage brokers and correspondent lenders in recent
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Management's Discussion and Analysis Risk Management | Counterparty Credit Risk
years. As a result, we acquire a greater portion of our single-family business volume directly from non-depository and smaller depository financial institutions. Since the financial crisis, there has been a shift in our single-family servicing from depository institutions to non-depository institutions. Some of these non-depository institutions have grown rapidly in recent years and now service a large share of our loans. The table below summarizes the concentration of non-depository servicers of our single-family credit guarantee portfolio. Table 50 - Single-Family Credit Guarantee Portfolio Non-Depository Servicers As of December 31, 2019 2018 % of Serious % of Serious Delinquent Delinquent Single-Family Single-Family % of Portfolio(1) Loans % of Portfolio(1) Loans Top five non-depository servicers 18 % 13 % 16 % 17 % Other non-depository servicers 20 55 20 40 Total 38 % 68 % 36 % 57 % (1) Excludes loans where we do not exercise control over the associated servicing. Working with Underperforming Counterparties and Limiting Our Losses from Their Nonperformance of Obligations, When Possible We actively manage the current quality of loan originations of our largest single-family sellers by performing loan quality control sampling reviews and communicating loan defect rates and the causes of those defects to such sellers on a monthly basis. If necessary, we work with these sellers to develop an appropriate plan of corrective action. We use a variety of tools and techniques to engage our single-family sellers and servicers and limit our losses, including the following: n Repurchases and other remedies - For certain violations of our single-family
selling or servicing policies, we can require the counterparty to repurchase
loans or provide alternative remedies, such as reimbursement of realized
losses or indemnification, and/or suspend or terminate the selling and
servicing relationship. We typically first issue a notice of defect and allow
a period of time to correct the problem prior to issuing a repurchase request. The UPB of loans subject to repurchase requests issued to our single-family sellers and servicers was $0.3 billion and $0.4 billion at December 31, 2019 and December 31, 2018, respectively. See Note 14 for additional information about loans subject to repurchase requests.
n Incentives and compensatory fees - We pay various incentives to single-family
servicers for completing workouts of problem loans. We also assess compensatory fees if single-family servicers do not achieve certain benchmarks with respect to servicing delinquent loans. n Servicing transfers - From time to time, we may facilitate the transfer of
servicing as a result of poor servicer performance, or for certain groups of
single-family loans that are delinquent or are deemed at risk of default, to
servicers that we believe have the capabilities and resources necessary to
improve the loss mitigation associated with the loans. We may also facilitate
the transfer of servicing on loans at the request of the servicer.
Credit Enhancement Providers -------------------------------------------------------------------------------- Overview We have exposure to credit enhancement providers through credit enhancements we obtain on single-family loans. If any of our credit enhancement providers fail to fulfill their obligations, we may not receive reimbursement for credit losses to which we are contractually entitled pursuant to our credit enhancements. With respect to primary mortgage insurers, we currently cannot differentiate pricing based on counterparty strength or revoke a primary mortgage insurer's status as an eligible insurer without FHFA approval. Further, we generally do not select the insurance provider on a specific loan, because the selection is made by the lender at the time the loan is originated. Accordingly, we are unable to manage our concentration risk with respect to primary mortgage insurers. As part of our insurance/reinsurance CRT transactions, we regularly obtain insurance coverage from global insurers and reinsurers. These transactions incorporate several features designed to increase the likelihood that we will recover on the claims we file with the insurers and reinsurers, including the following: n In each transaction, we require the individual insurers and reinsurers to
post collateral to cover portions of their exposure, which helps to promote
certainty and timeliness of claim payment and
FREDDIE MAC | 2019 Form 10-K 96
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Management's Discussion and Analysis Risk Management | Counterparty Credit Risk
n While private mortgage insurance companies are required to be monoline (i.e.,
to participate solely in the mortgage insurance business, although the
holding company may be a diversified insurer), our insurers and reinsurers
generally participate in multiple types of insurance businesses, which helps
to diversify their risk exposure.
Maintaining Eligibility Standards We maintain eligibility standards for mortgage insurers and other insurers and reinsurers. Our eligibility requirements include financial requirements determined using a risk-based framework and were designed to promote the ability of mortgage insurers to fulfill their intended role of providing consistent liquidity throughout the mortgage cycle. Our mortgage insurers are required to submit audited financial information and certify compliance with the Private Mortgage Insurer Eligibility Requirements on an annual basis. Evaluating Counterparty Creditworthiness and Monitoring Our Exposure We monitor our exposure to individual insurers by performing periodic analysis of the financial capacity of each insurer under various adverse economic conditions. Monitoring performance and potentially identifying underperformance allows us to plan for loss mitigation. The table below summarizes our exposure to single-family mortgage insurers as of December 31, 2019. In the event a mortgage insurer fails to perform, the coverage amounts represent our maximum exposure to credit losses resulting from such a failure. Table 51 - Single-Family Mortgage Insurers As of December 31, 2019 Credit Rating (In millions) Credit Rating(1) Outlook(1) UPB Coverage Arch Mortgage Insurance Company A- Stable $93,440 $23,956 Radian Guaranty Inc. (Radian) BBB+ Stable 84,434 21,397 Mortgage Guaranty Insurance Corporation (MGIC) BBB+ Stable 73,371 18,845 Genworth Mortgage Insurance Corporation BB+ Watch Dev 63,071 16,139 Essent Guaranty, Inc. BBB+ Stable 63,865 16,260 National Mortgage Insurance (NMI) BBB Stable 37,147 9,476 PMI Mortgage Insurance Co. (PMI) Not Rated N/A 2,889 723 Republic Mortgage Insurance Company (RMIC) Not Rated N/A 2,156 536 Triad Guaranty Insurance Corporation (Triad) Not Rated N/A 1,241 312 Others N/A N/A 256 46 Total $421,870 $107,690
(1) Ratings and outlooks are for the corporate entity to which we have the
greatest exposure. Coverage amounts may include coverage provided by
consolidated affiliates and subsidiaries of the counterparty. Latest rating
available as of December 31, 2019. Represents the lower of S&P and Moody's
credit ratings and outlooks stated in terms of the S&P equivalent.
The majority of our mortgage insurance exposure is concentrated with five mortgage insurers. Although the financial condition of our mortgage insurers improved in recent years, there is still a risk that some of these counterparties may fail to fully meet their obligations under a stress economic scenario since they are monoline entities primarily exposed to mortgage credit risk. On October 23, 2016, Genworth Financial, Inc. announced that it had entered into an agreement to be acquired byChina Oceanwide Holdings Group Co., Ltd. BecauseGenworth Mortgage Insurance Corporation , a subsidiary of Genworth Financial, Inc., is an approved mortgage insurer,Freddie Mac evaluated the planned acquisition and approvedChina Oceanwide Holdings Group's control ofGenworth Mortgage Insurance Corporation . In January 2020,Freddie Mac reapproved the acquisition. Regulatory and other approvals of the acquisition are still pending. For more information about counterparty credit risk associated with mortgage insurers, see Note 14. PMI and Triad are both under the control of their state regulators and no longer issue new insurance. Both of these insurers pay a substantial portion of their claims as deferred payment obligations. RMIC is under regulatory supervision and is no longer issuing new insurance; however, it continues to pay its claims in cash. If, as we currently expect, PMI and Triad do not pay the full amount of their deferred payment obligations in cash, we would lose a portion of the coverage from these insurers shown in the table above. As of December 31, 2019, we had cumulative unpaid deferred payment obligations of $0.5 billion from these insurers. We have reserved substantially all of these unpaid amounts as collectability is uncertain. Except for those insurers under regulatory supervision, which no longer issue new coverage, we continue to acquire new loans with mortgage insurance from the mortgage insurers shown in the table above, some of which have credit ratings below investment grade.FREDDIE MAC | 2019 Form 10-K 97
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Management's Discussion and Analysis Risk Management | Counterparty Credit Risk
Single Security Initiative -------------------------------------------------------------------------------- The Single Security Initiative has increased our counterparty credit risk exposure to Fannie Mae. With the implementation of the Single Security Initiative, we now have the ability to commingle TBA-eligible Fannie Mae collateral in certain of our resecuritization products. When we resecuritize Fannie Mae securities in our commingled resecuritization products, our guarantee covers timely payments of principal and interest on such securities. If Fannie Mae were to fail to make a payment on a Fannie Mae security that we resecuritized, we would be responsible for making the payment to the securities holders. Our pricing does not currently reflect any incremental credit, liquidity, or operational risk associated with our guarantee of resecuritized Fannie Mae securities. We will be dependent on FHFA, Fannie Mae, andTreasury (pursuant to Fannie Mae's and our respective Purchase Agreements withTreasury ) to avoid a liquidity event or default. We are not planning to modify our liquidity strategies to address the possibility of non-timely payment by Fannie Mae. For additional information on the Single Security Initiative and the associated risks, see MD&A - Our Business Segments - Single-Family Guarantee and Risk Factors. Financial Intermediaries, Clearinghouses, and Other Counterparties -------------------------------------------------------------------------------- Derivative Counterparties We use cleared derivatives, exchange-traded derivatives, OTC derivatives, and forward sales and purchase commitments to mitigate risk, and are exposed to the non-performance of each of the related financial intermediaries and clearinghouses.The Capital Markets segment manages this risk for the company. Our financial intermediaries and clearinghouse credit exposure relates principally to interest-rate derivative contracts. We maintain internal standards for approving new derivative counterparties, clearinghouses, and clearing members. n Cleared derivatives - Cleared derivatives expose us to counterparty credit
risk of central clearinghouses and our clearing members. Our exposure to the
clearinghouses we use to clear interest-rate derivatives has increased and
may become more concentrated over time. The use of cleared derivatives
mitigates our counterparty credit risk exposure to individual counterparties
because a central counterparty is substituted for individual counterparties,
and changes in the value of open contracts are settled daily via payments
made through the clearinghouse. We are required to post initial and variation
margin to the clearinghouses. The amount of initial margin we must post for
cleared and exchange-traded derivatives may be based, in part, on S&P or
Moody's credit rating of our long-term senior unsecured debt securities. Our
obligation to post margin may increase as a result of the lowering or withdrawal of our credit rating by S&P or Moody's or by changes in the potential future exposure generated by the derivative transactions. n Exchange-traded derivatives - Exchange-traded derivatives expose us to counterparty credit risk of the central clearinghouses and our clearing members. We are required to post initial and variation margin with our
clearing members in connection with exchange-traded derivatives. The use of
exchange-traded derivatives mitigates our counterparty credit risk exposure
to individual counterparties because a central counterparty is substituted
for individual counterparties, and changes in the value of open
exchange-traded derivatives are settled daily via payments made through the
financial clearinghouse.
n OTC derivatives - OTC derivatives expose us to counterparty credit risk of
individual counterparties, because these transactions are executed and
settled directly between us and each counterparty, exposing us to potential
losses if a counterparty fails to meet its contractual obligations. When a
counterparty in OTC derivatives that is subject to a master netting agreement
has a net obligation to us with a market value above an agreed upon
threshold, if any, the counterparty is obligated to deliver collateral in the
form of cash, securities, or a combination of both to satisfy its obligation
to us under the master netting agreement. Our OTC derivatives also require us
to post collateral to counterparties in accordance with agreed upon
thresholds, if any, when we are in a derivative liability position. The
collateral posting thresholds we assign to our OTC counterparties, as well as
the ones they assign to us, are generally based on S&P or Moody's credit
rating. The lowering or withdrawal of our or our counterparty's credit rating
by S&P or Moody's may increase our or our counterparty's obligation to post
collateral, depending on the amount of the counterparty's exposure to Freddie
Mac with respect to the derivative transactions. Only OTC derivatives
transactions executed prior to March 1, 2017 are subject to collateral
posting thresholds. Based upon regulations that took effect March 1, 2017,
OTC derivative transactions executed or materially amended after that date
require posting of variation margin without the application of any thresholds. Our OTC derivative transactions will become subject to new initial margin requirements on September 1, 2020.FREDDIE MAC | 2019 Form 10-K 98
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Management's Discussion and Analysis Risk Management | Counterparty Credit Risk
Evaluating Counterparty Creditworthiness and Monitoring Performance Over time, our exposure to derivative counterparties varies depending on changes in fair values, which are affected by changes in interest rates and other factors. Due to risk limits with certain counterparties, we may be forced to execute transactions with lower returns with other counterparties when managing our interest-rate risk. We manage our exposure through master netting and collateral agreements and stress-testing to evaluate potential exposure under possible adverse market scenarios. Collateral is typically transferred within one business day based on the values of the related derivatives. We regularly review the market values of the securities pledged to us as non-cash collateral, primarily agency andU.S. Treasury securities, to manage our exposure to loss. We conduct additional reviews of our exposure when market conditions dictate or certain events affecting an individual counterparty occur. When non-cash collateral is posted to us, we require collateral in excess of our exposure to satisfy the net obligation to us in accordance with the counterparty agreement. In the event a counterparty defaults, our economic loss may be higher than the uncollateralized exposure of our derivatives if we are not able to replace the defaulted derivatives in a timely and cost-effective fashion (e.g., due to a significant interest rate movement during the period or other factors). We could also incur economic losses if non-cash collateral posted to us by the defaulting counterparty cannot be liquidated at prices that are sufficient to recover the amount of such exposure. The table below compares the gross fair value of our derivative asset positions after counterparty netting with our net exposure to these positions after considering cash and non-cash collateral held. Table 52 - Derivative Counterparty Credit Exposure As of December 31, 2019 Fair Value - Gain Number of Fair Value - positions, net of (Dollars in millions) Counterparties Gain positions collateral OTC interest-rate swap and swaption counterparties (by rating) AA- or above 2 $17 $9 A+, A, or A- 12 2,563 11 BBB+, BBB, or BBB- - - - Total OTC 14 2,580 20 Cleared and exchange-traded derivatives 2 139 262 Total 16 $2,719 $282 Approximately 99% of our exposure at fair value for OTC interest-rate swap and option-based derivatives, excluding amounts related to our posting of cash collateral in excess of our derivative liability determined at the counterparty level, was collateralized at December 31, 2019. The remaining exposure was primarily due to market movements between the measurement of a derivative at fair value and our receipt of the related collateral, as well as exposure amounts below the then applicable counterparty collateral posting threshold, if any. The concentration of our derivative exposure among our primary OTC derivative counterparties remains high and could further increase. Other Counterparties We have exposure to other types of counterparties to transactions that we enter into in the ordinary course of business, including the following: n Other investments - We are exposed to the non-performance of institutions
relating to other investments (including non-mortgage-related securities and
cash and cash equivalents) transactions, including those entered into on behalf of our securitization trusts. Our policies require that the institution be evaluated using our internal rating model prior to our
entering into such transactions. We monitor the financial strength of these
institutions and may use collateral maintenance requirements to manage our
exposure to individual counterparties.
The major financial institutions with which we transact regarding our other investments (including non-mortgage-related securities and cash and cash equivalents) include other GSEs,Treasury , theFederal Reserve Bank of New York , GSD/FICC, highly-rated supranational institutions, depository and non-depository institutions, brokers and dealers, and government money market funds. For more information on our other investments portfolio, see Liquidity and Capital Resources. We utilize the GSD/FICC as a clearinghouse to transact many of our trades involving securities purchased under agreements to resell, securities sold under agreements to repurchase, and other non-mortgage related securities. As a clearing member of GSD/FICC, we are required to post initial and variation margin payments and are exposed to the counterparty credit risk of GSD/FICC (including its clearing members). In the event a clearing member fails and causes losses to the GSD/FICC clearing system, we could be subject to the loss of the margin that we have posted to the GSD/FICC. Moreover, our exposure could exceed that amount, as members are generally required to cover losses caused by defaulting members on a pro rata basis. It is difficult to estimate our maximum exposure under these transactions, as this
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Management's Discussion and Analysis Risk Management | Counterparty Credit Risk
would require an assessment of transactions that we and other members of the GSD/FICC may execute in the future. We believe that it is unlikely we will have to make any material payments under these arrangements and the risk of loss is expected to be remote because of the GSD/FICC's financial safeguards and our ability to terminate our membership in the clearinghouse (which would limit our loss). n Forward settlement counterparties - We are exposed to the non-performance (settlement risk) of counterparties relating to the forward settlement of loans and securities (including agency debt, agency RMBS, and cash loan purchase program loans). Our policies require that the counterparty be
evaluated using our internal counterparty rating model prior to our entering
into such transactions. We monitor the financial strength of these
counterparties and may use collateral maintenance requirements to manage our
exposure to individual counterparties.
We also execute forward purchase and sale commitments of mortgage-related securities, including dollar roll transactions, that are treated as derivatives for accounting purposes and utilize the Mortgage Backed Securities Division of theFixed Income Clearing Corporation (MBSD/FICC) as a clearinghouse. As a clearing member of the clearinghouse, we post margin to the MBSD/FICC and are exposed to the counterparty credit risk of the organization. In the event a clearing member fails and causes losses to the MBSD/FICC clearing system, we could be subject to the loss of the margin that we have posted to the MBSD/FICC. Moreover, our exposure could exceed the amount of margin we have posted to the MBSD/FICC, as clearing members are generally required to cover losses caused by defaulting members on a pro rata basis. It is difficult to estimate our maximum exposure, as this would require an assessment of transactions that we and other members of the MBSD/FICC may execute in the future. We believe that it is unlikely we will have to make any material payments under these arrangements and the risk of loss is expected to be remote because of the MBSD/FICC's financial safeguards and our ability to terminate our membership in the clearinghouse (which would limit our loss). As of December 31, 2019, the gross fair value of such forward purchase and sale commitments that were in derivative asset positions was $50 million. n Secured lending activities - As part of our other investments portfolio, we
enter into secured lending arrangements to provide financing for certain
in an attempt to improve the market for these assets. These transactions
differ from those we use for liquidity purposes, as the borrowers may not be
major financial institutions, potentially exposing us to the institutional
credit risk of these institutions. We also provide advances to lenders for
mortgage loans that they will subsequently either sell through our cash
purchase program or securitize into securities that they will deliver to us.
In addition, we may invest in other secured lending activities. For
additional information, see Note 14.
Other Market Participants -------------------------------------------------------------------------------- We have exposure to other market participant counterparties for transactions that we enter into in the ordinary course of business, including the following: n Document custodians - We use third-party document custodians to provide loan
document certification and custody services for the loans that we purchase
and securitize. In many cases, our sellers and servicers or their affiliates
also serve as document custodians for us. Our ownership rights to the loans
that we own or that back our securitization products could be challenged if a
seller or servicer intentionally or negligently pledges, sells, or fails to
obtain a release of prior liens on the loans that we purchased, which could
result in financial losses to us. When a seller or servicer, or one of its
affiliates, acts as a document custodian for us, the risk that our ownership
interest in the loans may be adversely affected is increased, particularly in
the event the seller or servicer were to become insolvent. To manage these
risks, we establish qualifying standards for our document custodians and
maintain legal and contractual arrangements that identify our ownership
interest in the loans. We also monitor the financial strength of our document
custodians on an ongoing basis in accordance with our counterparty credit
risk management framework, and we require transfer of documents to a different third-party document custodian if we have concerns about the solvency or competency of the document custodian.
n The MERS® System - The MERS System is an electronic registry that is widely
used by sellers and servicers,
mortgage industry to maintain records of beneficial ownership of mortgage
loans. A significant portion of the loans we own or guarantee are registered
in the MERS System. Our business could be adversely affected if we were
prevented from using the MERS System, or if our use of the MERS System
adversely affects our ability to enforce our rights with respect to our loans
registered in the MERS System.
FREDDIE MAC | 2019 Form 10-K 100
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Management's Discussion and Analysis Risk Management | Operational Risk
Operational Risk Operational risk is the risk of direct or indirect loss resulting from inadequate or failed internal processes, people, or systems or from external events. Operational risk is inherent in all our activities. Operational risk events include accounting, financial reporting, or operational errors, technology failures, business interruptions, non-compliance with legal or regulatory requirements, fraudulent acts, inappropriate acts by employees, information security incidents, or third parties who do not perform in accordance with their contracts. These operational risk events could result in financial loss, legal actions, regulatory fines, and reputational harm. Operational Risk Management and Risk Profile -------------------------------------------------------------------------------- Our operational risk management methodology includes risk identification, measurement, monitoring, controlling, and reporting. When operational risk events are identified, our policies require that the events be documented and analyzed to determine whether changes are required in our systems, people, and/or processes to mitigate the risk of future events. In order to evaluate and monitor the risks associated with business processes, each business line periodically completes an assessment using the RCSA methodology. The methodology is designed to identify and assess the business line's exposure to operational risk and determine if action is required to manage the risk to an acceptable level. In addition to the RCSA process, we employ several tools to identify, measure, and monitor operational risks, including loss event data, key risk indicators, root cause analysis, and testing. Our operational risk methodology requires that the primary responsibility for managing both the day-to-day risk and longer-term or emerging risks lies with the business lines, with independent oversight performed by the second line of defense. We continue to face heightened operational risk and expect the risk to remain elevated for the near term. This elevated risk profile is due to the layering impact of several factors including: legacy systems requiring upgrade for operational resiliency; reliance on manual processes and models; volume and complexity of business initiatives, including the UMBS and new initiatives we are pursuing as required by the Conservatorship Scorecards; external events such as cybersecurity threats and third-party failures; and issues requiring remediation. Other factors contributing to our heightened operational risk are discussed in Risk Factors - Operational Risks. We also continue to manage other operational risks, such as compliance risk. While our operational risk profile remains elevated, we are continuing to strengthen our operational control environment by building out our operational risk resources within the first line of defense and ERM. Business Resiliency Risk -------------------------------------------------------------------------------- We continue to enhance our business resiliency capabilities for mission critical systems and processes.Freddie Mac has established business resiliency policies and standards to strengthen enterprise-wide risk reduction activities, program execution, and program maturity. Program enhancements include geographical redundancies, expanded use of a third-party cloud platform for our business applications, as well as continuous technological transformation to achieve recovery of critical business functions and supporting assets in the event of a business disruption. Internal Processes and New Initiatives -------------------------------------------------------------------------------- We periodically make improvements to the design of our processes for business lines with increased business volumes and complexity of transactions to achieve effectiveness and efficiency in our operations. New initiatives that pose significant risks to the company are subject to additional evaluation, documentation, reporting, review, and approvals (including by the second line), prior to execution. Common Securitization Platform -------------------------------------------------------------------------------- We continue to make various multi-year investments to build and support the infrastructure for a better housing finance system, including the development of the CSP by CSS (jointly owned byFreddie Mac and Fannie Mae) and the UMBS. Regarding the CSP, while we exercise influence over CSS through our representation on the CSS Board of Managers, we do not control its day-to-day operations. CSS' day-to-day operations are managed by CSS management, which is overseen by the CSS Board of Managers. In January 2020, FHFA directedFreddie Mac and Fannie Mae to amend the CSS LLC agreement to change the structure of the CSS Board. These changes reduceFreddie Mac's and Fannie Mae's ability to control CSS Board decisions, even after conservatorship, including decisions about strategy, business operations, and funding. During conservatorship, FHFA will designate a CSS Board Chair that must affirmatively vote for all decisions of the CSS Board in order for the decisions to become effective, and FHFA also may appoint up to three additional independent members to the CSS Board, who along with
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Management's Discussion and Analysis Risk Management | Operational Risk
the Board Chair and the Chief Executive Officer of CSS may continue to serve on the CSS Board after conservatorship. FHFA appointed a new CSS Board member to serve as Chair in January 2020. If FHFA appoints three additional CSS Board members, the four members appointed byFreddie Mac and Fannie Mae will constitute a minority of the CSS Board. During conservatorship, the CSS Board members we and Fannie Mae appoint could be outvoted by non-GSE designated Board members on any matter, and if either we or Fannie Mae exits conservatorship, the GSE-appointed members could be outvoted on a number of significant actions, including approval of the annual budget and strategic plan for CSS, so long as it does not involve material decisions, such as a material change in CSS's functionality or capital contributions beyond those necessary to support CSS's ordinary business operations. For additional information on the changes in the structure of CSS and CSS-related risks, see Introduction - About Freddie Mac - Common Securitization Platform and UMBS and Risk Factors - Conservatorship and Related Matters - FHFA, as our Conservator, controls our business activities. We may be required to take actions that reduce our profitability, are difficult to implement, or expose us to additional risk. Following the implementation of CSP Release 2 in June 2019,Freddie Mac , Fannie Mae, FHFA, and CSS continue to work together to monitor the operational effectiveness of the platform. For additional information, see Risk Factors - Operational Risks - 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. Cybersecurity Risk -------------------------------------------------------------------------------- Our operations rely on the secure, accurate and timely receipt, processing, storage, and transmission of confidential and other information in our systems and networks and with customers, counterparties, service providers, and financial institutions. Information risks for companies like ours have increased significantly in recent years. Like many companies and government entities, from time to time we have been, and likely will continue to be, the target of attempted cyberattacks and other information security threats. We continue to invest in the information risk and security area to strengthen our capabilities to prevent, detect, respond to and mitigate risk, and protect our systems, networks, and other technology assets against unauthorized attempts to access confidential information or to disrupt or degrade our business operations. We have obtained insurance coverage relating to cybersecurity risks. However, this insurance may not be sufficient to provide adequate loss coverage. Although to date we have not experienced any cyberattacks resulting in significant impact to the company, there is no assurance that our cybersecurity risk management program will prevent cyberattacks from having significant impacts in the future. For additional information, see Risk Factors - Operational Risks - Potential cybersecurity threats are changing rapidly and growing in sophistication. We may not be able to protect our systems or the confidentiality of our information from cyberattack and other unauthorized access, disclosure, and disruption. Third-Party Risk -------------------------------------------------------------------------------- We continue to enhance our third-party risk management program in order to effectively manage risks that could manifest with the use of third parties to support business processes. Third parties overseen within the program include suppliers, seller/servicers, and other counterparties. The third-party risk management program provides oversight and governance throughout the third party life cycle including risk assessment, due diligence, contract negotiations, on-going monitoring, and termination of third parties. Model Risk -------------------------------------------------------------------------------- Model risk is the potential for adverse consequences from model errors or decisions based on incorrect or misused model outputs. Our business activities significantly rely on the use of models. We use a variety of models to inform management decisions related to our businesses. These include models that forecast significant factors such as interest rates, mortgage rates, and house prices, as well as models that project future cash flows related to borrower prepayment and default behavior. Model development, changes to existing models, and model risks are managed in each business line according to our three-lines-of-defense framework. New model development and changes to existing models undergo a review process. Each business periodically reviews model performance, embedded assumptions, and limitations and modeling techniques, and updates its models as it deems appropriate. ERM independently validates the work done by the business lines (e.g., conducting independent assessments of ongoing monitoring results, model risk ratings, performance monitoring, and reporting against thresholds and alerts). Given the importance and complexity of models in our business, model development may take significant time to complete. Delays in our model development process could affect our ability to make sound business and risk management decisions, and increase our exposure to risk. We have procedures designed to mitigate this risk. In 2019, we concluded work on the following items:
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Management's Discussion and Analysis Risk Management | Operational Risk
n New Model Risk Standard with enhanced governance protocols;
n Formalized model key risk indicators with an associated model risk appetite;
and
n Design completion of a peer review process serving as a secondary control
within the model risk function.
We face significant risks associated with our use of models, as discussed in Risk Factors - Operational Risks - We face risks and uncertainties associated with the models that we use to inform business and risk management decisions and for financial accounting and reporting purposes. Compliance Risk -------------------------------------------------------------------------------- We have established and continue to enhance our legal and compliance risk management program in order to effectively manage the risk of non-compliance with legal and regulatory requirements. This program leverages the three lines of defense enterprise risk framework for managing operational risks. It entails, among other things, identifying applicable legal and regulatory requirements as well as any changes to these requirements, educating employees on new and existing legal and regulatory requirements applicable to their areas of responsibility, and evaluating business processes and controls in light of applicable legal obligations and related compliance risks. Effectiveness of Our Disclosure Controls and Procedures -------------------------------------------------------------------------------- Management, including the company's CEO and CFO, conducted an evaluation of the effectiveness of our disclosure controls and procedures as of December 31, 2019. As of December 31, 2019, we had one material weakness related to conservatorship, which remained unremediated, causing us to conclude that our disclosure controls and procedures were not effective at a reasonable level of assurance. For additional information, see Controls and Procedures.
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Management's Discussion and Analysis Risk Management | Market Risk
Market Risk Overview -------------------------------------------------------------------------------- Our business segments have embedded exposure to market risk, which is the economic risk associated with adverse changes in interest rates, volatility, and spreads. Interest-rate risk is consolidated and primarily managed by the Capital Markets segment, while spread risk is owned and managed by each individual business segment. Market risk can adversely affect future cash flows, or economic value, as well as earnings and net worth. The majority of our interest-rate risk comes from our investments in mortgage-related assets (securities and loans), the debt we issue to fund our assets, and upfront fees (including buy-downs) related to our single-family credit guarantee activity. Typically, an existing loan or bond investment is worth less to an investor when interest rates (yields) rise and worth more when they decline. In addition, for a majority of our single-family mortgage-related assets, the borrower has the option to make unscheduled principal payments at any time before maturity without incurring a prepayment penalty. Thus, our mortgage-related asset portfolio is also exposed to uncertainty as to when borrowers will exercise their option and pay the outstanding principal balance of their loans. We face similar (and in most cases directionally opposite) exposure related to unsecured debt. Unsecured debt is typically worth less to an investor when interest rates (yields) rise and worth more when they decline. In addition, we issue debt with embedded options, such as an option to call, which provides us flexibility concerning the timing of our debt maturities. Another source of interest-rate risk comes from upfront fees (including buy-downs) related to our single-family credit guarantee activity. These fees are cash we receive at loan acquisition as compensation for our guarantee, which also typically includes a contractual monthly fee paid as a percentage of the UPB of the underlying loan. Determining the amount of the upfront fees we charge requires us to estimate loan prepayment activity, which varies based on estimates of future interest rates. From an interest-rate risk standpoint, receiving upfront fees increases risk as the actual prepayment rate of the loans we purchase may be different than our original estimates and may vary based on changes in interest rates. As interest rates decrease, loans typically prepay more quickly, resulting in accelerated recognition of upfront fees in earnings and a higher annualized rate of income. The opposite occurs as interest rates increase, resulting in slower recognition of upfront fees in earnings and a lower annualized rate of income. We incorporate upfront fees in our interest-rate risk metrics by assuming upfront fees are equivalent to the sale of an interest-only security, allowing for modeling and aggregation of the interest-rate exposure of upfront fees with the rest of our interest-rate exposures. We actively manage our economic exposure to interest rate fluctuations. Our primary goal in managing interest-rate risk is to reduce the amount of change in the value of our future cash flows due to future changes in interest rates. We use models to analyze possible future interest-rate scenarios, along with the cash flows of our assets and liabilities over those scenarios. Management of Market Risk -------------------------------------------------------------------------------- We employ risk management practices that seek to maintain certain interest-rate characteristics of our assets and liabilities within our risk limits through a number of different strategies, including: n Asset selection and structuring, such as acquiring or structuring mortgage-related securities with certain expected prepayment and other characteristics;
n Issuance of both callable and non-callable unsecured debt; and
n Use of interest-rate derivatives, including swaps, swaptions, and futures.
Our use of derivatives is an important part of our strategy to manage interest-rate risk. When deciding to use derivatives to mitigate our exposures, we consider a number of factors, including cost, exposure to counterparty credit risks, and our overall risk management strategy. See Risk Management - Counterparty Credit Risk and Risk Factors for more discussion of our market risk exposures, including those related to derivatives, institutional counterparties, and other market risks. Although we have limited ability to manage spread risk, we employ the following strategies: n Limiting the size of our assets that are exposed to spread risk;
n Using short-TBA positions to hedge certain assets, primarily loans acquired
through our cash loan purchase program that are awaiting securitization and
portions of our agency mortgage-related securities portfolio; and n Entering into certain spread-related derivatives to offset our spread exposures. Interest-Rate Risk -------------------------------------------------------------------------------- Interest-rate risk is the economic risk related to adverse changes in the level or volatility of interest rates. A change in the level of interest rates (represented by a parallel shift of the yield curve, all else constant) exposes our assets and liabilities to risk,
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Management's Discussion and Analysis Risk Management | Market Risk
potentially affecting expected future cash flows and their present values. This is reflected in our PVS-L and duration gap disclosures. Similarly, changes in the shape or slope of the yield curve (often reflecting changes in the market's expectation of future interest rates) expose our assets and liabilities to risk, potentially affecting expected future cash flows and their present values. This is reflected in our PVS-YC disclosure. Volatility risk is the risk that changes in the market's expectation of the magnitude of future variations in interest rates will adversely affect our economic value. We are exposed to volatility risk in both our mortgage-related assets and liabilities, especially in instruments with embedded options. In 1Q 2019, we changed the name of the Portfolio Market Value Sensitivity (PMVS) metrics to Portfolio Value Sensitivity (PVS). We removed "market" from these metrics as we economically hedge the present value of cash flows, which may not necessarily be the fair value of an instrument. In the case of upfront fees, we assume upfront fees are equivalent to the sale of an interest-only security, allowing for modeling and aggregation of the interest-rate exposure of upfront fees with the rest of our interest-rate exposures. Measurement of Interest-Rate Risk We calculate our exposure to changes in interest rates for our interest rate sensitive assets and liabilities using effective duration and effective convexity, based on our models. n Effective duration measures the percentage change in the price of financial
instruments from a 100 basis point change in interest rates. Financial
instruments with positive duration increase in value as interest rates
decline. Conversely, financial instruments with negative duration increase in
value as interest rates rise.
n Effective convexity measures the change in effective duration for a 100 basis
point change in interest rates. Effective duration is not constant over the
entire yield curve and effective convexity measures how effective duration
changes over large changes in interest rates.
Together, effective duration and effective convexity provide a measure of an instrument's overall price sensitivity to changes in interest rates. We utilize the concepts of effective duration and effective convexity in calculating our primary interest-rate risk measures: duration gap and PVS. n Duration gap - The net effective duration of our overall portfolio of
interest-rate sensitive assets and liabilities is expressed in months as our
duration gap. Duration gap measures the difference in price sensitivity to
interest rate changes between our financial assets and liabilities and is
expressed in months relative to the value of assets. For example, assets with
a six-month duration and liabilities with a five-month duration would result
in a positive duration gap of one month.
The table below shows various duration gap measurements and the effects that changes in interest rates would generally have on portfolio value.
Negative Duration Gap Zero Duration Gap Positive Duration Gap Asset Duration < Liability Asset Duration = Liability Asset Duration > Liability
Duration Duration Duration Net portfolio will increase Net portfolio economic Net portfolio will in value when interest value will be unchanged. increase in value when rates rise and decrease in The change in the value of interest rates fall and value when interest rates assets from an decrease in value when fall. instantaneous move in interest rates rise. interest rates, either up or down, would be expected to be accompanied by an equal and offsetting change in the value of liabilities. We actively measure and manage our duration gap exposure on a daily basis. In addition to duration gap management, we also measure and manage the price sensitivity of our portfolio to a number of different specific interest rate changes along the yield curve. The price sensitivity of an instrument to specific changes in interest rates is known as the instrument's key rate duration risk. By managing our duration exposure both in aggregate through duration gap and to specific changes in interest rates through key rate duration, we expect to limit our exposure to interest rate changes for a wide range of interest rate yield curve scenarios. n PVS - PVS is our estimate of the change in the value of our financial assets
and liabilities from an instantaneous shock to interest rates, assuming
spreads are held constant and no rebalancing actions are undertaken. PVS is
measured in two ways, one measuring the estimated sensitivity of our
portfolio's value to a 50 basis point parallel movement in interest rates
(PVS-L) and the other to a nonparallel movement (PVS-YC), resulting from a 25
basis point change in slope of the LIBOR yield curve. The 50 basis point
shift and 25 basis point change in slope of the LIBOR yield curve used for
our PVS measures reflect reasonably possible near-term changes that we
believe provide a meaningful measure of our interest-rate risk sensitivity.
To calculate PVS, the interest rate shock is applied to the duration (and convexity for PVS-L) of all interest-rate sensitive financial instruments. The resulting change in value for the aggregate portfolio is computed for both the up rate and down
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Management's Discussion and Analysis Risk Management | Market Risk
rate shock, and whichever produces the more adverse outcome is the PVS. In cases where both the up rate and down rate shocks result in a positive effect, the PVS is zero. PVS results are shown on a pre-tax basis. Interest-Rate Risk Results The following tables provide our duration gap, estimated point-in-time and minimum and maximum PVS-L and PVS-YC results, and an average of the daily values and standard deviation. The tables below also provide PVS-L estimates assuming an immediate 100 basis point shift in the LIBOR yield curve. The interest-rate sensitivity of a mortgage portfolio varies across a wide range of interest rates. We began to include upfront fees (including buy-downs) in our interest-rate metrics in 2Q 2019 as described above. Including upfront fees and related derivative activities significantly increased the Derivatives PVS-L and PVS-YC results for December 31, 2019 in the table below, with an offsetting impact in the Guarantees PVS-L and PVS-YC results. As of December 31, 2019, the inclusion of upfront fees interest rate risk added a PVS-L (50 basis points), PVS-L (100 basis points) and PVS-YC (25 basis points) equivalent of $1.4 billion, $2.7 billion and $0.4 billion, respectively. Table 53 - PVS-YC and PVS-L Results Assuming Shifts of the LIBOR Yield Curve December 31, 2019 December 31, 2018 PVS-YC PVS-L PVS-YC PVS-L (In millions) 25 bps 50 bps 100 bps 25 bps
50 bps 100 bps Assuming shifts of the LIBOR yield curve, (gains) losses on:(1) Assets: Investments ($307 ) $4,840 $10,011 ($536 ) $5,792 $11,761 Guarantees(2) (224 ) 351 706 89 (425 ) (773 ) Total Assets (531 ) 5,191 10,717 (447 ) 5,367 10,988 Liabilities 20 (1,563 ) (3,413 ) (109 ) (1,889 ) (3,948 ) Derivatives 513 (3,646 ) (7,409 ) 560 (3,446 ) (6,917 ) Total $2 ($18 ) ($105 ) $4 $32 $123 PVS $2 $- $- $4 $32 $123 (1) The categorization of the PVS impact between assets, liabilities, and derivatives on this table is based upon the economic characteristics of those assets and liabilities, not their accounting classification. For example, purchase and sale commitments of mortgage-related securities and debt securities of consolidated trusts held by the mortgage-related investments portfolio are both categorized as assets on this table. (2) Represents the interest-rate risk from our single-family guarantee
portfolio, which includes buy-ups, float, and, beginning in 2Q 2019, upfront
fees (including buy-downs).
Table 54 - Duration Gap and PVS Results
Year Ended December 31, 2019 2018 (Duration gap in months, Duration PVS-YC PVS-L Duration PVS-YC PVS-L dollars in millions) Gap 25 bps 50 bps Gap 25 bps 50 bps Average 0.8 $34 $96 - $11 $15 Minimum (0.8 ) - - (0.4 ) - - Maximum 8.6 345 950 0.3 31 77 Standard deviation 1.6 72 189 0.1 6 16 The disclosure in our Monthly Volume Summary reports, which are available on our website www.freddiemac.com/investors/financials/monthly-volume-summaries.html, reflects the average of the daily PVS-L, PVS-YC, and duration gap estimates for a given reporting period (a month, a quarter, or a year). Derivatives enable us to reduce our economic interest-rate risk exposure as we continue to align our derivative portfolio with the changing duration of our economically hedged assets and liabilities. The table below shows that the PVS-L risk levels, assuming a 50 basis point shift in the LIBOR yield curve for the periods presented, would have been higher if we had not used derivatives.
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Management's Discussion and Analysis Risk Management | Market Risk
Table 55 - PVS-L Results Before Derivatives and After Derivatives
PVS-L (50 bps) Before After Effect of (In millions) Derivatives Derivatives Derivatives December 31, 2019 $3,628 $- ($3,628 ) December 31, 2018 3,478 32 (3,446 ) In April 2019, we updated our interest-rate risk measures and began incorporating upfront fees (including buy-downs) related to single-family credit guarantee activity into our asset and liability interest-rate risk management strategy and definition. As a result, the PVS-L before derivatives is significantly higher as of December 31, 2019 than it would have been if we had not updated our interest-rate risk management strategy and definition to include upfront fees. The inclusion of upfront fees increased the volume of derivatives we used to hedge interest-rate risk, and this higher volume of derivatives, coupled with the volatility of market interest rates during the period, created variability in our PVS-L during 2019. The table below shows the average, minimum, and maximum PVS-L before derivatives and after derivatives during 2019. Table 56 - PVS-L Average, Minimum, and Maximum Year Ended December 31, 2019 PVS-L (50bps) (In millions) Before Derivatives After Derivatives Average $3,739 $96 Minimum 3,155 - Maximum 4,384 950 Limitations of Interest-Rate Risk Measures -------------------------------------------------------------------------------- While we believe that PVS and duration gap are useful risk management tools, they should be understood as estimates rather than as precise measurements. Mis-estimation of economic market risk could result in over or under hedging of interest-rate risk, significant economic losses, and an adverse impact on earnings. The limitations of our economic market risk measures include the following: n Our PVS and duration gap estimates are determined using models that involve our judgment of interest-rate and prepayment assumptions. n There could be times when we hedge differently than our model estimates during the period, such as when we are making changes or market updates to these models.
n PVS and duration gap do not capture the potential effect of certain other
market risks, such as changes in volatility and market spread risk. The effect of these other market risks can be significant.
n Our sensitivity analyses for PVS and duration gap contemplate only certain
movements in interest rates and are performed at a particular point in time
based on the estimated fair value of our existing portfolio.
n Although the mortgage-related investments portfolio is the main contributor
of interest-rate risk to the company, other core businesses also contribute
to our interest-rate risk and may be managed differently. We have certain
assets that have a relatively short holding period. As a result, we may
manage the risk of these assets based on their disposition, while our risk
measures use long-term cash flows. Hedging these businesses at times requires
additional assumptions concerning risk metrics to accommodate changes in
pricing that may not be related to the future cash flow of the assets. This
could create a perceived risk exposure as the hedged risk may differ from the
modeled risk.
n The choice of the benchmark rate used to model and hedge our positions is a
significant assumption. The effectiveness of our hedges ultimately depends on
how closely the different instruments (assets, liabilities, and derivatives)
react to the underlying chosen benchmark. In the simplest example, all instruments would have interest-rate risk based on the same underlying benchmark, in our case, the swap rate. In practice, however, different instruments react differently versus the benchmark rate, which creates a
market spread between the benchmark rate and the instrument. As the market
spreads of these instruments move differently, our ability to predict the
behavior of each instrument relative to the others is reduced, potentially
affecting the effectiveness of our hedges.
n Our reported measurements do not include the sensitivity to interest-rate
changes of net worth and the following assets and liabilities:
l Credit guarantee activities - We currently do not hedge the interest-rate
exposure of our credit guarantees except for the interest-rate exposure
related to upfront fees (including buy-downs), buy-ups, float, and STACR debt notes. Float, which arises from timing differences between the borrower's principal payments on the loan and the reduction of theFREDDIE MAC | 2019 Form 10-K 107
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Management's Discussion and Analysis Risk Management | Market Risk
security balance, can lead to significant interest expense if the interest rate paid to a security investor is higher than the reinvestment rate earned by the securitization trusts on payments received from borrowers and paid to us as trust management income. l Other assets and other liabilities - We do not include other miscellaneous
assets and liabilities, primarily deferred tax assets, accounts payable
and receivable, and non-cash basis adjustments.
Spread Risk -------------------------------------------------------------------------------- Spread risk is the risk that yields in different asset classes may not move together and may adversely affect our economic value. This risk arises principally because interest rates on our mortgage-related investments may not move in tandem with interest rates on our financial liabilities and derivatives, potentially affecting the effectiveness of our hedges. We are exposed to the following types of market spread risk: n Market spread risk arising from mortgage-related investments, including loans and securities, and certain non-mortgage investments; n Market spread risk arising from our use of SOFR- orTreasury -based instruments in our risk management activities;
n Market spread risk arising from the difference in time between when we commit
to purchase a mortgage loan through our pipeline path and when we either
securitize the loan or hedge it by using forward TBA securities or
derivatives. During this time, market spreads can widen, causing losses due
to changes in fair value. GAAP Earnings Variability -------------------------------------------------------------------------------- The GAAP accounting treatment for our financial assets and liabilities (i.e., some are measured at amortized cost, while others are measured at fair value) creates variability in our GAAP earnings when interest rates and spreads change. We manage this variability of GAAP earnings, which may not reflect the economics of our business, using fair value hedge accounting. Interest-Rate Volatility -------------------------------------------------------------------------------- While we manage our interest-rate risk exposure on an economic basis to a low level as measured by our models, our GAAP financial results are subject to significant earnings variability from period to period based on changes in market conditions. Based upon the composition of our financial assets and liabilities, including derivatives, at December 31, 2019, we generally recognize fair value losses in GAAP earnings when interest rates decline. In an effort to reduce our GAAP earnings variability and better align our GAAP results with the economics of our business, we elect hedge accounting for certain single-family mortgage loans and certain debt instruments. Beginning in September 2019, we implemented a new fair value hedge accounting strategy using single-family mortgage loans that applies certain hedge accounting elections allowable under amended hedge accounting guidance we adopted during 4Q 2017. See Note 9 for additional information on hedge accounting. GAAP Adverse Scenario We evaluate the potential benefits of fair value hedge accounting by evaluating a range of interest-rate scenarios and identifying which of those scenarios produces the most adverse GAAP earnings outcome. The interest-rate scenarios evaluated include parallel shifts in the yield curve of plus and minus 100 basis points, non-parallel yield curve shifts in which long-term interest rates increase or decrease by 100 basis points, and non-parallel yield curve shifts in which short-term and medium-term interest rates increase or decrease by 100 basis points. n At December 31, 2019, the GAAP adverse scenario (for both before and after fair value hedge accounting) was a parallel shift in which rates decrease by 100 basis points. n At December 31, 2018, the GAAP adverse scenario before fair value hedge accounting was a non-parallel shift in which long-term rates decrease by 100 basis points, while the adverse scenario after fair value hedge accounting was a non-parallel shift in which short and medium-term rates decrease by 100 basis points. The results of this evaluation are shown in the table below. Table 57 - GAAP Adverse Scenario Before and After Hedge Accounting GAAP Adverse Scenario (Before-Tax) (Dollars in billions) Before Hedge Accounting After Hedge Accounting % Change December 31, 2019 ($4.3 ) ($0.1 ) 98 % December 31, 2018 (2.7 ) (0.2 ) 93 FREDDIE MAC | 2019 Form 10-K 108
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Management's Discussion and Analysis Risk Management | Market Risk
The additional volume of derivatives from updating our interest-rate risk measures to include upfront fees (including buy-downs) related to single-family credit guarantee activity, and the volatility in market interest rates during 2019 created variability in our GAAP adverse scenarios. While the December 31, 2019 GAAP adverse scenario shows a 98% reduction after hedge accounting, this result includes the effect of the new hedge accounting strategy implemented in September 2019, which was not in effect for the entire year. As a result, the average GAAP adverse scenario after hedge accounting was higher during 2019 than it was as of December 31, 2019. With the implementation of the new hedge accounting strategy in September 2019, we expect the GAAP adverse scenario after hedge accounting in future periods to be similar to the result as of December 31, 2019. The table below shows the average, minimum, and maximum GAAP adverse scenario before hedge accounting and after hedge accounting during 2019. Table 58 - GAAP Adverse Scenario Average, Minimum, and Maximum Year Ended December 31, 2019 GAAP Adverse Scenario (Before-Tax) (In billions) Before Hedge Accounting After Hedge Accounting Average ($3.6 ) ($0.4 ) Minimum (2.1 ) - Maximum (5.2 ) (1.8 ) Hedge accounting is designed to reduce the impact to GAAP earnings in the adverse scenario described above. However, the after hedge accounting impact may not always result in an improvement over the before hedge accounting impact. For example, there are certain interest-rate scenarios in which the after hedge accounting impact would result in a lower gain or a larger loss than the before hedge accounting impact. For further discussion of financial results related to interest-rate risk, see Our Business Segments - Capital Markets. Net Interest Rate Effect on Comprehensive Income (Loss) The table below presents the effect of derivatives used in our interest-rate risk management activities on our comprehensive income (loss), net of tax, after considering any offsetting interest rate effects related to financial instruments measured at fair value and the effects of fair value hedge accounting. Table 59 - Estimated Net Interest Rate Effect on Comprehensive Income (Loss) Year Ended December 31, (In billions) 2019 2018 Interest rate effect on derivative fair values ($7.3 )
$2.5
Estimate of offsetting interest rate effect related to financial instruments measured at fair value(1)
3.6
(1.9 ) Gains (losses) on mortgage loans and debt in fair value hedge relationships
3.6 (1.6 ) Amortization of deferred hedge accounting gains and losses (0.3 )
0.3
Income tax (expense) benefit 0.1
0.1
Estimated net interest rate effect on comprehensive income (loss)
($0.3 )
($0.6 )
(1) Includes the interest rate effect on our trading securities,
available-for-sale securities, mortgage loans held-for-sale and other assets
and debt for which we elected the fair value option, which is reflected in
other non-interest income (loss) and total other comprehensive income (loss)
on our consolidated statements of comprehensive income.
The effect from the change in interest rates on derivative fair values is mostly offset by the effect from the change in interest rates related to financial instruments measured at fair value and gains and losses on mortgage loans and debt in fair value hedging relationships. However, the estimated net interest rate effect on comprehensive income (loss) in 2019 was higher than it otherwise would have been as a result of the additional volume of derivatives and volatility in market interest rates during 2019. The remaining net interest-rate effect on comprehensive income is largely attributable to the following: n The reversal of previously recognized derivative gains and losses; n The implied net cost on instruments such as swaptions, futures, and forward purchase and sale commitments from our hedging and interest-rate risk management activities, which are recognized in GAAP earnings over time as a component of derivative gains and losses as the instruments approach maturity; and n The amortization of previously deferred hedge accounting gains and losses, which we recognize in interest income over the contractual life of the hedged item.FREDDIE MAC | 2019 Form 10-K 109
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Management's Discussion and Analysis Risk Management | Market Risk
Spread Volatility -------------------------------------------------------------------------------- We have limited ability to manage our spread risk exposure and therefore the volatility of market spreads may contribute to significant GAAP earnings variability. For financial assets measured at fair value, we generally recognize fair value losses when market spreads widen. Conversely, for financial liabilities measured at fair value, we generally recognize fair value gains when market spreads widen. Certain accounting elections we make, such as election of the fair value option, may affect the amount of spread volatility recognized in our results of operations. The table below shows the estimated effect of spreads on our comprehensive income (loss), after tax, by segment. Table 60 - Estimated Spread Effect on Comprehensive Income (Loss) Year Ended December 31, (In billions) 2019 2018 Capital Markets $0.2 $0.4 Multifamily(1) (0.3 ) (0.4 ) Single-family Guarantee - 0.1 Spread effect on comprehensive income (loss) ($0.1 ) $0.1
(1) Represents the net spread-related fair value impacts due to changes in
spreads on loans and commitments where we have elected the fair value
option, mortgage-related securities, and spread-related derivatives.
For further discussion of significant financial results related to spread risk, see Our Business Segments - Multifamily and Our Business Segments - Capital Markets. Transition from LIBOR -------------------------------------------------------------------------------- In 2017, the Chief Executive of theUnited Kingdom's Financial Conduct Authority (FCA) announced that theFCA will no longer persuade or compel member panel banks to make LIBOR submissions after 2021. He has also indicated that market participants should expect LIBOR to be subsequently discontinued, or at least to no longer be deemed representative of market interest rates, and should proceed expeditiously with preparations for transitioning to an alternative reference interest rate.U.S. regulators have made similar statements. As a result, it is likely that LIBOR will be discontinued as a benchmark interest rate after 2021.Freddie Mac has exposure to LIBOR, including in financial instruments that mature after 2021. Our exposure arises from floating rate securities we issue, loans and securities we acquire (including loans we subsequently resecuritize), and derivatives we enter into that reference LIBOR. Senior management is actively evaluating and managing risks related to the LIBOR transition. To help prepare for an orderly transition from LIBOR, we established a LIBOR Working Group in 2018 that consists of members from the different business areas as well as the Legal and ERM divisions. We also have formed LIBOR transition committees across our businesses, functions, and products. Senior management and the LIBOR Working Group provide periodic updates to the Board and are working with FHFA on our transition implementation. TheFederal Reserve Board and theFederal Reserve Bank of New York convened the Alternative Reference Rates Committee (ARRC) to recommend a set of alternative reference interest rates for possible use as market-accepted benchmarks. Based on the ARRC's recommendation, theFederal Reserve Bank of New York began publishing SOFR in April 2018. Since then, certain derivative products and debt securities tied to SOFR have been introduced, and various industry groups have continued working to develop plans and documentation to facilitate a transition to SOFR as the new market-accepted benchmark. We have been a member of the ARRC since 2017 and have participated in many of its working groups. We support the ARRC's recommendation to replace LIBOR with SOFR. We have issued SOFR-based unsecured debt, and we have executed SOFR-based interest-rate swaps and futures transactions. In December 2019, we conducted an offering of multifamily K certificates that included a class of floating rate certificates indexed to SOFR. The transition from LIBOR will affect our new purchases of single-family hybrid ARMs. For example, in July 2019, we announced that we will work with our customers, investors, and servicers to transition existing LIBOR-based ARM products to SOFR-based ARM products by the end of 2021. In November 2019, we announced that, in coordination with FHFA and Fannie Mae, we intend to offer our lenders the opportunity to deliver a suite of SOFR-based ARM products that will be based on eligibility, underwriting, pricing, and delivery requirements which we intend to announce in an update to our Seller/Servicer Guide in 2020. On February 5, 2020, we announced that we will no longer purchase single-family ARMs and multifamily floating-rate loans tied to LIBOR with an application date on or after October 1, 2020. In addition, we will no longer purchase single-family ARMs and multifamily floating-rate loans tied to LIBOR after December 31, 2020, regardless of the application date or mortgage date. We
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Management's Discussion and Analysis Risk Management | Market Risk
will begin purchasing multifamily floating-rate loans tied to SOFR by November 1, 2020. We also announced our plans to purchase single-family ARMs tied to SOFR in the second half of 2020. Finally, we announced our intention to develop plans to cease purchasing single-family ARMs tied to constant maturityTreasury indices, which we anticipate will be implemented in 2021 upon guidance from FHFA. Our purchases of single-family ARMs and multifamily floating-rate loans may decrease after these changes are implemented as affected market participants may need more time to develop the systems and processes necessary to originate and sell ARMs and floating-rate loans tied to SOFR or any other new indices that may be developed. For a discussion of the risks related to the LIBOR transition, see Risk Factors - Market Risk - The discontinuance of LIBOR after 2021, or before the end of 2021 if LIBOR is deemed unreliable, could negatively affect the fair value of our financial assets and liabilities, results of operations, and net worth. A transition to an alternative reference interest rate could present operational problems, subject us to increased litigation risk, and result in market disruption. We may be unable to take a consistent approach across our financial products.FREDDIE MAC | 2019 Form 10-K 111
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Management's Discussion and Analysis Liquidity and Capital Resources
LIQUIDITY AND CAPITAL RESOURCES Overview Our business activities require that we maintain adequate liquidity to meet our financial obligations as they come due and meet the needs of customers in a timely and cost-efficient manner. We also must maintain adequate capital resources to avoid being placed into receivership by FHFA. Sources and Uses of Funds -------------------------------------------------------------------------------- Our primary source of funding for the assets on our balance sheet is the issuance of debt. In addition to the funding provided by issuing debt, our other sources of funds include: n Principal payments on and sales of securities and loans that we own;
n Repurchase transactions;
n Interest income on securities and loans that we own;
n Guarantee fees (inclusive of initial upfront fees);
n Net worth, which represents funding available to us prior to our dividend
requirement on our senior preferred stock; and
n Draws from Treasury under the Purchase Agreement, which are only made if we
have a quarterly deficit in our net worth.
We use these sources to fund the assets on our balance sheet. Our primary uses of funds include: n Principal payments upon the maturity, redemption, or repurchase of our other
debt;
n Payments of interest on our other debt and other expenses;
n Purchases of mortgage loans, including purchases of seriously delinquent or
modified loans underlying our securities, mortgage-related securities, and
other investments; n Payments related to derivative contracts and posting or pledging of
collateral to third parties in connection with secured financing and daily
trade activities; and
n Dividend requirements on our senior preferred stock.
In addition to the uses and sources of cash described above, we are involved in various legal proceedings, including those discussed in Legal Proceedings, which may result in a need to use cash to settle claims or pay certain costs or receipt of cash from settlements. Our securities and other obligations are not guaranteed by the U.S. government and do not constitute a debt or obligation of the U.S. government or any agency or instrumentality thereof, other than Freddie Mac. We continue to manage our debt issuances to remain in compliance with the aggregate indebtedness limits set forth in the Purchase Agreement. For a description of our debt products, see Our Business Segments - Capital Markets. Liquidity Management Framework The support provided by Treasury pursuant to the Purchase Agreement enables us to have adequate liquidity to conduct our normal business activities. However, the costs and availability of our debt funding could vary for a number of reasons, including the uncertainty about the future of the GSEs and any future downgrades in our credit ratings or the credit ratings of the U.S. government. We make extensive use of the Federal Reserve's payment system in our business activities. The Federal Reserve requires that we fully fund our accounts at the Federal Reserve Bank of New York to the extent necessary to cover cash payments on our debt and mortgage-related securities each day, before the Federal Reserve Bank of New York, acting as our fiscal agent, will initiate such payments. Although we seek to maintain sufficient intraday liquidity to fund our activities through the Federal Reserve's payment system, we have limited access to cash once the debt markets are closed for the day. Insufficient cash may cause our account to be overdrawn, potentially resulting in penalties and reputational harm. Maintaining sufficient liquidity is of primary importance to, and a cost of, our business. Under our liquidity management practices and policies, we: n Manage intraday cash needs and provide for the contingency of an unexpected
cash demand;
n Maintain cash and non-mortgage investments to enable us to meet ongoing cash
obligations for a limited period of time, assuming no access to unsecured
debt markets;
n Maintain unencumbered securities with a value greater than or equal to the
largest projected daily cash shortfall for an extended period of time, assuming no access to unsecured debt markets; and FREDDIE MAC | 2019 Form 10-K 112
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Management's Discussion and Analysis Liquidity and Capital Resources
n Manage the maturity of our unsecured debt based on our asset profile.
To facilitate cash management, we forecast cash outflows and inflows using assumptions and models. These forecasts help us to manage our liabilities with respect to the timing of our cash flows. Differences between actual and forecasted cash flows have resulted in higher costs from issuing a higher amount of debt than needed or unexpectedly needing to issue debt, and may do so in the future. Differences between actual and forecasted cash flows also could result in our account at the Federal Reserve Bank of New York being overdrawn. We maintain daily cash reserves to manage this risk. Liquidity Profile Primary Sources of Liquidity -------------------------------------------------------------------------------- The following table lists the sources of our liquidity, the balances as of December 31, 2019 and a brief description of their importance to Freddie Mac. Our ability to maintain sufficient liquidity, including by pledging mortgage-related and other securities as collateral to other institutions, could cease or change rapidly and the cost of the available funding could increase significantly due to changes in market interest rates, market confidence, operational risks, and other factors. Table 61 - Sources of Liquidity Source Balance(1) Description (In billions) Liquidity • Other Investments $68.0 • The Liquidity and Contingency Operating Portfolio - Portfolio, included within our other Liquidity and investments portfolio, is primarily used for Contingency short-term liquidity management. Operating Portfolio • Liquid Portion of $124.4 • The liquid portion of our mortgage-related the investments portfolio can be pledged or sold Mortgage-Related for liquidity purposes. The amount of cash Investments we may be able to successfully raise may be Portfolio substantially less than the balance.
(1) Represents carrying value for the Liquidity and Contingency Operating
Portfolio, included within our other investments portfolio, and UPB for the
liquid portion of the mortgage-related investments portfolio.
Other Investments Portfolio -------------------------------------------------------------------------------- The table below summarizes the balances in our other investments portfolio, which includes the Liquidity and Contingency Operating Portfolio. The investments in our other investments portfolio are important to our cash flow, collateral management, asset and liability management, and ability to provide liquidity and stability to the mortgage market. The other investments portfolio is primarily used for short-term liquidity management, cash and other investments held by consolidated trusts, and other investments, which include investments in debt securities used to pledge as collateral, LIHTC partnerships, and secured lending activities. Table 62 - Other Investments Portfolio As of December 31, 2019 As of December 31, 2018 Liquidity and Liquidity and Contingency Total Other Contingency Total Other Operating Custodial Investments Operating Custodial Investments (In billions) Portfolio Account Other Portfolio(1) Portfolio Account Other Portfolio(1) Cash and cash equivalents $4.2 $0.9 $0.1 $5.2 $6.7 $0.6 $- $7.3 Securities purchased under agreements to 40.6 23.1 2.4 66.1 20.2 12.1 2.5 34.8 resell Non-mortgage related securities 23.2 - 3.9 27.1 16.8 - 2.4 19.2 Secured lending and other - - 5.2 5.2 - - 1.8 1.8 Total $68.0 $24.0 $11.6 $103.6 $43.7 $12.7 $6.7 $63.1
(1) Represents carrying value.
Our non-mortgage-related investments in the Liquidity and Contingency Operating Portfolio consist of U.S. Treasury securities and other investments that we could sell to provide us with an additional source of liquidity to fund our business operations. We also maintain non-interest-bearing deposits at the Federal Reserve Bank of New York and interest-bearing deposits at commercial banks. Our interest-bearing deposits at commercial banks totaled $3.7 billion and $1.5 billion as of December 31, 2019 and December 31, 2018, respectively. FREDDIE MAC | 2019 Form 10-K 113
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Management's Discussion and Analysis Liquidity and Capital Resources
The Liquidity and Contingency Operating Portfolio also included collateral posted to us in the form of cash primarily by derivatives counterparties of $2.6 billion and $3.0 billion as of December 31, 2019 and December 31, 2018, respectively. We have invested this collateral in securities purchased under agreements to resell and non-mortgage-related securities as part of our Liquidity and Contingency Operating Portfolio, although the collateral may be subject to return to our counterparties based on the terms of our master netting and collateral agreements. Mortgage Loans and Mortgage-Related Securities -------------------------------------------------------------------------------- We invest principally in mortgage loans and mortgage-related securities, certain categories of which are largely unencumbered and liquid. Our primary source of liquidity among these mortgage assets is our holdings of single-class and multiclass agency securities, excluding certain structured agency securities collateralized by non-agency mortgage-related securities. In addition, we hold unsecuritized single-family loans and multifamily held-for-sale loans that could be securitized and would then be available for sale or for use as collateral for repurchase agreements. Due to the large size of our portfolio of liquid assets, the amount of mortgage-related assets that we may successfully sell or borrow against in the event of a liquidity crisis or significant market disruption may be substantially less than the amount of mortgage-related assets we hold. There would likely be insufficient market demand for large amounts of these assets over a prolonged period of time, which would limit our ability to sell or borrow against these assets. We hold other mortgage assets, but given their characteristics, they may not be available for immediate sale or for use as collateral for repurchase agreements. These assets consist of certain structured agency securities collateralized by non-agency mortgage-related securities, non-agency CMBS, non-agency RMBS, and unsecuritized seriously delinquent and modified single-family loans. We are subject to limits on the amount of mortgage assets we can sell in any calendar month without review and approval by FHFA and, if FHFA so determines, Treasury. Primary Sources of Funding -------------------------------------------------------------------------------- Debt securities that we issue are classified either as debt securities of consolidated trusts held by third parties or other debt. The following table lists the sources and balances of our funding as of December 31, 2019 and a brief description of their importance to Freddie Mac. Table 63 - Funding Sources Source Balance(1) Description (In billions) Funding • Other Debt $281.2 • Other debt is used to fund our business activities, including single-family guarantee activities not funded by debt securities of consolidated trusts. • Debt Securities of $1,898.4 • Debt securities of consolidated trusts are Consolidated used primarily to fund our single-family Trusts guarantee activities. This type of debt is principally repaid by the cash flows of the associated mortgage loans. As a result, our repayment obligation is limited to amounts paid pursuant to our guarantee of principal and interest and to purchase modified or seriously delinquent loans from the trusts.
(1) Represents carrying value of debt balances.
Other Debt Activities -------------------------------------------------------------------------------- We issue other debt to fund our operations. Competition for funding can vary with economic, financial market, and regulatory environments. During 2019, we had sufficient access to the debt markets due largely to support from the U.S. government. We rely significantly on our ability to issue debt on an on-going basis to refinance our effective short-term debt. Our effective short-term debt percentage, which represents the percentage of our total other debt that is expected to mature within one year, was 55.2% and 42.7% as of December 31, 2019 and December 31, 2018, respectively. Beginning January 1, 2019, our debt cap under the Purchase Agreement is $300.0 billion. As of December 31, 2019, our aggregate indebtedness, calculated as the par value of other debt, was $283.2 billion. We disclose the amount of our indebtedness on this basis monthly under the caption "Other Debt Activities - Total Debt Outstanding" in our Monthly Volume Summary reports, which are available on our website at www.freddiemac.com/investors/financials/monthly-volume-summaries.html.
FREDDIE MAC | 2019 Form 10-K 114
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Management's Discussion and Analysis Liquidity and Capital Resources
To fund our business activities, we depend on the continuing willingness of investors to purchase our debt securities. Changes or perceived changes in the government's support of us could have a severe negative effect on our access to the debt markets and on our debt funding costs. In addition, any change in applicable legislative or regulatory exemptions, including those described in Regulation and Supervision, could adversely affect our access to some debt investors, thereby potentially increasing our debt funding costs. For more information on our short- and long-term liquidity needs, see Contractual Obligations. The tables below summarize the par value and the average rate of other debt securities we issued or paid off, including regularly scheduled principal payments, payments resulting from calls, and payments for repurchases. We call, exchange, or repurchase our outstanding debt securities from time to time for a variety of reasons, including managing our funding composition and supporting the liquidity of our debt securities. Table 64 - Other Debt Activity Year Ended December 31, 2019 (Dollars in millions) Short-term Average Rate(1)
Long-term Average Rate(1)
Discount notes and Reference Bills Beginning balance $28,787 2.36 % $- - % Issuances 369,992 2.05 - - Repurchases - - - - Maturities (337,949 ) 2.20 - - Ending Balance 60,830 1.67 - - Securities sold under agreements to repurchase Beginning balance 6,019 2.40 - - Additions 325,512 2.04 - - Repayments (321,689 ) 2.07 - - Ending Balance 9,842 1.46 - - Callable debt Beginning balance 2,000 2.53 105,206 2.09 Issuances 13,590 2.48 107,544 2.38 Repurchases - - - - Calls (14,590 ) 2.52 (95,172 ) 2.65 Maturities - - (23,426 ) 1.35 Ending Balance 1,000 2.36 94,152 2.03 Non-callable debt Beginning balance 14,440 2.04 80,789 2.56 Issuances 48,984 2.34 15,774 2.43 Repurchases (345 ) 1.87 (869 ) 1.87 Maturities (23,671 ) 2.19 (33,465 ) 1.68 Ending Balance 39,408 2.31 62,229 2.86 STACR Debt and SCR Debt Notes(2) Beginning balance - - 17,729 6.02 Issuances - - 723 2.09 Repurchases - - - - Maturities - - (2,956 ) 4.49 Ending Balance - - 15,496 5.55 Total other debt $111,080 1.89 % $171,877 2.65 %
Referenced footnotes are included after the next table.
FREDDIE MAC | 2019 Form 10-K 115
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Management's Discussion and Analysis Liquidity and Capital Resources
Year Ended December 31, 2018 (Dollars in millions) Short-term Average Rate(1) Long-term Average Rate(1) Discount notes and Reference Bills Beginning balance $45,717 1.19 % $- - % Issuances 356,129 1.40 - - Repurchases - - - - Maturities (373,059 ) 1.29 - - Ending Balance 28,787 2.36 - - Securities sold under agreements to repurchase Beginning balance 9,681 1.06 - - Additions 162,524 1.82 - - Repayments (166,186 ) 1.75 - - Ending Balance 6,019 2.40 - - Callable debt Beginning balance - - 113,822 1.58 Issuances 2,000 2.28 26,191 3.13 Repurchases - - (1,396 ) 2.64 Calls - - (3,580 ) 2.23 Maturities - - (29,831 ) 1.06 Ending Balance 2,000 2.53 105,206 2.09 Non-callable debt Beginning balance 17,792 1.03 111,169 2.11 Issuances 14,965 2.02 11,514 2.21 Repurchases - - (1,340 ) 2.11 Maturities (18,317 ) 1.06 (40,554 ) 1.35 Ending Balance 14,440 2.04 80,789 2.56 STACR Debt and SCR Debt(2) Beginning balance - - 17,925 5.04 Issuances - - 1,885 3.67 Repurchases - - - - Maturities - - (2,081 ) 4.14 Ending Balance - - 17,729 6.02 Total other debt $51,246 2.28 % $203,724 2.62 %
(1) Average rate is weighted based on par value.
(2) STACR debt notes and SCR debt notes are subject to prepayment risk as their
payments are based upon the performance of a reference pool of mortgage
assets that may be prepaid by the related mortgage borrower at any time
generally without penalty and are therefore included as a separate category
in the table. FREDDIE MAC | 2019 Form 10-K 116
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Management's Discussion and Analysis Liquidity and Capital Resources
Our outstanding other debt balance increased during 2019, driven by an increase in the issuance of short-term SOFR debt primarily due to a higher mortgage loan pipeline forecast, coupled with near-term cash needs for upcoming debt maturities and anticipated calls. Our STACR debt balances should continue to decline as run off will primarily be replaced with STACR Trust note transactions. During 2019, we replaced a portion of called or matured medium-term and long-term debt with callable debt. Our callable debt provides us with the option to repay the outstanding principal balance of the debt prior to its contractual maturity date. As of December 31, 2019, $72 billion of the outstanding $95 billion of callable debt may be called within one year, not including callable debt due to contractually mature within one year. Other Short-Term Debt The tables below contain details on the characteristics of our other short-term debt. Table 65 - Other Short-Term Debt As of December 31, 2019 Ending Balance Yearly Average Weighted Weighted Average Average Maximum Carrying Effective Effective Value Outstanding (Dollars in millions) Carrying Value Rate(1) Carrying Value Rate(1) at Any Month End Discount notes and Reference Bills $60,629 1.67 % $44,675 2.16 % $60,629 Medium-term notes 40,405 2.31 29,781 2.36 43,096 Securities sold under agreements to repurchase 9,843 1.46 9,928 2.16 14,114 Total $110,877 1.89 % As of December 31, 2018 Ending Balance Yearly Average Weighted Weighted Average Average Maximum Carrying Effective Effective Value Outstanding (Dollars in millions) Carrying Value Rate(1) Carrying Value Rate(1) at Any Month End Discount notes and Reference Bills $28,621 2.36 % $35,126 1.79 % $46,892 Medium-term notes 16,440 2.10 15,403 1.37 18,200 Securities sold under agreements to repurchase 6,019 2.40 9,411 1.79 11,719 Total $51,080 2.28 % As of December 31, 2017 Ending Balance Yearly Average Weighted Weighted Average Average Maximum Carrying Effective Effective Value Outstanding (Dollars in millions) Carrying Value Rate(1) Carrying Value Rate(1) at Any Month End Discount notes and Reference Bills $45,596 1.19 % $50,867 0.85 % $60,967 Medium-term notes 17,792 1.03 12,172 0.78 17,967 Securities sold under agreements to repurchase 9,681 1.06 8,092 0.65 11,491 Total $73,069 1.14 %
(1) Average rate is weighted based on carrying value.
FREDDIE MAC | 2019 Form 10-K 117
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Management's Discussion and Analysis Liquidity and Capital Resources
Maturity and Redemption Dates The following graphs present our other debt by contractual maturity date and earliest redemption date. The earliest redemption date refers to the earliest call date for callable debt and the contractual maturity date for all other debt. Contractual Maturity Date as of December 31, 2019(1) [[Image Removed: chart-530129b075ea5b5c9fba01.jpg]]
Earliest Redemption Date as of December 31, 2019(1) [[Image Removed: chart-a2789de7374a5f5dbe8a01.jpg]] (1) STACR Debt Notes and SCR Debt Notes are subject to prepayment risk as their
payments are based upon the performance of a reference pool of mortgage
assets that may be prepaid by the related mortgage borrower at any time
generally without penalty and are therefore included as a separate category
in the graphs.
Debt Securities of Consolidated Trusts -------------------------------------------------------------------------------- The largest component of debt on our consolidated balance sheets is debt securities of consolidated trusts, which relates to securitization transactions that we consolidated for accounting purposes. We issue this type of debt by securitizing mortgage loans primarily to fund the majority of our single-family guarantee activities. When we consolidate securitization trusts, we recognize the following on our consolidated balance sheets: n The assets held by the securitization trusts, the majority of which are
mortgage loans. We recognized $1,940.5 billion and $1,842.9 billion of
mortgage loans, which represented 88.1% and 89.3% of our total assets, as of
December 31, 2019 and December 31, 2018, respectively.
n The debt securities issued by the securitization trusts, the majority of
which are pass-through securities, where the cash flows of the mortgage loans
held by the securitization trust are passed through to the holders of the
securities. We recognized $1,898.4 billion and $1,792.7 billion of debt
securities of consolidated trusts, which represented 87.1% and 87.7% of our
total debt, as of December 31, 2019 and December 31, 2018, respectively.
Debt securities of our consolidated trusts represent our liability to third parties that hold beneficial interests in our consolidated securitization trusts. Debt securities of consolidated trusts are principally repaid from the cash flows of the mortgage loans held by the securitization trusts that issued the debt securities. In circumstances when the cash flows of the mortgage loans are not sufficient to repay the debt, we make up the shortfall because we have guaranteed the payment of principal and interest on the debt. In certain circumstances, we have the right and/or obligation to purchase the loan from the trust prior to its contractual maturity. At December 31, 2019, our estimated exposure (including the amounts that are due to Freddie Mac for debt securities of consolidated trusts that we purchased) to these debt securities is recognized as the allowance for loan losses on mortgage loans held by consolidated trusts. See Note 4 for details on our allowance for loan losses.
FREDDIE MAC | 2019 Form 10-K 118
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Management's Discussion and Analysis Liquidity and Capital Resources
The table below shows the issuance and extinguishment activity for the debt securities of our consolidated trusts. Table 66 - Activity for Debt Securities of Consolidated Trusts Held by Third Parties Year Ended December 31, (In millions) 2019 2018 Beginning balance $1,748,738 $1,672,605 Issuances: New issuances to third parties 323,860
185,877
Additional issuances of securities 178,971
190,207
Total issuances 502,831
376,084
Extinguishments:
Purchases of debt securities from third parties (30,306 ) (41,453 ) Debt securities received in settlement of secured lending (46,670 ) (25,220 ) Repayments of debt securities (319,791 ) (233,278 ) Total extinguishments (396,767 ) (299,951 ) Ending balance 1,854,802 1,748,738 Unamortized premiums and discounts 43,553
43,939
Debt securities of consolidated trusts held by third parties $1,898,355
$1,792,677
The table below provides information on the UPB of debt securities issued by our consolidated trusts. Table 67 - Debt Securities of Consolidated Trusts Held by Third Parties As of December 31, (In millions) 2019 2018 Single-family Level 1 Securitization Products: 30-year or more amortizing fixed-rate $1,563,211 $1,434,879 20-year amortizing fixed-rate 80,340 79,079 15-year amortizing fixed-rate 241,835 253,245 Adjustable-rate 38,271 45,051 Interest-only 4,828 6,697 FHA/VA and other governmental 1,718 1,939 Total single-family Level 1 Securitization Products 1,930,203 1,820,890 Other single-family 2,397 2,961 Total single-family 1,932,600 1,823,851 Total multifamily 8,642 7,220 Total Freddie Mac mortgage-related securities 1,941,242
1,831,071
Freddie Mac mortgage-related securities repurchased or retained at issuance
(86,440 ) (82,333 ) Debt securities of consolidated trusts held by third parties $1,854,802 $1,748,738 FREDDIE MAC | 2019 Form 10-K 119
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Management's Discussion and Analysis Liquidity and Capital Resources
Credit Ratings -------------------------------------------------------------------------------- Our ability to access the capital markets and other sources of funding, as well as our cost of funds, may be affected by our credit ratings. The table below indicates our credit ratings as of January 31, 2020. Table 68 - Freddie Mac Credit Ratings Nationally Recognized Statistical Rating Organization S&P Moody's Fitch Senior long-term debt AA+ Aaa AAA Short-term debt A-1+ P-1 F1+ Subordinated debt AA Aa2 AA- Preferred stock(1) D Ca C Outlook Stable Stable Stable
(1) Does not include senior preferred stock issued to Treasury.
Our credit ratings and outlooks are primarily based on the support we receive from Treasury and, therefore, are affected by changes in the credit ratings and outlooks of the U.S. government. A security rating is not a recommendation to buy, sell, or hold securities. It may be subject to revision or withdrawal at any time by the assigning rating organization. Each rating should be evaluated independently of any other rating. Cash Flows -------------------------------------------------------------------------------- n 2019 vs. 2018 - Cash and cash equivalents (including restricted cash and cash equivalents) decreased by $2.1 billion from $7.3 billion as of December 31, 2018 to $5.2 billion as of December 31, 2019, as we invested the proceeds from issuances of other debt in securities purchased under agreements to resell due to higher near-term cash needs for upcoming debt maturities and anticipated calls of other debt and a higher expected loan purchase forecast. n 2018 vs. 2017 - Cash and cash equivalents (including restricted cash and cash equivalents) decreased by $2.5 billion from $9.8 billion as of December 31, 2017 to $7.3 billion as of December 31, 2018, primarily driven by fewer proceeds from debt issuances as we continued to reduce our indebtedness along with the decline in our mortgage-related investments portfolio. The decrease in cash and cash equivalents (including restricted cash and cash equivalents) was partially offset by a decrease in securities purchased under agreements to resell due to lower near-term cash needs for fewer upcoming maturities and anticipated calls of other debt. Capital Resources Primary Sources of Capital -------------------------------------------------------------------------------- Our entry into conservatorship resulted in significant changes to the assessment of our capital adequacy and our management of capital. Under the Purchase Agreement, Treasury made a commitment to provide us with equity funding, under certain conditions, to eliminate deficits in our net worth. Obtaining equity funding from Treasury pursuant to its commitment under the Purchase Agreement enables us to avoid being placed into receivership by FHFA and to maintain the confidence of the debt markets as a very high-quality credit, upon which our business model is dependent. At December 31, 2019, our assets exceeded our liabilities under GAAP; therefore, no draw is being requested from Treasury under the Purchase Agreement. Based on our Net Worth Amount of $9.1 billion as of December 31, 2019 and the applicable Capital Reserve Amount of $20.0 billion, we will not have a dividend requirement to Treasury for the quarter ending December 31, 2019. Under the Purchase Agreement, the payment of dividends does not reduce the outstanding liquidation preference on the senior preferred stock. See Introduction - About Freddie Mac - Conservatorship and Government Support for Our Business for more information. If for any reason we were not to pay our dividend requirement on the senior preferred stock in full in any future period, the unpaid amount would be added to the liquidation preference and our applicable Capital Reserve Amount would thereafter be zero, but this would not affect our ability to draw funds from Treasury under the Purchase Agreement. Our cumulative senior preferred stock dividend payments totaled $119.7 billion as of December 31, 2019. The aggregate liquidation preference of the senior preferred stock owned by Treasury was $79.3 billion and the amount of available funding remaining under the Purchase Agreement was $140.2 billion as of December 31, 2019. To the extent we draw FREDDIE MAC | 2019 Form 10-K 120
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Management's Discussion and Analysis Liquidity and Capital Resources
additional funds in the future, the aggregate liquidation preference will increase and the amount of available funding will decrease by the amount of those draws. See Conservatorship and Related Matters and Regulation and Supervision for more information. The CECL accounting standard relating to the measurement of credit losses on financial instruments became effective as of January 1, 2020. CECL replaces the incurred loss impairment methodology with a methodology that reflects lifetime expected credit losses. We expect to recognize a decrease to retained earnings of $0.2 billion from our adoption of CECL on January 1, 2020. See Note 1 for additional information about our adoption of CECL. The table below presents activity related to our net worth. Table 69 - Net Worth Activity Year Ended December 31, (In millions) 2019 2018 2017 Beginning balance $4,477 ($312 ) $5,075 Comprehensive income (loss) 7,787 8,622 5,558 Capital draws from Treasury - 312 -
Senior preferred stock dividends declared (3,142 ) (4,145 ) (10,945 ) Total equity / net worth
$9,122 $4,477 ($312 )
Aggregate draws under Purchase Agreement $71,648 $71,648 $71,336 Aggregate cash dividends paid to Treasury 119,680 116,538 112,393
Conservatorship Capital Framework -------------------------------------------------------------------------------- In May 2017, FHFA, as Conservator, issued guidance to us to evaluate and manage our financial risk and to make economic business decisions, while in conservatorship, utilizing a newly-developed risk-based CCF, a capital system with detailed formulae provided by FHFA. The CCF also provides the foundation for the risk-based component of the proposed Enterprise Capital Rule published by FHFA in the Federal Register in July 2018. We use the CCF to evaluate business decisions and ensure the company makes such decisions prudently when pricing transactions and managing its businesses. This framework focuses on return on conservatorship capital versus an estimated cost of equity capital needed to support the risk assumed to generate those returns. The CCF has been and may be further revised by FHFA from time to time, including in connection with FHFA's consideration and adoption of a final Enterprise Capital Rule, which could possibly result in material changes in our conservatorship capital, and, thus, our returns on conservatorship capital. In November 2019, FHFA announced that it plans to re-propose the Enterprise Capital Rule in 2020. The existing regulatory capital requirements have been suspended by FHFA during conservatorship. Consequently, we refer to the capital needed under the CCF for analysis of transactions and businesses as "conservatorship capital." Under the Purchase Agreement and the September 2019 Letter Agreement, we are not able to retain equity, as calculated under GAAP, in excess of the $20.0 billion Capital Reserve Amount. As a result, we do not have capital sufficient to support our aggregate risk-taking activities. Return on Conservatorship Capital -------------------------------------------------------------------------------- The table below provides the ROCC, calculated as (1) annualized comprehensive income for the period divided by (2) average conservatorship capital during the period. Each quarter, we consider whether certain "significant items" occurred that should be excluded from comprehensive income and our calculation of ROCC. If we have identified significant items in any of the periods presented, we also include comprehensive income excluding significant items as well as an adjusted ROCC based on comprehensive income excluding significant items, both non-GAAP measures. We believe that these non-GAAP financial measures are useful to investors as they better reflect our on-going financial results. The ROCC shown in the table below is not based on our total equity and does not reflect actual returns on total equity. We do not believe that returns on total equity are meaningful because of the net worth limit imposed since 2012 under the Purchase Agreement.
FREDDIE MAC | 2019 Form 10-K 121
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Management's Discussion and Analysis Liquidity and Capital Resources
Table 70 - Returns on Conservatorship Capital(1)
Year Ended December 31, (Dollars in billions) 2019 2018 GAAP comprehensive income $7.8 $8.6 Significant items: Non-agency mortgage-related securities judgment(2) - (0.3 ) Tax effect related to judgment(2) -
0.1
Total significant items(3) - (0.2 ) Comprehensive income, excluding significant items(3) $7.8
$8.4
Conservatorship capital (average during the period)(4) $51.8
$56.6
ROCC, based on GAAP comprehensive income(4) 15.0 % 15.2 % Adjusted ROCC, based on comprehensive income excluding 15.0 % 14.8 % significant items(3)(4) (1) Average conservatorship capital and ROCC for 2019 are preliminary and subject to change until official submission to FHFA.
(2) 2018 GAAP comprehensive income included a benefit of $334 million (pre-tax)
from a final judgment against Nomura Holding America, Inc. in litigation
involving certain of our non-agency mortgage-related securities. The tax effect related to this judgment was ($70) million.
(3) No significant items were identified for 2019. Numbers for 2019 are included
for comparison purposes only.
(4) Average conservatorship capital for each period is based on the CCF in
effect during the period. The CCF in effect as of December 31, 2019, was
largely unchanged from the CCF as of December 31, 2018.
ROCC and Adjusted ROCC for 2019 were relatively flat compared to the returns for 2018, primarily driven by the decrease in comprehensive income, partially offset by the lower level of conservatorship capital needed, resulting from an increase in CRT activity in both the Single-family Guarantee and Multifamily segments, home price appreciation, the efficient disposition of legacy assets, and a decrease in our deferred tax assets. We find the returns calculated above, as well as the returns calculated on specific transactions and individual business lines, to be a reasonable measure of return-versus-risk to support our decision-making while we remain in conservatorship. These returns may not be indicative of the returns that would be generated if we were to exit conservatorship, especially as the terms and timing of any such exit are not currently known and will depend upon future actions by the U.S. government. Our belief, should we leave conservatorship, is that returns at that time would most likely be below the levels calculated above, assuming the same portfolio of risk assets, as we expect that we would hold capital post-conservatorship above the minimum required regulatory capital. It is also likely that we would be required to pay fees for federal government support, thereby reducing our total comprehensive income.
FREDDIE MAC | 2019 Form 10-K 122
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Management's Discussion and Analysis Conservatorship and Related Matters
CONSERVATORSHIP AND RELATED MATTERS Supervision of Our Company During Conservatorship FHFA has broad powers when acting as our 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. However, the GSE Act provides that 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 conduct our business subject to the direction of FHFA as our Conservator. The Conservator has provided authority to the Board of Directors to oversee management's conduct of our business operations so we can operate in the ordinary course. The directors serve on behalf of, exercise authority as provided by, and owe their fiduciary duties of care and loyalty to the Conservator. The Conservator retains the authority to withdraw or revise the authority it has provided at any time. The Conservator also retains certain significant authorities for itself, and has not provided them to the Board. The Conservator continues to provide strategic direction for the company and directs the efforts of the Board and management to implement its strategy. Many management decisions are subject to review and/or approval by FHFA and management frequently receives direction from FHFA on various matters involving day-to-day operations. Our current business objectives reflect direction we have received from the Conservator including the Conservatorship Scorecards. 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. Given our public mission and the important role our Conservator has placed on Freddie Mac in addressing housing and mortgage market conditions, we sometimes take actions that could have a negative impact on our business, operating results or financial condition, and could thus contribute to a need for additional draws under the Purchase Agreement. Certain of these actions are intended to help homeowners and the mortgage market. Purchase Agreement, Warrant, and Senior Preferred Stock In connection with our entry into conservatorship, we entered into the Purchase Agreement with Treasury. Under the Purchase Agreement, we issued to Treasury both senior preferred stock and a warrant to purchase common stock. The Purchase Agreement, the warrant, and the senior preferred stock do not contain any provisions causing them to terminate or cease to exist upon the termination of conservatorship. The conservatorship, the Purchase Agreement, the warrant, and the senior preferred stock materially limit the rights of our common and preferred stockholders (other than Treasury). Pursuant to the Purchase Agreement, which we entered into through FHFA, in its capacity as Conservator, on September 7, 2008, we issued to Treasury one million shares of Variable Liquidation Preference Senior Preferred Stock with an initial liquidation preference of $1 billion and a warrant to purchase, for a nominal price, shares of our common stock equal to 79.9% of the total number of shares outstanding. The senior preferred stock and warrant were issued to Treasury as an initial commitment fee in consideration of Treasury's commitment to provide funding to us under the Purchase Agreement. We did not receive any cash proceeds from Treasury as a result of issuing the senior preferred stock or the warrant. 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 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 consolidated balance sheet for the applicable fiscal quarter, provided that the aggregate amount funded under the Purchase Agreement may not exceed Treasury's commitment. The amount of any draw will be added to the aggregate liquidation preference of the senior preferred stock and will reduce the amount of available funding remaining. Deficits in our net worth have made it necessary for us to make substantial draws on Treasury's funding commitment under the Purchase Agreement. The 2017 Letter Agreement increased the aggregate liquidation preference of the senior preferred stock by $3.0 billion on December 31, 2017. In addition, pursuant to the September 2019 Letter Agreement, the liquidation preference of the senior preferred stock will be increased, at the end of each fiscal quarter, beginning September 30, 2019, by an amount equal to the increase in the Net Worth Amount, if any, during the immediately prior fiscal quarter, until the liquidation preference has increased by $17.0 billion. As of December 31, 2019, the aggregate liquidation preference of the senior preferred stock was $79.3 billion, and the amount of available funding remaining under the Purchase Agreement was $140.2 billion.
FREDDIE MAC | 2019 Form 10-K 123
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Management's Discussion and Analysis Conservatorship and Related Matters
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. The dividends we have paid to Treasury on the senior preferred stock have been declared by, and paid at the direction of, the Conservator, acting as successor to the rights, titles, powers, and privileges of the Board. Under the August 2012 amendment to the Purchase Agreement, our cash dividend requirement 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. Under the 2017 Letter Agreement, the dividend for the dividend period from October 1, 2017 through and including December 31, 2017 was reduced to $2.25 billion, and the applicable Capital Reserve Amount from January 1, 2018 through June 30, 2019 was $3.0 billion. Pursuant to the September 2019 Letter Agreement, from July 1, 2019 and thereafter, the applicable Capital Reserve Amount is $20.0 billion. As a result of the net worth sweep dividend, our future profits in excess of the applicable Capital Reserve Amount will be distributed to Treasury, and the holders of our common stock and non-senior preferred stock will not receive benefits that could otherwise flow from such future profits. If for any reason we were not to pay the amount of our dividend requirement on the senior preferred stock in full, the unpaid amount would be added to the liquidation preference and our applicable Capital Reserve Amount would thereafter be zero, but this would not affect our ability to draw funds from Treasury under the Purchase Agreement. 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. We are not permitted to redeem the senior preferred stock prior to the termination of Treasury's funding commitment under the Purchase Agreement. The Purchase Agreement and warrant contain covenants that significantly restrict our business and capital activities. For example, 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: n Pay dividends on our equity securities, other than the senior preferred stock
or warrant, or repurchase our equity securities;
n Issue any additional equity securities, except in limited instances;
n Sell, transfer, lease, or otherwise dispose of any assets, other than dispositions for fair market value in the ordinary course of business, consistent with past practices, and in other limited circumstances; and
n Issue any subordinated debt.
Limits on Our Mortgage-Related Investments Portfolio and Indebtedness Our ability to acquire and sell mortgage assets is significantly constrained by limitations under the Purchase Agreement and other limitations imposed by FHFA: n Since 2014, we have been managing the mortgage-related investments portfolio
so that it does not exceed 90% of the cap, which reached $250 billion as of
December 31, 2018. In February 2019, FHFA directed us to maintain the
mortgage-related investments portfolio at or below $225 billion at all times.
n Under the Purchase Agreement, we 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. Our debt cap under the Purchase Agreement was $346.1
billion in 2018 and declined to $300.0 billion on January 1, 2019. As of
December 31, 2019, our aggregate indebtedness for purposes of the debt cap
was $283.2 billion.
n FHFA has indicated that any portfolio sales should be commercially reasonable
transactions that consider impacts to the market, borrowers, and neighborhood
stability.
Our decisions with respect to managing the mortgage-related investments portfolio affect all three business segments. In order to achieve all of our portfolio goals, it is possible that we may forgo economic opportunities in one business segment in order to pursue opportunities in another business segment. Our results against the limits imposed on our mortgage-related investments portfolio and aggregate indebtedness for the year ended December 31, 2019 are shown below. FREDDIE MAC | 2019 Form 10-K 124
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Management's Discussion and Analysis Conservatorship and Related Matters
Mortgage Assets as of December 31,
[[Image Removed: chart-ef7f34e1fab351519b2a01.jpg]]
Indebtedness as of December 31, [[Image Removed: chart-7581e8a6cb945502933a01.jpg]] Managing Our Mortgage-Related Investments Portfolio Over Time -------------------------------------------------------------------------------- Our mortgage-related investments portfolio includes assets held by all three business segments and consists of: n Agency securities, which include both single-family and multifamily Freddie
Mac mortgage-related securities and non-Freddie Mac agency mortgage-related
securities; n Non-agency mortgage-related securities, which include single-family
non-agency mortgage-related securities, CMBS, housing revenue bonds, and
other multifamily securities; and
n Single-family and multifamily unsecuritized loans.
We evaluate the liquidity of the assets in our mortgage-related investments portfolio based on three categories (in order of liquidity): n Liquid - single-class and multi-class agency securities, excluding certain
structured agency securities collateralized by non-agency mortgage-related
securities; n Securitization Pipeline - primarily includes performing multifamily and
single-family loans purchased for cash and primarily held for a short period
until securitized, with the resulting Freddie Mac issued securities being
sold or retained; and
n Less Liquid - assets that are less liquid than both agency securities and
loans in the securitization pipeline (e.g., reperforming loans, single-family
seriously delinquent loans, and non-agency mortgage-related securities).
FREDDIE MAC | 2019 Form 10-K 125
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Management's Discussion and Analysis Conservatorship and Related Matters
Freddie Mac mortgage-related securities include mortgage-related securities issued or guaranteed by Freddie Mac. In prior periods, certain of these securities that were issued by third-party trusts but guaranteed by Freddie Mac were classified as non-agency mortgage-related securities. Prior periods have been revised to conform to the current period presentation. 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. In February 2019, FHFA directed us to maintain this portfolio at or below $225 billion at all times. In November 2019, FHFA directed us, by January 31, 2020, to include 10% of the notional value of certain interest-only securities owned by Freddie Mac in the calculation of this portfolio, while continuing to maintain the portfolio below the limit imposed by FHFA. Table 71 - Mortgage-Related Investments Portfolio Details As of December 31, 2019 As of December 31, 2018 Securitiz-ation Securitiz-ation (Dollars in millions) Liquid Pipeline Less Liquid Total Liquid Pipeline Less Liquid Total Capital Markets segment - Mortgage investments portfolio Single-family unsecuritized loans Performing loans $- $19,144 $- $19,144 $- $8,955 $- $8,955 Reperforming loans - - 26,134 26,134 - - 39,402 39,402 Total single-family unsecuritized loans - 19,144 26,134 45,278 - 8,955 39,402 48,357 Agency securities 119,156 - 2,518 121,674 113,848 - 3,108 116,956 Non-agency mortgage-related - - 1,458 1,458 - - 2,122 2,122 securities Total Capital Markets segment - Mortgage 119,156 19,144 30,110 168,410 113,848 8,955 44,632 167,435 investments portfolio Single-family Guarantee segment - Single-family unsecuritized seriously delinquent loans - - 8,589 8,589 - - 8,473 8,473 Multifamily segment Unsecuritized mortgage loans - 18,531 11,254 29,785 - 23,203 11,584 34,787 Mortgage-related securities 5,209 - 680 5,889 6,570 - 815 7,385 Total Multifamily segment 5,209 18,531 11,934 35,674 6,570 23,203 12,399 42,172 Total mortgage-related $124,365 $37,675 $50,633 $212,673 $120,418 $32,158 $65,504 $218,080 investments portfolio Percentage of total mortgage-related 58 % 18 % 24 % 100 % 55 % 15 % 30 % 100 % investments portfolio We are particularly focused on reducing, in an economically sensible manner, the balance of the less liquid assets that we hold in our mortgage-related investments portfolio. Our efforts to reduce our holdings of these assets help satisfy several objectives, including to improve the overall liquidity of our mortgage-related investments portfolio and comply with the mortgage-related investments portfolio limits. The decline in our holdings of less liquid assets, which included repayments and active dispositions, accounted for the majority of the decline in our mortgage-related investments portfolio during 2019. Our active dispositions of less liquid assets included the following: n Sales of $13.6 billion of less liquid assets, including $0.5 billion in UPB
of single-family non-agency mortgage-related securities, $0.2 billion in UPB
of seriously delinquent unsecuritized single-family loans, and $12.9 billion
in UPB of single-family reperforming loans, which use our senior subordinate
securitization structures;
n Securitizations of $3.9 billion in UPB of less liquid multifamily loans; and
n Transfers of $1.9 billion in UPB of less liquid multifamily loans to the
securitization pipeline.
FHFA's Strategic Plan and Scorecards for Freddie Mac and Fannie Mae Conservatorships In October 2019, FHFA issued its 2019 Strategic Plan. The 2019 Strategic Plan described FHFA's new direction to reform the housing finance system and Freddie Mac and Fannie Mae. The 2019 Strategic Plan established three reformulated strategic goals for the conservatorships of Freddie Mac and Fannie Mae: n Focus on their core mission responsibilities to foster competitive liquid, efficient, and resilient (CLEAR) national housing finance markets that support sustainable homeownership and affordable rental housing; FREDDIE MAC | 2019 Form 10-K 126
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Management's Discussion and Analysis Conservatorship and Related Matters
n Operate in a safe and sound manner appropriate for entities in conservatorship; and
n Prepare for their eventual exits from the conservatorship.
FHFA has also published annual Conservatorship Scorecards for Freddie Mac and Fannie Mae, which establish annual objectives as well as performance targets and measures since 2014. FHFA issued the 2019 Conservatorship Scorecard in December 2018. FHFA issued the 2020 Conservatorship Scorecard in October 2019, which aligns with the reformulated strategic goals of the 2019 Strategic Plan. We continue to align our resources and internal business plans to meet the goals and objectives provided by FHFA. For information about how the Conservatorship Scorecard affects executive compensation, see Executive Compensation - Compensation Discussion and Analysis. For information about the 2019 Conservatorship Scorecard, see our Current Report on Form 8-K filed on December 20, 2018. For information about the 2020 Conservatorship Scorecard, see our Current Report on Form 8-K filed on October 29, 2019. For more information on the conservatorship and related matters, see Regulation and Supervision, Risk Factors - Conservatorship and Related Matters, Note 2, Note 11, and Directors, Corporate Governance, and Executive Officers - Board and Committee Information - Authority of the Board and Board Committees.
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Management's Discussion and Analysis Regulation and Supervision
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 and to certain regulation by other government agencies. Furthermore, regulatory activities by other government agencies can affect us indirectly, even if we are not directly subject to such agencies' regulation or oversight. For example, regulations that modify requirements applicable to the purchase or servicing of mortgages can affect us. 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. 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. Receivership -------------------------------------------------------------------------------- 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 set forth in the GSE Act. Certain aspects of conservatorship and receivership operations of Freddie Mac, Fannie Mae, and the FHLBs are addressed in an FHFA rule. Among other provisions, the rule indicates that FHFA generally 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 rule indicates that administrative expenses of the conservatorship will also be deemed to be administrative expenses of receivership and that capital distributions may not be made during conservatorship, except as specified in the rule. Capital Standards -------------------------------------------------------------------------------- FHFA suspended capital classification of us during conservatorship in light of the Purchase Agreement. The existing statutory and FHFA regulatory capital requirements are not binding during the conservatorship. These capital standards are described in Note 17. Under the GSE Act, FHFA has the authority to increase our minimum capital levels temporarily or to establish additional capital and reserve requirements for particular purposes. Pursuant to an FHFA rule, FHFA-regulated entities are required 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 conduct annual stress tests using scenarios specified by FHFA that reflect certain economic and financial conditions and publicly disclose the results of the stress test under the "severely adverse" scenario. In August 2019, we disclosed the results of our most recent "severely adverse" scenario stress test which projected an improvement in the amount of available funding remaining under the Purchase Agreement compared to the test results disclosed in August 2018. New Products -------------------------------------------------------------------------------- The GSE Act requires Freddie Mac and Fannie Mae to obtain the approval of FHFA before initially offering any product (as defined in the statute), 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 published an interim final rule on prior approval of new products, it 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. Affordable Housing Goals -------------------------------------------------------------------------------- We are subject to annual affordable housing goals. We view the purchase of 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 very low-, low-, and moderate-income families. In light of the affordable housing goals, we may make
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Management's Discussion and Analysis Regulation and Supervision
adjustments to our strategies for purchasing loans, which could potentially increase our credit losses. These strategies could include entering into purchase and securitization transactions with lower expected economic returns than our typical transactions. In February 2010, FHFA stated that it 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. Current FHFA housing goals applicable to our purchases consist of four goals and one subgoal for single-family owner-occupied housing, one multifamily affordable housing goal, and two multifamily affordable housing subgoals. Single-family goals are expressed as a percentage of the total number of eligible loans underlying our total single-family loan purchases, while the multifamily goals are expressed in terms of minimum numbers of units financed. Three of the single-family housing goals and the subgoal target purchase mortgage loans for low-income families, very low-income families, and/or families that reside in low-income areas. The single-family housing goals also include one goal that targets refinancing loans for low-income families. The multifamily affordable housing goal targets multifamily rental housing affordable to low-income families. The multifamily affordable housing subgoals target multifamily rental housing affordable to very low-income families and small (5- to 50-unit) multifamily properties affordable to low-income families. We may achieve a single-family or multifamily housing goal by meeting or exceeding the FHFA benchmark for that goal (Goal). We also may achieve a single-family goal by meeting or exceeding the actual share of the market that meets the criteria for that goal (Market Level). If the Director of FHFA finds that we failed (or there is a substantial probability that we will fail) to meet a housing goal and that achievement of the housing goal was or is feasible, the Director may require the submission of a housing plan that describes the actions we will take to achieve the unmet goal. FHFA has the authority to take actions against us if we fail to submit a required housing plan, submit an unacceptable plan, fail to comply with a plan approved by FHFA, or fail to submit certain mortgage purchase data, 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 duty to serve requirements, which may adversely affect our profitability. 2018 Affordable Housing Goal Results and Housing Plan -------------------------------------------------------------------------------- In December 2019, FHFA informed us that, for 2018, we achieved all five of our single-family affordable housing goals and all three of our multifamily goals. Our performance compared to our goals, as determined by FHFA for 2018 and 2017, is set forth below. Table 72 - 2018 and 2017 Affordable Housing Goals Results 2018 2017 Affordable Housing Goals Goals Market Level Results Goals Market Level Results Single-family purchase money goals Low-income 24 % 25.5 % 25.8 % 24 % 24.3 % 23.2 % Very low-income 6 % 6.5 % 6.3 % 6 % 5.9 % 5.7 % Low-income areas 18 % 22.6 % 22.6 % 18 % 21.5 % 20.9 % Low-income areas subgoal 14 % 18.0 % 17.3 % 14 % 17.1 % 16.4 % Single-family refinance low-income goal 21 % 30.7 % 27.3 % 21 % 25.4 % 24.8 % Multifamily low-income goal (In units) 315,000 N/A 474,062 300,000 N/A 408,096 Multifamily very low-income subgoal (In units) 60,000 N/A 105,612 60,000 N/A 92,274 Multifamily small property low-income subgoal (In units) 10,000 N/A 39,353 10,000 N/A 39,473 Due to our failure to meet two of the five single-family housing goals for 2014 and 2015, we operated under an FHFA-required housing plan through 2018. FHFA has not required us to extend our housing plan beyond 2018. Although FHFA has determined that we met our affordable housing goals in 2018, FHFA will continue to closely monitor and evaluate our 2019 housing goals performance.
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Management's Discussion and Analysis Regulation and Supervision
2019-2020 Affordable Housing Goals -------------------------------------------------------------------------------- Our affordable housing goals for 2019 and 2020 are set forth below. Table 73 - 2019-2020 Affordable Housing Goals
2019
2020
Single-family purchase money goals (Benchmark levels): Low-income 24 % 24 % Very low-income 6 % 6 % Low-income areas 19 % TBD Low-income areas subgoal 14 % 14 % Single-family refinance low-income goal (Benchmark level) 21 % 21 % Multifamily low-income goal (In units) 315,000
315,000
Multifamily very low-income subgoal (In units) 60,000
60,000
Multifamily small property low-income subgoal (In units) 10,000 10,000
We expect to report our performance with respect to the 2019 affordable housing goals in March 2020. At this time, based on preliminary information, we believe we met all five of our single-family goals and our three multifamily goals for 2019. We expect that FHFA will make a final determination on our 2019 performance following the release of market data in 2020. Duty to Serve Underserved Markets Plan -------------------------------------------------------------------------------- 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 providing leadership in 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. In December 2017, FHFA released Freddie Mac's underserved markets plan for 2018-2020. The plan became effective January 1, 2018. On December 20, 2019, FHFA published Freddie Mac's modified underserved markets plan for 2018-2020. FHFA evaluated Freddie Mac's performance under the plan for 2018 and determined it was satisfactory. Affordable Housing Fund Allocations -------------------------------------------------------------------------------- The GSE Act requires us to set aside in each fiscal year an amount equal to 4.2 basis points of each dollar of total new business purchases, and pay such amount to certain housing funds. FHFA suspended this requirement when we were placed into conservatorship. However, in December 2014, FHFA terminated the suspension and instructed us to begin setting aside and paying amounts into those funds, subject to any subsequent guidance or instruction from FHFA. During 2019, we completed $529.1 billion of new business purchases subject to this requirement and accrued $222.2 million of related expense, of which $144.4 million is related to the Housing Trust Fund administered by HUD and $77.8 million is related to the Capital Magnet Fund administered by Treasury. We are prohibited from passing through the costs of these allocations to the originators of the loans that we purchase. Portfolio Activities -------------------------------------------------------------------------------- The GSE Act provides FHFA with the 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 our mission and safe and sound operations. FHFA adopted 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 Our Mortgage-Related Investments Portfolio and Indebtedness for more information. FREDDIE MAC | 2019 Form 10-K 130
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Management's Discussion and Analysis Regulation and Supervision
Subordinated Debt -------------------------------------------------------------------------------- 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. Under the Purchase Agreement, we may not issue subordinated debt without Treasury's consent. During 2019 and 2018, we did not call, repurchase, or issue any Freddie SUBS® securities. The last outstanding issue of Freddie SUBS securities matured in December 2018. Department of Housing and Urban Development HUD has regulatory authority over Freddie Mac with respect to fair lending. Our loan purchase activities are subject to federal anti-discrimination laws. In addition, the GSE Act prohibits discriminatory practices in our loan 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. 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 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. Our Charter also authorizes Treasury to purchase Freddie Mac debt obligations not exceeding $2.25 billion in aggregate principal amount at any time. In October 2019, Treasury released its 2019 Strategic Plan, which includes a goal of reforming the housing finance system and ending the conservatorships of Freddie Mac and Fannie Mae. Consumer Financial Protection Bureau The CFPB regulates consumer financial products and services. The CFPB adopted a number of final rules relating to loan origination, finance, and servicing practices that generally went into effect in January 2014. The rules include an ability-to-repay rule, which requires loan 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. The ability-to-repay rule applies to most loans acquired by Freddie Mac, and for loans covered by the rule, FHFA has directed us to limit our single-family acquisitions to loans that generally would constitute qualified mortgages under applicable CFPB regulations. The directive generally restricts us from acquiring loans that are not fully amortizing, have a term greater than 30 years, or have points and fees in excess of 3% of the total loan amount. Under CFPB rules, one category of qualified mortgages consists of loans that are eligible for purchase or guarantee by either Freddie Mac or Fannie Mae. This category of qualified mortgages is scheduled to expire in January 2021, although the CFPB has indicated that it may permit an extension of this category of qualified mortgages. The CFPB also has indicated that it intends to amend the ability-to-repay rule, including by making revisions to the definition of qualified mortgage. 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: n Securities we issue or guarantee are "exempted securities" and may be sold
without registration under the Securities Act of 1933;
n We are excluded from the definitions of "government securities broker" and
"government securities dealer" under the Exchange Act;
n The Trust Indenture Act of 1939 does not apply to securities issued by us; and
n 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.
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Management's Discussion and Analysis Regulation and Supervision
Legislative and Regulatory Developments Legislation Related to Freddie Mac and Its Future Status -------------------------------------------------------------------------------- Our future structure and role will be determined by the Administration, Congress, and FHFA, and it is possible, and perhaps likely, that there will be significant changes beyond the near-term. Several bills have been introduced in past sessions of Congress concerning the future status of Freddie Mac, Fannie Mae, and the mortgage finance system, including bills that provided for the wind down of Freddie Mac and Fannie Mae, modification of the terms of the Purchase Agreement, or an increase in CRT transactions. None of these bills have been enacted. It is likely that similar or new bills will be introduced and considered in the future. We cannot predict whether any of such bills will be enacted. Treasury Housing Reform Plan -------------------------------------------------------------------------------- On September 5, 2019, Treasury released its plan to reform the housing finance system pursuant to the goals specified in the presidential memorandum issued on March 27, 2019. The Treasury Housing Reform Plan (the Plan) includes 49 recommended legislative and administrative reforms that would advance the reform goals outlined in the presidential memorandum: ending the conservatorships of the GSEs, facilitating competition in the housing finance system, establishing regulation of the GSEs that safeguards their safety and soundness and minimizes the risks they pose to the financial stability of the United States, and providing that the federal government is properly compensated for any explicit or implicit support it provides to the GSEs or the secondary housing finance market. Among other things, Treasury states that its preference and recommendation is for Congress to enact comprehensive housing finance reform legislation. Specifically, the Plan indicates that legislative reforms should replace the existing Purchase Agreements with an explicit, paid-for guarantee backed by the full faith and credit of the federal government that is limited to the timely payment of principal and interest on qualifying MBS. The explicit government guarantee should be available to re-chartered GSEs and to any other FHFA-approved guarantors of MBS collateralized by eligible conventional mortgage loans or eligible multifamily mortgage loans. Further, the government's guarantee would stand behind significant first-loss private capital and would be triggered only in exigent circumstances. To ensure stability in the housing finance system pending comprehensive housing finance reform legislation, the Plan indicates that it will be necessary to maintain limited and tailored government support for the GSEs by leaving the Purchase Agreement commitments in place after the GSE conservatorships. The Plan notes that the government should be compensated for its continued support through a periodic commitment fee. The Plan also indicates that FHFA should begin the process of ending the GSE conservatorships. It recommends that the Purchase Agreements be amended to enhance Treasury's ability to mitigate the risk of a draw on the commitments after the conservatorships have ended. It also indicates that other Purchase Agreement amendments should ensure that each GSE continues to be subject to appropriate mission and safety and soundness regulation after conservatorship and that future GSE activities are limited to those that have a close nexus to the underlying rationale for government support. Treasury has indicated that it will continue to support FHFA's administrative actions to enhance regulation of the GSEs, promote private sector competition, and satisfy preconditions for ending the GSEs' conservatorships. We cannot predict whether Congress will enact legislation or FHFA will take administrative action that is consistent with these recommendations.
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Management's Discussion and Analysis Contractual Obligations
CONTRACTUAL OBLIGATIONS Our contractual obligations affect our short- and long-term liquidity and capital resource needs. The table below provides aggregated information about the listed categories of our contractual obligations as of December 31, 2019. The table includes information about undiscounted future cash payments due under these contractual obligations, aggregated by type of contractual obligation, including the contractual maturity profile of our debt securities (other than debt securities of consolidated trusts held by third parties, STACR transactions, and SCR notes). The timing of actual future payments may differ from those presented due to a number of factors, including discretionary debt repurchases. The amounts of future interest payments on debt securities outstanding at December 31, 2019 are based on the contractual terms of our debt securities at that date. These amounts were determined using certain assumptions, including that variable-rate debt continues to accrue interest at the contractual rates in effect at December 31, 2019 until maturity and callable debt continues to accrue interest until its contractual maturity. Accordingly, the amounts presented in the table do not represent a forecast of our future cash interest payments or interest expense. Our contractual obligations include purchase obligations that are enforceable and legally binding, and exclude contracts that we may cancel without penalty. We include our purchase obligations through the termination date specified in the respective agreement, even if the contract is renewable. The table excludes certain obligations that could significantly affect our short- and long-term liquidity and capital resource needs. These items, which are listed below, have generally been excluded because the amount and timing of the related future cash payments are uncertain: n Future payments of principal and interest related to debt securities of
consolidated trusts held by third parties because the amount and timing of
such payments are generally contingent upon the occurrence of future events
and are therefore uncertain. These payments generally include payments of
principal and interest we make to the holders of our guaranteed
mortgage-related securities in the event a loan underlying a security becomes
delinquent. We remove loans from pools underlying our securities in certain
circumstances, including when loans are 120 days or more delinquent, and
retire the associated debt securities of consolidated trusts;
n Future payments of principal and interest related to STACR transactions and
SCR notes, as well as payment of premiums related to ACIS transactions and
payments to support the interest due on STACR Trust notes, because the amount
and timing of such payments are contingent upon the occurrence of future
events on the reference pool of mortgage loans and are therefore uncertain;
n Future cash payments associated with the liquidation preference of the senior
preferred stock, the quarterly commitment fee (which has been suspended), and
dividends on the senior preferred stock;
n Future cash settlements on derivative agreements not yet accrued, because the
amount and timing of such payments are dependent upon items such as changes
in interest rates; n Future dividends on outstanding preferred stock (other than the senior
preferred stock), because dividends on these securities are non-cumulative
and because we are currently prohibited from paying dividends on these securities; and n The guarantee payments and commitments to advance funds pertaining to off-balance sheet arrangements. Table 74 - Contractual Obligations (In millions) Total 2020 2021 2022 2023 2024 Thereafter Other long-term debt(1) $156,381 $45,133 $30,069 $23,185 $13,413 $26,966 $17,615 Other short-term debt(1) 111,080 111,080 - - - - - Interest payable(2) 20,933 10,066 2,345 1,828 1,461 1,159 4,074 Other contractual liabilities reflected on our consolidated balance sheets(3) 3,243 2,550 386 94 8 9 196 Purchase obligations: Purchase commitments(4) 47,381 44,559 1,128 1,315 379 - - Other purchase obligations(5) 380 170 96 56 29 20 9 Lease obligations 93 17 13 10 8 8 37 Total specified contractual obligations $339,491 $213,575 $34,037 $26,488 $15,298 $28,162 $21,931
(1) Represents par value. Callable debt is included in this table at its
contractual maturity. For additional information about our debt, see Note 8.
(2) Includes estimated future interest payments on our short-term and long-term
debt securities as well as the accrual of periodic cash settlements of
derivatives, netted by counterparty. Also includes accrued interest payable
recorded on our consolidated balance sheet.
(3) Includes (i) obligations related to our qualified and non-qualified defined
contribution plans, retiree medical plan, and other benefit plans; (ii)
future cash payments due under our contractual obligations to make delayed
equity contributions to LIHTC partnerships; and (iii) payables to the
consolidated trusts established for the administration of cash remittances
received related to the underlying assets of Freddie Mac mortgage-related
securities. (4) Purchase commitments represent our obligations to purchase loans and
mortgage-related securities from third parties, most of which are accounted
for as derivatives in accordance with the accounting guidance for derivatives and hedging. Future cash payments for certain purchase commitments are based on the contractual maturity date. (5) Primarily includes unconditional purchase obligations that are legally binding and that are subject to a cancellation penalty. FREDDIE MAC | 2019 Form 10-K 133
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Management's Discussion and Analysis Off-Balance Sheet Arrangements
OFF-BALANCE SHEET ARRANGEMENTS We enter into certain business arrangements that are not recorded on our consolidated balance sheets or that may be recorded in amounts that differ from the full contract or notional amount of the transaction and that may expose us to potential losses in excess of the amounts recorded on our consolidated balance sheets. See Note 3 and Note 5 for more information on our off-balance sheet securitization and guarantee activities. Securitization Activities and Other Guarantees We have certain off-balance sheet arrangements related to our securitization activities involving guaranteed loans and mortgage-related securities, though most of our securitization activities are on-balance sheet. Our off-balance sheet arrangements related to these securitization activities primarily consist of K Certificates and SB Certificates. We also have off-balance sheet arrangements related to certain other securitization products and other mortgage-related guarantees. Our maximum potential off-balance sheet exposure to credit losses relating to these securitization activities and guarantees is primarily represented by the UPB of the underlying loans and securities, which was $296.5 billion and $254.9 billion at December 31, 2019 and December 31, 2018, respectively. The amount as of December 31, 2019 excludes Fannie Mae securities backing Freddie Mac resecuritization products discussed below. With the implementation of the Single Security Initiative, we now have the ability to commingle TBA-eligible Fannie Mae collateral in certain of our resecuritization products. When we resecuritize Fannie Mae securities in our commingled resecuritization products, our guarantee covers timely payments of principal and interest on such securities. Accordingly, commingling Fannie Mae collateral in our resecuritization transactions increases our off-balance sheet exposure as we do not have control over the Fannie Mae collateral. As of December 31, 2019, the total amount of our off-balance sheet exposure related to Fannie Mae securities backing Freddie Mac resecuritization products was approximately $27.4 billion. We expect this exposure to increase over time. As part of the guarantee arrangements pertaining to certain multifamily housing revenue bonds and securities backed by multifamily housing revenue bonds, we provided commitments to advance funds, commonly referred to as "liquidity guarantees," which were $5.5 billion and $6.7 billion at December 31, 2019 and December 31, 2018, respectively. These guarantees require us to advance funds to third parties that enable them to repurchase tendered bonds or securities that are unable to be remarketed. At both December 31, 2019 and December 31, 2018, there were no liquidity guarantee advances outstanding. Our exposure to losses on the transactions described above would be partially mitigated by the recovery we would receive through exercising our rights to the collateral backing the underlying loans and the available credit enhancements. In addition, we provide for incurred losses each period on these guarantees within our provision for credit losses. Other Agreements We own interests in numerous entities that are considered to be VIEs for which we are not the primary beneficiary and which we do not consolidate in accordance with the accounting guidance for the consolidation of VIEs. These VIEs relate primarily to our investment activity in mortgage-related assets. Our consolidated balance sheets reflect only our investment in the VIEs, rather than the full amount of the VIEs' assets and liabilities. As part of our credit guarantee business, we routinely enter into forward purchase and sale commitments for loans and mortgage-related securities. Some of these commitments are accounted for as derivatives. Their fair values are reported as either derivative assets, net or derivative liabilities, net on our consolidated balance sheets. For more information, see Risk Management - Counterparty Credit Risk - Financial Intermediaries, Clearinghouses, and Other Counterparties -Derivative Counterparties and Note 9. We also enter into purchase commitments primarily related to future guarantor swap transactions for single-family loans, and, to a lesser extent, index lock commitments and commitments to purchase or guarantee multifamily loans. These non-derivative commitments totaled $450.1 billion and $382.1 billion in notional value at December 31, 2019 and December 31, 2018, respectively. In connection with the execution of the Purchase Agreement, we, through FHFA, in its capacity as Conservator, issued a warrant to Treasury to purchase 79.9% of our common stock outstanding on a fully diluted basis on the date of exercise. See Note 11 for further information.
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Management's Discussion and Analysis Critical Accounting Policies and Estimates
CRITICAL ACCOUNTING POLICIES AND ESTIMATES The preparation of financial statements in accordance with GAAP requires us to make a number of judgments, estimates, and assumptions that affect the reported amounts within our consolidated financial statements. 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 require management to make 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. Our critical accounting policies and estimates relate to the single-family allowance for loan losses and fair value measurements. For additional information about our critical accounting policies and estimates and other significant accounting policies, as well as recently issued accounting guidance, see Note 1. Single-Family Allowance for Loan Losses The single-family allowance for loan losses represents an estimate of probable incurred credit losses. The single-family allowance for loan losses pertains to all single-family loans classified as held-for-investment on our consolidated balance sheets. Determining the appropriateness of the single-family allowance for loan losses is a complex process that is subject to numerous estimates and assumptions requiring significant management judgment about matters that involve a high degree of subjectivity. This process involves the use of models that require us to make judgments about matters that are difficult to predict, the most significant of which are the probability of default, prepayment, and loss severity. We regularly evaluate the underlying estimates and models we use when determining the single-family allowance for loan losses and update our assumptions to reflect our historical experience and current view of economic factors. See Risk Factors - Operational Risks - We face risks and uncertainties associated with the models that we use to inform business and risk management decisions and for financial accounting and reporting purposes. We believe the level of our single-family allowance for loan losses is appropriate based on internal reviews of the factors and methodologies used. No single statistic or measurement determines the appropriateness of the allowance for loan losses. Changes in one or more of the estimates or assumptions used to calculate the single-family allowance for loan losses could have a material impact on the allowance for loan losses and provision for credit losses. Most single-family loans are aggregated into pools based on similar risk characteristics and measured collectively using a statistically based model that evaluates a variety of factors affecting collectability, including but not limited to current LTV ratios, trends in home prices, loan product type, delinquency/default status and history, and geographic location. Inputs used by the model are regularly updated for changes in the underlying data, assumptions, and market conditions. We review the output of this model by considering qualitative factors such as macroeconomic and other factors to see whether the model outputs are consistent with our expectations. Management adjustments may be necessary to take into consideration external factors and current economic events that have occurred but that are not yet reflected in the factors used to derive the model outputs. Significant judgment is exercised in making these adjustments. Some examples of the qualitative factors considered include: n Regional housing trends;
n Applicable home price indices;
n Unemployment and employment dislocation trends;
n The effects of changes in government policies and programs;
n Industry trends; n Consumer credit statistics;
n Third-party credit enhancements; and
n Natural disasters (such as hurricanes and wildfires).
The inability to realize the benefits of our loss mitigation activities, a lower realized rate of seller/servicer repurchases, declines in home prices, deterioration in the financial condition of our mortgage insurers, or increases in delinquency rates would cause our losses to be significantly higher than those currently estimated. Individually impaired single-family loans include loans that have undergone a TDR and are measured for impairment as the excess of our recorded investment in the loan over the present value of the expected future cash flows. Our expectation of future cash flows incorporates many of the judgments indicated above. FREDDIE MAC | 2019 Form 10-K 135
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Management's Discussion and Analysis Critical Accounting Policies and Estimates
Fair Value Measurements We use fair value measurements for the initial recording of certain assets and liabilities and periodic remeasurement of certain assets and liabilities on a recurring or non-recurring basis. Assets and liabilities within our consolidated financial statements measured at fair value include: n Mortgage-related and non-mortgage related securities;
n Certain loans held-for-sale;
n Derivative instruments; and
n Certain debt securities of consolidated trusts held by third parties and
certain other debt.
The accounting guidance for fair value measurements establishes a framework for measuring fair value, and also establishes a three-level fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value based on the assumptions a market participant would use at the measurement date. Fair value measurements under this hierarchy are distinguished among quoted market prices, observable inputs, and unobservable inputs. The measurement of fair value requires management to make judgments and assumptions. The process for determining fair value using unobservable inputs is generally more subjective and involves a higher degree of management judgment and assumptions than the measurement of fair value using observable inputs. These judgments and assumptions may have a significant effect on our measurements of fair value, and the use of different judgments and assumptions, as well as changes in market conditions, could have a material effect on our consolidated statements of comprehensive income and consolidated balance sheets. See Note 15 for additional information regarding fair value hierarchy and measurements, valuation risk, and controls over fair value measurement.
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Risk Factors Conservatorship and Related Matters
Risk Factors The following section discusses material risks and uncertainties that could adversely affect our business, financial condition, results of operations, cash flows, reputation, strategies, and/or prospects. CONSERVATORSHIP AND RELATED MATTERS Freddie Mac's future is uncertain. It is possible and perhaps likely that future legislative or regulatory action will materially affect our role in the mortgage industry, business model, structure, and 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 occur, our shares could further diminish in value, or cease to have any value. Our stockholders may not receive any compensation for such loss in value. Several bills have been introduced in past sessions of Congress concerning the future status of Freddie Mac, Fannie Mae, and the mortgage finance system, including bills which provided for the wind down of Freddie Mac and Fannie Mae, modification of the terms of the Purchase Agreement, or an increase in CRT transactions. While none of these bills has been enacted, it is likely that similar or new bills will be introduced and considered in the future. In addition, in September 2019, Treasury released a plan to reform the housing finance system, which includes recommended legislative and administrative reforms that would advance the reform goals outlined in the presidential memorandum issued in March 2019, including ending the conservatorships of Freddie Mac and Fannie Mae, facilitating competition in the housing finance system, establishing regulation of the GSEs that safeguards their safety and soundness and minimizes the risks they pose to financial stability, and providing that the federal government is properly compensated for any explicit or implicit support it provides to the GSEs or the secondary housing finance market. It is possible that the Administration could take steps, even in the absence of legislative action, to implement certain aspects of such a plan. The conservatorship is indefinite in duration. The timing, likelihood, and circumstances under which we might emerge from conservatorship are uncertain. Under the Purchase Agreement, Treasury would be required to consent to the termination of the conservatorship, except in connection with receivership, and there can be no assurance it would do so. Even if the conservatorship is terminated, we would remain subject to the Purchase Agreement and the terms of the senior preferred stock. It is possible that the conservatorship could end with our being placed into receivership. Because Treasury holds a warrant to acquire nearly 80% of our common stock for nominal consideration, we could effectively remain under the control of the U.S. government even if the conservatorship ends and the voting rights of common stockholders are restored. If Treasury exercises the warrant, the ownership interest of our existing common stockholders will be substantially diluted. In the past several years, numerous lawsuits have been filed against the U.S. government, Freddie Mac, and Fannie Mae challenging certain government actions related to the conservatorship and the Purchase Agreement. These lawsuits may add to the uncertainty surrounding our future. For more information, see MD&A - Regulation and Supervision - Legislative and Regulatory Developments, Legal Proceedings and Note 16. FHFA and the Administration have announced that ending the conservatorships of Freddie Mac and Fannie Mae is one of their goals for housing finance reform. It remains uncertain whether or when, and the terms under which, we may exit from conservatorship. We continue to take steps to help prepare Freddie Mac for a potential exit from conservatorship. We continue to increase our capital level as a result of the increase in the applicable Capital Reserve Amount under the Purchase Agreement to $20.0 billion. However, the increases in our capital level since September 30, 2019 pursuant to the September 2019 Letter Agreement have been or will be added to the aggregate liquidation preference of the senior preferred stock. In addition, in order to raise a sufficient level of capital, the applicable Capital Reserve Amount will need to be further increased or the terms of the senior preferred stock will need to be otherwise amended to allow us to retain and/or raise capital through equity offerings. It is uncertain whether or when we will be able to retain or raise sufficient capital for FHFA to end our conservatorship, and this may not happen for several years or at all. It is also uncertain whether our level of capital will be the only factor FHFA considers in deciding whether or when to end our conservatorship. If we were to exit from conservatorship, our post-conservatorship capital, legal, and governance structure and the terms of our exit are unclear. In order to build sufficient capital, we may need to raise private capital through the issuance of new equity securities. The terms of any new securities offered, such as any new classes of preferred stock, could be onerous and could adversely affect long-term profitability. It may not be possible for us to raise private capital on acceptable terms, if at all, and may be particularly challenging so long as the senior preferred stock and warrant held by Treasury remain outstanding. In addition, actions taken by Treasury with respect to the senior preferred stock or exercise of the warrant could adversely affect
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Risk Factors Conservatorship and Related Matters
our ability to raise capital. Treasury's imposition of a commitment fee for its ongoing support of our business could adversely affect our profitability and ability to raise private capital. Further, actions taken by FHFA, the Administration, or Congress, pursuant to the Treasury Housing Reform Plan or otherwise, could change or limit our business activities, operations, or competitive landscape, which could adversely affect our business or financial results and render us a less attractive investment opportunity. We cannot retain capital from the earnings generated by our business operations in excess of the applicable Capital Reserve Amount under the Purchase Agreement, which could result in our having to request additional draws from Treasury in future periods. As a result of the net worth sweep dividend requirement, we cannot retain capital from the earnings generated by our business operations in excess of the applicable Capital Reserve Amount, which is currently $20.0 billion. If for any reason we were not to pay our dividend requirement on the senior preferred stock in full in any future period, the applicable Capital Reserve Amount would thereafter be zero, and we would not be able to retain any capital from the earnings generated by our business. While in conservatorship, dividends we pay to Treasury are declared by, and paid at the direction of, the Conservator, acting as successor to the rights, titles, powers, and privileges of the Board. Our inability to build and retain capital in excess of the applicable Capital Reserve Amount could cause us to require draws in future periods. A variety of factors could influence whether we could require a draw, including the following: n Deterioration of economic conditions, including increased levels of unemployment and declines in home prices or family incomes; n Adverse changes in interest rates, yield curves, implied volatility, or
market spreads, which could affect our financial assets and liabilities,
including derivatives, and increase realized and unrealized losses recorded
in earnings or AOCI;
n The success of any transactions or other steps we may take intended to help
reduce earnings variability and address some of the measurement differences
between our GAAP financial results and the underlying economics of our business, including the adoption of hedge accounting; n Limitations on the size of our mortgage-related investments portfolio,
reductions of higher yielding assets, or other limitations on our investment
activities that reduce our earnings capacity;
n Restrictions on our single-family guarantee activities that could reduce our
income from these activities;
n 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;
n Adverse changes in our liquidity, funding, or hedging costs or limitations on
our access to public debt markets; n A failure of one or more of our major counterparties to meet their obligations to us;
n The effects of our loss mitigation efforts and foreclosure and REO activities;
n Changes in accounting policies, practices, or guidance (e.g., our adoption of
CECL);
n The occurrence of a major natural or other disaster in areas in which our
offices or significant portions of our total mortgage portfolio are located;
or n Changes in business practices resulting from legislative and regulatory developments or direction from our Conservator. Additional draws, which will increase the already substantial liquidation preference of our senior preferred stock and decrease the amount of Treasury's remaining commitment under the Purchase Agreement, may add to the uncertainty regarding our long-term financial sustainability. FHFA, as our Conservator, controls our business activities. We may be required to take actions that reduce our profitability, are difficult to implement, or expose us to additional risk. We are under the control of FHFA, as our Conservator, and are not managed to maximize stockholder returns. FHFA determines our strategic direction. We face a variety of different, and sometimes competing, business objectives and FHFA-mandated activities, such as the initiatives we are pursuing under the Conservatorship Scorecards. Some of the activities FHFA has required us to undertake have been costly and difficult to implement, such as our support of the CSP. FHFA has required us to make changes to our business that have adversely affected our financial results and could require us to make additional changes at any time. For example, FHFA may require us to undertake activities that: n Reduce our profitability; n Expose us to additional credit, market, funding, operational, and other risks; or
n Provide additional support for the mortgage market that serves our public
mission, but adversely affects our financial results. FREDDIE MAC | 2019 Form 10-K 138
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Risk Factors Conservatorship and Related Matters
FHFA also has required us to take other actions that may adversely affect our business or financial results, such as directing us to amend the CSS LLC agreement in January 2020. These amendments, which expanded the size of the CSS Board and removed the requirement that any CSS Board decision must be approved by at least one of the CSS Board members appointed by Freddie Mac, reduce our ability to control CSS Board decisions, even after conservatorship, including decisions about strategy, business operations, and funding. Under the revised CSS LLC agreement, the CSS Board will continue to include two Freddie Mac representatives and two Fannie Mae representatives, and it will also include two new members: the Chief Executive Officer of CSS and an independent, non-Executive Chair. During conservatorship, the CSS Board Chair will be designated by FHFA, and all CSS Board decisions will require the affirmative vote of the Board Chair. During conservatorship, FHFA also may appoint up to three additional independent members to the CSS Board, who along with the Board Chair and the Chief Executive Officer of CSS may continue to serve on the CSS Board after conservatorship. If FHFA appoints three additional CSS Board members, the CSS Board members we and Fannie Mae appoint could be outvoted by non-GSE designated Board members on any matter during conservatorship and on a number of significant matters, including approval of the annual budget and strategic plan for CSS (so long as they do not involve a material business change or involve capital contributions beyond those necessary to support CSS's ordinary business operations), if either we or Fannie Mae exits from conservatorship. It is possible that FHFA may require us to make additional changes to the CSS LLC agreement, or may otherwise impose restrictions or provisions relating to CSS or the UMBS, that may adversely affect us. From time to time, FHFA has prevented us from engaging in business activities or transactions that we believe would be profitable, and it may do so again in the future. For example, FHFA could further limit the size of our mortgage-related investments portfolio or the amount of new multifamily business we may obtain, or it could establish limits on our single-family business. Due to the reduced earnings capacity of our mortgage-related investments portfolio, we are placing greater emphasis on our guarantee activities to generate revenue. However, our ability to do so may be limited for several reasons. We may be required to adopt business practices that help serve our public mission and other non-financial objectives, but that may negatively affect our future financial results. Congress or FHFA may require us to set aside or otherwise pay monies to fund third-party initiatives, such as the existing requirement under the GSE Act that we allocate amounts for certain housing funds. 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. The Purchase Agreement and the terms of the senior preferred stock significantly limit our business activities. The Purchase Agreement and the terms of the senior preferred stock place significant restrictions on our ability to manage our business, including limiting: n The amount of indebtedness we may incur;
n The size of our mortgage-related investments portfolio; and
n Our ability to pay dividends, transfer certain assets, raise capital, and pay
down the liquidation preference of the senior preferred stock.
The limitation on the size of our mortgage-related investments portfolio, as required by the Purchase Agreement and FHFA, and other limitations on our investment activity, including significant constraints on our ability to purchase or sell mortgage assets, will reduce the earnings capacity of our mortgage-related investments portfolio. The cap on our mortgage-related investments portfolio may, at times, force us to sell mortgage assets at unattractive prices. There can be no assurance that our current strategies will not have an adverse impact on our business or financial results. For more information, see MD&A - Conservatorship and Related Matters - Limits on Our Mortgage-Related Investments Portfolio and Indebtedness. The Purchase Agreement prohibits us from taking a variety of actions without Treasury's consent. Treasury has the right to withhold its consent for any reason. The warrant held by Treasury, the restrictions on our business under the Purchase Agreement, and the senior status and net worth sweep dividend provisions of the senior preferred stock could adversely affect our ability to attract capital from the private sector in the future, should we be in a position to do so. If FHFA placed us into receivership, our assets would be liquidated. The liquidation proceeds might not be sufficient to pay claims outstanding against Freddie Mac, repay the liquidation preference of our preferred stock, or make any distribution to our common stockholders. We can be put into receivership at the discretion of the Director of FHFA at any time for a number of reasons set forth in the GSE Act. Several bills considered by Congress in the past several years provided for Freddie Mac to be placed into receivership. In addition, FHFA could be required to place us into receivership if Treasury were 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 not fully operational because Congress had failed to approve funding or the government had reached its borrowing limit. For more information, see MD&A - Regulation and Supervision - Federal Housing Finance Agency - Receivership. Being placed into receivership would terminate the conservatorship. The purpose of receivership is to liquidate our assets and resolve claims against us. The appointment of FHFA as our receiver would terminate all rights and claims that our stockholders FREDDIE MAC | 2019 Form 10-K 139
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Risk Factors Conservatorship and Related Matters
and creditors might have against our assets or under our Charter as a result of their status as stockholders or creditors, other than possible payment upon our liquidation. The GSE Act provides that, if we were placed into receivership, the receiver would hold the mortgages underlying our mortgage-related securities (and the payments thereon) for the benefit of the holders of those securities. However, payments on the mortgages underlying our mortgage-related securities might not be sufficient to make full payments of principal and interest on the securities. In that event, if we were unable to fulfill our guarantee, the holders of our mortgage-related securities would experience delays in receiving payments on the securities because the relevant systems are not designed to make partial payments. If our assets were liquidated, the liquidation proceeds might not be sufficient to pay the secured and unsecured claims against us (including claims on our guarantees), repay the liquidation preference on any series of our preferred stock, or make any distribution to our common stockholders. Proceeds would first be applied to the secured and unsecured claims against the company, the administrative expenses of the receiver, and the liquidation preference of the senior preferred stock. Any remaining proceeds would then be available to repay the liquidation preference of other series of preferred stock. Only after the liquidation preference of all series of preferred stock is repaid would any proceeds be available for distribution to the holders of our common stock. Our business and results of operations may be materially adversely affected if we are unable to attract and retain well-qualified, talented employees across the company. The conservatorship, the uncertainty of our future, and limitations on our compensation structure may put us at a disadvantage compared to other companies in attracting and retaining employees. Our business is highly dependent on the talents and efforts of our employees. We face competition, particularly from the financial services and technology industries, for qualified talent. If we are unable to attract and retain talent, we increase our risk of operational failures. Restrictions on employee compensation have been and may be imposed on us, while we remain in conservatorship, by Congress, FHFA, or Treasury. For example, FHFA as Conservator has the authority to approve the terms and amount of our executive compensation and may require us to make changes to our executive compensation program. In August 2019, FHFA directed us to limit base salaries for all of our employees to $600,000, and in September 2019, FHFA directed us to obtain conservator approval for any compensation arrangements for newly hired employees where the proposed target total direct compensation is $600,000 or above, or any increase in target total direct compensation for existing employees where the proposed target total direct compensation is $600,000 or above. These limitations on our employee compensation structure, as well as the ongoing conservatorship and uncertainty about our future, could have an adverse effect on our ability to attract and retain talent. High-level departures, or a combination of such departures at approximately the same time, could materially adversely affect our business, results of operations, and financial condition. For example, turnover in key management positions and challenges in integrating new management could harm our ability to manage our business effectively and successfully implement our and FHFA's current strategic initiatives and could adversely affect our financial performance.
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Risk Factors Credit Risk CREDIT RISK We are subject to mortgage credit risk. Credit losses and costs related to this risk could adversely affect our financial results. Mortgage credit risk is the risk that a borrower will fail to make timely payments on a loan we own or guarantee. This exposes us to the risk of credit losses and credit-related expenses, which could adversely affect our financial results. We are primarily exposed to mortgage credit risk with respect to the single-family and multifamily loans and securities reflected as assets on our consolidated balance sheets. We are also exposed to mortgage credit risk with respect to guaranteed securities and guarantee arrangements that are not reflected as assets on our consolidated balance sheets, including K Certificates, SB Certificates, and certain senior subordinate securitization structures. We continue to have 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 to borrowers with credit scores less than 620 at the time of origination, that expose us to greater credit risk than other types of loans. See MD&A - Risk Management - Single-Family Mortgage Credit Risk - Monitoring Loan Performance and Characteristics. We also expect to continue acquiring loans with higher LTV ratios through our Home Possible initiatives, as well as loans with higher DTI ratios, generally up to 50%, which will increase our exposure to credit risk. Our efforts to increase eligible borrowers' access to single-family mortgage credit, including our affordable housing program and our plan for fulfilling our duty to serve underserved markets, expose us to increased mortgage credit risk. We face significant risks related to our delegated underwriting process for single-family loans, including risks related to data accuracy and mortgage fraud. Changes to the process could increase our risks. We delegate to our sellers the underwriting for the single-family loans we purchase or securitize. Our contracts with sellers describe mortgage eligibility and underwriting standards, and the sellers represent and warrant to us that the loans they deliver to us meet these standards. We do not independently verify most of the information provided to us before we purchase or securitize a loan. This exposes us to the risk that one or more of the parties involved in a transaction (such as the borrower, property seller, broker, appraiser, title agent, loan officer, or lender) misrepresented facts about the borrower, underlying property, or loan, or otherwise engaged in fraud. We review a sample of loans after we purchase them to determine if they comply with our contractual standards. However, our review may not detect any misrepresentations by the parties involved in the transaction, deter loan fraud, or reduce our exposure to these risks. We can exercise certain contractual remedies, including requiring repurchase of the loan, for loans that do not meet our standards. However, at the direction of FHFA, we have significantly revised our representation and warranty framework (including changes to remedies for certain defects) to relieve sellers of certain repurchase obligations in specific cases with respect to single-family loans. As a result, we may face greater exposure to credit and other losses under this revised framework, because our ability to seek recovery or repurchase from sellers is more limited and we must identify breaches of representations and warranties early in the life of the loan. Our suite of tools, collectively referred to as Loan Advisor, offers limited representation and warranty relief for certain loan components that satisfy automated data analytics related to appraisal quality, collateral valuation, borrower assets, and borrower income. In general, limited representation and warranty relief is offered when information provided by the lender is validated against independent data sources. However, there is a risk that the enhanced tools and processes provided by Loan Advisor will not enable us to identify all breaches in a timely manner. For more information, see MD&A - Risk Management - Single-Family Mortgage Credit Risk - Maintaining Prudent Underwriting Standards and Quality Control Practices and Managing Seller/Servicer Performance. Declines in national or regional home prices or other adverse changes in the housing market could negatively affect our business and financial results. Our financial results and business volumes can be negatively affected by declines in home prices and other adverse changes in the housing market. This could: n Reduce our return or result in losses on our single-family guarantee
business, as default rates could be higher than we expected when we issued
the guarantees; n Negatively affect loan pricing, which could cause us to change our disposition strategies for our single-family seasoned loans; or n Increase our losses on foreclosure alternatives, third-party sales, and dispositions of REO properties. For more information regarding these risks, see MD&A - Risk Management - Credit Risk. The proportion of our refinance loan purchases to total loan purchases could decrease if mortgage interest rates increase. This could increase our exposure to mortgage credit risk, as refinance loans (particularly those that do not involve "cash-out") generally present less credit risk than purchase loans. Some of our seller/servicer counterparties are highly dependent on
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Risk Factors Credit Risk
refinance loan volumes. A decrease in such volumes could adversely affect these counterparties, which could increase our exposure to counterparty credit risk. We are exposed to counterparty credit risk with respect to our business counterparties. Our financial results may be adversely affected if one or more of our counterparties fail to meet their contractual obligations to us. We depend on our institutional counterparties to provide services that are critical to our business. We face the risk that one or more of our counterparties may fail to meet their contractual obligations to us. Our major counterparties include seller/servicers, credit enhancement providers, and counterparties to derivatives, short-term lending, and other funding transactions (e.g., cash and other investments transactions). Many of our major counterparties provide several types of services to us. The concentration of our exposure to our counterparties remains high. Efforts we take to reduce exposure to financially weak counterparties could concentrate our exposure to other counterparties, increase our costs, and reduce our revenue. It is possible that our counterparties could experience challenging market conditions that could adversely affect their liquidity and financial condition and cause some of them to fail. Many of our counterparties are subject to increasingly complex regulatory requirements and oversight, which place additional stress on their resources and may affect their ability or willingness to do business with us. Credit risk related to single-family seller/servicers We are exposed to credit risk from the seller/servicers of our single-family loans, as described below. n A decline in servicing performance - A decline in a servicer's performance,
such as delayed foreclosures or missed opportunities for loan modifications,
could significantly affect our ability to mitigate credit losses and could
affect the overall credit performance of our single-family credit guarantee
portfolio. A large volume of seriously delinquent loans, the complexity of
the servicing function, and heightened liquidity requirements are significant
factors contributing to the risk of a decline in performance by servicers. We
could be adversely affected if our servicers lack appropriate controls,
experience a failure in their controls, or experience a disruption in their
ability to service loans, including as a result of legal or regulatory
actions or ratings downgrades. We also are exposed to fraud by third parties
in the loan servicing function, particularly with respect to short sales and
other dispositions of non-performing assets.
We could attempt to mitigate our exposure to a poorly performing servicer by terminating its right to service our loans; however, in a highly adverse economic environment, there could be a scarce capacity in the marketplace and we may not be able to find successor servicers who have the capacity to service the affected loans and who are also willing to assume the representations and warranties of the terminated servicer. In addition, terminating a large servicer may not be feasible because of the operational and capacity challenges related to transferring large servicing portfolios. There is also a possibility that the performance of some loans may degrade during the transition to new servicers. During a period of heightened delinquencies, we may incur costs and potential increases in servicing fees if we replace a servicer with a high concentration of loans in default which are more costly to service. We may also be exposed to concentrations of credit risk among certain servicers. n A failure by seller/servicers to fulfill their obligations to repurchase
loans or indemnify us as a result of breaches of representations and
warranties - While we may have the contractual right to require a seller or
servicer to repurchase loans from us, it may be difficult, expensive, and
time-consuming to enforce such repurchase obligations. We could enter into
settlements to resolve repurchase obligations; however, the amounts we
receive under any such settlements may be less than the losses we ultimately
incur on the underlying loans.
Under our representation and warranty framework, revised as directed by FHFA, we are required in some cases to utilize an alternative remedy, such as indemnification, in lieu of repurchase. The amount we recover under an alternative remedy may be less than the amount we could have recovered in a repurchase. n Increased exposure to non-depository and smaller financial institutions - A
large and increasing volume of our single-family loans is acquired from and
serviced by non-depository and smaller financial institutions. Some of these
institutions may not have the same financial strength or operational
capacity, or be subject to the same level of regulatory oversight, as large
depository institutions. As a result, we face increased risk that these
counterparties could fail to perform their obligations to us. In particular,
non-depository servicers rapidly grew their servicing portfolios in the last
several years. This appears to have resulted in operational strains that have
subjected some of these servicers to regulatory scrutiny. This rapid growth
could expose us to increased risks if any operational strain adversely
affects these servicers' servicing performance or their financial strength.
These institutions also service portfolios for other investors and guarantors
and operational issues related to those portfolios could affect the
performance of our portfolio. In addition, these servicers may not always
have ready access to appropriate sources of liquidity to finance their operations, particularly during periods when the mortgage market is experiencing a downturn. If these servicers reduce their servicing portfolios, overall servicing capacity may be constrained. 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 a decline in their servicing performance. We are also exposed to settlement risk on the non-performance of sellers and servicers as a result of our forward settlement
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Risk Factors Credit Risk
loan purchase programs in our single-family and multifamily businesses. For more information, see MD&A - Risk Management - Counterparty Credit Risk - Sellers and Servicers. Credit risk related to counterparties to derivatives, funding, short-term lending, securities, and other transactions We have significant exposure to institutions in the financial services industry relating to derivatives, funding, short-term lending, securities, and other transactions (e.g., cash and other investments transactions). These transactions are critical to our business, including our ability to: n Manage interest-rate risk and other risks related to our investments in
mortgage-related assets;
n Fund our business operations; and
n Service our customers.
We face the risk of operational failure of the clearing members, exchanges, clearinghouses, or other financial intermediaries we use to facilitate derivatives, short-term lending, securities, and other transactions. If a clearing member or clearinghouse were to fail, we could lose the collateral or margin posted with the clearing member or clearinghouse. We are a clearing member of the clearinghouses through which we execute mortgage-related and Treasury securities transactions. As a result, we could be subject to losses because we are required to participate in the coverage of losses incurred by other clearing members if they fail to meet their obligations to the clearinghouse. If our counterparties to short-term lending transactions fail, we are exposed to losses to the extent the transaction is unsecured or the collateral posted to us is insufficient. Certain of our derivatives counterparties and a major derivatives clearinghouse are based in the United Kingdom. If these entities are adversely affected by Brexit, this could affect their ability to do business with us, potentially resulting in further concentration of our exposure to other derivative counterparties, as well as reduced liquidity and increased costs in the derivatives market. For more information, see MD&A - Risk Management - Counterparty Credit Risk - Financial Intermediaries, Clearinghouses, and Other Counterparties - Other Counterparties. Credit risk related to credit enhancement providers It is unlikely that we will receive full payment of our claims from a few of the mortgage insurers of single-family loans that we purchased prior to 2009, as these insurers are insolvent or are paying only a portion of our claims under our mortgage insurance policies. For more information, see Note 14. If a mortgage insurer fails to meet its obligations to reimburse us for claims, our credit losses could increase. In addition, if a regulator determines that a mortgage insurer lacks 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. We face similar risks with respect to our counterparties on ACIS transactions. We cannot differentiate pricing based on the strength of a mortgage insurer or revoke a mortgage insurer's status as an eligible insurer without FHFA approval. In addition, we generally do not select the mortgage insurance provider on a specific loan because the selection is usually made by the lender at the time the loan is originated. As a result, we could acquire a concentration of risk to certain insurance providers. We continue to acquire new loans with mortgage insurance from mortgage insurers that have credit ratings below investment grade. For more information, see MD&A - Risk Management - Counterparty Credit Risk - Credit Enhancement Providers. Our loss mitigation activities may be unsuccessful or costly and may adversely affect our financial results. Our loss mitigation activities may not be successful. The costs we incur related to loan modifications and other loss mitigation activities have been, and could continue to be, significant. For example, we generally bear the full cost of the monthly payment reductions related to modifications of loans we own or guarantee, as well as all applicable servicer incentive fees for our mortgage modifications. We could be required to make changes to our loss mitigation activities that could make these activities more costly to us. FHFA, as Conservator, may continue to issue directives and Advisory Bulletins to assist borrowers and align servicing practices for the GSEs. These directives could make these activities more costly to us, especially with regard to loan modification initiatives. FHFA may continue to issue these directives for a variety of reasons, including consumer relief and alignment of the prepayment behavior of our and Fannie Mae's respective UMBS. We have loans on trial period plans as required under certain loan modification programs. Some of these loans will fail to complete the trial period or fail to qualify for our other borrower assistance programs. For these loans, the trial period will have effectively delayed the foreclosure process and could increase our costs. Many of our HAMP loans, which initially were set at a below-market interest rate, have provisions for the interest rates to increase gradually until they reach the market rate that was in effect at the time of the modification. The resulting increase in the FREDDIE MAC | 2019 Form 10-K 143
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Risk Factors Credit Risk
borrowers' payments may increase the risk that these borrowers will default. The type of loss mitigation activities we pursue could affect prepayments on our UMBS, 55-day MBS, PCs, and REMICs, which could affect the value of these securities or the earnings from mortgage-related assets in our Capital Markets segment mortgage investments portfolio. In addition, loss mitigation activities may adversely affect our ability to securitize, resecuritize, and sell the loans subject to those activities. We devote significant resources to our borrower assistance initiatives. The size and scope of these efforts may compete with other business opportunities or corporate initiatives. For more information on our loss mitigation activities, see MD&A - Our Business Segments - Single-Family Guarantee - - Business Results - Loss Mitigation Activities and MD&A - Risk Management - Single-Family Mortgage Credit Risk - Engaging in Loss Mitigation Activities. We have been, and will continue to be, adversely affected by delays and deficiencies in the single-family foreclosure process. The average length of time for foreclosure of a Freddie Mac loan has significantly increased since 2008, particularly in states that require a judicial foreclosure process, and may further increase. Delays in the foreclosure process could: n Cause our expenses to increase. For example, properties awaiting foreclosure
could deteriorate until we acquire them, resulting in increased expenses to
repair and maintain the properties and
n Adversely affect trends in home prices regionally or nationally, which could
adversely affect our financial results.
We are exposed to increased credit losses and credit related expenses in the event of a major natural disaster, other catastrophic event, or significant climate change effects. The occurrence of a major natural or environmental disaster or similar catastrophic event, as well as significant climate change effects such as rising sea levels or wildfires, in an area where we own or guarantee mortgage loans or REO properties, especially in densely populated geographic areas, could increase our credit losses and credit related expenses. A natural disaster or catastrophic event or other significant climate change effect that either damages or destroys residential or multifamily real estate underlying mortgage loans or REO properties we own or guarantee, or negatively affects the ability of borrowers 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 areas. Such events could have a material adverse effect on our business and financial results. We may not have adequate insurance coverage for some of these natural, catastrophic, or climate change-related events. Our CRT transactions may not be available to us in adverse economic conditions. These transactions also lower our profitability. We are increasingly using CRT transactions to mitigate some of our potential credit losses. Our ability to transfer credit risk (and the cost to us of doing so) could change rapidly depending on market conditions. In particular, it is possible that there will not be sufficient investor demand for CRT transactions at acceptable prices during a housing downturn. Some of our CRT transactions are new, and it is uncertain if there will be adequate demand for them over the long term. Some of these transactions use structures that have not yet been tested in adverse market conditions. It is possible that, under such conditions, they will provide less protection than we expect, and they may not prevent us from incurring substantial losses. Most of these transactions have termination dates that are earlier than the maturities of the related loans, and losses on the loans occurring beyond the terms of the transactions are not covered. The costs associated with these transactions are significant and may increase. For many of these transactions, there could be a significant difference in time between when we recognize a credit loss in earnings and when we recognize the related recovery in earnings, and this lag could adversely affect our financial results in the earlier period. For more information regarding these transactions, see Note 4. FREDDIE MAC | 2019 Form 10-K 144
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Risk Factors Market Risk MARKET RISK Changes in interest rates could negatively affect the fair value of financial assets and liabilities, our results of operations, and our net worth. Our financial results can be significantly affected by changes in interest rates. Interest rates can fluctuate for many reasons, including changes in the fiscal and monetary policies of the federal government and its agencies as well as geopolitical events or changes in general economic conditions. Changes in interest rates could adversely affect the cash flows and prepayment rates on assets that we own and related debt and derivatives. In addition, changes in interest rates could adversely affect the prepayment rate or default rate on the loans that we guarantee. For example: n When interest rates decrease, borrowers are more likely to prepay their loans
by refinancing them at a lower rate. An increased likelihood of prepayment on
the loans underlying our mortgage-related securities may adversely affect the
value of these securities.
n When interest rates increase:
l Borrowers with higher risk adjustable-rate loans may have fewer opportunities to refinance into fixed-rate loans and
l A borrower's payments on loans with adjustable payment terms, including
any additional debt obligations (such as home equity lines of credit and second liens) with such terms, may increase, which in turn increases the risk that the borrower may default on a loan we own or guarantee. Additionally, we issue callable debt instruments to manage the duration and prepayment risk of expected cash flows of the mortgage assets we own. We may exercise the option to repay the outstanding principal balance when interest rates decrease. However, we may replace the called debt at a higher spread rate due to the market conditions at that time. In the event we decide not to call our debt, we may incur higher hedging costs. We incur costs to manage these risks, which may not be successful. Our interest-rate risk management activities are designed to reduce our economic exposure to changes in interest rates to a low level as measured by our models. However, the accounting treatment for certain of our assets and liabilities, including derivatives, creates variability in our earnings when interest rates fluctuate, as some assets and liabilities are measured at amortized cost and some are measured at fair value, while all derivatives are measured at fair value. This variability generally is not indicative of the underlying economics of our business. We use hedge accounting for certain single-family mortgage loans and long-term debt, which is intended to reduce the interest-rate volatility in our GAAP earnings. Our single-family mortgage hedge accounting program is complex and unique in the industry. We may fail to properly implement this program and related changes to systems and processes. Even if implemented properly, our hedge accounting programs may not be effective in reducing earnings volatility, and our hedges may fail in any given future period, which could expose us to significant earnings variability in that period. In addition, changes in fair value of the hedged item related to discontinued fair value hedges that we have recognized on our consolidated balance sheet are amortized into earnings over the contractual life of the associated asset or liability and may adversely affect our earnings in future periods. Changes in market spreads could negatively affect the fair value of financial assets and liabilities, our results of operations, and net worth. 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 market spreads (also referred to as OAS). Our financial results and net worth can be significantly affected by changes in market spreads, especially results driven by financial instruments that are measured at fair value. These instruments include trading securities, available-for-sale securities, derivatives, loans held-for-sale, and loans and debt with the fair value option elected. A widening of the market spreads on a given asset is typically associated with a decline in the fair value of that asset, which may adversely affect our near-term financial results and net worth. While wider market spreads may create favorable investment opportunities, our ability to take advantage of any such opportunities is limited due to various restrictions on our mortgage-related investments portfolio activities. See MD&A - Conservatorship and Related Matters - Limits on Our Mortgage-Related Investments Portfolio and Indebtedness. A narrowing or tightening of the market spreads on a given asset is typically associated with an increase in the fair value of that asset. Narrowing market spreads may reduce the number of attractive investment opportunities and could increase the cost of our activities to support the liquidity and price performance of our UMBS and other securities. Consequently, a tightening of the market spreads on our assets may adversely affect our future financial results and net worth. Changes in market spreads also affect the fair value of our debt with the fair value option elected. A narrowing or tightening of the market spreads on a given liability is typically associated with an increase in the fair value of that liability, which is recognized as a loss by us.
FREDDIE MAC | 2019 Form 10-K 145
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Risk Factors Market Risk The discontinuance of LIBOR after 2021, or before the end of 2021 if LIBOR is deemed unreliable, could negatively affect the fair value of our financial assets and liabilities, results of operations, and net worth. A transition to an alternative reference interest rate could present operational problems, subject us to increased litigation risk, and result in market disruption. We may be unable to take a consistent approach across our financial products. We are not able to predict whether LIBOR will actually cease to exist after 2021, whether SOFR will become the market-accepted benchmark in its place, or what impact such a transition may have on our business, results of operations, and financial condition. The transition from LIBOR could affect the financial performance of instruments we hold, require changes to hedging strategies, and adversely affect our financial performance. We have various financial products, including mortgage loans, mortgage-related securities, other debt securities, and derivatives, that are tied to LIBOR, and we continue to enter into transactions involving many of these products that will mature after 2021. While the documentation for certain of these products provides us with discretion to select an alternative reference rate if LIBOR is discontinued, there is a possibility of disputes arising with investors and counterparties concerning our exercise of this discretion. In certain cases, the documentation may not provide us with discretion to select an alternative reference rate if LIBOR is discontinued or our discretion may be limited, creating uncertainty and the risk of legal disputes. These potential challenges in implementing alternative reference rates could result in investors and counterparties acquiring fewer products and entering into fewer transactions, which could adversely affect our business. The large volume of products and transactions that may require changes to documentation or remediation could present substantial operational and legal challenges and result in significant costs. We may be unable to have a consistent approach to a LIBOR transition, including within a particular class of products, which could disrupt the market for that product. It is possible that actions we take in connection with the discontinuance of LIBOR, including the adoption of an alternative reference rate for certain products, could subject us to basis risk, monetary losses, and possible litigation. The use of SOFR as the alternative reference rate for LIBOR-based products currently presents certain market concerns. Among the concerns, a term structure for SOFR has not yet been developed and there is not yet a generally accepted methodology for adjusting SOFR so that it will be substantially comparable to LIBOR. SOFR represents an overnight, risk-free rate, whereas LIBOR has various tenors and reflects a credit risk component. There is no guarantee that a market-accepted term structure for SOFR will exist prior to any discontinuance of LIBOR. In addition, recent volatility in the SOFR index has raised concerns among certain market participants about the transition to SOFR as an alternative reference rate. It is uncertain what other rates might be appropriate to use and how soon widespread market adoption of SOFR will occur. Although the majority of the single-family ARMs and multifamily floating-rate loans that we currently purchase is tied to LIBOR, we also currently purchase single-family ARMs tied to constant maturity Treasury indices published by the Federal Reserve Board. On February 5, 2020, we announced that we will cease purchasing single-family ARMs and multifamily floating-rate loans tied to LIBOR in 4Q 2020, and we announced our intention to develop a plan to cease purchasing single-family ARMs tied to constant maturity Treasury indices, which we anticipate will be implemented in 2021 upon guidance from FHFA. It is uncertain how long it will take affected market participants to develop the systems and processes necessary to originate and sell ARMs and floating-rate loans tied to SOFR or any other new indices that may be developed, which may cause a reduction in our purchase of single-family ARMs and multifamily floating-rate loans after these changes are implemented. Inconsistent approaches to a transition from LIBOR to an alternative rate among different market participants and for different financial products may cause market disruption and operational problems, which could adversely affect us, including by exposing us to increased basis risk and resulting in increased costs in connection with our hedging and other business activities. As described above, we have identified material exposures to LIBOR but cannot reasonably estimate the expected impact of such exposure. For additional information regarding the actions we have taken to prepare for an orderly transition from LIBOR, see MD&A - Risk Management - Market Risk - Transition from LIBOR. FREDDIE MAC | 2019 Form 10-K 146
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Risk Factors Operational Risks
OPERATIONAL RISKS 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 size and complexity of our business operations, the amount of change to our core systems required to keep pace with regulatory and other requirements and business initiatives, and the ever-changing cybersecurity landscape. Shortcomings or failures in our internal processes, people, or systems, or those of third parties with which we interact, could lead to impairment of our liquidity, disruption of our business (e.g., issuing mortgage and/or debt securities), incorrect payments to investors in our securities, errors in our financial statements, liability to customers or investors, further legislative or regulatory intervention, reputational damage, and financial and economic loss. 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. This information may be incorrect, or we may fail to properly manage or analyze it. The transactions we process are complex and are subject to various legal, accounting, and regulatory standards, which 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 contain design flaws or may fail to operate properly, adversely affecting our ability to process these transactions, including our ability to compile and process legally required information. We have certain systems that require manual support and intervention, which may lead to heightened risk of system failures. 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 improve existing business activities. Our technological connections with our customers, counterparties, service providers, and other financial institutions continue to increase, which increases our risk exposure with respect to an operational failure of their infrastructure systems. We have developed, and expect to continue to develop, software tools for use by our customers in the customers' loan production and other processes. These tools may fail to operate properly, which could disrupt our or our customers' business and adversely affect our relationships with our customers. We are in the process of migrating a number of our core information technology and other systems and customer-facing applications to a third-party cloud infrastructure platform. If we do not execute the transition to these new environments in a well-managed, secure, and effective manner, we may experience unplanned service disruption or unforeseen costs which may harm our business and operating results. In addition, our cloud infrastructure providers, or other service providers, could experience system breakdowns or failures, outages, downtime, cyber-attacks, adverse changes to financial condition, bankruptcy, or other adverse conditions, which could have a material adverse effect on our business and reputation. Thus, our plans to increase the amount of our infrastructure that we outsource to the cloud or to other third parties may increase our risk exposure. We face increased operational risk due to the magnitude and complexity of the new initiatives we are undertaking, including our efforts to help build a better 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 create increased operational risk for these new initiatives. Internal corporate reorganizations, such as the VERP, may also increase our operational risk, particularly during the period of implementation. We also face significant risks related to CSS and the operation and continued development of the CSP. We rely on CSS and the CSP (which is owned and operated by CSS) for the operation of our single-family securitization activities. Our business activities would be adversely affected and the market for Freddie Mac securities would be disrupted if the CSP were to fail or otherwise become unavailable to us or if CSS were unable to perform its obligations to us, including as a result of an operational failure by Fannie Mae. In the event of a CSS operational failure, we may be unable to issue certain new single-family mortgage-related securities, and investors in mortgage-related securities hosted on the CSS platform may experience payment delays. Any measures we could take to mitigate these risks might not be sufficient to prevent our business from being harmed. We update our internal systems and processes on a regular basis, including to improve existing processes and respond to market and regulatory developments. We could be adversely affected if CSS and/or the CSP are unable to make any necessary corresponding changes to their systems and processes in a timely manner. Our employees could act improperly for their own or third-party gain and cause unexpected losses or reputational damage. While we have processes and systems in place designed to prevent and detect fraud, these processes may not 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, an infrastructure disruption in or around our offices or affecting the power grid, such as from a terrorist event, active shooter, or natural disaster, could significantly adversely affect our ability to conduct normal business operations. Any measures we take to mitigate this risk may not be sufficient to respond to the full range of events that may occur or allow us to resume normal business operations in a timely manner.
FREDDIE MAC | 2019 Form 10-K 147
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Risk Factors Operational Risks
Potential cybersecurity threats are changing rapidly and growing in sophistication. We may not be able to protect our systems or the confidentiality of our information from cyberattack and other unauthorized access, disclosure, and disruption. Our operations rely on the secure, accurate, and timely receipt, processing, storage, and transmission of confidential and other information in our computer systems and networks and with customers, counterparties, service providers, and financial institutions. Information risks for companies like ours have significantly increased in recent years, in part because of the proliferation of new technologies, the use of the internet and telecommunications technologies to conduct financial transactions, and the increased sophistication and activities of organized crime, hackers, terrorists, and other external parties, including foreign state-sponsored actors. There have been several highly publicized cases involving financial services companies, consumer-based companies, and other organizations reporting the unauthorized disclosure of client, customer, or other confidential information, as well as cyberattacks involving the dissemination, theft, or destruction of corporate information, intellectual property, cash, or other valuable assets. There have also been several highly publicized cases where hackers have requested "ransom" payments in exchange for not disclosing customer information or for not making the targets' computer systems unavailable. In addition, there have been cases where hackers have misled company personnel into making unauthorized transfers of funds to the hackers' accounts. Like many companies and government entities, from time to time we have been, and likely will continue to be, the target of attempted cyberattacks, including malware, denial-of-service, and phishing, as part of an effort to disrupt operations, potentially test cybersecurity capabilities, or obtain confidential, proprietary, or other information. We could also be adversely affected by cyberattacks that target the infrastructure of the internet, as such attacks could cause widespread unavailability of websites and degrade website performance. Our risk and exposure to these matters remain heightened because of, among other things, the evolving nature of these threats, our role in the financial services industry, the outsourcing of some of our business operations, and the current global economic and political environment. Because we are interconnected with and dependent on third-party vendors, exchanges, clearinghouses, fiscal and paying agents, and other financial institutions, we could be adversely affected if any of them is subject to a successful cyberattack or other information security event. Third parties with which we do business may also be sources of cybersecurity or other technology risks. We routinely transmit and receive personal, confidential, and proprietary information by electronic means. This information could be subject to interception, misuse, or mishandling. Our exposure to these risks could increase as a result of our migration of core systems and applications to a third-party cloud environment. Although we devote significant resources to protecting our critical assets and provide employee awareness training about phishing, malware, and other cyber risks, these measures may not provide effective security. Our computer systems, software, end point devices, and networks may be vulnerable to cyberattack, unauthorized access, supply chain disruptions, computer viruses or other malicious code, or other attempts to harm them or misuse or steal information. We routinely identify cyber threats as well as vulnerabilities in our systems and work to address them, but these efforts may be insufficient. Breaches of our security measures may result from employee error or misconduct. Outside parties may attempt to induce employees, customers, counterparties, service providers, financial institutions, or other users of our systems to disclose sensitive information in order to gain access to our systems and the information they contain. We may not be able to anticipate, detect, or recognize threats to our systems and assets, or implement effective preventative measures against security breaches, especially because the techniques used change frequently or are not recognized until launched. A cyberattack could occur and persist for an extended period of time without detection. We expect that any investigation of a cyberattack would take time, during which we would not necessarily know the extent of the harm or how best to remediate it. Although to date we have not experienced any cyberattacks resulting in significant impacts to the company, our cybersecurity risk management program may not prevent cyberattacks from having significant impacts in the future. We have obtained insurance coverage relating to cybersecurity risks, but this insurance may not be sufficient to provide adequate loss coverage. The occurrence of one or more cyberattacks could result in thefts of important assets (such as cash or source code) or the unauthorized disclosure, misuse, or corruption of confidential and other information (including information about our borrowers, our customers, or our counterparties) or could 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 affect our competitive position, or otherwise harm our business. We could also face regulatory and other legal action, including for any failure to provide timely disclosure concerning, or appropriately to limit trading in our securities following, an attack. We might be required to expend significant additional resources to modify our internal controls and other 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, customers, counterparties, financial intermediaries, and governmental organizations may not be adequately protecting the information that we share with them. As a result, a cyberattack on their systems and networks, or a breach of their security measures, may result in harm to our business and business relationships.
FREDDIE MAC | 2019 Form 10-K 148
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Risk Factors Operational Risks
We rely on third parties for certain important functions. Any failures by those vendors and service providers (or other third parties that work for the vendors/service providers) could disrupt our business operations or expose us to loss of confidential information or intellectual property. Our use of third-party service providers exposes us to the risk of failures in their risk and control environments. We outsource certain key functions to external parties, including some that are critical to financial reporting (including our use of hedge accounting), valuations, our mortgage-related investment activity, loan underwriting, loan servicing, and UMBS issuance and administration (i.e., CSS). We may enter into other key outsourcing relationships in the future and continue to expand our existing reliance on public cloud services. If one or more of these key external parties were not able to perform their functions for a period of time, perform them at an acceptable service level or handle increased volumes, or if one of them experiences a disruption in its own business or technology from any cause, our business operations could be constrained, disrupted, or otherwise negatively affected. Our use of third-party service providers also exposes us to the risk of losing intellectual property or confidential information and to other harm, including to our reputation. Our ability to monitor the activities or performance of third-party service providers may be constrained, which may make it difficult for us to assess and manage the risks associated with these relationships. We face risks and uncertainties associated with the models that we use to inform business and risk management decisions and for financial accounting and reporting purposes. We use models to project significant factors in our businesses, including, but not limited to, interest rates and house prices under a variety of scenarios. We also use models to project borrower prepayment and default behavior and loss severity over long periods of time. Models are inherently imperfect predictors of actual results. There is inherent uncertainty associated with model projections of economic variables and the downstream projections of prepayment and default behavior dependent on these variables. Uncertainty and risks related to models may arise from a number of sources, including the following: n We could fail to design, implement, operate, adjust, or use our models as intended. We may fail to code a model correctly, we could use incorrect or insufficient data inputs or fail to fully understand the data inputs, or model implementation software could malfunction. The complexity and
interconnectivity of our models create additional risk regarding the accuracy
of model output. We may not be able to deploy or update models in a timely
manner.
n When market conditions change in unforeseen ways, our model projections may
not accurately reflect these conditions, or we may not fully understand the
model outputs. For example, models may not fully reflect the effect of
certain government policy changes or new industry trends. In such cases, it
is often necessary to make assumptions and judgments to accommodate the
effect of scenarios that are not sufficiently well represented in the
historical data. While we may adjust our models in response to new events,
considerable residual uncertainty remains.
n We also use selected third-party models. While the use of such models may
reduce our risk where no internal model is available, it exposes us to
additional risk, as third parties typically do not provide us with
proprietary information regarding their models. We have little control over
the processes by which these models are adjusted or changed. As a result, we
may be unable to fully evaluate the risks associated with the use of such
models.
We risk making poor business decisions in situations where we rely on models to provide key information. Our use of models could affect decisions concerning the purchase, sale, securitization, and credit risk transfer of loans; the purchase and sale of securities; funding; the setting of guarantee fee prices; and the management of interest-rate, market, and credit risk. Our use of models also affects our quality-control sampling strategies for loans in our single-family credit guarantee portfolio and potential settlements with our counterparties. Our use of hedge accounting increases our reliance on models for financial reporting. See MD&A - Risk Management - Market Risk and Critical Accounting Policies and Estimates for more information on our use of models.
FREDDIE MAC | 2019 Form 10-K 149
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Risk Factors Liquidity Risks LIQUIDITY RISKS Our activities may be adversely affected by limited availability of financing and increased funding costs. The amount, type, and cost of our unsecured funding 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, including: n Market and other factors;
n Changes in U.S. government support for us; and
n Reduced demand for our debt securities.
Market and Other Factors Our ability to obtain funding in the public unsecured debt markets or by selling or pledging mortgage-related and other securities as collateral to other institutions could change rapidly or cease. The cost of available funding could increase significantly due to changes in market interest rates, market confidence, operational risks, regulatory requirements, and other factors. Prolonged wide market spreads on long-term debt could cause us to reduce our long-term debt issuances and increase our reliance on short-term and callable debt issuances. Such increased reliance on short-term and callable debt could increase the risk that we may be unable to refinance our debt when it becomes due and result in a greater use of derivatives. Greater derivatives use could increase the variability of our comprehensive income or increase our credit exposure to our counterparties. Additionally, we may incur higher hedging costs in the event we decide not to call our debt. We may incur higher funding costs due to our liquidity management practices and procedures. Our practices and procedures may not 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 inadequate or difficult 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 significantly impaired or eliminated, as our alternative sources of liquidity (e.g., cash and other investments) may not be sufficient to meet our liquidity needs. We have limited ability to use the less liquid assets in our mortgage-related investments portfolio as a significant source of liquidity (e.g., through sales or as collateral in secured borrowing transactions). We make extensive use of the Federal Reserve's payment system in our business activities. The Federal Reserve requires that we fully fund accounts at the Federal Reserve Bank of New York to the extent necessary to cover cash payments on our debt and mortgage-related securities each day, before the Federal Reserve Bank of New York, acting as our fiscal agent, will initiate such payments. Although we seek to maintain sufficient intraday liquidity to fund our activities through the Federal Reserve's payment system, we have limited access to cash once the debt markets are closed for the day. Insufficient cash may cause our account to be overdrawn, potentially resulting in penalties and reputational harm. Unlike certain of our competitors, we do not have access to the Federal Reserve's discount window. Changes in U.S. 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. Changes or perceived changes in the U.S. government's support for us could have a severe negative effect on our access to the unsecured debt markets and our debt funding costs. Our access to the unsecured debt markets and the costs of our debt funding could be adversely affected by several factors relating to U.S. government support, including: n Uncertainty about the future of the GSEs;
n Any concerns by debt investors that we face increasing risk of being placed
in receivership; and
n Future draws that significantly reduce the amount of available funding
remaining under the Purchase Agreement.
At such time as our Net Worth Amount exceeds the applicable Capital Reserve Amount of $20.0 billion, the amount of the net worth sweep dividends we pay to Treasury 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, such as increases in the fair value of our securities or a reduction in our loan loss reserves, 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. For more information, see MD&A - Liquidity and Capital Resources - Capital Resources. Reduced Demand for Debt Securities 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 investors to purchase and hold our debt securities can be influenced by many factors, including changes in the world economy, changes in exchange rates, and regulatory and political factors, as well as the availability of and investor preferences for other investments. We compete for debt funding with Fannie Mae, the FHLBs, and other institutions. Our funding costs and liquidity contingency plans may also be affected by changes in the amount of, and FREDDIE MAC | 2019 Form 10-K 150
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Risk Factors Liquidity Risks demand for, debt issued by Treasury. If investors were to reduce their purchases of our debt securities or divest their holdings, our funding costs could increase and our business activities could be curtailed. The market for our debt securities may become less liquid as a result of our having reached the Purchase Agreement limits on the size of our mortgage-related investments portfolio and the amount of our unsecured debt. This could lead to a decrease in demand for our debt securities and an increase in our funding costs. See MD&A - Our Business Segments - Capital Markets for a description of our debt issuance programs. 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. Our credit ratings are important to our liquidity. We currently receive ratings for our unsecured debt from three nationally recognized statistical rating organizations (S&P, Moody's, and Fitch). 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. In addition to a downgrade in the credit ratings of or outlook on the U.S. government, several other events could adversely affect our debt credit ratings, including actions by governmental entities, 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. For more information, see MD&A - Liquidity and Capital Resources - Liquidity Profile - Primary Sources of Funding - Credit Ratings.
FREDDIE MAC | 2019 Form 10-K 151
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Risk Factors Legal and Regulatory Risks
LEGAL AND REGULATORY RISKS Legislative or regulatory actions could adversely affect our business activities and financial results. We operate in a highly regulated industry and are subject to heightened supervision from FHFA, as our Conservator. Our compliance systems and programs may not be adequate to ensure that we are in compliance with all legal and other requirements. We could incur fines or other negative consequences for inadvertent violations. Our business may be directly adversely affected by future legislative, regulatory, or judicial actions at the federal, state, and local levels. Such actions could affect us in a number of ways, including by imposing significant additional legal, compliance, and other costs on us, limiting our business activities, and diverting management attention or other resources. In particular, changes to our capital requirements could adversely affect our business and risk management strategies, including our risk appetite, our risk-adjusted returns such as ROCC, and the impact of our CRT transactions on our capital needs. Changes to our capital requirements could also negatively affect our ability to build capital to a level which FHFA would deem sufficient to end our conservatorship, such as by extending the time it will take for us to retain or raise such level of capital. Our existing regulatory capital requirements have been suspended by FHFA during conservatorship, but we have adopted FHFA's risk-based CCF guidelines to evaluate and manage our financial risk and to make economic business decisions while in conservatorship. The CCF has been and may be further revised by FHFA from time to time, including in connection with FHFA's consideration and adoption of a final Enterprise Capital Rule, which could result in material changes in the capital needed under the CCF during conservatorship as well as the capital requirements which will be applicable to us after conservatorship. In November 2019, FHFA announced that it plans to re-propose the Enterprise Capital Rule in 2020. We do not know what changes to the Enterprise Capital Rule FHFA may propose or eventually adopt. We could also be negatively affected by legislative, regulatory, or judicial action that: n Changes the foreclosure process;
n Limits or otherwise adversely affects the rights of a holder of a first lien
on a mortgage (such as by granting priority rights in foreclosure proceedings
for homeowner associations or providing a lien priority in connection with
loans to finance energy efficiency or similar improvements);
n Expands the responsibilities of and costs to servicers for maintaining vacant
properties prior to foreclosure; or
n Prevents us from using the MERS System or disrupts foreclosures of loans
registered in the MERS System.
We are subject to complex and evolving laws and regulations governing privacy and the protection of personal information of individuals as well as the protection of material, non-public information. Our business could be adversely affected if we fail to protect the confidentiality of such information or if it is mishandled or misused. Regulatory changes related to the Dodd-Frank Act, including expiration or modification of the temporary exemption for GSE-eligible mortgages included in the CFPB's Qualified Mortgage Rule, could cause or require us to make changes to our business practices, such as practices related to mortgage underwriting and servicing. Legislation or regulatory actions could indirectly adversely affect us to the extent they affect the activities of banks, savings institutions, insurance companies, derivative counterparties, clearinghouses, securities dealers, and other regulated entities that constitute a significant portion of our customers or counterparties, or to the extent that they modify industry practices. Legislative or regulatory actions that remove incentives for these entities to purchase our securities or enter into derivatives or other transactions with us could have a material adverse effect on our business and financial results. Changes in business practices resulting from new laws and regulations could have a negative effect on the volume of loan originations or could modify or remove incentives for financial institutions to sell loans to us, either of which could adversely affect the number of loans available for us to purchase or guarantee. In addition, the regulatory framework based on the Basel III standards developed by the Basel Committee on Banking Supervision could decrease demand for our debt and mortgage-related securities and/or affect competition in the market for loan originations and servicing, with possible adverse consequences for our business and financial results. Enhanced capital and liquidity requirements for banking organizations may also reduce the level of participation of such organizations in (and thus the liquidity of) trading markets for various types of financial instruments, including asset-backed securities. In turn, this could decrease the liquidity of the markets for our debt and mortgage-related securities, which could increase our funding and other costs and adversely affect our business. We may make certain changes to our business in an attempt to meet our housing goals and duty to serve requirements, which may adversely affect our profitability. We may make adjustments to our loan sourcing and purchase strategies in an effort to meet our housing goals and subgoals, including modifying some of our underwriting standards and expanding the 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. We may also make changes to our business in response to our duty to serve underserved markets that could adversely affect our profitability.
FREDDIE MAC | 2019 Form 10-K 152
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Risk Factors Legal and Regulatory Risks
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 potentially adversely affect our profitability. Due to our failure to meet two single-family housing goals for 2014 and 2015, we operated under an FHFA-approved housing plan that addressed achievement of the missed goals through 2018. FHFA has determined that we met our affordable housing goals in 2018. However, FHFA will continue to closely monitor and evaluate our 2019 housing goal performance and could require us to take additional steps or operate under a housing plan again in the future. 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 governmental investigations and regulatory proceedings 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 related costs and expenses. We may be required to establish reserves and to make substantial payments in the event of adverse judgments or settlements of any such claims, proceedings, investigations, or examinations. Any related issue, even if resolved in our favor, could result in negative publicity or cause us to incur significant legal and other expenses. Furthermore, the costs (including settlement costs) related to these legal proceedings and governmental investigations and examinations may differ from our expectations and exceed our reserves or require adjustments to such reserves. These various matters could divert management's attention and other resources from the needs of the business. In addition, numerous 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 16 for information about these various pending legal proceedings. FREDDIE MAC | 2019 Form 10-K 153
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Risk Factors Other Risks OTHER RISKS The loss of business from a key customer or a decrease in the availability of mortgage insurance could result in a decline in our market share and revenues. Our business depends on our ability to acquire a steady flow of loans. We purchase a significant percentage of our single-family loans from several large loan originators. Similarly, we acquire a significant portion of our multifamily loans from several large lenders. For more information, see Note 14. We enter into loan purchase commitments with many of our single-family customers that are typically less than one year in duration. Lenders may fail to deliver loans to us in accordance with their commitments. The loss of business from any of our major lenders could adversely affect our market share and revenues. Our Charter requires that single-family loans with LTV ratios above 80% at the time of purchase be covered by mortgage insurance or other credit enhancements. 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 institutions (including Fannie Mae and FHA/VA with Ginnie Mae securitization) may harm our business. FHFA's actions, as Conservator of both companies, could affect competition between us and Fannie Mae. Competition in the secondary mortgage market may make it more difficult for us to purchase mortgage loans. Increased competition from Fannie Mae, FHA/VA (with Ginnie Mae securitization), and new entrants may alter our product mix, lower our volumes, and reduce our revenues on new business. We also compete with other financial institutions that retain or securitize loans, such as commercial and investment banks, dealers, savings institutions, and insurance companies. There is a risk that financial institutions may retain loans with better credit characteristics rather than sell them to us, or otherwise seek to structure financial transactions that result in our loan purchases having a higher proportion of loans with lower credit scores and higher LTV ratios. While we charge upfront fees for higher levels of credit risk, sellers' retention of loans with better credit characteristics could result in us having lower overall purchase volumes and a more adverse credit risk profile, reducing our revenues and returns. FHFA is also Conservator of Fannie Mae, our primary competitor. 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 also may prevent us from taking actions that could give us a competitive advantage. We have faced increased competition in the multifamily market in recent years from life insurers, banks, CMBS conduits, and other market participants as multifamily market fundamentals have improved. FHFA may take actions that could encourage further competition or limit our ability to meet such competition. A significant decline in the price performance of or demand for our UMBS could have an adverse effect on the volume and/or profitability of our new single-family guarantee business. Historically, the price performance of our Gold PCs (the predecessor to the UMBS) relative to comparable Fannie Mae-issued securities was one of Freddie Mac's more significant risks and competitive issues. On June 3, 2019, in connection with the implementation of the Single Security Initiative, we ceased issuing Gold PCs and commenced issuing UMBS and non-TBA-eligible 55-day MBS. While the Single Security Initiative and the UMBS (which may be issued by Freddie Mac or Fannie Mae) are intended to reduce the pricing disparity between our securities and Fannie Mae's securities, we cannot ensure they will do so. For example, in certain cases, pricing disparities can exist due to differences in pool composition. Our UMBS are an integral part of our loan purchase program. Our competitiveness in purchasing single-family loans from our sellers and the volume and profitability of our new single-family guarantee business are directly affected by the price performance of UMBS issued by us relative to comparable Fannie Mae-issued UMBS. If our UMBS were to trade at a discount relative to comparable Fannie Mae securities, such a difference in relative pricing could create an economic incentive for sellers to conduct a disproportionate share of their single-family business with Fannie Mae. It is possible that a liquid market for our UMBS may not be sustained over the short- or long-term, which could adversely affect their price performance and our single-family market share. A significant reduction in our market share, and thus in the volume of loans that we securitize, or a reduction in the trading volume of our UMBS could reduce the liquidity of our UMBS. While we may decide to employ various strategies to support the liquidity and price performance of our UMBS, any such strategies may fail or adversely affect our business and financial results. We may cease any such activities at any time, or FHFA could require us to do so, which could adversely affect the liquidity and price performance of our UMBS. We may incur costs to support our presence in the agency securities market and to support the liquidity and price performance of our securities. Liquidity-related price differences could occur between UMBS issued by us and comparable Fannie Mae-issued UMBS due to factors that are largely outside of our control. For example, the level of the Federal Reserve's purchases and sales of agency FREDDIE MAC | 2019 Form 10-K 154
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Risk Factors Other Risks mortgage-related securities, including the balance sheet normalization program to reduce the Federal Reserve's holdings of mortgage-related securities, could affect the demand for and values of our UMBS. Therefore, any strategies we employ to reduce any liquidity-related price differences may not reduce or eliminate any such price differences over the long term. We may experience price differences with Fannie Mae on individual new production pools of TBA-eligible mortgages, particularly with respect to specified pools and our multilender securities. From time to time, we may need to adjust our pricing for a particular new production pool category to maintain competitiveness with Fannie Mae with respect to the acquisition of such pools. Depending on the amount of pricing adjustments in any period, it is possible they could adversely affect the profitability of our single-family guarantee business for that period. For more information, see MD&A - Our Business Segments - Capital Markets Segment - Business Overview - Products and Activities. Implementation of the Single Security Initiative presents increased operational and counterparty risk. If the UMBS does not continue to receive widespread market acceptance, the liquidity and price performance of our single-family mortgage-related securities and our market share and profitability could be adversely affected. As part of the new combined UMBS market, we have been required by FHFA to align certain of our single-family mortgage purchase offerings, servicing, and securitization programs, policies and practices with Fannie Mae to achieve market acceptance of the UMBS and other aspects of the Single Security Initiative, but we cannot provide any assurance that these efforts will reduce the pricing disparities discussed above over the long-term. These alignment activities may adversely affect our business and our ability to compete with Fannie Mae. We may be required to further align our business processes with those of Fannie Mae. Uncertainty concerning the extent of the alignment between Freddie Mac's and Fannie Mae's mortgage purchase, servicing, and securitization programs, policies, and practices may affect the degree to which the UMBS and other aspects of the Single Security Initiative receive widespread market acceptance. If investors do not continue to accept the fungibility of Freddie Mac and Fannie Mae UMBS and instead prefer Fannie Mae UMBS over Freddie Mac UMBS, it could have a significant adverse impact on our business, liquidity, financial condition, net worth, and results of operations, and could adversely affect the liquidity or market value of our single-family mortgage-related securities. We are offering an optional exchange program for security holders to exchange certain existing 45-day payment delay fixed-rate Gold PCs and Giant PCs for new 55-day payment delay Freddie Mac securities. As part of this program, we make a one-time payment to exchanging security holders for the value of the 10 additional days of payment delay, based on float compensation rates we calculate. We do not expect the return from this additional float to fully offset our payments to the security holders. The Single Security Initiative has caused us to have counterparty credit exposure to Fannie Mae due to investors' ability to commingle certain Freddie Mac and Fannie Mae securities in resecuritizations. When we resecuritize Fannie Mae securities, our guarantee of timely principal and interest extends to the underlying Fannie Mae securities. In the event Fannie Mae were to fail to make a payment on a Fannie Mae security that we resecuritized, Freddie Mac would be responsible for making the payment. We do not control or limit the amount of resecuritized Fannie Mae securities that we could be required to guarantee. We are dependent on FHFA, Fannie Mae, and Treasury (pursuant to Fannie Mae's and our respective Purchase Agreements with Treasury) to avoid a liquidity event or default. We have not modified our liquidity strategies to address the possibility of non-timely payment by Fannie Mae. We and Fannie Mae both rely on the Federal Reserve Banks to make payments on our respective mortgage-backed securities. As noted above, in the event Fannie Mae were to fail to make a payment on a Fannie Mae security that we resecuritized, Freddie Mac would be responsible for providing the Federal Reserve Banks with the funds to make the payment. If we failed to provide the Federal Reserve Banks with all funds to make such payment on such resecuritized Fannie Mae securities, the Federal Reserve Banks would not make any payment on any of our outstanding Freddie Mac-issued UMBS, Supers, REMICs, or other securities to be paid on that payment date, regardless of whether such Freddie Mac-issued securities were backed by Fannie Mae-issued securities. The profitability of our multifamily business could be adversely affected by a significant decrease in demand for our K Certificates and SB Certificates. Our current multifamily business model is highly dependent on our ability to finance purchased multifamily loans through securitization into K Certificates and SB Certificates. A significant decrease in demand for K Certificates and SB Certificates could have an adverse impact on the profitability of the multifamily business to the extent that our holding period for the loans increases and we are exposed to credit, spread, and other market risks for a longer period of time or receive reduced proceeds from securitization. We employ various strategies to support the liquidity of our K Certificates and SB Certificates, but those strategies may fail or adversely affect our business. We may cease such activities at any time, or FHFA could require us to do so, which could adversely affect the liquidity and price performance of our K Certificates and SB Certificates. FREDDIE MAC | 2019 Form 10-K 155
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Risk Factors Other Risks 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, which could make it difficult for investors to execute transactions in our securities and could cause declines or volatility in the prices of our equity securities.
FREDDIE MAC | 2019 Form 10-K 156
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