Industry News

Freddie Mac Announces Record Earnings For Third Quarter 2002

October 23, 2002

McLean, VA - Freddie Mac (NYSE:FRE) today announced record earnings for third quarter 2002.

Operating earnings for third quarter 2002 were $987 million, compared to $813 million for the same period a year ago and $968 million for second quarter 2002. Diluted operating earnings per common share were $1.34 for third quarter 2002, compared to $1.08 for third quarter 2001 and $1.30 for second quarter 2002.

Freddie Mac?s operating earnings and diluted operating earnings per common share exclude certain accounting effects related to SFAS 133, ?Accounting for Derivative Instruments and Hedging Activities,? as amended. Operating earnings and diluted operating earnings per common share are pro forma performance measures used by Freddie Mac that provide for consistent treatment of similar economic transactions such as callable debt and purchased option-based derivatives. Freddie Mac?s operating earnings and diluted operating earnings per common share measures may not be comparable to similarly titled measures used by other companies.

As reported under generally accepted accounting principles (?GAAP?), net income for third quarter 2002 was $1.378 billion, an increase of 34 percent from third quarter 2001 net income of $1.032 billion. Diluted earnings per common share for third quarter 2002 were $1.90, an increase of 36 percent from third quarter 2001 diluted earnings per common share of $1.40. Second quarter 2002 net income and diluted earnings per common share were $1.110 billion and $1.50, respectively. Appendix I (included in the financial tables that accompany this press release) provides a reconciliation of GAAP (or ?reported?) earnings to operating earnings.

?Freddie Mac produced extremely strong third quarter results,? said Leland C. Brendsel, Chairman and Chief Executive Officer. ?Operating earnings per share grew 24 percent. Already this year Freddie Mac has financed homes for nearly 3 million families.?

?In this environment of historically low mortgage rates and record refinancing, Freddie Mac continued to demonstrate our risk management discipline,? Brendsel added. ?Freddie Mac?s interest-rate and credit risk remain low, and we are well-positioned to produce low double-digit operating earnings growth in 2003.?

?Freddie Mac?s third quarter performance reflected solid portfolio growth and exceptional credit results,? remarked David W. Glenn, Vice Chairman and President. ?Consistent with our disciplined investment approach, we grew our retained portfolio by $12 billion during the quarter. In addition, for the sixth consecutive quarter, our credit losses represented less than 1 basis point of our total portfolio.?

Highlights for third quarter 2002:

• Freddie Mac?stotal mortgage portfolio grew by $17 billion during the third quarter, representing annualized growth of 5 percent. This growth reflects strong new business purchases, partially offset by sharply higher liquidations, which were driven by the surge in refinance activity in the low interest-rate environment.
• Freddie Mac?sretained portfolio grew by $12 billion during the third quarter, representing annualized growth of 9 percent. Investment opportunities were more attractive than during the second quarter, although there continued to be strong demand from other mortgage investors.
• Freddie Mac?s fully taxable equivalent (FTE)operating net interest yield was 86 basis points in the third quarter, down 2 basis points from second quarter 2002. This modest decline primarily reflects higher PC variance expense, which resulted from the significant increase in mortgage prepayments during the quarter.
• Freddie Mac?sportfolio market value sensitivity averaged 2.84 percent in the third quarter and only 4.50 percent in September, despite significant interest-rate volatility. In addition, Freddie Mac?sduration gap averaged approximately negative 1 month in the third quarter, unchanged from second quarter 2002. These results reflect the corporation?s continued prudent interest-rate risk management.
• Freddie Mac?s third quartercredit losses represented 0.8 basis points of its average mortgage portfolio, unchanged from second quarter 2002. The corporation?s credit losses remained low despite higher real estate owned (?REO?) activity, due to its strong credit position and the sustained strength of the housing market.
• Freddie Mac?s safety and soundness regulator, the Office of Federal Housing Enterprise Oversight (?OFHEO?), announced that as of June 30, 2002, the corporation?s total capital exceeded the requirement of therisk-based capital standard by $11.5 billion. This assessment reflects Freddie Mac?s low risk profile and the conservative manner in which it operates.

Total Portfolio Growth

Freddie Mac?s total mortgage portfolio grew at a 5 percent annualized rate from $1.244 trillion at June 30, 2002 to $1.261 trillion at September 30, 2002. This growth was driven by new business purchase volume (which excludes purchases of PCs for the retained portfolio) of $137 billion in third quarter 2002, up from $126 billion for third quarter 2001 and second quarter 2002?s volume of $115 billion. Also affecting total mortgage portfolio growth were liquidations of $120 billion in third quarter 2002, up from $67 billion in third quarter 2001 and $74 billion in second quarter 2002.

Operating Revenues

Freddie Mac?s operating revenues reached $1.599 billion in third quarter 2002, a 14 percent increase over $1.399 billion for third quarter 2001, and down from $1.614 billion for second quarter 2002. Operating revenues include operating net interest income and operating other income, net (both defined below), but exclude SFAS 133-related changes in derivative market values, which are reported on Freddie Mac?s Income Statement as ?Hedging gains (losses).? Reported revenues for third quarter 2002 were $2.201 billion, compared to $1.737 billion for third quarter 2001 and $1.833 billion for second quarter 2002.

Portfolio Investment Business

Retained Portfolio Growth

The retained portfolio grew at a 9 percent annualized rate, increasing from $519 billion at June 30, 2002 to $531 billion at September 30, 2002. Mortgage investment opportunities were more attractive than during the second quarter, although growth was tempered by continued, strong demand from other investors as well as increased liquidations driven by record refinance activity.

Operating Net Interest Income

Operating net interest income reflects adjustments to reported net interest income to exclude certain accounting effects associated with SFAS 133. These adjustments include the recognition of straight-line amortization expense on purchased option premiums and the reversal of certain SFAS 133 mark-to-market adjustments.

Freddie Mac?s operating net interest income totaled $1.296 billion in third quarter 2002, compared to $1.015 billion in third quarter 2001 and $1.292 billion for second quarter 2002. Reported net interest income for third quarter 2002 was $1.811 billion, compared to $1.438 billion in third quarter 2001 and $1.560 billion in second quarter 2002.

FTE operating net interest yield on earning assets was 86 basis points in third quarter 2002, compared to 80 basis points in third quarter 2001 and 88 basis points in second quarter 2002. The decline in operating net interest yield during the third quarter reflects, in part, higher PC variance expense, which resulted from the significant increase in mortgage prepayments in the low interest-rate environment.

Interest-Rate Risk Measures

Freddie Mac continued to be well-protected against interest-rate changes. Despite the significant interest-rate volatility and record low mortgage rates experienced during the third quarter, the corporation?s primary indicator of interest-rate risk?portfolio market value sensitivity (PMVS)?remained at low levels. PMVS averaged 2.84 percent in third quarter 2002, up slightly from 2.74 percent for both third quarter 2001 and second quarter 2002.

In addition, Freddie Mac?s duration gap averaged approximately negative 1 month in the third quarter 2002, compared to zero months in third quarter 2001 and unchanged from second quarter 2002.

Securitization Business

PC Portfolio Growth

The Total PC portfolio grew at a 2 percent annualized rate from $1.053 trillion at June 30, 2002 to $1.058 trillion at September 30, 2002. The Total PC, net portfolio (which excludes PCs held in the retained portfolio) grew at a 3 percent annualized rate from $725 billion at June 30, 2002 to $730 billion at September 30, 2002. Slower growth in Freddie Mac?s PC portfolios is typical in a refinance environment due to the acceleration in mortgage prepayments. As prepayments abate and refinanced loans are sold into the secondary market, the pace of portfolio growth typically increases.

Guarantee Fees

Management and guarantee income totaled $490 million in third quarter 2002, compared to $416 million for third quarter 2001 and $478 million for second quarter 2002. During third quarter 2002, the average balance of Total PCs increased by $19 billion, or 2 percent, from second quarter 2002, while the average guarantee fee rate was 18.6 basis points, up from 18.5 basis points in both third quarter 2001 and second quarter 2002.

Credit

Freddie Mac demonstrated excellent credit performance during the third quarter, driven by the strength of its portfolio and favorable economic conditions. The corporation?s credit results continue to reflect the benefits of its automated underwriting and loss mitigation activities, high levels of credit enhancement, and consistently strong, nationwide house-price appreciation. Specific indicators of Freddie Mac?s strong credit performance are discussed in the paragraphs that follow.

The corporation?s single-family, at-risk delinquency rate?an indicator of potential future credit losses?was 0.37 percent for August 2002, compared to 0.38 percent in September 2001 and 0.36 percent in June 2002.

The net carrying value of delinquent multifamily loans was $4 million at the end of August 2002, compared to $7 million at September 30, 2001 and $5 million at June 30, 2002. As a percentage of the unpaid principal balance of multifamily mortgages serviced, the multifamily delinquency rate was 0.01 percent at the end of August 2002, compared to 0.03 percent at September 30, 2001 and 0.02 percent at June 30, 2002.

At September 30, 2002, total REO balances were $575 million, compared to $376 million at September 30, 2001 and $505 million at June 30, 2002. Single-family REO balances were $575 million at September 30, 2002, compared to $375 million at September 30, 2001 and $504 million at June 30, 2002. Multifamily REO balances were zero at September 30, 2002, down from $1 million at both September 30, 2001 and June 30, 2002.

Despite higher REO activity during third quarter 2002, Freddie Mac?s credit losses increased only $1 million. This reflects continued house-price gains as well as Freddie Mac?s on-going use of credit enhancements. Annualized third quarter 2002 credit losses (charge-offs plus REO operations income (expense)) were 0.8 basis points of the average total mortgage portfolio (excluding non-Freddie Mac mortgage securities), compared to 0.6 basis points in third quarter 2001 and unchanged from second quarter 2002.

In third quarter 2002, mortgage charge-offs were $26 million, compared to $15 million in third quarter 2001 and unchanged from second quarter 2002. Third quarter 2002 single-family charge-offs were $26 million, compared to $16 million for third quarter 2001 and unchanged from second quarter 2002.

Freddie Mac?s credit-related expenses consist of the ?Provision for mortgage losses? and ?REO operations income (expense)?. The provision, which increases or decreases the corporation?s loan loss reserves, may be positive or negative, as deemed appropriate by management based on its periodic assessment of probable credit losses. For third quarter 2002, Freddie Mac had credit-related income of $48 million, compared to expenses of $18 million for third quarter 2001 and income of $4 million for second quarter 2002. The provision for mortgage losses was a negative $45 million for third quarter 2002, compared to a positive $19 million for third quarter 2001 and zero for second quarter 2002.

Loan Loss Reserves

As disclosed in the corporation?s second quarter 2002 earnings press release dated July 23, 2002, Freddie Mac conducted a review of its loan loss reserves and concluded that its loan loss reserve balance has been approximately $250 million more than the level required by GAAP. As a result, Freddie Mac will reduce its loan loss reserve balance by approximately $250 million pre-tax. The adjustment will result in an increase in net income and/or retained earnings of approximately $160 million after-tax. Such adjustment is not yet reflected in the Condensed Consolidated Financial Statements and financial tables that accompany this press release.

The corporation is discussing the accounting for this adjustment with the Securities and Exchange Commission (?SEC?). Freddie Mac will reflect this adjustment in its quarterly financial statements after the accounting treatment has been finalized.

Other Corporate Results

Operating Other Income, Net

Freddie Mac?s Other income, net consists of a variety of components that tend to fluctuate from period to period. The primary components of Other income, net include losses on debt retirements, resecuritization fees, and gains or losses on investment activity.

Operating other income, net, was a loss of $187 million in third quarter 2002, compared to a loss of $32 million for third quarter 2001 and a loss of $156 million for second quarter 2002. The change in Operating other income, net from second quarter 2002 reflects several factors. Lower losses on debt retirements, higher resecuritization fees, and higher gains on no-hedge designation derivatives contributed to increased Operating other income, net. These increases were offset by write-downs on certain interest-only (?I/O?) securities, which totaled approximately $315 million in third quarter 2002. With the significant decrease in interest rates during the third quarter, the prices of the corporation?s I/O securities declined. Under GAAP, the entire price decline of the I/O securities must be recorded in current period earnings. Freddie Mac purchases securities that have the effect of economically offsetting the price change of the I/Os. However, the price change related to these instruments is typically not included in current period earnings.

Operating other income, net, reflects adjustments to reported Other income, net, to exclude certain accounting effects associated with SFAS 133. These adjustments represent the difference in gain/loss recognition on sales of options or hedged assets and on repurchases of hedged debt between SFAS 133 and operating earnings. Reported other income, net, for third quarter 2002 was a loss of $118 million, compared to a loss of $32 million for the same period a year ago and a loss of $90 million for second quarter 2002.

During third quarter 2002, Freddie Mac repurchased $2.4 billion of long-term debt and incurred operating losses of $0.16 per diluted common share, compared to $1.4 billion of debt repurchased in third quarter 2001 and operating losses of $0.09 per diluted common share. During second quarter 2002, the corporation repurchased $7.3 billion of long-term debt and incurred operating losses of $0.23 per diluted common share.

Administrative Expenses

Third quarter 2002 administrative expenses totaled $208 million, compared to $201 million for third quarter 2001 and $204 million for second quarter 2002. Annualized administrative expenses represented 6.7 basis points of the average total mortgage portfolio in third quarter 2002, compared to 7.5 basis points in third quarter 2001 and unchanged from second quarter 2002.

Capital

The corporation?s core capital was $22.496 billion at September 30, 2002, compared to $17.743 billion at September 30, 2001 and $21.446 billion at June 30, 2002.

Freddie Mac repurchased 2.4 million shares, or $150 million of common stock in third quarter 2002. The corporation did not repurchase common stock in third quarter 2001. In second quarter 2002, Freddie Mac repurchased 0.5 million shares, or $32 million of common stock.

Freddie Mac?s minimum capital surplus, the excess of Freddie Mac?s core capital over the minimum capital requirement, was estimated at approximately $2.0 billion at September 30, 2002, compared to $0.4 billion and $1.9 billion at September 30, 2001 and June 30, 2002, respectively.

During September 2002, OFHEO announced that Freddie Mac?s total capital exceeded the risk-based capital standard by $11.5 billion as of June 30, 2002. Freddie Mac?s surplus against the risk-based standard reflects its low level of interest-rate and credit risk and favorable market conditions.

Freddie Mac?s risk-based capital requirement became effective during September 2002. Pursuant to implementation of this requirement, Freddie Mac elected to reclassify mortgage securities with a fair value of approximately $75 billion from held-to-maturity to available-for-sale. This reclassification had no effect on Freddie Mac?s operating earnings or reported net income.

Business Outlook

Given its strong year-to-date performance, Freddie Mac expects operating earnings per share growth of about 20 percent in 2002. The corporation now anticipates that 2002 retained portfolio growth will be at the higher end of the 8 to12 percent range. Freddie Mac also expects its average operating net interest yield to decline in fourth quarter 2002 as it incurs additional hedging costs and higher PC variance expense. Finally, the corporation anticipates that credit losses in 2002 will be about 1 basis point of its average total portfolio.

In 2003, Freddie Mac expects to generate low double-digit operating earnings per share growth, while maintaining its low risk profile. Freddie Mac also expects to grow its retained portfolio by 8 to 12 percent next year. In addition, the corporation believes that its net interest margin will likely compress as it further reduces portfolio options risk and as spreads on mortgage assets purchased in the steep yield curve environment naturally decay. As a result, Freddie Mac expects its operating net interest yield for 2003 will be somewhat lower than 2002?s average. Finally, given the corporation?s strong credit position, Freddie Mac expects credit losses to increase modestly in 2003 but remain less than 2 basis points of its average total portfolio.

Source: Freddie Mac

Contact ALTA at 202-296-3671 or [email protected].