Derivative Gains Could Add $3 Billion To Freddie Mac’s Next Quarterly Earnings …

Holding everything else constant, Freddie Mac’s (OTCQB:FMCC) total comprehensive income could be as much as $3.0 billion higher than last quarter based on one item alone–derivative gains. Of course, everything else will not be constant, making Freddie Mac’s income for Q2 2015 hard to predict. Also, Freddie Mac’s total comprehensive income is swept to the U.S. Treasury (Treasury) rather than going to shareholders as it should. Nevertheless, improved earnings could benefit investors in FMCC common stock as well as FMCKJ and other Freddie Mac preferred stocks.

During Q2 2015, the Treasury yield curve has gone up, especially at the long end of the yield curve, with 30-year Treasury bonds trading 57 basis points higher (as of June 30) compared to the end of the first quarter. A higher and steeper Treasury yield curve may result in derivative gains rather than derivative losses in Freddie Mac’s next earnings report.

In a previous Seeking Alpha article, I had anticipated that the derivative losses for Q1 2015 would be $1.4 billion less than the previous quarter. In Q1 2015, the derivative losses were, in fact, $1.0 billion less than the previous quarter, resulting in derivative losses of $2.4 billion. For Q2 2015, I anticipate that there will be derivative gains rather than losses, totaling perhaps $0.6 billion.

Freddie Mac long ago established derivative positions to emulate “as if” they were instead issuing long-term bonds. With current GAAP accounting, this means quarterly mark to market. Given this, Freddie Mac is working toward replacing more of the derivative positions with long-term bonds. In the meantime, Freddie Mac has a quarterly mark to market “problem” that increases the volatility of its total comprehensive income. This quarter, however, derivative gains could add to Freddie Mac’s total comprehensive income.

The Prospect for Derivative Gains Rather than Losses

I do not have access to the exact methodology and inputs used to calculate Freddie Mac’s derivative gains (losses). To calculate estimated derivative gains (losses) for Q2 2015, I have instead developed a methodology using quarterly changes in the Treasury yield curve as a proxy for the actual methodology used by Freddie Mac.

In Table 1, I present the Treasury yield curve as of March 31, 2015 and June 30, 2015 as well as the delta (change) between the two. Note: a basis point is 1/100th of one percent so three basis points is equal to 0.03 percent. Treasury yield curve data can be found here. I include all of the various maturities (one month, three month, all the way to the thirty years) in my calculations.

Table 1: Delta (Change) in U.S. Treasury Yield Curve (3/31/2015 vs. 6/30/2015)

For each quarter in the 2009-2015 period, I then calculate correlation coefficients between the changes in the yield curve in Q2 2015 and the selected quarter in order to find the quarters that are most comparable to the changes in the yield curve during Q2 2015. This is easy to calculate using standard spreadsheet software.

Next, I identify the derivative gains (losses) that occurred in the quarters that I use as a proxy for Q2 2015. I found this information in the Freddie Mac earnings reports. For example, the press release earnings report for Q1 2015 can be found here.

Table 2 presents the correlation coefficients that I calculated and the derivative gains from the earnings reports for the six quarters that are in the proxy group. The six quarters shown in Table 2 are the ones that may best provide a proxy for the Q2 2015 results. Derivative gains (losses) vary widely for these six quarters, reflecting the volatility of this line item on Freddie Mac’s income statement. It may also reflect the imperfect nature of the methodology used in this report.

Table 2: Correlation Coefficients and Derivative Costs for Quarters that are in the Proxy Group

While numerous uncertainties exist, I selected $0.6 billion as my base-case estimate for Freddie Mac’s Q2 2015 derivative gains. I calculated this based on the simple average of the three most recent quarters (zero, $0.4 billion, and $1.4 billion).

I subjectively selected the seemingly anomalous derivative loss of $1.1 billion in Q1 2012 as my worst case estimate.

A best-case estimate might factor in the derivative gains in Q4 2009 and Q4 2010 in some fashion.

Given the derivative losses of $2.4 billion in Q1 2015, my base-case estimate would be an improvement of $3.0 billion in Q2 2015 earnings. My worst-case estimate would be a $1.3 billion improvement relative to Q1 2015. This is a substantive improvement given that Freddie Mac’s total comprehensive income for Q1 2015 was only $0.746 billion.

There are obvious limits to the methodology used in this article. Life is uncertain and Freddie Mac’s derivative gains (losses) are hard to predict. Nevertheless, Freddie Mac’s derivative gains for Q2 2015 may be somewhere in the neighborhood of $0.6 billion, which would be $3.0 billion better than the Q1 2015 results.

Time will tell. Freddie Mac is expected to announce its Q2 2015 earnings sometime before August 10, 2015.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

Disclosure: I am/we are long FMCKJ AND OTHER FREDDIE MAC AND FANNIE MAE PREFERRED STOCKS. (More…)


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