This article examines an important reason-derivative losses-that helps to explain why Freddie Mac (OTCQB:FMCC) needed to draw on the U.S. Treasury during the 2008-2012 period. Freddie Mac is underfollowed by professional sell-side analysts. Thus, it seems useful to “deep dive” into an important cause of FMCC’s draws on the Treasury.
My hope has always been that derivative gains would eventually replace derivative losses on FMCC’s income statement. However, it is likely the case that the counterparties to the derivative contracts with FMCC are smarter than FMCC, which is essentially a public utility. With the end of quantitative easing, interest rates are likely to go up over time and the era of derivative losses should soon be over. However, as reported by Jody Shenn of Bloomberg, it is unfortunately the case that FMCC has already begun to replace its derivative contracts with bonds that do not require mark to market accounting. This may mean that derivative gains will not eventually offset the derivative losses of the last few years. Still, with the end of quantitative easing and a relatively strong U.S. economy the era of derivative losses should soon be over.
FMCC made cumulative cash draws on the U.S. Treasury totaling $71.3 billion during the 2008-2012 period. In return, FMCC has made cumulative dividend payments of $91.8 billion to the Treasury. The last time FMCC drew on the Treasury was in the first quarter of 2012, when it drew only $19 million. For FNMA, cumulative draws total $116.1 billion, dividends total $136.4 billion, and FNMA’s last draw was in 2011. For FMCC and FNMA combined (familiarly known as the government-sponsored enterprises or GSEs), the two companies have drawn $187.4 billion from the Treasury and repaid $228.2 billion in the form of dividends, resulting in payments that are $40.8 billion in excess of Treasury’s “net investment” in the GSEs.
While neither FMCC nor FNMA has drawn on the Treasury since early 2012, on August 17, 2012 the Treasury and the Federal Housing Finance Agency agreed to a “third amendment” to the Senior Preferred Stock Purchase Agreement (SPSPA) that essentially replaced a 10 percent dividend with a “sweep” of FMCC and FNMA earnings to Treasury. This will, by 2018, result in FMCC and FNMA having no book common equity on their balance sheets. The legality of the third amendment is now being separately scrutinized in the U.S. Federal Court of Claims and the U.S. Court of Appeals D.C. Circuit.
Assuming normal economic conditions, FMCC is not expected to draw further on the Treasury, although “worst case” financial stress-test results indicate the potential for FNMA and FMCC to draw as much as $190 billion if a financial crisis similar to the 2008 financial crisis were to occur. With essentially no book equity capital, FMCC and FNMA are not well-positioned to withstand a period of financial stress. Nevertheless, the Treasury and FHFA seem to be locked into continuing existing arrangements for the GSEs rather than trying to reduce taxpayer exposure to possible (albeit relatively unlikely) severe financial stress in the future.
One-half of FMCC’s draws were the result of changed macroeconomic conditions-sharply lower interest rates-resulting from the financial crisis. Derivative losses (net of derivative gains), as reported on FMCC’s income statements during the 2008-1Q2012 period led to exactly 50 percent of FMCC’s draws on the US Treasury. For FNMA, the effects of derivative losses were somewhat less severe and thus are not the focus of this article. FMCC’s derivative-related draws on the US Treasury reflected changes in macroeconomic conditions that were beyond its control.
Disclaimer: focusing on a specific line item on FMCC’s financial statements is somewhat reductionist-FMCC’s draws were based on a number of factors. Nevertheless, it is true that FMCC had $35.747 billion of derivative losses in 2008-1Q2012, compared to $71.317 billion of draws. Table 1 presents FMCC’s cumulative derivative gains and losses and cumulative draws on the Treasury. This table shows that at 1Q2012 derivative losses were equal to exactly 50 percent of FMCC’s draws on the Treasury.
Table 1: Percent of FMCC Cumulative Draws on the US Treasury Resulting from Cumulative Net Derivative Losses
FMCC’s derivative losses were less severe in 2012-2014, totaling $7.051 billion during this period, compared to total comprehensive income of $78.854 billion. Thus, absent these derivative losses, FMCC’s dividends to the US Treasury would have been $7.051 billion larger than was actually the case.
FMCC uses derivatives to hedge their interest-rate exposure. While FMCC’s derivatives programs are complex, in general it can be said that derivative gains and losses can result from both shifts in the slope of the yield curve and increases or reductions in the overall level of certain interest rates. Interest rates fell during the “financial crisis” period and have continued at historically low levels. Moreover, the Treasury yield curve has flattened in recent years relative to year-end 2007 levels.
For the entire 2008-2012 period, the U.S. Treasury yield curve was entirely below the yield curve at year-end 2007. Interest rates fell during the “financial crisis” period and have continued to be low relative to historical experience. These lower-than-normal interest rates result both from market conditions and Federal Reserve intervention in the markets (e.g., quantitative easing). Table 2 shows the U.S. Treasury yield curve at year-end 2007 compared to the Treasury yield curve at March 31, 2015. This provides a succinct explanation of why FMCC had substantial derivative losses in recent years.
Table 2: Change in U.S. Treasury Yield Curve (12/31/2007 vs. 3/31/2015)
FMCC’s derivative losses are likely to continue in the first quarter of 2015 given that the U.S. Treasury yield curve declined and flattened during this period. Simple visual inspection indicates that the changes in the yield curve are roughly comparable to what happened during the second quarter of 2014, when there were derivative losses of about $2.0 billion, which would be about $1.4 billion or so less than the derivative losses experienced during the fourth quarter of 2014. Note, however, that the exact nature of FMCC’s hedging programs are not clearly specified in its notes to its financial statements and thus it is difficult to estimate FMCC’s future derivative gains and losses, even for the next quarter.
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Disclosure: The author is long FNMAS, FMCKJ, AMONG OTHERS. (More…)The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Mr. Olson holds long positions in a number of Freddie Mac and Fannie Mae preferred stocks, including FNMAS, FMCKJ, among others.