RISK AT FREDDIE MACBank Wide Risk Management

[2007]

IIM Indore

Abhishek Anand2006PGP002Section A

What could impact the level of credit, prepayment and interest rate risk for Freddie Mac?

The factors impacting the level of interest rate, credit and prepayment risks for Freddie Mac are:

Credit Risk:

Freddie Mac credit guarantee portfolio is subject primarily to two types of credit risk:

Mortgage credit risk is the risk that a borrower will fail to make timely payments on a mortgage or security Freddie Mac owns or guarantees

Institutional credit risk is the risk that a counterparty that has entered into a business contract or arrangement with Freddie Mac will fail to meet its obligations.

Mortgage Credit Risk

Mortgage credit risk is primarily influenced by

the credit profile of the borrower on the mortgage the features of the mortgage itself the type of property securing the mortgage the general economy.

Hence any change in the above factors could result in change in the risk profile of the firm. The factors which could impact the mortgage credit risk profile are

significant volatility in the credit profile of the borrower lower levels of liquidity; wider credit spreads; rating agency downgrades of mortgage-related securities; and higher levels of foreclosures and delinquencies

Institutional credit risk

Freddie Mac’s primary institutional credit risk exposure, other than counterparty credit risk exposure relating to derivatives, arises from agreements with the following entities:

mortgage loan insurers mortgage seller/servicers issuers, guarantors or third party providers of credit enhancements on

non-Freddie Mac mortgage-related securities held in our Retained portfolio; mortgage investors and originators; and Issuers, guarantors and insurers of investments held in our Cash and investments portfolio.

A significant failure by a major entity in one of these categories to perform in their obligations to Freddie Mac could have an adverse effect on the retained portfolio, cash and investments portfolio or credit guarantee activities of Freddie Mac. For example, some of the mortgage seller/servicers could experience ratings downgrades and liquidity constraints which may adversely affect their ability to perform their obligations to Freddie Mac, or the quality of the services that they provide to the firm.

Interest Rate and Prepayment Risk

Freddie Mac’s retained portfolio activities exposes the firm to interest-rate risk and other market risks arising primarily from the uncertainty as to when borrowers will pay the outstanding principal balance of

mortgage loans and mortgage-related securities held in the retained portfolio (prepayment risk), and the resulting potential mismatch in the timing of the receipt of cash flows on the assets versus the timing of the obligation to make payments on Freddie Mac’s liabilities. For the vast majority of mortgage-related investments, the mortgage borrower has the option to make unscheduled payments of additional principal or to completely pay off a mortgage loan at any time before its scheduled maturity date (without having to pay a prepayment penalty) or to hold the mortgage loan to its stated maturity.

The credit guarantee activity also exposes Freddie Mac to interest-rate risk because changes in interest rates can cause fluctuations in the fair value of the existing credit guarantee portfolio. Freddie Mac generally does not hedge these changes in fair value except for interest-rate exposure related to net buy-ups and float. Float, which arises from timing differences between when the borrower pays the firm and when the firm reduces the Mortgage Participatory Certificate (PC) balance, can lead to significant interest expense if the interest rate paid to a PC investor is higher than the reinvestment rate Freddie Mac earns on payments received from mortgage borrowers.

Duration Risk and Convexity Risk

Duration is a measure of a financial instrument's price sensitivity to changes in interest rates. Convexity is a measure of how much a financial instrument's duration changes as interest rates change. Freddie Mac’s convexity risk primarily results from prepayment risk. The firm actively manages duration risk and convexity risk through asset selection and structuring by issuing a broad range of both callable and non-callable debt instruments and by using interest-rate derivatives. Freddie Mac uses prepayment models to determine the estimated duration and convexity of mortgage assets for Portfolio Market Value Sensitivity (PMVS) and duration gap measures. Expected results can be affected by differences between prepayments forecasted by the models and actual prepayments.

Yield Curve Risk

Yield curve risk is the risk that non-parallel shifts in the yield curve will adversely affect shareholder value. The changes in the shape, or slope, of the yield curve often arise due to changes in the market's expectation of future interest rates at different points along the yield curve,

Volatility Risk

Volatility risk is the risk that changes in the market's expectation of the magnitude of future variations in interest rates will adversely affects shareholder value. Implied volatility is a key determinant of the value of an interest-rate option. Since mortgage assets generally include the borrower's option to prepay a loan without penalty, changes in implied volatility affect the value of mortgage assets.

Basis Risk

Basis risk is the risk that interest rates in different market sectors will not move in tandem and will adversely affect shareholder value. This risk arises principally because Freddie Mac generally hedge mortgage-related investments with debt securities and does not actively manage the basis risk arising from funding Retained portfolio investments with its debt securities.

Does Freddie Mac’s capital structure allow it the flexibility to respond to changes in its risk profile as discussed in question 1 above?

In order to judge the capital structure of Freddie Mac flexibility to respond to changes in its risk profile we need to analyze the compliance of the firms to regulatory capital requirement.

The Federal Housing Enterprises Financial Safety and Soundness Act of 1992, or GSE Act, established minimum, critical and risk-based capital standards for Freddie Mac. First two terms must be defined. Core capital consists of the par value of outstanding common stock (common stock issued less common stock held in treasury), the par value of outstanding non-cumulative, perpetual preferred stock, additional paid-in capital and retained earnings, as determined in accordance with GAAP. Total capital includes Core capital and general reserves for mortgage and foreclosure losses and any other amounts available to absorb losses that OFHEO includes by regulation.

Minimum Capital Requirement: The minimum capital standard requires Freddie Mac to hold an amount of Core capital that is generally equal to the sum of 2.50% of aggregate on-balance sheet assets and approximately 0.45 % of the sum of outstanding mortgage-related securities Freddie Mac guaranteed and other aggregate off-balance sheet obligations. OFHEO defines the minimum capital required as above plus 30% additional capital to provide for due to operating risk exposure, and increasing deficiencies in internal controls, systems and accounting (defined from April 2004 onwards). The table below shows the Minimum capital requirements for Freddie Mac and the core capital levels. The graph below shows the surplus as a percentage of Minimum Capital requirements.

 (USD billions) 3/31/04 12/31/03 Min Capital Requirement 24.029 23.774 OFHEO-directed Minimum Requirement 31.237 Not Defined Core Capital 34.058 32.985 Surplus (Deficit) (based on Statutory Requirement) 10.029 9.211 Surplus (Deficit) (based on OFHEO Directed Requirement) 2.821 Not Defined

The graph shows that Freddie Mac has not only complied with the minimum capital requirement but also the firm is in a very healthy position in terms of minimum capital requirement.

Critical Capital: The critical capital standard requires Freddie Mac to hold an amount of Core capital that is generally equal to the sum of 1.25% of aggregate on-balance sheet assets and approximately 0.25 percent of the sum of outstanding mortgage-related securities Freddie Mac guaranteed and other aggregate off-balance sheet obligations. Critical Capital is a leverage ratio defined in statute, which is essentially ½ of the minimum capital level. Enterprises that fall below the critical capital level are critically undercapitalized and would normally result in the appointment of a conservator.

Since Freddie Mac complies with minimum capital requirement norms hence critical capital level norms are definitely complied. The table below shows the Critical capital requirement and Core Capital.

 (USD billions) 3/31/04 12/31/03 Critical Capital Requirement 12.233 12.098 Core Capital 34.058 32.985Surplus 21.825 20.887

Risk-Based Capital: The risk-based capital (RBC) standard requires the application of a stress test to determine the amount of Total capital that Freddie Mac must hold to absorb projected losses resulting from adverse interest-rate and credit-risk conditions specified by the GSE Act. The adverse interest-rate conditions prescribed by the GSE Act include one scenario in which 10-year Treasury yields rise by as much as 75 percent (up-rate scenario) and one in which they fall by as much as 50 percent (down-rate scenario).

3/31/2004 (USD billion)Interest Rate Scenario Up Down RBC Requirement 7.047 7.131 Total Capital   34.898Surplus (Deficit)   27.76712/31/2003  Interest Rate Scenario Up Down RBC Requirement 5.094 5.426Total Capital   33.436Surplus (Deficit)   28.01

The table above shows the Risk Based Capital requirements and Freddie Mac’s compliance with the capital requirement. A better analysis of the risk adjusted capital requirement would be a comparison between the past year performance of Freddie Mac on this parameter. The graph below shows the change in the factor defined as the ratio between Total Capital of Freddie Mac and RBC requirement.

The graph clearly indicates that the company has complied with the risk adjusted capital requirement for the defined parameters.

Freddie Mac has always been classified as “adequately capitalized” by OFHEO clearly reflecting the compliance of the firm with minimum, critical and risk based capital requirements. The risk based capital scenario adequately captures the high variations in interest rate scenario hence the performance in this parameter signifies that Freddie Mac is in a good position to tackle high volatility conditions. Further the minimum capital requirement parameter is also fulfilled by the firm. However because of the restatement of the accounts, better criteria for minimum capital requirement will be as given by OFHEO (130% of minimum capital required) as it covers the risks because of operating risk exposure, and increasing deficiencies in internal controls, systems and accounting. Freddie Mac had a surplus of $2.8 billion on account of this parameter too. However the performance in the coming years would give a better indication of Freddie Mac’s compliance with this parameter.

In order to deal with credit risks Freddie Mac has focussed on three key areas: underwriting requirements and quality control standards; portfolio diversification; and portfolio management activities, including loss mitigation and the use of credit enhancements.

What kind of role does the present (FY 06 and FY 07) capital structure and business strategy allow Freddie Mac to play in the present housing market crisis in the US? As part of this question, please do write about a page on your understanding of the present housing market crisis in the US and this note should form the basis for your discussion on Freddie Mac’s role?

US subprime mortgage crisis has resulted from the defaults by the subprime category in mortgages. Many factors contributed to the crisis, but the most immediate causes were a rising interest rate environment which caused people with adjustable rate mortgages to see significant increases in their loan payments amid declining property values. This left many borrowers unable or unwilling to meet their financial commitments, and many lenders without a means to recoup their losses.

The risks due to subprime crisis are three folds:

1. Credit risk: This risk arises due to the increasing defaults in the mortgage backed securities

2. Asset Price risk: Most CDOs require that a number of tests be satisfied on a periodic basis, such as tests of interest cash flows, collateral ratings, or market values. Because the ability of sub-prime and lower-quality (e.g., Alt-A) mortgage homeowners to pay is now in question, the value of the mortgage asset may be reduced suddenly.

3. Liquidity Risk: A related risk involves the commercial paper market, a key source of funds (i.e., liquidity) for many companies. Companies and SPE called structured investment vehicles (SIV) often obtain short-term loans by issuing commercial paper, pledging mortgage assets or CDO as collateral. Investors provide cash in exchange for the commercial paper, receiving money-market interest rates. However, because of concerns regarding the value of the mortgage asset collateral linked to subprime and Alt-A loans, the ability of many companies to issue such paper has been significantly affected. In addition, the interest rate charged by investors to provide loans for commercial paper has increased substantially above historical levels. As a result a liquidity crunch exists in the market.

Freddie Mac and Subprime Crisis

At December 31, 2006 and 2005, the Structured Securities backed by subprime mortgages constituted approximately 0.1% and 0.2%, respectively of Freddie Mac’s credit guarantee portfolio. With respect to their retained portfolio, at December 31, 2006 and 2005, Freddie Mac held approximately $124 billion and $139 billion, respectively, of non-agency mortgage-related securities backed by subprime loans. These securities include significant credit enhancement based on their structure and more than 99.9% of these securities were rated AAA at December 31, 2006. However the rating of AAA is clearly against the whole idea of subprime loans. Hence the company had substantial exposure in subprime loans market.

Inorder to decide on the role of Freddie Mac in US mortgage market we need to understand the mission of the company. Freddie Mac’s mission is to provide liquidity, stability and affordability to the U.S. housing market. This mission was the driving force in its strategy in the early part of the subprime crisis. As stated by one of the company’s press release on the plan of action-

“.. includes a major investment in new subprime products, tougher underwriting standards, aggressive foreclosure prevention efforts, as well as borrower education and anti-predatory lending initiatives.

These and other actions aim to stabilize markets by ensuring an uninterrupted supply of liquidity to the housing sector, while strengthening investor confidence here and abroad in the resiliency of the U.S. mortgage market. By stepping up our mortgage purchases and investments, we help keep mortgage rates low, stable and affordable for millions of families seeking to purchase or refinance homes they can afford and keep.”

Clearly in the early part the strategy of Freddie Mac was to inject liquidity in the subprime market and mortgage market as a whole. However the result of this policy is evident in the graphs shown below. Surplus as a percentage of minimum capital requirements as defined by OFHEO has been falling for past few quarters. The surplus as a percentage of minimum capital requirement was steady till March 2006. However since then it has declined from 13% on March, 2006 to 5% on June 2007.

Similar pattern is shown by the graph below depicting the surplus as a percentage of minimum capital requirement for statutary requirement.It has been declining from March 2006 (47%) to June 2007 (37%).

Next parameter of Capital Adequacy is the risk based capital requirement. The graph below shows the ratio of total capital and Risk based Capital requirement. The graph follows a pattern similar to that of the minimum capital requirement. However in March 2007 we see a rise in the ratio from 2.4 to 2.67. Freddie Mac has maintained a near constant total capital for past few years. Hence the increase in ratio is primarily due to the decrease in risk based capital requirement. However in June 2007 the ratio between total capital and risk based capital requirement dropped to an all time low of 1.96. Further increase in investment in subprime mortgage securities could impact the compliance of Freddie Mac on Risk Based Capital parameter.

Freddie Mac post September 2007

Freddie Mac had declared a loss of $1.2 billion in provisions for credit losses and reduced the value of assets by $3.6 billion in the third quarter of FY07. A slump in the value of mortgages reduced core capital by two-thirds resulted in the surplus core capital after meeting the regulatory requirements to $600 million from $1.78 billion in June 2007. This means that the surplus as a percentage of minimum capital required has dropped from 5% in June 2007 to 1.7% in September 2007. Therefore in short term Freddie Mac needs to raise more capital to meet its regulatory requirements.

One way to go ahead is reduction in its fourth quarter dividends. In FY06 the company paid out $1.31 billion as dividend to its shareholders. The capital requirement can be met by decreasing the dividend payout this will almost double the capital surplus. Further the company should consider limiting the growth by slowing the purchases in its guarantee portfolio. Also the company can look into the option of issuing preferred stock or convertible preferred stock.

Although these steps might oppose the initial stand of Freddie Mac, Freddie Mac needs to meet the capital norms inorder to achieve the objectives of stability and supply liquidity. Buying subprime portfolios may inject liquidity in the short term but the liquidity injected is likely to disappear more quickly until and unless the loans given are properly rated and probability of default is especially low. In short Freddie Mac in short term needs to follow a prudent investment policy.