Freddie Mac (OTCQB:FMCC) Q4 2015 Results Earnings Conference Call February 18, 2016 8:00 AM ET
Sharon McHale - Corporate Communications & Marketing VP
Don Layton - Chief Executive Officer
Jim Mackey - Chief Financial Officer
Joe Light - The Wall Street Journal
Paul Muolo - Inside Mortgage Finance
Good day and welcome to the Freddie Mac Fourth Quarter Full Year Financial Results Call. Today’s conference is being recorded. At this time, I would like to turn the call over to Ms. Sharon McHale. Please go ahead, ma’am.
Thank you. Good morning everyone, and thank you for joining us as we discuss Freddie Mac’s fourth quarter and full year 2015 financial results. I am here today with our Company’s Chief Executive Officer, Don Layton; our Chief Financial Officer, Jim Mackey; and our Principal General Counsel, Alicia Myara.
Before we begin, we would like to point out that during this call, Freddie Mac’s executives may make forward-looking statements, which are based upon a set of assumptions about the Company’s key business drivers and other factors. Changes in these factors could cause the Company’s actual results to vary materially from its expectations. A description of these factors can be found in the Company’s 10-K report filed today.
As a company in conservative shift, Freddie Mac’s commentary will be limited to business and market topics. As you know, we are not able to comment on the development of public policy or legislation concerning Freddie Mac. As a reminder, this is a call for the media and only they will have the ability to ask questions, this call is being recorded and a replay will be made available on Freddie Mac’s website later today.
With that, I will now turn the call over to Don Layton, Chief Executive Officer of Freddie Mac.
Good morning. And thank you all for joining us so early. My comments this morning will focus on three areas: First, I’ll discuss our financial results, focusing primarily on the full year 2015 while touching briefly on the fourth quarter; second, I’ll highlight our progress in building a better Freddie Mac and how this helps produce a better housing finance system for the nation; and third, I’ll talk a little bit about our focus for 2016.
Let me jump right into the financials.
This morning, Freddie Mac reported comprehensive income of $5.8 billion for the full year 2015, and $1.6 billion for the fourth quarter. And conservatorship I remind you, our primary focus is on comprehensive income. Net income, the more traditional measure of profits, was $6.4 billion for the year and $2.2 billion for the quarter. These positive results mark our fourth straight year of profitability.
Fourth quarter results were up significantly from the third quarter, highlighting the quarterly volatility on our earnings from market related items, specifically movements in interest rate and credit spreads.
As I have said before, we economically hedge our interest rate risk primarily using a derivative hedging strategy, which can result in GAAP earnings volatility. This volatility is mainly due to accounting asymmetries and not real economic gain or loss. Simply put, for accounting purposes, we fair value our derivatives, but we do not fair value all the assets being hedged, creating the accounting asymmetry. As a broad generalization, we’ll have an accounting loss, but not an economic one, if rates decline and the gain of rates increase. For example, 10-year LIBOR moved down 44 basis points in the third quarter, resulting in a $1.4 billion reduction in earnings and increased by 18 basis points in the fourth quarter, resulting in a $0.3 billion increase in earnings. And as of yesterday, the 10-year is down 52 basis points for the current quarter of 2016. Additionally, credit spread sensitivity in our GAAP results, which does reflect the underlying economics by comparison is inherent in our business model and can also contribute to a significant volatility, although historically with less impact on earnings than interest rate movements themselves.
Despite the quarterly volatility, these market-related items had minimal impact on our full-year 2015 results. Interest rate movements resulted in only about a $200 million after tax earnings decrease while spread widening resulted in only about $100 million after tax decrease as well. The big driver in fact of our results in 2015 was robust net interest income, which includes single-family guarantee fees or G fees.
NII was $14.9 billion up 5% from 2014, reflecting improved fundamentals in the single-family business. This increase is notable, given that we continue to shrink our retained portfolio, as required by the government. In 2015, the retained portfolio declined another $62 billion, somewhat exceeding the mandated reduction set forth by the purchase agreement we have with the U.S. Treasury.
Here some highlights of the year. One, the single-family business volume played a significant role in these overall results. Year-over-year purchase volume was up 37% and at higher G fees than our historic average. As a result, guarantee fee income continued to be a growing source of revenue for us, accounting for about 45% of our net interest income in 2015, up from approximately only 35% in 2014.
Two, our strong post-2008, or as we call it, core single-family book of business, now makes up more than 65% of the single-family portfolio, and there is an additional 18% consisting of HARP and other relief refinance loans. Remaining legacy single-family portfolio declined from 20% of the credit guarantee book to 16% last year. In 2015, we also responsibility disposed of another $15 billion in less liquid assets including nearly $3 billion of NPL sales. Taken together, the serious delinquency rate on our entire single-family book including the legacy assets is down more than 50 basis points since the end of 2014 and was at its lowest level in seven years at 1.32% by the end of 2015.
And fourth, turning to the multifamily business, fundamentals were simply very strong. Purchase volume increased 67% from 2014, hitting a record $47 billion in 2015, reflecting both a strong market and our growing share of it. We continue to securitize more than 90% of our multifamily volume with the vast majority of the risk is transferred to the capital markets and very importantly, delinquency rates on these loans still remain near zero.
So, we are both -- we are providing much needed liquidity explanation to rental markets as well as the pioneer in transferring risk to private capital markets to fund multifamily properties. All-in-all, we had another good year enabling us to return and additional $5.5 billion dividends to tax payers. The additional $1.7 billion in dividends we expect to pay at the end of March will bring the cumulative total to $98.2 billion, almost $27 billion more than we have received cumulatively.
Now turning to a new topic with the New Year, our permitted capital buffer in the purchase agreement declined to $1.2 billion from $1.8 billion. As a reserve continues to decline to zero in 2018, we continue to monitor our earnings volatility and the potentially increasing risk that we will have to take a draw from treasury. As such, we are actively working on various alternatives to better align our GAAP results to the economics of the business and to ameliorate the true underlying volatility associated with credit spreads.
It is important to note however that regardless of any actions that we do or do not take to reduce our exposure to these market related items, the decline in the capital buffer to zero, creates the real risk of our needing a draw in future periods, given the irreducible volatility of GAAP earnings in the GSE business.
I’d also wish to remind everyone that the concept of capital, equity primarily, in our conservatorship is very unusual. The many firms and industries which deal with us, look not to our small permitted capital buffer but to the unused portion of the purchase agreement as the source of the capital stream behind our liabilities and thus us appropriately as a very strong credit. That unused PSPA amount has been a very large number for some time specifically $140.5 billion.
I’ll move on now to my next topic, our efforts to build a better Freddie Mac, so as to better support our customers and the housing finance markets generally. Much of our focus in 2015 was on improving the Company’s competitiveness and operating performance. In fact, it was a pivotal year in which we were able to concentrate most of our energies on moving the Company forward, after spending five years, focusing pretty heavily on working through legacy and post-crisis issues. This going forward focus includes such things as one, product expansion and refinement; two, investing in customer facing and risk management systems; while three, controlling overhead expenses; and four, evolving our culture to be more customer-focused and competitive. The goal of these types of efforts is to ensure that Freddie Mac is in the best possible position to support our customers, to be efficient with the tax payers’ funds which support us and we are broadly, to support to the nation’s housing finance system. We are doing this in several ways.
First, we are developing responsible product offerings that meet our customers’ needs and then help them better serve low and moderate income borrowers and underserved markets. Second, we are providing customers with better tools and technology to lower their costs and make it easier for them to do business with us. Third, we are focused on the needs of the market, particularly the smaller and mid-sized lender segment where increasing share of mortgages are now being funded. Our efforts are paying off. Last year, we funded one out of every four home loans. And as I noted earlier, we were the largest source of funding for rental housing; in total, between both businesses, making home possible for more than 2.2 million families.
Here are some specifics. 2015 was our best year in funding first time home buyers since the housing crisis with purchases of loans to first time home buyers up 13% over the prior year. Two, our 3% Down Home Possible Mortgage volume continues to see our original expectations. While purchase volumes of these very targeted products are effectively small, they are steadily increasing. Three, about 90% of the multifamily apartments we financed were affordable to families earnings at or below the area median income. Four, in fact an increasing focus in growth in our multifamily business is on financing for smaller multifamily properties, senior’s housing and manufacture housing communities among underserved segments. Five, on the technology front for single-family our Loan Advisor Suite known as LAS on technology applications which we previewed in 2015, it sets more broadly launch later this year. Loan Advisor Suite will help our customers, one, cut the cost of producing high quality loans to reliable and user friendly technology; and two, provide greater loan purchase certainty and earlier insight into representation and warranty relief, which is a very important feature that is now becoming a part of the mortgage markets of the future. We view Loan Advisor Suite as key to superior customer focus in years to come. And sixth, we enhanced our single-family cash purchase program through which many smaller single-family lenders prefer to do business. This program known in the industry as the cash window, allows them to sell the loans for cash to us instead of swapping them for a mortgage backed security. Delivery volumes through this channel grew more than 60% last year.
And everything we’re doing in these programs is also done with the tax payer very much in money. Specifically, we are transferring credit risk on the growing volume of mortgages. In our single-family business, we expanded our credit risk offerings significantly last year, introducing new types of transactions and increasing the volumes of our offerings. Since we pioneered single-family credit risk transfer in 2013, we secured approximately $16 billion of protection for mortgage default losses to tax payers.
In the multifamily business where as I said more than 90% of the loans we purchased were designated for securitization last year. The vast majority of the expected credit losses is also transferred to private investors. At the same time, we are working with the FHFA to improve the operations of the nation’s mortgage markets, actively supporting initiatives related to such priorities as developing the common securitization platform and improving the representation and warranty framework in the industry. As an example of the latter, we recently announced a new independent dispute resolution process that further simplifies rep and warranty relief to our customers. These other steps will help the strength in the nation’s mortgage market.
Finally, as I said, I will talk a little bit about our focus for 2016. We expect this year’s single-family and multifamily markets to be broadly similar to those found in 2015. And just as we did last year, we’re going to compete hard to win more business from our customers. Responsibly expanding access to credit will also remain a top priority for us this coming a year.
On the single-family side, one, we’re working directly with state and local housing finance agencies, something we have not focused on in many years. Two, fine-tune our program for purchasing real property mortgages on manufactured housing, including leveraging our network of borrower help centers to increase liquidity for this important segment of the market. Three, we’ve launched what we consider a test and learn program with Quicken Loans, one of our major customers, to identify new ways to responsibly serve low and moderate income borrowers. And four, we’re developing new strategies to support our customers own CRA needs.
In multifamily, we’ll continue to focus in growing our small balance loan program and generally expanding funding for workforce housing including property preservation and potentially new offerings in the green building that is energy efficient space. And we will continue to lead the market in credit risk transfer by evolving our offerings and introducing new loans in both the single-family and multifamily businesses, focusing on improving liquidity of our offerings, increasing transparency with investors and broadening the investor base, both domestically and overseas.
I look forward to updating you in these efforts as the year progresses. With that, let me wrap up by saying that 2015 was another strong year for Freddie Mac. And I feel very good about our customer and product progress and momentum in 2016.
I’ll now open up for your questions.
[Operator Instructions] We’ll go first to Joe Light with The Wall Street Journal.
Hi, good morning. Thanks for taking the question. So, you touched on this a little bit already but if we could talk a little bit about the derivative accounting issues and such, I guess was gone on with rates this year. So, I guess who knows whether what it’s going to look like at the end of the quarter, but I think over the 10-year, it’s dropped by 45 basis points or something like that which I know doesn’t correlate exactly to what sort of impact they’ll have on your derivatives. But with kind of that magnitude of drop, are we already at the point where you guys -- where you guys would be thinking about changing how you’re hedging in order to avoid accounting driven loss or draw?
First of all, thanks for joining us Joe. Glad, you got up early for this. We stated in the tax that rates have dropped; I think we used 10-year LIBOR 52 basis points, which is roughly similar to the drop in interest rates found in the third quarter of last year. The big difference of course is the drop in the third quarter of last year happened at the end of the quarter. In this case, as you accurately described, it happened early in the quarter and we don’t know what’s going to happen. Obviously, we’re not going to comment on earnings, but there is a similarity so far to the rate moves with third quarter.
We’ve also been transparent that the vast majority of this is about GAAP accounting economics. We stated very clearly, we’re looking at how to address the volatility, consistent with proper financial concepts and being efficient with the tax payers’ funds. We’re not going to preannounce anything we’re going to do until we are ready to announce we’re doing it, if we decide to. But obviously, as the capital buffer declines, it becomes a bigger issue. I do note that we still have the $1.2 billion this year. Otherwise, I’ll just say, stay tuned.
[Operator Instructions] We’ll go next to Paul Muolo with Inside Mortgage Finance.
Hi. Hey Don, thanks for taking my question. I assume and you can talk about the sort of -- you called on you are actively working on alternatives. I assume you can tell us what some of those hedging alternatives might be, would you guys consider not hedging at all?
You’re right. We’re not going to give you -- we’re looking at a whole bunch of things. But we won’t announce things until we announce them. Just not hedging at all is not on the list. I’ll go that far. By the way, while many financial institutions will take interest rate risk as part of their regular risk activates, it is considered improper for a company conservatorship with tax payer funds be doing that. So, it’s sort of a government policy that we keep our actual economic interest rate list as modest as we reasonably can, as one can measure and model it.
We’ll take a follow-up question from Joe Light with The Wall Street Journal.
Hi, thanks for the follow-up. So, you mentioned earlier that -- the counterparties that rely on your guarantee are looking to that unused PSPA amount as the source of your safety and the guarantee safety. If at some point that PSPA now were to fall, not even because of accounting issues or because of the other issues you mentioned earlier in the call, at what point does that -- the safety of the guarantee or I guess more like a perceived safety in the guarantee becomes threatened?
Okay. You are asking me to talk about investor psychology and which of course can be fickle in different market environments. I will point out some numbers to you however. We currently have unused $140.5 billion. The question of course is how big is that? The FHFA publishes once a year the results of stress test done consistent with the Fed stress test you are most familiar with in the banking system, sometimes referred to DFAST stress test which comes from Dodd-Frank sometimes, CCAR stress test versus the Fed labeling program. We do that and they announced the results for these as we’re required to do for the severely adverse scenario which would be toughest of the three scenarios. I am looking at Jim, our stress losses last year were $65 billion loss. So, in the very stressful worst scenario they came up with 65. As you can quickly discern 65 versus 140 is a very good position to be at. So, concepts of the unused PSPA dwindling would be very, very far out in the future after multiple financial crises. I’ve also had it explained to me by investors that they also view the PSPA not just mathematically but symbolically that government supports the two GSEs and they get a lot of comfort from that as well.
And we’ll take a follow-up question from Paul Muolo with Inside Mortgage Finance.
Do you expect in general that your guarantee fee income is going to be better or about the same this year or worse in 2015?
It is almost a mathematical calculation that our average guarantee fee on the existing outstanding book will go up in 2016 over 2015. The reason I say that is because the guarantee fee which is basically controlled by the FHFA conservatorship, was much lower and was raised over several years, about 10 basis points a year. So, the current level of guarantee fees is considerably higher than the average. So, old mortgages are prepared and roll off or mature and roll off, the new ones come on at a higher G fee. So, for several years, there will be this normal ramp up, as the new stuff averages in against the old book. Is that understandable?
Yes. Can you also talk a little bit about Freddie Mac’s headcount? You guys continue to shrink but can you give us a rough number on Freddie Mac employees at year-end ‘15 compared to say the year before?
I am not sure where you got your information that the number of employees continues to shrink.
Oh! Your assets continue to shrink.
Okay. Yes, let me just talk about the underlying businesses and then I’ll get to employees. The discretionary investments in the retained portfolio are on a required long-term shrinkage. As a conservatorship, I believe they were about $750 billion to $800 billion at the time; obviously it would be shrinking to the required $250 billion. And in fact the FHFAs require us to shrink it somewhat further than the $250 billion. So, that will effect. That part of the business employs very few people, because it’s just a wholesale portfolio operation.
The guarantee businesses, we are asked the government to help support a vibrant housing finance system to do all the many projects listed in the conservatorship score card, which is published every year; for this year now, the most noteworthy is helping to build the CSP and integrating the CSP for example, as well all new products, credit risk transfer and other operations. So, in fact, our employment in the guarantee businesses is going up. And those are much more body count intensive businesses. So, we are actually increasing the number of employees.
In addition, as you may be familiar of various employees and then often companies have personnel in the form of contract workers that’s very common in Washington. We have had through our other program to try to put more of the contract workers as employees for a variety of reasons. The actual headcount, do we have it here? I believe the actual headcount went up several people during the year, but I don’t have the number readily -- do we have it?
Yes, 5,400 now and I bet it was a few hundred less at the end of the prior year.
We’ll take another question from Joe Light with Wall Street Journal.
Hi, thanks. I also wanted to ask you about headcount and the numbers I have, I mean everybody should look it up themselves I guess. But, I think it’s 4,957 for the last annual report and 5,416 for this report. So, this 5,416, I mean it looks like it’s the most since 2006 maybe when you had about 5,400. So, of those kind of 500 or 460 some odd people who are added in the last year, you’re saying that most of those are related to developing the CSP or I guess how does that break down?
I can’t give you an easy breakdown, but I will give you some rough parameters. Systems development is the biggest area of growth that includes everything from the large project to integrate to the CSP to the loan advisor suite, which is customer focused to reduce costs and improve rep and warranty relief in the industry, all of which public policy wishes us to do, as well as all the many mandated systems things that large financial institutions have to do more and more like cyber security budget is going up things like that, that’s the largest part.
The second thing going on is I referred to it, it’s oddly; we’re substituting labor for capital. We’re hiring people to do all the credit risk transfer activities of the Company. So the tax payer exposure is reduced, just keep doing all the risk on tax payer exposure -- on the tax payer doesn’t require as many people with developing the tools and techniques and doing the transactions, put them into the capital markets. And then of course the volume increases, multifamily, I already mentioned was up 67%; they required people to do that and even single-family volumes are up. I mentioned I think was 37 or so percent. So volumes are going up. And so that’s why we have more people.
Got it. And all those trends that you mentioned, I mean the headcount has stayed at about 5,000 for a few years before this increase. So, all the stuff kind of happened at once in 2015?
No, we’re also doing actually efficiency things, so like any company there is ins and outs. And some of the outs offset the ins those earlier years. In addition, as I mentioned, we did have -- because we need to move fast, we end up with a lot of contract workers which we have been converting. And in retrospect, it would have been better if we had fewer contract workers and more employees, which is why we’re pushing to transfer now.
Got it. Thank you.
Yes. One of my colleagues here pointed out, because we were off in the era of legislation is eminent, in conservatorship, we did emphasize contract workers, because we didn’t know if the employment would last that long and obviously we’re in protracted conservatorship. And so, it’s better if they’re employees.
[Operator Instructions] And we have no more questions at this time. So, I turn the call back over to our speakers for any additional or closing remarks.
Again, thank you for joining us. We think the full year results 2015 and in fact the fourth quarter, you will notice were three of some of the recovery items that were so present in many of the prior years. There were no big lawsuit benefits, there was no giant reduction in credit reserves helping income as house prices return to more normal levels from the crisis. So, what you see is a good picture of the underlying Company and our earnings and our activities. And we’re proud of our results and we’re happy to have our strong momentum moving forward. Thank you.
That does conclude our conference. We thank you for your participation.
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