Derivatives Weigh Down Freddie Mac

First, the bad news. Despite solid operational performance, Freddie Mac's 2004 net income declined by $2 billion, reflecting a substantial decrease in the value of derivatives that are used to manage interest rate risk exposure.

Now, the good news: investors didn't panic.

Freddie Mac earned $2.8 billion last year, down from $4.8 billion in the record-breaking home loan year of 2003. While business volume and interest margins contracted a bit last year, the big culprit was Freddie Mac's derivatives portfolio. Those derivative securities are key to offset interest rate risk in Freddie's investment portfolio, but they don't qualify for hedge accounting treatment. Hence, Freddie Mac reported a $4.5 billion loss related to the portfolio.

Still, Freddie Mac executives explained to investors that the impact of the derivatives does not paint a full picture of the company's condition. A better measure than GAAP earnings, they suggested, is the "fair value" of the enterprise, which puts all assets and liabilities on the same page.

Freddie Mac said its fair value rose to $26.7 billion last year, from $22.9 billion at the end of 2003. That's a 17% increase from a year earlier.

Patricia Cook, executive vice president at Freddie Mac, said in a conference call with investors and analysts that the fair value measure eliminates the "bias" that changes in derivative gains and losses have on earnings under GAAP.

The fair value measure better takes into account "the risk management of the overall portfolio," she said.

At the same time, Freddie Mac said that it exceeded a minimum regulatory capital threshold by $10.8.

If the "fair value" explanation sounds like some kind of Enron-inspired accounting trick, think again. Investors and analysts reacted largely positively to Freddie Mac's earnings, despite the pay-no-attention-to-GAAP caveats. The stock price rose after Freddie Mac's first official earnings report in almost two years was released. Analysts continue to say that at today's prices (Freddie's shares were trading around $61 on April 4) the company remains undervalued.

In fact, investors seem more interested in the outlook for mortgage lending than the intricacies of Freddie Mac's hedging and accounting issues. During a conference call with investors and analysts, chairman and CEO Richard Syron acknowledged that Freddie Mac is facing a "challenging, lower-growth environment" this year, but he said Freddie Mac believes it can prosper despite the decline in mortgage lending volume.

Martin Baumann, the company's chief financial officer, helped explain the company's hedging strategy. He said "put swaptions" were among the derivative contracts that contributed to the loss in derivative value last year. The value was negatively affected by a decline in interest rate volatility and a natural decay in value over time, he said.

Meanwhile, "pay-fixed" swaps without a hedge designation increased in Freddie Mac's strategy last year, resulting in negative carry expense, he said. The value of "pay-fixed" swaps also declined as a result of the decline in forward long-term interest rates during the year.

"As you will recall, we moved a substantial amount of pay-fixed swaps to no hedge designation during 2004," he said. "As a result, the negative carry on these swaps now flows through derivative gains and losses rather than net interest income."

However, the decline in the derivatives was partially offset by reduced losses related to debt repurchases.

Meanwhile, Freddie Mac has been reducing the size of its derivative portfolio as it migrates toward a higher use of callable debt rather than derivatives to manage interest rate risk exposure. Mr. Baumann said Freddie Mac has made a conscious decision in recent years to increase the use of callable debt in managing interest rate exposure, which allows it to rely less heavily on option-based contracts.

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