HLSS (MM)

Federal Home Loan Mortgage Corporation (FMCC) or Freddie Mac’s first-quarter 2014 results had a minimal effect on its share price. Though the company reflected the 10th consecutive quarter of positive earnings, net income of $4.0 billion was below the prior-quarter earnings of $8.6 billion. Notably, the results included legal settlement benefit of post-tax $3.4 billion and derivative losses of $1.6 billion after-tax.

Results were negatively impacted by derivative losses, reduced legal settlement proceeds and elevated income tax expense. These negatives were partially offset by lower net impairment expense.

Freddie Mac reported pre-tax income of $5.8 billion, down 37.6% sequentially.

Performance in Detail

Net interest income declined 7.9% sequentially to $3.5 billion. Net interest yield stood at 0.72%, down 4 basis points sequentially. The decline reflects reduced higher-yielding mortgage-related assets. Moreover, non-interest income decreased 46.6% sequentially to $3.1 billion.

Non-interest expense increased 97.7% from the prior quarter to $771 million. Notably, the prior quarter included benefit of the Lehman bankruptcy settlement.

Freddie Mac reported provision for credit losses of $85 million in the quarter, compared with a benefit of $201 million in the prior quarter. The provision was driven by $0.5 billion reduction in recoveries from counterparty settlements.

Furthermore, segment-wise, on a sequential basis, Single-family Guarantee, Investments and Multifamily segments recorded a fall of 76.9%, 52.2% and 20% in earnings, respectively.

Based on net worth of $6.9 billion, Freddie Mac’s dividend obligation to the Treasury will stand at $4.5 billion in Jun 2014. Notably, including this dividend obligation, the company’s aggregate cash dividends paid to the Treasury will total $86.3 billion as compared with cumulative cash draws of $71.3 billion received from the Treasury through Mar 2014.

Further, since Jan 1, 2009, Freddie Mac provided $2.3 trillion of liquidity to the mortgage market, which helped in funding 7.8 million refinancings, 2.1 million home purchases and 1.7 million units of multifamily rental housing. Moreover, the company helped about 987,000 borrowers to avoid foreclosure, which included 34,000 in first-quarter 2014.

Credit Quality

As of Mar 31, 2014, Freddie Mac’s new single-family book (loans acquired after 2008, excluding HARP and other relief refinance mortgages) was 55% of the UPB of Freddie Mac’s single-family credit guarantee portfolio, while HARP and other relief refinance loans accounted for 21% of the portfolio.

Further, Freddie Mac’s 2005-2008 legacy single-family book continued to decline. As of Mar 31, 2014, the book represented 15% of the portfolio and recorded 77% of the company’s single-family credit losses during the quarter.

Recent Settlements

During first-quarter 2014, Freddie Mac and the Federal Housing Finance Agency (FHFA) entered into agreements with a number of firms for settling litigations related to Freddie Mac’s investment in certain private label securities (PLS). These settlements increased the company’s pre-tax income by $4.5 billion in the quarter.

Further, Freddie Mac entered into deals with many of its sellers to resolve certain representation and warranty claims in lieu of one-time cash payments. Notably, these agreements increased the company’s pre-tax income by $0.3 billion.

Performance by Peer

Federal National Mortgage Association (FNMA) or Fannie Mae reported first-quarter 2014 net income of $5.3 billion, down significantly from $58.7 billion earned in the prior- year quarter. However, this was the company’s ninth consecutive quarterly profit. Further, the first-quarter results included a $4.1 billion revenue flow related to the settlement with Bank of America Corporation (BAC).

Results were adversely impacted by lower credit related income and higher expenses, partially offset by growth in both net revenue as well as investment income. Further, improvement in credit quality and a strong liquidity position were the quarterly tailwinds.

Our Viewpoint

We believe that Freddie Mac’s recent settlements will yield profitability in the coming quarters. Moreover, enhanced credit quality was the other positive. However, decline in the top line and undisciplined expense management remain concerns.

Currently, Freddie Mac carries a Zacks Rank #5 (Strong Sell). A better-ranked company in the same sector is Home Loan Servicing Solutions, Ltd. (HLSS) with a Zacks Rank #1 (Strong Buy).

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