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Federal Home Loan Mortgage Corporation (FMCC) or Freddie Mac’s fourth-quarter results had a minimal effect on its share price. The company reported net income of $8.6 billion, significantly below the prior-quarter earnings of $30.5 billion. Notably, the prior-quarter results included benefit for federal income taxes of $23.9 billion related to valuation allowance against net deferred tax assets.

Freddie Mac reported pre-tax income of $9.3 billion, up 43.1% sequentially, reflecting the 9th consecutive quarter of positive earnings. Results benefited from increased other non-interest income and derivative gains, partially offset by higher net impairment expense and reduced benefit for credit losses.

For 2013, net income came in at $48.7 billion, significantly up from $11.0 billion in 2012. Notably, 2013 results included an income tax benefit of $23.3 billion, resulting from deferred tax asset valuation allowance release in the third quarter.

Performance in Detail

Net interest income declined 11.6% sequentially to $3.8 billion. Net interest yield stood at 0.76%, down 10 basis points sequentially. The decline reflects reduced higher-yielding mortgage-related assets. However, non-interest income more than doubled from the prior quarter to $5.8 billion.

Non-interest expense decreased 32.4% from the prior quarter to $390 million. The fall in expense was due to the Lehman bankruptcy settlement. Nevertheless, this was partially offset by increased real estate-owned (REO) holding period write-downs, along with reduced disposition gains.

Freddie Mac reported benefit for credit losses of $201 million in the quarter, compared with $1.1 billion in the prior quarter. The benefit was driven by $0.8 billion of recoveries from counterparty settlements though the figure was lower that the prior quarter due to moderate improvement in national home prices.

Furthermore, segment-wise, on a sequential basis, Investments segment recorded 83.8% rise in earnings while Single-family Guarantee and Multifamily segments recorded a fall of 35% and 25%, respectively.

Based on net worth of $12.8 billion, Freddie Mac’s dividend obligation to the Treasury will stand at $10.4 billion in Mar 2014. Notably, including this dividend obligation, the company’s aggregate cash dividends paid to the Treasury will total $81.8 billion as compared with cumulative cash draws of $71.3 billion received from the Treasury.

Further, since Jan 1, 2009, Freddie Mac provided $2.2 trillion of liquidity to the mortgage market, which helped in funding 7.7 million refinancings, 2.0 million home purchases and 1.6 million units of multifamily rental housing. Moreover, the company helped about 953,000 borrowers to avoid foreclosure.

Recent Settlements

During 2013, 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 $5.5 billion in 2013.

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 $1.8 billion in 2013.

Continuing with settlements, in Feb 2014, Freddie Mac entered into a settlement with Lehman Brothers under which it will get $767 million for the losses suffered due to the latter’s bankruptcy. Moreover, in 2013, Freddie Mac realized $350 million in pre-tax income related to the settlement.

Recently, Freddie Mac and FHFA also entered into a litigation settlement agreement with Morgan Stanley (MS - Analyst Report) over Freddie Mac’s investment in certain PLS. As per the terms of the deal, Freddie Mac received $625 million, which will be reflected in its first-quarter 2014 results.

Performance by Peers

Federal National Mortgage Association (FNMA) reported fourth-quarter 2013 net income of $6.5 billion, down 26% from $8.7 billion earned in the prior quarter. However, this was the company’s eighth consecutive quarterly profit.
Results were adversely impacted by lower investment income, partially offset by growth in revenues and credit-related income, along with lower expenses. The quarterly tailwinds consisted of an improving credit quality and stable liquidity position.

Our Viewpoint

We believe that Freddie Mac’s improving non-interest income and recent settlements will yield profitability in the coming quarters. Moreover, enhanced credit quality and prudent expense management were the other positives. However, decline net interest income remains a concern.

Currently, Freddie Mac carries a Zacks Rank #3 (Hold). A better-ranked company in the same sector is Home Loan Servicing Solutions, Ltd. (HLSS - Snapshot Report) with a Zacks Rank #2 (Buy).

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