Information Statement Freddie Mac V Freddie Mac is a

Information Statement Freddie Mac V Freddie Mac is a shareholder-owned government-sponsored enterprise (""GSE'') established by Congress to provide a continuous Öow of funds for residential mortgages. Freddie Mac performs this function by buying residential mortgage loans and mortgage-related securities, which it Ñnances by selling mortgage-related securities, debt and equity securities. Freddie Mac's securities are exempt from registration under the federal securities laws. Freddie Mac's guarantees of securities are obligations of Freddie Mac only. Neither the United States nor any agency or instrumentality of the United States is obligated to fund the mortgage purchase or Ñnancing activities of Freddie Mac. This Information Statement contains important Ñnancial and other information concerning Freddie Mac. It is supplemented at least quarterly. All available supplements should be read together with this Information Statement. Freddie Mac also provides information about the securities it issues in the OÅering Circular and any OÅering Circular Supplement for each particular oÅering. You can obtain copies of this Information Statement, OÅering Circulars, all available supplements, Ñnancial reports and other similar information by writing or calling Freddie Mac at Mailstop A57, 8250 Jones Branch Drive, McLean, Virginia 22102 (telephone (800) FREDDIE (373-3343)). You can also obtain selected Ñnancial and other information by accessing Freddie Mac's World Wide Web site (http://www.freddiemac.com). Freddie Mac's principal oÇce is located at 8200 Jones Branch Drive, McLean, Virginia 22102 (telephone (703) 903-2000). INFORMATION STATEMENT DATED MARCH 31, 2000 TABLE OF CONTENTS Page FREDDIE MAC ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ FORWARD-LOOKING STATEMENTSÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ BUSINESSÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ General ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Mortgage Purchases ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Mortgage Purchase Volume ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Financing of Mortgage and Mortgage-Related Security Purchases ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Customer and Market Support Activities ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Market Conditions and Competition ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Defaults, Foreclosures and REOÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Litigation ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ REGULATION AND GOVERNMENTAL RELATIONSHIPSÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Regulation of Freddie Mac ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Regulations AÅecting Mortgages and Mortgage-Related SecuritiesÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Governmental Relationships ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ PROPERTIES AND EMPLOYEES ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ CAPITALIZATION ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ EQUITY SECURITIESÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Common Stock ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Preferred Stock ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Dividends ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ REIT SUBSIDIARIES ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ MANAGEMENT ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Executive OÇcersÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ INDEPENDENT PUBLIC ACCOUNTANTS ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ FIVE-YEAR FINANCIAL HIGHLIGHTSÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ CONSOLIDATED FINANCIAL STATEMENTS AND NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ ADDITIONAL FINANCIAL INFORMATION ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ MANAGEMENT'S REPORT ON CONSOLIDATED FINANCIAL STATEMENTS AND INTERNAL CONTROL STRUCTURE ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON MANAGEMENT'S ASSERTION ABOUT THE EFFECTIVENESS OF THE INTERNAL CONTROL STRUCTURE OVER FINANCIAL REPORTING ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON CONSOLIDATED FINANCIAL STATEMENTS ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ 3 3 3 3 4 8 9 11 12 14 16 16 16 18 19 20 21 21 22 22 23 23 23 24 27 A-1 A-29 A-30 A-66 A-68 A-69 A-69 2 FREDDIE MAC The Federal Home Loan Mortgage Corporation (""Freddie Mac'') was chartered on July 24, 1970 pursuant to the Federal Home Loan Mortgage Corporation Act (the ""Freddie Mac Act''). Freddie Mac's statutory purposes are: ‚ to provide stability in the secondary market for residential mortgages ‚ to respond appropriately to the private capital market ‚ to provide ongoing assistance to the secondary market for residential mortgages (including mortgages on housing for low- and moderate-income families) ‚ to promote access to mortgage credit throughout the United States (including central cities, rural areas and underserved areas) by increasing the liquidity of mortgage investments and improving the distribution of investment capital available for residential mortgage Ñnancing. To meet these statutory purposes, Freddie Mac purchases residential mortgages and mortgage-related securities from mortgage lenders, other mortgage sellers and securities dealers. Freddie Mac purchases mortgages that Ñnance homes in every geographic segment of the United States, which reduces the cost of homeownership and rental housing and improves the quality of life by making the American dream of decent, accessible housing a reality. The principal oÇce of Freddie Mac is located in McLean, Virginia. Freddie Mac also has oÇces located in Atlanta, Georgia; Chicago, Illinois; Dallas, Texas; New York, New York; and Woodland Hills, California. FORWARD-LOOKING STATEMENTS Freddie Mac regularly communicates information concerning its business activities to investors, securities analysts, the news media and others as part of its normal operations. Some of these communications include ""forward-looking statements'' pertaining to management's current expectations for Freddie Mac's future business plans, results of operations and/or Ñnancial condition. Management's expectations for the corporation's future involve a number of assumptions and estimates. Actual results could diÅer materially from management's expectations because of factors such as: ‚ national or regional recessions, or substantial changes in interest rates or employment rates ‚ house-price appreciation rates ‚ the rate of growth in outstanding mortgage debt and the size of the conforming mortgage market ‚ the success or failure of credit loss mitigation strategies ‚ legislative and regulatory developments. Additional discussions of these expectations and factors are set forth in the text below and in Management's Discussion and Analysis of Financial Condition and Results of Operations attached to this Information Statement, and are included in the quarterly supplements to this Information Statement. BUSINESS General Freddie Mac's principal business activity is the purchase and Ñnancing of single-family and multifamily residential mortgages and mortgage-related securities. Freddie Mac Ñnances its purchases of residential mortgages and mortgage securities with securitization Ñnancing and debt Ñnancing. Securitization Ñnancing involves the securitization of purchased mortgages in the form of guaranteed mortgage passthrough securities (""PCs''). Debt Ñnancing involves the use of debt securities and, to a lesser extent, other liabilities and equity capital to Ñnance mortgages and mortgage-related securities held as portfolio investments. Freddie Mac also engages in other activities that help the corporation to fulÑll its statutory purposes. For a discussion of Freddie Mac's mortgage purchase and Ñnancing activities, see ""Management's Discussion and Analysis of Financial Condition and Results of Operations Ì BUSINESS REVIEW.'' 3 Freddie Mac's success is dependent largely on the skill of its management and employees in managing risks associated with its business activities and responding to conditions in the mortgage markets and the general capital markets. Freddie Mac has generated proÑtable returns and maintained a sound Ñnancial condition since it commenced operations in 1970 while operating in a wide variety of economic and market environments. Freddie Mac is subject to two primary types of risks: credit risk associated with the mortgages it purchases and the institutions with which it conducts business; and interest-rate risk that results principally from mismatches between the durations of its assets and liabilities. Freddie Mac also is subject to operational and other related risks resulting from human error, system failures, fraud or circumvention of internal controls. For a discussion of the impact and management of these and other risks, see ""Management's Discussion and Analysis of Financial Condition and Results of Operations Ì RISK MANAGEMENT.'' Mortgage Purchases Freddie Mac purchases a variety of single-family mortgages, including both Ñxed-rate mortgages and adjustable-rate mortgages (""ARMs''). Freddie Mac purchases single-family mortgages mainly from mortgage bankers and from federally insured Ñnancial institutions (primarily commercial banks and thrift institutions). Most mortgages purchased by Freddie Mac are conventional mortgages which are not guaranteed or insured by the United States or any of its agencies or instrumentalities. However, Freddie Mac purchases some mortgages that are fully insured by the Federal Housing Administration (""FHA'') or guaranteed, in part, by the Department of Veterans AÅairs (""VA'') (collectively, ""FHA/VA mortgages''). Freddie Mac also purchases multifamily mortgages with Ñxed or adjustable interest rates or interest-rate reset features from a limited network of multifamily mortgage lenders, including federally insured Ñnancial institutions, mortgage bankers, investment bankers and insurance companies. In most instances, single-family mortgages purchased by the corporation may be repaid by the borrower, in whole or in part, at any time prior to maturity without penalty. By contrast, multifamily mortgages purchased by Freddie Mac often may be repaid prior to maturity only upon payment of a prepayment premium or, in some cases, are subject to contractual restrictions on prepayment for a period of time following origination. Freddie Mac Act Mortgage Purchase Requirements The Freddie Mac Act imposes limits, which are subject to annual adjustment, on the maximum original principal amount of single-family mortgages that Freddie Mac may purchase. These limits are commonly referred to as ""conforming loan limits.'' For 2000, the maximum original principal amount of a Ñrst-lien conventional single-family mortgage that Freddie Mac may purchase is $252,700 for a one-family dwelling, $323,400 for a two-family dwelling, $390,900 for a three-family dwelling and $485,800 for a four-family dwelling. Conforming loan limits for second-lien mortgages are 50 percent of those for Ñrst-lien mortgages. When Freddie Mac purchases both the Ñrst-lien and second-lien mortgage on the same property, the Freddie Mac Act provides that the total amount Freddie Mac may purchase may not exceed the applicable conforming loan limit. The applicable loan purchase limits are 50 percent higher for properties located in Alaska, Guam, Hawaii or the U.S. Virgin Islands. No statutory limits currently apply to Freddie Mac's multifamily mortgage purchases. The Freddie Mac Act also prohibits Freddie Mac from purchasing Ñrst-lien conventional single-family mortgages if the outstanding principal balance at the time of purchase exceeds 80 percent of the value of the real property securing the mortgage unless one of several conditions is met. Meeting these conditions generally provides credit enhancements to Freddie Mac (and therefore limits Freddie Mac's exposure to loss) or incentives for sellers to deliver only mortgages of acceptable quality. The conditions consist primarily of mortgage insurance from a Freddie Mac-approved mortgage insurer, a seller's agreement to repurchase or replace (for such periods and under such conditions as Freddie Mac may determine) any mortgage that has defaulted, or the retention of at least a 10 percent participation interest in the mortgages by the seller. Similar conditions apply to the purchase of conventional single-family second mortgages where the total loan-to-value (""LTV'') ratio exceeds 80 percent. These conditions do not apply to the purchase of conventional multifamily mortgages or FHA/VA mortgages. Freddie Mac also may receive additional credit enhancements that exceed the levels required by the Freddie Mac Act. 4 Finally, the Freddie Mac Act provides that Freddie Mac may purchase only mortgages that it deems to be of such quality as to meet the purchase standards of private institutional mortgage investors. This aspect of the Freddie Mac Act requires that the mortgages purchased be readily marketable to institutional mortgage investors. Single-Family Mortgage Purchases Freddie Mac purchases single-family mortgages (primarily ""conventional'' mortgages that are not insured or guaranteed by agencies of the U.S. Government) for cash and in exchange for PCs. Single-family mortgage purchases generally are subject to the corporation's credit, appraisal, underwriting and other purchase policies and guidelines set forth in its Single-Family Seller/Servicer Guide and incorporated into Loan Prospector, the corporation's automated underwriting service for single-family mortgages. Freddie Mac may modify these guidelines or grant waivers with respect to the purchase of speciÑc mortgages. Freddie Mac purchases single-family 15-year, 20-year and 30-year Ñxed-rate mortgages, ARMs and balloon/reset mortgages. Balloon/reset mortgages typically have original terms to maturity of either Ñve or seven years and provide for level payments of principal and interest during the original term with principal payments typically based on a 30-year amortization schedule. At the expiration of the original term, the remaining unpaid principal balance of the mortgage is payable in full, although the borrower may elect to extend the mortgage term with an interest-rate adjustment if the borrower satisÑes certain conditions associated with such an extension. Single-family mortgages purchased for cash are Ñnanced primarily through their resale in the form of PCs. Freddie Mac generally commits to issue PCs at approximately the same time it commits to purchase mortgages for cash. This procedure eÅectively enables Freddie Mac to reduce interest-rate risk on cash purchases Ñnanced with PCs. The remaining cash mortgage purchases are held for investment in the retained portfolio and are Ñnanced by debt securities, equity capital and other liabilities. Freddie Mac's cash purchase prices for mortgages generally reÖect the prices at which Freddie Mac can sell the related PCs. Freddie Mac also purchases mortgages in exchange for PCs. Sellers may exchange mortgages for PCs for several reasons. Owning PCs rather than mortgages reduces the exposure of an institution to credit risk. PCs also increase the Ñnancial Öexibility and liquidity of the institution, because it may use the PCs as collateral for repurchase agreement transactions and other borrowings or sell the PCs for cash. In addition, regulatory capital requirements for depository institutions generally favor holding mortgage assets in securitized form. Multifamily Mortgage Purchases Freddie Mac purchases multifamily mortgages from approved lenders in exchange for cash or multifamily mortgage-related securities. In addition to the statutory requirements for the purchase of multifamily mortgages set forth in the Freddie Mac Act, the corporation has established multifamily mortgage purchase standards, including credit, appraisal and underwriting guidelines as set forth in internal credit policies and in its Multifamily Seller/Servicer Guide. From time to time, Freddie Mac modiÑes its mortgage purchase standards. Freddie Mac may also grant waivers or modiÑcations to these standards in connection with the purchase of speciÑc mortgages when compensating factors (such as high debt coverage ratios, low LTV ratios or credit enhancements) are present. Freddie Mac purchases conventional multifamily mortgages for cash or in exchange for PCs with terms generally ranging from Ñve to 30 years. Any prepayment of a multifamily mortgage purchased for cash or in exchange for PCs may be subject to payment of a prepayment premium, which can be in the form of a yield maintenance fee based on a benchmark interest rate at the time of prepayment, or a percentage of the amount prepaid. Freddie Mac also provides reÑnancing of multifamily mortgages Ñnanced with PCs or held in its retained portfolio. Technology and Service Initiatives Freddie Mac continually examines and modiÑes its programs and policies in order to bring innovation and eÇciency to the mortgage markets and increase the attractiveness and competitiveness of its mortgage purchase programs and mortgage-related securities. Freddie Mac develops innovative tools, technology, 5 products and services that are attractive to diÅerent types of mortgage sellers and security investors. These services allow Freddie Mac to fulÑll its statutory purposes. Freddie Mac earns fees on certain of these services. Loan Prospector @. Loan Prospector is the corporation's automated underwriting service for singlefamily mortgages that allows lenders to evaluate mortgage application information electronically. The service uses statistical models and credit policy guidelines to generate a Freddie Mac purchase decision within minutes. Mortgage applications that do not receive favorable purchase decisions through the service are referred to the originator's underwriters for manual underwriting, together with an analysis from Loan Prospector about the reasons for the referral. Loan Prospector on the Internet is an internet-based version of Loan Prospector that Freddie Mac introduced in 1999. This service makes Loan Prospector's risk assessment and management tools available at the point-of-sale, facilitates the business relationships among the various primary mortgage market participants and allows mortgage originators to evaluate mortgage applications within minutes. In March 2000, Freddie Mac announced that it was entering into a joint venture with Microsoft and several large lenders to provide innovative, Internet-based applications that will streamline the mortgage process by facilitating lender originations of mortgages through the Internet. In 1999, Freddie Mac used Loan Prospector to purchase, through a pilot program, residential mortgages in alternative segments of the mortgage market. Through the use of Loan Prospector, Freddie Mac intends to utilize its credit risk expertise to enlarge its presence in these non-traditional market areas. GoldWorks@. GoldWorks is an electronic information network system that provides mortgage market participants with a single link to Freddie Mac and other parties involved in the mortgage origination and purchase process, such as credit bureaus and mortgage insurers. GoldWorks is an open system through which Freddie Mac customers may conduct business with the corporation as well as access third party services, including automated underwriting, credit reporting, appraisal ordering and receipt, and other applications intended to improve the Öow of information in the mortgage origination, delivery and servicing process. Gold Cash Xtra@. Gold Cash Xtra is an automated service designed to assist mortgage sellers in managing the risk of being unable to fulÑll their mortgage commitments by assuring them a price for the sale of a mortgage to Freddie Mac at the time of the mortgage loan application, but requiring a sale to Freddie Mac only if the mortgage loan closes. Under Gold Cash Xtra, mortgages may be sold to Freddie Mac with the rights to mortgage servicing ""released'' for sale to servicers other than the seller, or with servicing rights retained by the seller. For a description of the corporation's mortgage purchase commitment process see ""Business Ì Mortgage Purchase Volume'' below, and ""Commitments'' in Note 9 to Freddie Mac's Consolidated Financial Statements. Gold Connection@ for Delivery. Gold Connection for Delivery is an interactive software application designed to expedite the delivery of mortgage loan data to Freddie Mac. Under Gold Connection for Delivery, the seller screens mortgage delivery data at its own location, corrects any deÑciencies and then delivers the mortgage data to Freddie Mac. With the screening process conducted by the seller prior to delivery of the mortgages to Freddie Mac, the disqualiÑcation or ""fallout'' of ineligible mortgages is reduced or eliminated, and redelivery of mortgage data avoided, allowing for faster purchase of mortgage loans following the delivery of all necessary purchase information to Freddie Mac. Workout Prospector and EarlyIndicatorSM. Workout Prospector and EarlyIndicator are software applications which enable mortgage servicers to prioritize the management of non-performing mortgage loans and to evaluate and recommend alternatives to foreclosure. Workout Prospector is a loan level decision support tool designed to help Freddie Mac servicers negotiate high quality workouts. Based upon loan, property, and borrower Ñnancial data and proposed workout parameters, Workout Prospector determines the relative eÅectiveness and impact of several types of workout alternatives to foreclosure (including loan modiÑcations, pre-foreclosure sales and forbearances). EarlyIndicator is a modeling system that determines the probability of delinquent loans continuing through to foreclosure. Mortgage servicers can use EarlyIndicator to allocate resources to delinquent borrowers who are least likely to cure the delinquency, minimize expenses, reduce credit losses, and assist borrowers who are experiencing credit diÇculties. See ""Manage6 ment's Discussion and Analysis of Financial Condition and Results of Operations Ì Risk Management Ì Mortgage Credit Risk.'' HomeSteps and HomeSteps Asset ServicesTM. HomeSteps and HomeSteps Asset Services are the marketing names within the Freddie Mac Servicer Division for the management and sale of real estate owned (""REO'') properties. HomeSteps markets the corporation's REO properties. HomeSteps Asset Services provides rehabilitation, marketing and disposition services for REO properties. Expanding Markets@. Freddie Mac supplements its standard mortgage purchase programs with Expanding Markets products and services and targeted initiatives directed at promoting aÅordable lending and community development lending. These single-family mortgage products, services and initiatives are designed to bring the beneÑts of the secondary market to more people and expand access to mortgage credit for underserved communities. Expanding Markets products and services include: ‚ AÅordable Gold@ Ì mortgage products designed to help homebuyers who need assistance with down payment and closing costs and Öexibility in the application of income and debt ratios ‚ AÅordable Seconds@ Ì permits a wide range of secondary Ñnancings and other subsidies from non-proÑt organizations, government entities and other housing Ñnance agencies in connection with the use of aÅordable Ñrst mortgage products ‚ Fair Lending: an Introduction to Self Evaluation Ì a guide for lenders considering a selfevaluation program to assess their fair lending performance ‚ Discover Gold@ Through Homeownership Education Ì a publication that oÅers best practices in homeownership education to help lenders select suitable homeownership education and counseling programs and that includes a ""how-to'' booklet (also available separately in English and Spanish) for lenders to provide to potential borrowers on conducting a consumer home inspection ‚ Freddie Mac: The Catalyst For Community Development Lending Ì a brochure that explains to lenders, community-based organizations and local housing service providers Freddie Mac's available resources and approach to community development lending. As part of its community development lending activities, Freddie Mac seeks to establish public-private collaborations that increase access to mortgage credit for underserved families (including low and moderate income and minority households) and eliminate barriers to homeownership in targeted communities. Freddie Mac works closely with aÅordable housing providers to design creative mortgage solutions, explore eÇcient use of public subsidies and services, and help develop eÅective homeownership education programs. The core of Freddie Mac's community development lending approach is the formation of ""alliances'' between government agencies, nonproÑt organizations, trade associations, and Freddie Mac seller-servicers. Freddie Mac has introduced speciÑc community development lending products and initiatives that address the speciÑc needs of homebuyers targeted through governmental agencies and nonproÑt organizations. In addition, Freddie Mac has undertaken a number of pilot projects to gain experience with particular mortgage products, borrower groups or lender groups in order to incorporate beneÑcial features of these transactions into its standard mortgage purchase products. These pilots include lease-purchase products, FHA and conventional rehabilitation mortgage products (including Community Gold@ and HOME WORKS!) and 2- to 4-unit aÅordable lending products. Other oÅerings include HUD Native American mortgage products and U.S. Department of Agriculture's Rural Housing Service mortgage products. These initiatives are intended to expand access to the secondary market for underserved communities. Freddie Mac also is a major investor in mortgage revenue bonds. Housing Ñnance agencies issue mortgage revenue bonds to Ñnance below-market-rate mortgages for low- and moderate-income borrowers in underserved communities. In addition to buying mortgage revenue bonds, Freddie Mac also provides credit enhancements by securitizing and guaranteeing pools of one-family to four-family mortgages which housing Ñnance agencies buy from originating lenders. Freddie Mac also works with housing Ñnance agencies that use the Mortgage Credit CertiÑcate Program, which combines federal tax credits with conventional mortgage Ñnancing to beneÑt low- and moderate-income families. The use of Freddie Mac's AÅordable Gold products 7 combined with the down payment assistance and secondary Ñnancing provided by housing Ñnance agencies help support home ownership opportunities for low-income borrowers with limited cash resources. Freddie Mac's multifamily program also supports aÅordable housing through its investments in lowincome rental housing that qualify for tax credits. Since 1988, Freddie Mac has invested more than $1,163 million in tax credit equity funds and has become one of the country's largest tax credit investors. Through these investments, Freddie Mac has helped to Ñnance more than 123,979 rental housing units aÅordable to low-income families in 49 states, Washington, D.C. and Puerto Rico. Mortgage Purchase Volume Set forth below is a summary of Freddie Mac's mortgage purchase activity for the years shown. Purchases of Mortgages(1) (dollars in millions) Year Ended December 31, 1998 1997 1996 1995 1999 Single-family 30-year Ñxed-rate ÏÏÏÏÏÏÏÏÏÏÏÏ Single-family 15-year Ñxed-rate ÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Single-family ARMs/Öoating-rate ÏÏÏÏÏÏÏÏÏÏÏÏ Single-family balloon/resetsÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Multifamily ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Total ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ (2) $195,974 48,320 16,524 4,473 7,181 $272,472 $213,659 58,897 9,338 2,534 3,910 $288,338 $ 85,605 18,697 10,105 4,842 2,241 $121,490 $ 86,246 22,629 8,631 8,830 2,229 $128,565 $ 58,244 13,806 20,949 3,822 1,565 $ 98,386 (1) Includes mortgages exchanged for Freddie Mac PCs and purchased for cash, and non-Freddie Mac guaranteed mortgage securities. Excludes repurchased Freddie Mac PCs because repurchases do not aÅect the unpaid principal balance of the total mortgage portfolio. (2) Includes 20-year Ñxed-rate mortgages, second mortgages and mobile home loans. Freddie Mac purchases single-family mortgages primarily by issuing commitments under which it agrees in advance to purchase speciÑed dollar amounts of mortgages for delivery for cash or securities over a speciÑed period of time. These commitments are made under contracts called ""master commitments.'' Sellers enter into master commitments to assure a secondary market outlet for the mortgages they expect to originate and sell over the term of the contract and to lock in the underwriting standards that will apply to those mortgages, and in some cases, to lock in the management and guarantee fees payable to Freddie Mac. By entering into master commitments with sellers, Freddie Mac seeks to assure that it will receive a competitive share of the mortgages the sellers originate over the contract term. Master commitments normally are fulÑlled by successive separate deliveries of mortgages by sellers. OÅers to sell mortgages also are considered on a negotiated basis outside of the master commitment process. Freddie Mac's mortgage purchase activities have historically been concentrated in the single-family Ñxed-rate segment of the mortgage market. In part, this is because Ñxed-rate mortgages are originated in greater volumes than ARMs since most borrowers in the conventional conforming market prefer Ñxed-rate mortgages to ARMs, particularly in lower interest-rate environments. It also reÖects the preference shown by many large depository institutions for holding ARMs in their own portfolios, at least during the Ñrst several years after originating them, rather than promptly selling them in the secondary market as they routinely do with most of their new Ñxed-rate originations. Depository institutions favor holding ARMs because ARMs match their liabilities better than Ñxed-rate mortgages. The ability of such institutions to fund ARMs with relatively low-cost deposit liabilities provides them with an attractive spread and enables them to compete eÅectively for ARM originations against mortgage bankers and other originators. As a result, the volume of ARMs purchased by Freddie Mac has been and continues to be considerably smaller than the volume of Ñxedrate mortgages. 8 Financing of Mortgage and Mortgage-Related Security Purchases Freddie Mac's purchase activities provide stability and liquidity to the mortgage markets by providing an uninterrupted Öow of funds even during periods of market illiquidity and volatility. Freddie Mac Ñnances its mortgage and mortgage-related security purchases by securitizing mortgages as PCs, or issuing and selling short-term and long-term callable and non-callable debt securities, other liabilities and equity capital. The amount of mortgages and mortgage-related securities that are purchased is determined in accordance with Freddie Mac's overall proÑtability, capital and interest-rate and credit risk management strategies. Mortgages Ñnanced by PCs are referred to in our Ñnancial statements as an oÅ-balance sheet contingency called ""Total Mortgage Participation CertiÑcates'' or ""Total PCs.'' Mortgages and mortgage-related securities held for investment by Freddie Mac and Ñnanced by debt, equity and other liabilities are referred to in our Ñnancial statements as the ""retained portfolio.'' The total mortgage portfolio consists of Total PCs, net of PCs held in the retained portfolio, plus the retained portfolio. Mortgage-related securities held for trading purposes and Freddie Mac's liquidity and contingency investment portfolio held for cash management and working capital purposes are included in the corporation's Ñnancial statements under ""Investments.'' See ""Management's Discussion and Analysis of Financial Condition and Results of Operations Ì LIQUIDITY AND CAPITAL MANAGEMENT.'' The following table presents the relative proportions of the total mortgage portfolio represented by Total PCs, net and the retained portfolio as of December 31 for each of the years shown. Total Mortgage Portfolio 1999 As of December 31, 1998 1997 1996 1995 Total PCs, net Single-Class PCsÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Multiple-Class PCsÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Total PCs, net ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Retained Portfolio ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Total Mortgage Portfolio ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ (1) Excludes Freddie Mac PCs held in the retained portfolio. (1) 31.16% 31.22 62.38 37.62 34.4% 30.8 65.2 34.8 41.3% 33.0 74.3 25.7 39.3% 38.1 77.4 22.6 37.4% 43.6 81.0 19.0 100.0% 100.0% 100.0% 100.0% 100.0% 9 The following table sets forth information about Freddie Mac's PC securitization and resecuritization volume during the years shown. Securitization and Resecuritization Volume (dollars in billions) 1999 Year ended December 31, 1998 1997 1996 1995 Original Issue PCs(1) Single-family 30-year Ñxed-rate(2) ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Single-family 15-year Ñxed-rate ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Single-family ARM/Öoating-rate ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Single-family balloon/resetsÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Multifamily ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Total ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Gold PCs ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Structured Securitizations(3) ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $169.0 50.2 7.4 4.4 2.0 $233.0 $224.9 $119.6 $188.2 51.9 7.2 2.4 0.9 $250.6 $241.6 $135.2 $ 82.1 17.9 9.0 4.8 0.5 $114.3 $103.7 $ 84.4 $ 81.7 22.1 6.5 8.6 0.8 $119.7 $112.7 $ 34.1 $ 54.4 13.1 14.3 3.7 0.4 $ 85.9 $ 71.6 $ 15.4 (1) Original issue PCs are either Gold PCs or 75-day PCs, and include both single-class PCs and Multiclass PCs backed by mortgages, rather than previously issued PCs. Gold PCs and 75-day PCs diÅer with respect to the time period for pass-through of principal and interest payments to investors, the terms of Freddie Mac's guarantees, and in other respects, as described in the applicable OÅering Circular and OÅering Circular Supplement. (2) Includes PCs backed by single-family 20-year Ñxed-rate mortgages. (3) Includes Ginnie Mae certiÑcates resecuritized primarily as Freddie Mac Multiclass PCs. Single-Class Securities PCs. The majority of mortgages acquired by Freddie Mac are securitized and resold to investors in the form of PCs. PCs are original issue single-class securities that represent undivided interests in mortgages and provide for monthly payment of interest and pass through of principal due or collected on the underlying mortgages. Freddie Mac receives a management and guarantee fee with respect to its outstanding PCs. Freddie Mac guarantees the payment of interest due on PCs and the principal of the underlying mortgages. Certain single-class mortgage-related securities issued by Freddie Mac are backed by mortgage-related securities issued by other issuers. The securities of these issuers may be backed by mortgages of a lower credit quality than, or originated pursuant to underwriting standards that diÅer from, Freddie Mac's normal criteria. These mortgage-related securities are structured to provide subordination or other forms of credit enhancement to oÅset the credit risk to Freddie Mac that may be associated with performance of the underlying mortgages. Issuance of these securities allows Freddie Mac to provide liquidity to non-traditional segments of the mortgage market. Multiple-Class Securities Freddie Mac issues several types of securities that divide the cash Öows of the underlying mortgages, PCs or other securities into two or more classes having a variety of features. These features include varying maturities, allocation of principal and interest, and Ñxed or variable-rate coupons. Freddie Mac's principal activity in the area of multiple-class securities is the issuance and sale of Multiclass PCs and Multiclass Securities that qualify for treatment as Real Estate Mortgage Investment Conduits (""REMICs'') under the Internal Revenue Code. Multiple-class securities backed directly or indirectly by PCs provide a means for improving the liquidity and value of PCs. Multiclass PCs generally do not generate additional management and guarantee fee income or impose additional credit risk, but do generate resecuritization fee income for Freddie Mac. Debt Securities As Freddie Mac's retained portfolio has grown, the proportion of Freddie Mac's mortgage purchases Ñnanced with unsecured short- and long-term debt securities, rather than through mortgage securitization, has grown substantially. At December 31, 1999, the retained portfolio represented approximately 38 percent of 10 Freddie Mac's total mortgage portfolio. Freddie Mac often enters into interest-rate contracts and other oÅbalance sheet transactions to adjust the payment obligations of its debt securities to better suit the corporation's asset-liability management objectives. See ""Management's Discussion and Analysis of Financial Condition and Results of Operations Ì RISK MANAGEMENT Ì Interest-Rate Risk'' and ""Ì Derivative Financial Instruments.'' Short-Term Debt. Freddie Mac raises funds to meet operating cash needs primarily through the issuance of Reference BillsSM and other discount notes. These are short-term instruments with maturities of one year or less that are sold on a discounted basis and pay only principal at maturity. In November 1999, Freddie Mac announced the Reference BillsSM program, which consists of large issues of short-term debt that are auctioned on a regular schedule and conducted the Ñrst auction in January 2000. Reference BillsSM with 1-, 2- and 3-month maturities are auctioned weekly. Reference BillsSM with 6- and 12-month maturities are auctioned every four weeks. Freddie Mac issues discount notes with maturities of less than 1 month from time to time in response to investor demand and its own cash needs. Medium- and Long-Term Debt. Freddie Mac issues medium- and long-term debt primarily through its medium-term note program and its global note facility. Each of these programs accommodates a variety of structures, including callable and non-callable Ñxed-rate securities, zero coupon securities and variable-rate securities. In 1998, Freddie Mac commenced two new debt Ñnancing programs under its global note facility known as Reference NotesSM and Reference BondsSM. These programs allow the corporation to sell large issues of debt that provide investors worldwide with a high-quality, liquid investment vehicle. In April, 1999, Freddie Mac enhanced this program by introducing Callable Reference NotesSM in order to create additional liquidity in the callable debt market. In fourth quarter 1999, Freddie Mac announced a $65 billion Ñnancing calendar for 2000, which provides investors information about the timing of new issues and the reopening of outstanding issues of Reference Notes and Reference Bonds, the anticipated size of individual oÅerings and settlement dates for issuances. Under its medium-term notes program, Freddie Mac also issues securities with a variety of structures. While the investor base for Freddie Mac medium-term notes remains predominantly institutional, a growing number of oÅerings during 1999 were designed to meet the needs of retail investors. Under its global note program, Freddie Mac can issue securities denominated in U.S. dollars or various other currencies. Freddie Mac enters into currency swaps to oÅset the currency risk of these transactions. See the discussion of foreign currency swaps in Notes 1 and 9 of the Notes to Consolidated Financial Statements. Customer And Market Support Activities Securities Sales and Trading Group Freddie Mac makes a market in its own mortgage-related and debt securities by distributing these securities to, and trading these securities with, Freddie Mac's customers and other counterparties, including mortgage sellers, investors and dealers in such securities. Trading services are managed and conducted through Freddie Mac's Securities Sales and Trading Group (""SS&TG''). SS&TG buys, sells and exchanges Freddie Mac Ñxed-income securities in various Ñnancial transactions (including forward sales and reverse repurchase transactions) that use mortgage pass-through, debt and resecuritized securities. These transactions are subject to limits established by the Board of Directors. The securities positions maintained by SS&TG, as well as the interest-rate risks of these Ñnancial transactions, are hedged with purchases and sales of Freddie Mac securities, or in certain cases with transactions in Treasury securities and mortgage pass-through securities of Fannie Mae and Ginnie Mae. To manage customer credit risk, SS&TG analyzes and monitors the Ñnancial condition and trading positions of all customers and establishes trading limits consistent with these reviews. In addition, SS&TG has established overall policies, procedures and controls, that are reviewed on an ongoing basis, to manage credit, interest-rate and operational risk. Freddie Mac engages in reverse repurchase (""reverse repo'') transactions through SS&TG with approved seller/servicers, depository institutions and other Ñnancial institutions and investors. In these transactions, 11 SS&TG customers sell PCs or other Freddie Mac securities to Freddie Mac and agree to repurchase them at a later date. From time to time, SS&TG assists Freddie Mac in the distribution of its securities by acquiring securities directly from Freddie Mac at the time of issuance for sale to investors and other market participants. Distribution activities may include participation in dealer auctions of Freddie Mac securities, resecuritization of outstanding Freddie Mac securities, participation in dealer syndicates for underwritten oÅerings of Freddie Mac securities and other transactions. Market Support Activities Freddie Mac supports the market for its PCs and PC prices relative to prices for Fannie Mae passthrough securities and other comparable securities in a variety of ways, including the acquisition of PCs for resecuritization as REMICs and other securities, market-making activities of SS&TG, and the purchase of PCs for Freddie Mac's retained portfolio and for other corporate purposes. Market support activities have included the use of external money management Ñrms to actively manage and trade a relatively small portion of Freddie Mac's retained portfolio, active participation in the dollar roll market for Freddie Mac PCs, focused marketing eÅorts to present to dealers and investors the relative advantages of trading and investing in Freddie Mac PCs, and the production of new mortgage-related securities, products and services. Freddie Mac anticipates undertaking additional activities to support the market for PCs in the future, although it may determine to increase, reduce or discontinue these activities at any time. Market Conditions and Competition Freddie Mac operates within the secondary mortgage market. The secondary market encompasses institutions engaged in buying and selling mortgages and mortgage-related investments. The magnitude of investment and trading activity in this market supports a continuous Öow of funds to the primary market. Stable mortgage Öows help moderate cyclical swings in the housing market. The volume of Freddie Mac's mortgage purchases depends primarily on the volume of conventional, conforming mortgages originated in the primary market, the share of conventional, conforming mortgages sold into the secondary market and the share of those mortgages sold to Freddie Mac rather than to its competitors, principally Fannie Mae. For information on certain limits applicable to Freddie Mac's mortgage purchases, see ""Business Ì Mortgage Purchases Ì Freddie Mac Act Mortgage Purchase Requirements.'' Freddie Mac estimates that approximately $1.09 trillion of conforming single-family mortgages were originated in 1999; a total of approximately $523 billion, or 48 percent of that amount, were sold to Freddie Mac and Fannie Mae, compared to 50 percent in 1998. Freddie Mac and Fannie Mae compete for the purchase of the same types of mortgages. Both companies compete for purchases of newly originated mortgages as well as mortgages originated in the past that were initially retained by mortgage lenders. Freddie Mac competes on the basis of its products, services and business processes, the liquidity of its securities in the secondary mortgage markets and its pricing strategies and credit standards. From time to time Freddie Mac forms strategic alliances with large single-family mortgage lenders that provide for both companies to share technology and related data in order to improve services and lower costs for mortgage borrowers. These alliances also may provide for the lender to sell to Freddie Mac a signiÑcant portion of the conventional, conforming loans it originates for sale in the secondary market. Freddie Mac's success in these activities and Fannie Mae's success in similar activities could have a signiÑcant positive or adverse impact on Freddie Mac's market share of single-family mortgages. Freddie Mac's market share as a percentage of combined Freddie Mac and Fannie Mae purchases of both newly originated single-family mortgages and single-family mortgages originated more than 12 months prior to purchase by Freddie Mac was approximately 43 percent for 1999, compared to approximately 42 percent for both 1998 and 1997. See ""Management's Discussion and Analysis of Financial Conditions and Results of Operation Ì MARKET OVERVIEW'' and "" Ì LIQUIDITY AND CAPITAL MANAGEMENT Ì Capital Adequacy.'' 12 Freddie Mac competes for multifamily mortgages not only with Fannie Mae but also with primary lenders such as banks, insurance companies and ""conduits'' that originate mortgages for securitization via private-label commercial mortgage-backed securities. Competition for multifamily mortgages continued to be intense in 1999. Freddie Mac, Fannie Mae and the other multifamily lenders compete on the basis of service, price and (to a lesser extent) loan size and repayment terms. The markets for Freddie Mac's original issue and resecuritized securities are closely interrelated. The issuance of resecuritized mortgage securities by Freddie Mac helps support the market for PCs. Although interest rates are generally the most signiÑcant determinant of PC prices, signiÑcant resecuritization activity also tends to increase the prices (and thus reduce the yields) of both PCs and mortgages. When demand for Multiclass PCs and other resecuritized securities diminishes, PC prices may be adversely aÅected. See ""Customer and Market Support Activities''. The level of Freddie Mac's Multiclass PC issuances in future periods may be adversely aÅected by increasing activity by other issuers of multiple-class securities similar to those of Freddie Mac and Fannie Mae (including Ginnie Mae as well as larger depository institutions and other private issuers of mortgage-related and asset-backed securities). In 1999, there was an increase in Ginnie Mae multiple-class securities issuances over prior years. Investors have tended to favor these Ginnie Mae securities over Freddie Mac's Multiclass Ginnie Mae-Backed Securities. To date, Ginnie Mae's program has had a limited eÅect on the volume and fees of Freddie Mac's multiple-class securities program backed by either Freddie Mac or GNMA securities. Freddie Mac competes with other GSEs, including Fannie Mae and the Federal Home Loan Bank (""FHLB'') system, for funds raised through the issuance of unsecured debt in the ""agency'' debt market. Increases in the issuance of unsecured debt by other GSEs may have an adverse eÅect on the issuance of Freddie Mac's unsecured debt, or result in the issuance of such debt at higher interest rates than would otherwise be the case. Similarly, the unavailability in the derivatives market of call options comparable to those provided by callable debt also could adversely aÅect Freddie Mac's debt funding costs. The availability and cost of funds raised through the issuance of certain types of unsecured debt also may be adversely aÅected by regulatory initiatives that tend to reduce investments by certain depository institutions in debt issued by GSEs or debt having greater than normal volatility or interest-rate sensitivity. Freddie Mac and Fannie Mae enjoy signiÑcant advantages because of their economies of scale and longterm market presence in the secondary market for conforming mortgages. However, an increasing number of mortgage originators, including members of the FHLB system, retain newly originated mortgages for at least some period of time (in particular, ARMs prior to their initial rate adjustments). The ability of such portfolio lenders to Ñnance mortgage originations by means other than through sales of mortgages into the secondary market has heightened competition for mortgage purchases. This source of competition became more signiÑcant in 1999 because as the Federal Reserve raised overnight bank lending rates, mortgage originations shifted towards ARM originations. In October 1999, the Federal Housing Finance Board (""FHFB'') adopted a pilot program that allows each of the twelve Federal Home Loan Banks, with the approval of FHFB staÅ, to purchase residential mortgages, called Member Mortgage Assets (""MMA''), from members of that Federal Home Loan Bank. This program includes the Chicago Home Loan Bank's Mortgage Partnership Finance pilot, which has been in operation since 1997. At present, the pilot is limited to $9 billion in purchases, and it is too early to predict whether the MMA pilot will expand to become a signiÑcant source of competition for Freddie Mac's mortgage purchases in the future. From time to time the President, the Secretary of HUD, Congress and others have proposed signiÑcant changes in the role and structure of FHA. FHA provides insurance for both single-family and multifamily housing. The reform proposals have generally addressed only the single-family FHA program. The singlefamily FHA insurance program insures the full principal amount of individual mortgages with original principal amounts up to 87 percent of the corporation's conventional loan limits ($219,849 for a one-unit property in 1999), depending upon property location. Most mortgages insured under the FHA single-family program have LTV ratios in excess of 90 percent and are underwritten to standards that are often less stringent than those used by Freddie Mac. The reform proposals have included privatizing FHA and expanding its authority to insure diÅerent types of mortgage products, increasing the maximum mortgage size eligible for 13 FHA insurance up to the conforming loan size of mortgages purchased by Freddie Mac, establishing a pilot program to use risk-based pricing in FHA mortgage programs, or restricting FHA's authority by limiting it to providing pool insurance on mortgages held by Freddie Mac or other market participants. Modifying FHA's structure and expanding its authority could place additional competitive pressures on Freddie Mac. Alternatively, restricting FHA's authority could increase the share of mortgages originated by the conventional market. Defaults, Foreclosures and REO General In the normal course of business, certain of the mortgages retained or securitized by Freddie Mac will default and be foreclosed upon. In most of these cases, Freddie Mac acquires the real estate securing these mortgages as REO. Defaults that lead to foreclosure and/or acquisition of property as REO often result in losses to Freddie Mac because the amount realized on the ultimate disposition of a property and/or recoveries under applicable mortgage insurance policies or from other sources may not be suÇcient to pay all principal, Ñnancing costs, foreclosure expenses and other costs related to holding the property pending disposition. Certain defaults do not result in principal losses to Freddie Mac because they involve either repurchases by sellers of conventional mortgages or FHA/VA mortgages on which Freddie Mac receives insurance or guaranty payments. For those mortgages that default, signiÑcant periods of time may elapse after default and foreclosure before Freddie Mac acquires title to, and may exercise its right to sell, REO. Foreclosure proceedings on multifamily mortgages typically are not initiated until a mortgage has been delinquent for at least 60 days while foreclosure proceedings on single-family mortgages typically are not initiated until a mortgage has been delinquent for at least 90 days. State law imposes varying notice and other requirements with respect to foreclosure actions (including, in some states with judicial foreclosure procedures, a requirement for timeconsuming court proceedings at several stages of the foreclosure process). In addition, some state statutes grant borrowers the right to redeem properties for periods of up to two years after foreclosure. Freddie Mac generally does not acquire clear title to these properties until the expiration of any such right. For those properties that become REO, Freddie Mac's policy generally is to dispose of such properties at market value as quickly as possible, taking into consideration local market conditions. Multifamily properties that become REO are tenant-occupied and rental activity continues in the ordinary course of business. Freddie Mac also may make repairs prior to sale in order to increase the value of the acquired property and, in the case of a multifamily property, in order to increase the cash Öow on the property. See ""Technology and Service Initiatives Ì HomeSteps and HomeSteps Asset Services'' above. Due to the time and expense of acquiring, managing and disposing of property, foreclosure is not always the most eÅective method of resolving problems associated with non-performing mortgages. Accordingly, Freddie Mac frequently uses early intervention alternatives to foreclosure such as loan modiÑcations, preforeclosure sales (in which the corporation accepts less than the full principal balance outstanding on the mortgage) and note sales. Foreclosure alternatives have tended to accelerate charge-oÅs for aÅected properties, but also have reduced overall credit costs by eliminating costs associated with acquisition, management and disposition of properties taken in foreclosure. See ""Management's Discussion and Analysis of Financial Condition and Results of Operations Ì RISK MANAGEMENT Ì Credit Risk'' and ""Ì FORWARD-LOOKING STATEMENTS.'' Freddie Mac manages the risk of loss from defaults, foreclosure and REO activities by monitoring and managing the various factors that inÖuence this risk. The most signiÑcant of these factors are the quality and eÅectiveness of the corporation's mortgage purchase underwriting standards; the sensitivity of the total mortgage portfolio to changing economic conditions; the corporation's ability to minimize the delinquency timelines of loans prior to foreclosure sale; and the corporation's ability to resolve and dispose of its REO assets on terms advantageous to Freddie Mac. See ""Management's Discussion and Analysis of Financial Condition and Results of Operations Ì RISK MANAGEMENT Ì Credit Risk Ì Mortgage Credit Risk.'' 14 REO Activities Freddie Mac's single-family and multifamily REO activities during 1999 and 1998 are reÖected in the following tables. Single-Family REO Number of REO Number of REO properties in Number of Number of properties in inventory as of property property inventory as of Average holding January 1 acquisitions dispositions December 31 period (in days) Average net loss per property disposition(1) 1999 ÏÏÏÏÏÏÏÏÏÏÏÏÏ 1998 ÏÏÏÏÏÏÏÏÏÏÏÏÏ 6,773 8,387 11,463 15,485 12,621 17,099 5,615 6,773 188 174 $16,965 (18% loss rate) $25,785 (25% loss rate) Multifamily REO Number of REO Number of REO properties in Number of Number of properties in inventory as of property property inventory as of Average holding January 1 acquisitions dispositions December 31 period (in days) Average net loss per property disposition(1) 1999 ÏÏÏÏÏÏÏÏÏÏÏÏ 1998 ÏÏÏÏÏÏÏÏÏÏÏÏ 8 15 11 5 15 12 4 8 295 428 $104,368 (15% loss rate) $493,359 (52% loss rate) (1) Cumulative net mortgage and REO-related losses with respect to properties disposed of in the indicated year. Comprised principally of mortgage charge-oÅs, uncollected interest, REO holding period income and expenses, REO valuation adjustments and REO disposition gains or losses. Excludes net losses on facilitated sales of defaulted mortgages prior to foreclosure. Note 6 to Freddie Mac's Consolidated Financial Statements summarizes Freddie Mac's REO activity for the years ended 1999, 1998 and 1997. For further information concerning Freddie Mac's single-family and multifamily REO, see ""Management's Discussion and Analysis of Financial Condition and Results of Operations Ì RISK MANAGEMENT Ì Credit Risk Ì Mortgage Credit Risk.'' Set forth below is a three-year mortgage loss analysis of the total mortgage portfolio. Mortgage Loss Analysis 1999 Total Mortgage Portfolio: 1998 1997 (dollars in millions) Average portfolio balance ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Year-end portfolio balance ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Net charge-oÅs ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Provision for mortgage losses ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Reserve for mortgage losses ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Net charge-oÅs to average portfolio balance(1) ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Reserve to year-end portfolio balance(1) ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ (1) Expressed in basis points (""bp'') or one-hundredths of one percent. $809,719 $862,326 $56 $60 $772 0.7 bp 9.0 bp $678,390 $733,360 $116 $190 $768 1.7 bp 10.5 bp $622,245 $640,406 $296 $310 $694 4.8 bp 10.8 bp Management maintains the corporation's ""Reserve for losses on retained mortgages'' and ""Reserve for losses on Mortgage Participation CertiÑcates'' (collectively, ""Reserve for mortgage losses'') at levels it deems adequate to absorb estimated losses incurred on the total mortgage portfolio. Reserves are increased through periodic provisions charged to expense and decreased by charge-oÅs, net of recoveries. Charge-oÅs are recognized when a mortgage is modiÑed in a troubled debt restructuring or foreclosed, and are equal to the cost basis of the mortgage less the fair value of the mortgage or property received. In estimating losses incurred on the single-family mortgage portfolio, management utilizes a statistically based model that evaluates numerous factors including general and regional economic conditions, expected future default experience and mortgage collateral values. Multifamily mortgages are individually evaluated for losses, with reserves established to cover collateral deÑciencies based on the current fair value of the underlying properties, less estimated costs to sell and repair the properties and/or remove hazardous conditions. Management also considers uncertainties related to estimations in the reserve setting process. 15 Litigation Freddie Mac is involved as a party to a variety of legal proceedings arising from time to time in the normal course of its business including, among other things, contractual disputes, personal injury claims, employment-related litigation and other legal proceedings incidental to the business. Freddie Mac is most frequently involved, directly or indirectly, in litigation involving mortgage foreclosures. Another type of proceeding arises out of the termination by the corporation of a seller/servicer's eligibility to sell mortgages to and service mortgages for Freddie Mac. In these cases, the former seller/servicer sometimes seeks damages against Freddie Mac for wrongful termination under a variety of legal theories. In addition, Freddie Mac is sometimes sued in connection with the origination or servicing of mortgages. These suits generally involve claims alleging wrongful actions of seller/servicers. The contracts between Freddie Mac and its seller/servicers generally provide for indemniÑcation of the corporation for liability arising from wrongful actions by such seller/servicers. Another type of dispute arises from Freddie Mac's ownership of properties after foreclosure as REO, such as tort liability to third parties and compliance with applicable housing code and other requirements associated primarily with Freddie Mac's multifamily and 2- to 4-unit REO. Among the tort claims with which the corporation is currently dealing are claims involving alleged injury to juvenile tenants caused by exposure to lead-based paint. In addition, Freddie Mac is named as a defendant in a class action lawsuit (German v. FHLMC, et al., 93 Civ. 6941 (S.D.N.Y.) involving alleged lead paint hazards in certain buildings it owns in New York City. Although this litigation is in its initial procedural stages and it is not possible to predict the outcome, Freddie Mac does not believe that the litigation will have a material adverse eÅect on the corporation's Ñnancial condition or results of operations. In June 1998, a complaint was Ñled against Freddie Mac in the U.S. District Court for the District of Columbia by a former employee. The initial complaint asserted that the case should proceed as a class action and alleges, among other things, discrimination against African Americans in various of the corporation's employment practices and the existence of a racially hostile work environment. Freddie Mac has answered the complaint, denied each of the allegations and denied that the case should be litigated as a class action. Thereafter, the plaintiÅ moved to drop his class claims, but recently attempted to rescind this motion. Based on the plaintiÅ's allegations, the Equal Employment Opportunity Commission (""EEOC'') has undertaken its own investigation and has sought to intervene in this litigation. The court has not yet ruled on any of the pending pleadings. The EEOC has stated that it has found reason to believe that certain of the plaintiÅ's allegations are true and has invited Freddie Mac to conciliate the matter. Freddie Mac is cooperating with the EEOC in conciliation, although Freddie Mac continues to believe the allegations are without merit. Management believes that neither the pending suit nor the EEOC proceeding will have a material adverse eÅect on Freddie Mac's results of operations or Ñnancial condition. Litigation and claims resolution are subject to many uncertainties and are not susceptible to accurate prediction. Nevertheless, management believes that the outcome of all currently pending claims will not have a material adverse eÅect on the corporation's Ñnancial condition or results of operations. REGULATION AND GOVERNMENTAL RELATIONSHIPS From time to time, Freddie Mac's statutory and regulatory relationships with the federal government may be subject to review or modiÑcation. While Freddie Mac's GSE status is often advantageous for the corporation, on occasion proposals have been advanced that could adversely aÅect Freddie Mac's fulÑllment of its statutory purposes, as well as the corporation's results of operations. Regulation of Freddie Mac Freddie Mac is subject to oversight by three agencies of the federal government: the OÇce of Federal Housing Enterprise Oversight (""OFHEO''), an independent oÇce within HUD created by the Federal Housing Enterprises Financial Safety and Soundness Act of 1992 (the ""GSE Act''); the Secretary of HUD; and the Secretary of the Treasury. 16 OFHEO Oversight The GSE Act provided for the creation of a separate oÇce within HUD, substantially independent of the Secretary of HUD, headed by a director (the ""Director''), appointed by the President of the United States and conÑrmed by the Senate, for a Ñve-year term. The Director has exclusive regulatory authority for ensuring the adequate capitalization and safe operation of Freddie Mac and Fannie Mae in accordance with the GSE Act. For a discussion of OFHEO's oversight of Freddie Mac see ""Management's Discussion and Analysis of Financial Conditions and Results of Operations Ì REGULATORY MATTERS Ì Capital Standards.'' HUD Oversight Housing Goals. The GSE Act requires the Secretary of HUD to establish three mortgage purchase goals for Freddie Mac and Fannie Mae: a goal for the purchase of mortgages for low- and moderate-income borrowers (the ""Low- and Moderate-Income Goal''); a goal for the purchase of mortgages on housing located in central cities, rural areas and other underserved areas (the ""Underserved Areas Goal''); and a special aÅordable housing goal for the purchase of mortgages on housing for low-income persons in low-income areas and for very low-income persons, including purchases of multifamily mortgages (the ""Special AÅordable Goal''). Freddie Mac purchases most single-family and multifamily mortgages in support of aÅordable housing through its standard mortgage purchase programs and under the same credit standards as its other mortgage purchases. Freddie Mac met each of its aÅordable housing goals in 1999. On March 9, 2000, HUD published a proposed rule that would establish new housing goals for Freddie Mac and Fannie Mae for calendar years 2000 through 2003. For additional information about the proposed rule, see ""Management's Discussion and Analysis of Financial Condition and Results of Operations Ì REGULATORY MATTERS Ì Housing Goals.'' Fair Lending. Freddie Mac is subject to the anti-discrimination provisions of the Fair Housing Act. In addition, the GSE Act requires the Secretary of HUD to adopt regulations prohibiting Freddie Mac from engaging in discriminatory practices in its mortgage purchase activities and periodically to review and comment on Freddie Mac's underwriting and appraisal guidelines for consistency with the Fair Housing Act and the GSE Act. HUD initiated a review of both Freddie Mac's and Fannie Mae's automated and traditional underwriting systems in February 1999 and Freddie Mac is fully cooperating with HUD's review. HUD's review of Freddie Mac's underwriting systems will continue in 2000. Freddie Mac does not believe HUD's review will have a signiÑcant impact on Freddie Mac's underwriting practices or systems. The GSE Act also requires the Secretary of HUD to direct the enterprises to: (i) submit data to HUD to assist HUD in investigating whether a mortgage lender with which the enterprise does business has failed to comply with the Fair Housing Act or the Equal Credit Opportunity Act (""ECOA'') and (ii) undertake remedial actions, including suspension, probation, reprimand or settlement, against lenders that are found to have engaged in discriminatory lending practices in violation of the Fair Housing Act or ECOA pursuant to a Ñnal adjudication and after opportunity for an administrative hearing. New Program Approval. Under the GSE Act, Freddie Mac must obtain the approval of the Secretary of HUD for any new program for the purchasing, servicing, selling, lending on the security of, or otherwise dealing in, conventional mortgages that: (i) is signiÑcantly diÅerent from programs that were approved or engaged in by Freddie Mac before the date the GSE Act was enacted or (ii) represents a material expansion of programs above limits expressly contained in any prior approval. There have been no such HUD-imposed limits applicable to Freddie Mac's mortgage programs. The Secretary of HUD is required to approve any new program unless the Secretary of HUD determines that the new program is not authorized under the Freddie Mac Act or that the program is not in the public interest. In addition, the GSE Act also provides new program approval authority to the Director of OFHEO for a transition period ending 12 months after the risk-based capital regulation becomes eÅective. In December 1995, HUD issued a Ñnal regulation implementing the new program approval authority granted under the GSE Act. Under the regulation, HUD may request information about any program which it believes may be subject to prior approval. Freddie Mac is required to seek prior approval only for new programs that are ""signiÑcantly diÅerent'' from current activities. The term ""signiÑcantly diÅerent'' is not deÑned in the regulation. 17 Non-Mortgage Investments. In December of 1997, HUD issued an advanced notice of proposed rulemaking seeking public comments regarding the advisability of proposing regulations concerning nonmortgage investments by Freddie Mac and Fannie Mae. HUD has not yet proposed any speciÑc regulations and it is too early to predict whether and to what extent HUD may seek to regulate Freddie Mac's nonmortgage investments or the impact such proposed regulations may have on Freddie Mac's Ñnancial condition or results of operations. Treasury Oversight Freddie Mac provides the Secretary of the Treasury monthly reports on the corporation's projected and actual issuance of unsecured debt obligations. The Secretary of the Treasury must approve the issuance of any types of securities not issued prior to the enactment of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (""FIRREA''). Regulations AÅecting Mortgages and Mortgage-Related Securities In addition to being subject to governmental regulation of its own business activities, Freddie Mac's issuance and sale of mortgage-related and debt securities is aÅected by a variety of legislative and regulatory actions related to the activities of banks, savings institutions, insurance companies, securities dealers and other regulated entities that comprise a signiÑcant part of Freddie Mac's customer base for these securities. As is the case with the regulation of many businesses, certain aspects of the regulations aÅecting its customers are beneÑcial to Freddie Mac (for example, the generally favorable treatment of mortgage-related securities as compared with unsecuritized mortgages under risk-based capital regulations applicable to depository institutions). Other provisions (for example, limitations on the ability of regulated institutions to purchase and own certain types of mortgage-related securities based upon concerns about the prepayment sensitivity and illiquidity of such securities) may have a constraining eÅect on the marketability of the corporation's securities. The more signiÑcant of these regulatory provisions are summarized below. Regulation of Investments in Mortgage-Related Securities Risk-based capital regulations adopted by the various federal bank and savings association regulatory agencies aÅect Freddie Mac's single-class and multiple-class securities programs. Among other things, these regulations assign lower credit-risk weights to most mortgage-related securities issued or guaranteed by Freddie Mac and Fannie Mae than to the underlying mortgages themselves, thereby requiring regulated Ñnancial institutions to maintain higher levels of capital for a given quantity of unsecuritized mortgages than would be required for an equivalent quantity of mortgage-related securities. Risk-based capital regulations applicable to insured depository institutions also may aÅect the market for mortgage-related securities issued by Freddie Mac and others. These regulations generally assign Freddie Mac and Fannie Mae mortgage-related securities, including those backed by GNMA CertiÑcates, to the second lowest risk weight, while GNMA-guaranteed securities are assigned the lowest risk weight, thereby eliminating the need to maintain any risk-weighted capital in support of GNMA securities. Accordingly, the capital costs, under the risk-based capital rules, of holding Freddie Mac and Fannie Mae securities as investments are higher for federally insured depository institutions than the costs of holding comparable GNMA-guaranteed securities. The Federal Deposit Insurance Corporation Improvement Act of 1991 (""FDICIA'') mandated that each of the federal bank and savings association regulatory agencies revise their risk-based capital standards to ensure that those standards adequately take into account interest-rate risk. Under these standards, the banking agencies will include in their evaluations of a bank's capital adequacy an assessment of the exposure to declines in the economic value of the bank's capital due to changes in interest rates. To a certain extent, these rules may have an adverse eÅect on the market for certain types of mortgage-related securities that increase the capital requirements for insured depository institutions. Conversely, certain aspects of these rules permit (and may even facilitate) purchases of certain types or combinations of mortgage-related securities that tend to reduce the interest-rate risk exposure of a particular institution. Ultimately, federal banking regulators may issue capital rules that establish an explicit minimum capital charge for interest-rate risk. OTS, the federal 18 savings association regulator, currently has a rule imposing such a charge with respect to thrift institution capital calculations, but has delayed implementation of this rule pending adoption of comparable rules by the banking agencies. On February 17, 2000, the Board of Governors of the Federal Reserve System (""Federal Reserve Board''), the OÇce of the Comptroller of the Currency (""OCC''), the Federal Deposit Insurance Corporation (""FDIC'') and the OTS published for comment an interagency proposal applicable to banks and thrifts that would revise the current risk-based capital treatment, including risk weighting, of certain asset-backed securitizations, recourse obligations and direct credit substitutes. The proposal is intended to provide consistent regulatory treatment for recourse obligations and direct credit substitutes and to align risk-based capital requirements more closely with related risk. This interagency proposal, if adopted in its present form, would assign highly rated private-label asset-backed securities to the same 20 percent risk weight category as mortgage related securities issued by Freddie Mac. The impact of this proposal on Freddie Mac will depend upon the Ñnal form of the interagency regulation. Other Legislation and Regulations AÅecting Financial Institutions The FDIC is considering a proposal to increase the regulatory capital requirement for depository institutions with signiÑcant concentrations of subprime loans. Management believes it is too early to predict the impact such proposals, if adopted, would have on Freddie Mac's ability to purchase residential mortgages in alternative segments of the mortgage market. On November 12, 1999, the President signed into law the Gramm-Leach-Bliley Financial Services Modernization Act of 1999. Among other things, this legislation imposes requirements and restrictions on a Ñnancial institution's ability to disclose nonpublic personal information to nonaÇliated third parties, unless the institution has provided the consumer with notice of its privacy policies and an opportunity to opt out of disclosure, or the transfer of information otherwise falls within one of the numerous exceptions provided in the statute. These exceptions include (i) provisions for securitization servicing, including transfers of servicing rights, and (ii) transfers of nonpublic personal information with consumer consent and for reporting to consumer reporting agencies. In February 2000, the Federal Trade Commission (""FTC'') issued a Notice of Proposed Rulemaking relating to the ability of Ñnancial institutions to disclose nonpublic personal information about consumers to nonaÇliated third parties. Under both the statute and the FTC proposed rule, Freddie Mac is excluded from the deÑnition of Ñnancial institution as long as Freddie Mac does not itself sell or transfer non-public personal information to non-aÇliated third parties outside the exceptions contained in the statute. Management believes that neither the statute nor the proposed rule will have a material adverse eÅect on Freddie Mac's results of operations or Ñnancial condition. Governmental Relationships Freddie Mac's congressional charter provides the corporation certain beneÑts such as the corporation's exemption from the registration requirements of the federal securities laws (although Freddie Mac is subject to the antifraud provisions of those laws), favorable treatment of the corporation's securities under various legal investment laws and other regulations, and access to the Federal Reserve Bank's book-entry system for the corporation's mortgage-related and debt securities. In addition, the Secretary of the Treasury has discretionary authority to purchase obligations issued by Freddie Mac up to a maximum of $2.25 billion outstanding at any one time. Finally, Freddie Mac also is exempt from state and local taxes, except real property tax on real estate which it owns. In part because of these beneÑts, investors consider Freddie Mac's mortgage-related and debt securities attractive investments with little credit risk, and Freddie Mac is able to sell its securities on favorable terms. From time to time, proposals have been made to change the relationship of GSEs such as Freddie Mac to the federal government. For example, legislative or regulatory proposals have advocated the partial or complete elimination of the exemptions from registration under the federal securities laws of securities issued by the GSEs (including Freddie Mac), elimination of the Treasury Secretary's discretionary authority to purchase GSE obligations, and establishment of limits on the ability of federally insured depository institutions to invest in GSE debt securities. Similarly, both federal and local government oÇcials have 19 proposed that the income of the GSEs be subjected to state taxation. In addition, other policy changes (such as the modiÑcation or elimination of the mortgage interest tax deduction or the creation of a new housing GSE to compete with Freddie Mac and Fannie Mae) have been suggested that may aÅect the mortgage markets, including the secondary mortgage market. Legislative and other proposals have recommended the imposition of certain fees by the federal government on securities issued by Freddie Mac, Fannie Mae and other GSEs. All or a portion of such fees might be passed on in the form of higher fees on newly purchased mortgages, and higher mortgage interest rates, and could cause the GSEs to shift funding of mortgage purchases away from the issuance of certain types of securities. Legislation was recently introduced in Congress that would overhaul the regulatory oversight of Freddie Mac, Fannie Mae and the Federal Home Loan Banks by consolidating the three regulatory agencies that currently oversee the three housing GSEs into a single regulator. This legislative proposal also would limit the ability of Freddie Mac, Fannie Mae and the Federal Home Loan Banks to engage in new programs and eliminate the discretionary authority of the Treasury Department to purchase GSE debt securities. The proposed legislation is unlikely to be adopted in its present form. In the past, legislation has been introduced in Congress that would regulate the ""derivatives activities'' of Freddie Mac and other companies. These legislative proposals could subject Freddie Mac to new or additional capital requirements, accounting requirements, risk management requirements, supervisory oversight and other substantive regulation of its present business activities with respect to certain transactions (such as forward sales and repurchase agreements involving mortgage-related securities, and transactions involving interest-rate swaps, currency swaps and ""over-the-counter'' derivative instruments). Elimination or modiÑcation of Freddie Mac's various exemptions, new or additional fees or substantive regulation of Freddie Mac's business activities, alteration or elimination of Freddie Mac's major ties to the federal government or any signiÑcant amendments to the Freddie Mac Act or other federal legislation bearing on Freddie Mac could require or cause Freddie Mac to change the nature and/or extent of its business activities, and could adversely aÅect the scope of its activities and results of operations. Any amendments to the Freddie Mac Act or modiÑcation of Freddie Mac's relationship to the federal government, including assessment of user fees or oversight fees, repeal of its exemptions or any modiÑcation of the present tax treatment of mortgage interest payments, would require legislation to be passed by Congress and signed by the President. Legislation that adversely aÅects Freddie Mac or its shareholders, if challenged, would be subject to judicial review to ensure its conformity with the requirements of the United States Constitution (including the Fifth Amendment's ban on uncompensated takings of property). PROPERTIES AND EMPLOYEES Freddie Mac owns a 75 percent interest in a limited partnership that owns Freddie Mac's principal oÇces, consisting of three oÇce buildings in McLean, Virginia that comprise approximately 900,000 square feet and provide oÇces for two-thirds of Freddie Mac's 3,638 employees. Freddie Mac expects to begin construction of the fourth phase of its corporate headquarters complex in the spring of 2000. Freddie Mac also has oÇces in Washington, D.C., in Reston and Tysons Corner, Virginia, and in Atlanta, Georgia; Chicago, Illinois; Dallas, Texas; New York, New York; and Woodland Hills, California. As of December 31, 1999, Freddie Mac had 3,481 full-time and 157 part-time employees. 20 CAPITALIZATION The following table sets forth Freddie Mac's capitalization as of December 31, 1999. Dollars are in millions. Debt securities: Notes and bonds payable due within one year: Discount notes, medium-term notes and securities sold under agreements to repurchase ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Current portion of long-term debt ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Notes and bonds payable due after one year ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Total debt securities, net ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Subordinated borrowings ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Stockholders' equity ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Total capitalizationÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ $166,203 9,322 175,525 185,056 360,581 130 11,525 $372,236 See Notes 7 and 8 to Consolidated Financial Statements for further information about Freddie Mac's debt securities, subordinated borrowings and stockholders' equity. Amounts of debt securities and subordinated borrowings are net of unamortized discounts or premiums and hedging gains or losses. EQUITY SECURITIES Freddie Mac is authorized to issue preferred stock and common stock in the manner and amount, and, in the case of voting common stock, subject to any limitations on concentration of ownership, as may be prescribed by the Board of Directors of Freddie Mac. There is no limitation on the number of shares of preferred stock or of voting common stock that Freddie Mac is authorized to issue. Freddie Mac had issued and outstanding 695,091,006 shares of its voting common stock (the ""Common Stock'') as of December 31, 1999. Each share of the Common Stock has a par value of $0.21 per share. Since 1995, Freddie Mac has engaged in repurchases of common stock in open market transactions pursuant to authorization from the Board of Directors. On September 5, 1997, the Board of Directors authorized the repurchase by the Corporation of up to Ñve percent of the 681,242,537 shares of common stock outstanding on September 5, 1997, or approximately 34 million shares. In March 2000, Freddie Mac's Board of Directors increased the 2000 quarterly dividend on the corporation's Common Stock to $0.17 per share, up from $0.15 per share in each of the four quarters of 1999. See ""Management's Discussion and Analysis of Financial Condition and Results of Operations Ì LIQUIDITY AND CAPITAL MANAGEMENT Ì Capital Management.'' Freddie Mac had 11 classes of preferred stock (the ""Preferred Stock'') outstanding at December 31, 1999. Freddie Mac's outstanding classes of preferred stock have a par value of $1 per share, and are redeemable (on speciÑed dates) at the corporation's option at their redemption price (or redemption value) plus dividends accrued through the redemption date. In addition, all 11 classes of preferred stock are perpetual and non-cumulative, and carry no signiÑcant voting rights or rights to purchase additional Freddie Mac stock or securities. See Note 8 to Consolidated Financial Statements and ""Management's Discussion and Analysis of Financial Condition and Results of Operations Ì LIQUIDITY AND CAPITAL MANAGEMENT Ì Capital Management'' for further information about Freddie Mac's outstanding classes of preferred stock. Under Section 303(b)(2) of the Freddie Mac Act, Freddie Mac's right to declare dividends on, and its right to redeem, any of its stock is subject to prior regulatory approval by the Director of OFHEO if such ""capital distribution'' (as deÑned in the GSE Act) would decrease Freddie Mac's capital below the risk-based capital level for Freddie Mac established in the GSE Act or would decrease its core capital to an amount less than the minimum capital level Freddie Mac is required to maintain by the GSE Act. In addition, pursuant to the GSE Act, the Director may require Freddie Mac to submit a report to the Director after the declaration of, and before making, any such capital distribution. 21 The descriptions of the Common Stock and the Preferred Stock set forth below do not purport to be complete and are qualiÑed in their entirety by the respective CertiÑcates of Designation for such securities. Common Stock The Board of Directors may increase the authorized number of shares of Common Stock at any time without the consent of the holders of the Common Stock. Dividends on shares of the Common Stock are not mandatory. Subject to the dividend priorities of the outstanding classes of Preferred Stock described below, holders of outstanding shares of Common Stock are entitled to receive cash dividends when, as and if declared by the Board of Directors. The Common Stock is not subject to optional redemption by Freddie Mac. No holder of the Common Stock has any preemptive right to purchase or subscribe for any other shares, rights, options or other securities of any class of stock of Freddie Mac that at any time may be sold or oÅered for sale by Freddie Mac. The holders of shares of the Common Stock do not have any right to convert such shares into or exchange such shares for any other class or series of stock or obligations of Freddie Mac. Holders of Common Stock are entitled to one vote per share in the election of non-appointed Directors and on all other matters presented to them for their vote. Freddie Mac has the right to create and issue additional classes or series of stock ranking prior to, on a parity with or junior to the Common Stock, as to dividends, liquidation or otherwise, without the consent of the holders of the Common Stock. Ownership Reporting System. The Board of Directors has adopted an ownership reporting system similar to the disclosure system applicable to public companies that have a class of securities registered with the Securities and Exchange Commission under the Securities Exchange Act of 1934. BeneÑcial owners of more than 5 percent of the outstanding shares of Common Stock are required to Ñle ownership reports with Freddie Mac's Shareholder Relations Department and with the New York and PaciÑc Stock Exchanges, on which the stock is listed. Freddie Mac may impose sanctions upon shareholders for failure to comply with its beneÑcial ownership reporting system, including forfeiture of voting rights for the portion of the stock that is held in excess of the reporting threshold. Freddie Mac's policy is to make available copies of ownership reports Ñled with the corporation upon request to the Shareholder Relations Department. In addition, information regarding the stock ownership of certain shareholders is provided on an annual basis in Freddie Mac's proxy statement. Insider Equity Ownership and Short-swing Transactions. Freddie Mac has a short-swing trading policy for transactions in the corporation's common and preferred stock by directors and certain oÇcers (""insiders'') similar to the short-swing transaction reporting provisions applicable to insiders of public companies with equity securities registered with the Securities and Exchange Commission under the Securities Exchange Act of 1934. Under the corporation's policy, insiders must Ñle initial reports of beneÑcial ownership of the corporation's equity securities, and reports of changes in beneÑcial ownership, with the corporation's legal division. Subject to certain exemptions, purchases and sales, or sales and purchases, of any Freddie Mac equity security of the same class beneÑcially owned by an insider within a six-month period generally are prohibited by the policy. Freddie Mac will make available to the public copies of ownership reports Ñled under the policy upon request to the corporation's Shareholder Relations Department. General. The Common Stock is identiÑed by the ticker symbol ""FRE'' on the New York and PaciÑc Stock Exchanges. From time to time, the Common Stock may be admitted to unlisted trading status on other national securities exchanges. Put and call options with respect to the Common Stock are traded on the American Stock Exchange. The transfer agent for the Common Stock is First Chicago Trust, a division of EquiServe, P.O. Box 2506, Jersey City, N.J., 07303-2506. Preferred Stock Authorized Issuance. The Board of Directors may increase the authorized number of shares of Preferred Stock at any time, without the consent of the holders of the Preferred Stock. Dividends. Dividends on shares of the Preferred Stock are not mandatory. Holders of Preferred Stock are entitled to receive non-cumulative, quarterly cash dividends that are payable on March 31, June 30, September 30 and December 31 of each year (each, a ""Dividend Payment Date''), at the annual rate set forth in the applicable preferred stock oÅering circular. Dividends will be paid to holders of record on the record 22 date Ñxed by the Board of Directors, not to be earlier than 45 days or later than 10 days preceding the applicable payment date. The Preferred Stock ranks prior to the Common Stock with respect to dividends, to the extent provided in the CertiÑcate of Designation for the Preferred Stock. No dividend can be declared or paid or set apart for payment on the Common Stock unless dividends have been declared and paid or set apart on the Preferred Stock in respect of the then-current quarterly dividend period. Each class of Preferred Stock ranks on a parity with each other class with respect to dividends. Dividends on the Preferred Stock are not cumulative. Dividends In 1998 and 1999, Freddie Mac paid aggregate quarterly dividends of approximately $743 million on the outstanding shares of Common Stock and approximately $274 million on the outstanding shares of Preferred Stock. Freddie Mac will pay approximately $118 million in aggregate dividends on the Common Stock and $44 million in aggregate dividends on the Preferred Stock for the Ñrst quarter of 2000. REIT SUBSIDIARIES In February 1997, Freddie Mac formed two real estate investment trust (""REIT'') subsidiaries for federal income tax purposes. The REITs issued $4 billion in step-down preferred stock (the ""Preferred Shares'') to certain institutional investors and used the proceeds to purchase mortgage-related securities from Freddie Mac in transactions intended to reduce after-tax funding costs. Subsequent to the issuance of the Preferred Shares, the U.S. Department of the Treasury (the ""Treasury'') published Notice 97-21 stating its intention to deny certain of the intended tax beneÑts associated with REIT preferred stock having features similar to those of the Preferred Shares. On January 5, 1999, the Treasury published proposed regulations intended to modify the federal income tax consequences of stock having features similar to the Preferred Shares and on January 7, 2000 the Treasury published Ñnal regulations for stock having features similar to the Preferred Shares. The Preferred Shares are redeemable under certain circumstances where changes in applicable tax law could adversely aÅect the tax treatment of the REIT or the Preferred Shares. To date, neither REIT has decided to redeem the Preferred Shares. MANAGEMENT Freddie Mac's Board of Directors consists of 18 members, including 13 members elected annually by the holders of the Common Stock and Ñve members appointed annually by the President of the United States. The Presidential appointees must include at least one person from each of the mortgage lending, home building and real estate industries and one person from a consumer or community interest organization or one person who has demonstrated a career commitment to the provision of low-income housing. All directors serve for a term ending on the date of the next annual meeting of stockholders, unless they are re-elected or reappointed, as applicable, and have identical Ñduciary duties to the corporation's stockholders. Information concerning the directors of Freddie Mac, compensation of certain executive oÇcers and of directors, stock ownership of management and any person or group owning more than Ñve percent of the Common Stock and related matters may be found in the Proxy Statement (the ""Proxy Statement'') for the Annual Meeting of Stockholders of Freddie Mac to be held on May 4, 2000. The Proxy Statement, as and when available, is incorporated by reference into this Information Statement. Freddie Mac will provide a copy of the Proxy Statement, without charge, to each person to whom this Information Statement has been delivered, upon the written or oral request of that person. Such requests should be addressed to Freddie Mac at Mailstop A57, 8250 Jones Branch Drive, McLean, Virginia 22102 (telephone (800) FREDDIE (373-3343)). 23 Executive OÇcers As of March 31, 2000, the executive oÇcers of Freddie Mac are as follows: Name Age Year of AÇliation Position Leland C. Brendsel ÏÏÏÏÏÏÏÏÏ David W. Glenn ÏÏÏÏÏÏÏÏÏÏÏÏ Maud Mater ÏÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Paul T. PetersonÏÏÏÏÏÏÏÏÏÏÏÏ David A. AndrukonisÏÏÏÏÏÏÏÏ Donald J. Bisenius ÏÏÏÏÏÏÏÏÏÏ Henry J. Cassidy ÏÏÏÏÏÏÏÏÏÏÏ Vaughn A. Clarke ÏÏÏÏÏÏÏÏÏÏ Margaret Colon ÏÏÏÏÏÏÏÏÏÏÏÏ Adrian B. CorbiereÏÏÏÏÏÏÏÏÏÏ R. Mitchell Delk ÏÏÏÏÏÏÏÏÏÏÏ Patricia M. Dodson ÏÏÏÏÏÏÏÏÏ Nazir G. Dossani ÏÏÏÏÏÏÏÏÏÏÏ Melvin M. KannÏÏÏÏÏÏÏÏÏÏÏÏ William I. Ledman ÏÏÏÏÏÏÏÏÏ Jerome T. Lienhard ÏÏÏÏÏÏÏÏÏ Peter F. Maselli ÏÏÏÏÏÏÏÏÏÏÏÏ Michael C. May ÏÏÏÏÏÏÏÏÏÏÏÏ Candice D. MendenhallÏÏÏÏÏÏ Gregory J. Parseghian ÏÏÏÏÏÏÏ Gregory E. Reynolds ÏÏÏÏÏÏÏÏ Dwight Robinson ÏÏÏÏÏÏÏÏÏÏÏ Patrick Sheehy ÏÏÏÏÏÏÏÏÏÏÏÏÏ David StevensÏÏÏÏÏÏÏÏÏÏÏÏÏÏ Joel Van Ryckeghan ÏÏÏÏÏÏÏÏ 57 56 52 50 42 41 56 46 43 56 47 39 58 59 51 44 42 41 50 39 41 47 42 44 43 1982 1987 1976 1989 1980 1992 1984 1998 1983 1999 1991 1983 1993 1993 1994 1999 1981 1983 1995 1996 1991 1998 1999 1999 1999 Chairman and Chief Executive OÇcer President and Chief Operating OÇcer Executive Vice President Ì General Counsel and Secretary Executive Vice President Ì Single Family Securitization Group Senior Vice President and Chief Credit OÇcer Senior Vice President Ì Risk Assessment and Model Development Senior Vice President Ì Portfolio Management Senior Vice President Ì Finance and Chief Financial OÇcer Senior Vice President Ì Servicer Division Senior Vice President Ì Multifamily Lending Senior Vice President Ì Government Relations Senior Vice President Ì Investor and Dealer Services Senior Vice President Ì Asset/Liability Management and Research Senior Vice President and General Auditor Senior Vice President Ì Information Systems and Services Senior Vice President Ì Investment Funding Senior Vice President Ì Business Development Senior Vice President Ì Customer Services and Control Senior Vice President Ì Human Resources Senior Vice President Ì Corporate Finance and Chief Investment OÇcer Senior Vice President and Corporate Controller Senior Vice President Ì Corporate Relations Senior Vice President Ì Marketing, Sales and Production Senior Vice President Ì Sales Senior Vice President Ì Customer Capabilities The following is a brief biographical description of each executive oÇcer of Freddie Mac. Leland C. Brendsel was elected Chairman and Chief Executive OÇcer in November 1989. He served as President and Chief Executive OÇcer from September 1985 to November 1989 and Executive Vice President Ì Finance and Chief Financial OÇcer from September 1982 to September 1985. David W. Glenn was appointed President and Chief Operating OÇcer in March 1990. He served as Executive Vice President Ì Chief Operating OÇcer from November 1989 to March 1990 and Executive Vice President Ì Finance and Chief Financial OÇcer from November 1987 to November 1989. Prior to joining Freddie Mac, Mr. Glenn was Senior Vice President of CalFed, Inc., and California Federal Savings and Loan Association (currently California Federal Bank, FSB) from August 1984 to October 1987. Maud Mater was appointed Executive Vice President Ì General Counsel and Secretary in June 1998. Ms. Mater served as Senior Vice President Ì General Counsel and Secretary from June 1984 to June 1998. Prior to that time, Ms. Mater served as Vice President Ì General Counsel and Secretary from October 1982 to June 1984. Paul T. Peterson was appointed Executive Vice President Ì Single Family Securitization Group in December 1999. Mr. Peterson previously served as Senior Vice President of Business Strategy and continues to serve in that role as Freddie Mac's business strategy executive. Mr. Peterson also served as Senior Vice President Ì Servicer Division from 1995 to 1999. Prior to that, he had served as Senior Vice President Ì Corporate Finance from January 1992 to January 1995, as Vice President Ì Corporate Finance from March 1990 to January 1992 and as Director of Portfolio Management from April 1989 to March 1990. 24 David A. Andrukonis was appointed Senior Vice President and Chief Credit OÇcer in August 1998. Mr. Andrukonis served as Senior Vice President and General Manager Ì Seller Division from March 1994 to August 1998. From May 1993 to March 1994, he was Senior Vice President Ì Competitive Advantage Program. Mr. Andrukonis served as Vice President Ì Mortgage Finance from January 1991 to May 1993 and Director of Product Development and Pricing from June 1988 to January 1991 and has held various other positions at Freddie Mac since he joined the corporation in June 1980. Donald J. Bisenius was appointed Senior Vice President of the Risk Assessment and Model Development Division in the Single Family Securitization Group in August 1998. Mr. Bisenius previously served as Vice President of Mortgage Credit Policy from 1996 to 1998 and has held various other positions at Freddie Mac since he joined the corporation in 1992. Henry J. Cassidy was appointed Senior Vice President Ì Portfolio Management in the Single Family Securitization Group in August 1998. Mr. Cassidy served as Senior Vice President Ì Single Family Risk Management from January 1996 to August 1998. Prior to that Mr. Cassidy served as Vice President Ì Mortgage Credit Policy since March 1990. From October 1986 to March 1990 he served as Vice President Ì Corporate Finance and held various other positions at Freddie Mac since he joined the corporation in 1984. Vaughn A. Clarke was appointed Senior Vice President and Chief Financial OÇcer in March 2000. Mr. Clarke continues to serve as Senior Vice President Ì Finance, a position he has held since joining Freddie Mac in September 1998. Before joining Freddie Mac, Mr. Clarke was Senior Vice President and Treasurer of Viacom Inc., a large entertainment company from 1994 to 1998 and was Vice President and Treasurer from 1993 to 1994. Prior to that, Mr. Clarke held several positions at Gannett Co., Inc. and Chase Manhattan Bank. Margaret Colon was appointed Senior Vice President Ì Servicer Division in August 1999. Ms. Colon previously served as Vice President of Corporate Finance Operations from October 1997 to August 1999, Vice President and Assistant to the President from August 1994 to October 1997, and Vice President and Controller, Multifamily Lending from April 1993 to August 1994. Adrian B. Corbiere was appointed Senior Vice President Ì Multifamily Lending in August 1999. Before joining Freddie Mac, Mr. Corbiere had served as Managing Director, Real Estate Investments at Allstate Insurance Company since 1996. Prior to that, Mr. Corbiere held various positions at New England Financial, a subsidiary of Metropolitan Life Insurance Company, including Senior Vice President, Private Lending and Senior Vice President of the Commercial Mortgage Department from 1986 to 1996. Mr. Corbiere replaces Thomas J. Watt, who retired from Freddie Mac. R. Mitchell Delk was appointed Senior Vice President Ì Government Relations in March 1999. Mr. Delk was previously Vice President of Government Relations from 1991 to 1999. Prior to that, Mr. Delk spent seven years on Capitol Hill in various positions and four years as an investment banker at First Boston Corporation. Patricia M. Dodson was appointed Senior Vice President Ì Investor and Dealer Services, in the Single Family Securitization Group in August 1999. Ms. Dodson has previously served as Vice President, Credit Risk and Capital Management in the Corporate Finance Division from February 1999 to August 1999, Senior Vice President, Investor and Dealer Services on an interim basis from September 1997 to December 1998 and Vice President of the Securities Sales and Trading Group from May 1994 to September 1997. Ms. Dodson also serves on the Board of Directors of the Mortgage-Backed Securities Clearing Corporation. Nazir G. Dossani was appointed Senior Vice President of Asset/Liability Management and Research in the Corporate Finance Division in December 1998. Mr. Dossani previously served as Vice President of Asset Liability from 1993 to 1998. Melvin M. Kann was appointed Senior Vice President and General Auditor in August 1993. Prior to joining Freddie Mac, Mr. Kann served as Senior Vice President of Bank United of Texas, FSB from 1991 to 1993 and as Senior Vice President of Southeast Banking Corporation in Miami, Florida from 1983 to 1991. William I. Ledman was appointed Senior Vice President Ì Information Systems and Services in January 1995. He had been Vice President Ì Computer and Network Operations since he joined Freddie Mac in February 1994. Prior to joining Freddie Mac, Mr. Ledman held a variety of information systems-related 25 positions with GEICO, a property-casualty insurance company, between 1974 and 1994, the most recent being Vice President Ì Systems and Data Processing. Jerome T. Lienhard was appointed Senior Vice President Ì Investment Funding in the Corporate Finance Division in June 1999. Before joining Freddie Mac, Mr. Lienhard held several Ñnance and management positions at Toyota Motor Credit Corporation from 1989 to 1999, most recently as Corporate Treasury Manager. Peter F. Maselli was appointed Senior Vice President Ì Business Development in January 1998. Mr. Maselli served as Vice President of Loan Prospector from 1993 to January 1998. Prior to that time, Mr. Maselli served as Vice President of Marketing Programs and has held a variety of other positions at Freddie Mac since he joined the company in 1981. Michael C. May was appointed Senior Vice President Ì Customer Services and Control in the Single Family Securitization Group in September 1999, a position Mr. May held on an interim basis since August 1998. Mr. May served as Vice President of Loan Prospector from 1996 to 1998. Prior to that, Mr. May served as Vice President of Structured Finance from 1993 to 1996 and has held a variety of other positions at Freddie Mac since he joined the company in 1983. Candice D. Mendenhall was appointed Senior Vice President Ì Human Resources in June 1995. Before joining Freddie Mac, Ms. Mendenhall held several positions at Manchester, Inc., a large outplacement Ñrm, between 1992 and 1995, the most recent being Executive Vice President of Operations. Prior to that, Ms. Mendenhall was Vice President and Chief Administrative OÇcer for The Hair Cuttery, a large, privately owned retail chain, from 1988 to 1992. From 1983 to 1987, Ms. Mendenhall was Senior Vice President of Employee Relations at Mellon Bank. Gregory J. Parseghian was appointed Senior Vice President Ì Corporate Finance in February 1996 and Chief Investment OÇcer in September 1998. Prior to joining Freddie Mac, Mr. Parseghian was a managing director, chief Ñxed-income strategist and head of collateralized mortgage obligations and mortgage derivatives trading at Salomon Brothers, Inc. Prior to that, Mr. Parseghian was a partner and senior portfolio manager at BlackRock Financial Management, Inc. Mr. Parseghian worked at First Boston Corporation from 1982 through 1993, most recently as managing director and head of Ñxed-income research. Gregory E. Reynolds was appointed Senior Vice President and Corporate Controller in February 1998. Mr. Reynolds has served as Vice President Ì Corporate Accounting since January 1992. Prior to that time, Mr. Reynolds served as a Director in Corporate Accounting between the time he joined the company in January 1991 and January 1992. Prior to joining Freddie Mac, Mr. Reynolds served as a manager in the Audit Division of Arthur Andersen. Dwight Robinson was appointed Senior Vice President Ì Corporate Relations in September 1999. Mr. Robinson previously served as Vice President of Industry Relations. Prior to that, Mr. Robinson served as Deputy Secretary of the U.S. Department of Housing and Urban Development and as President of the Government National Mortgage Association. Patrick Sheehy was appointed Senior Vice President Ì Marketing, Sales and Production in the Single Family Securitization Group in April 1999. Before joining Freddie Mac, Mr. Sheehy served as Executive Vice President of Institutional Lending for Norwest Mortgage, Inc. from 1995 to 1999. Prior to that, Mr. Sheehy was Managing Director of Residential Lending for General Motors Acceptance Corporation. David Stevens was appointed Senior Vice President Ì Sales in the Single Family Securitization Group in August of 1999. Before joining Freddie Mac, Mr. Stevens held several senior executive positions at World Savings from 1983 through 1999, most recently as a Group Senior Vice President. Joel Van Ryckeghen was appointed Senior Vice President Ì Customer Capabilities in October 1999. Before joining Freddie Mac, Mr. Van Ryckeghen was Executive Vice President and Chief Operating OÇcer at Charter One Mortgage Company. Prior to that, Mr. Van Ryckeghen served in various capacities at Homeside Lending, Inc., Bank of America, Bear Stearns and Weyerhaeuser Mortgage Company. 26 INDEPENDENT PUBLIC ACCOUNTANTS The Consolidated Financial Statements and the supplemental Consolidated Fair Value Balance Sheets of the corporation included in this Information Statement have been audited by Arthur Andersen LLP, independent public accountants, as stated in their report. 27 Freddie Mac Financial Review Management's Discussion and Analysis of Financial Condition and Results of Operations A-1 A-1 A-1 A-2 A-3 A-4 A-4 A-5 A-6 A-6 A-6 A-10 A-12 A-12 A-15 A-16 A-17 A-17 A-17 A-18 A-21 A-22 A-24 A-27 A-28 A-28 A-28 Financial Highlights 1999 Performance Business Strategy and Outlook Forward-Looking Statements Market Overview Business Review Securitization Financing Debt Financing Risk Management Credit Risk Mortgage Credit Risk Institutional Credit Risk Interest-Rate and Other Market Risks Interest-Rate Risk Other Market Risks Derivative Financial Instruments Operational and Other Related Risks Liquidity and Capital Management Liquidity Capital Management Volume Statistics Average Balance Sheets and Rate/Volume Analysis Consolidated Results of Operations Regulatory Matters Tax Matters EÅect of New Accounting Standard Recent Events Consolidated Financial Information A-29 A-30 A-34 A-66 A-68 A-69 Five-Year Financial Highlights Consolidated Financial Statements Notes to Consolidated Financial Statements Additional Financial Information Management's Report on Consolidated Financial Statements and Internal Control Structure Reports of Independent Public Accountants Freddie Mac Management’s Discussion and Analysis of Financial Condition and Results of Operations FINANCIAL HIGHLIGHTS 1999 Performance In 1999, Freddie Mac achieved another year of record revenues and earnings. “Total revenues” increased 22 percent, to $4.055 billion in 1999 from $3.337 billion in 1998. “Net income” increased 31 percent, to $2.223 billion in 1999 from $1.700 billion in 1998. Diluted earnings per common share grew 28 percent, to $2.96 per share in 1999 from $2.31 per share in 1998. Freddie Mac’s return on common equity was 26 percent in 1999, exceeding 20 percent for the eighteenth consecutive year. Exhibit 1 – Earnings Per Common Share-Diluted (1) $3.00 $2.80 $2.60 $2.40 $2.20 $2.00 $1.80 $1.60 $1.40 $1.20 $1.00 $0.80 $0.60 $0.40 $0.20 $0.00 89 90 91 92 93 94 95 96 97 98 99 (1) “Earnings per common share-diluted” are computed based on the total of weighted average common shares outstanding and the effect of dilutive common equivalent shares outstanding. Freddie Mac’s revenues in 1999 were driven by mortgage portfolio growth. In a year of rising interest rates, the corporation’s total mortgage portfolio grew 18 percent, while the retained portfolio grew 27 percent. Freddie Mac achieved this growth while strengthening both its credit risk and interest-rate risk profiles. Freddie Mac’s total mortgage portfolio growth rate of 18 percent exceeded the estimated 9 percent growth in total outstanding U.S. residential mortgage debt. The corporation’s total mortgage portfolio growth reflects 1999 new business purchases totaling $273 billion, only slightly below 1998’s record purchase volume of $288 billion, accompanied by slowing total portfolio liquidations which fell to 20 percent in 1999 from 31 percent in 1998. Nearly twothirds of 1999’s total mortgage portfolio growth occurred during the first half of the year, reflecting mortgage refinancing volumes. Refinancing activity slowed during the latter half of the year as mortgage interest rates rose. Retained portfolio growth continued to be a key component of Freddie Mac’s earnings growth in 1999. The corporation grew the retained portfolio $69 billion, or 27 percent, during 1999, while significantly reducing its exposure to interest-rate risk. A significant portion of retained portfolio purchases during 1999 consisted of investments in A-1 non-Freddie Mac guaranteed mortgage-related securities. These investments consist of securities from agencies such as the Government National Mortgage Association (“Ginnie Mae”) and securities collateralized by products such as home equity loans. Growth in “Net income” of 31 percent in 1999 exceeded revenue growth of 22 percent due primarily to a decrease in non-interest expense, which consists predominantly of credit-related and administrative expenses. The decrease in non-interest expense was driven by a decline of $183 million, or 54 percent, in credit-related expenses, partially offset by a $77 million, or 13 percent, increase in “Administrative expenses.” The decrease in credit-related expenses in 1999 reflects continued favorable economic conditions, particularly house-price appreciation, and Freddie Mac’s credit risk management activities. The increase in “Administrative expenses” compared to 1998 primarily reflects costs related to the corporation’s year 2000 readiness efforts, as well as continued investment in business process improvements. Disciplined deployment of shareholders’ capital underlies all of Freddie Mac’s activities. The corporation seeks to invest capital only when it can achieve attractive long-term returns and when related risks are acceptable. When profitable investment opportunities are not available, Freddie Mac will return capital to its shareholders through common stock repurchases. Since November 1998, Freddie Mac raised $1.7 billion of additional capital through a $1.0 billion common stock offering in November 1998 and three preferred stock offerings totaling $688 million during 1999. This additional capital supported portfolio growth and provided the corporation with added liquidity in the period leading up to the century date change. As profitable investment opportunities diminished during fourth quarter 1999, Freddie Mac returned $92 million of capital to shareholders through common stock repurchases. Business Strategy and Outlook Underlying Freddie Mac’s financial performance and strength is its fundamental role in America’s housing market of linking the residential mortgage and capital markets. In this role, Freddie Mac focuses on two key business strategies: • Maintaining the lowest possible cost of financing for its mortgage purchases and investments by creating more liquid markets for its mortgage-backed securities and debt and • Bringing innovation and efficiency to the mortgage market. Freddie Mac participates as an investor in the secondary mortgage market through purchases of residential mortgages originated by mortgage lenders. The corporation finances purchased mortgages by securitizing the mortgages and FREDDIE MAC selling them in the form of mortgage-backed securities to investors in the mortgage market, or by issuing other financing instruments, principally debt, in the capital markets. Because of its financial performance, its regular and significant participation as an issuer in the capital markets, its risk management capabilities and its public mission as a government-sponsored enterprise (“GSE”), Freddie Mac is positioned to create liquid markets for its mortgage-backed securities and debt to lower its overall costs of financing mortgage-related investments. The benefits of lower financing costs are ultimately passed on to mortgage originators and borrowers in the form of lower mortgage interest rates. The strength of Freddie Mac’s credit guarantee and the large volume of its mortgage-backed securities support the liquidity of these securities. By attracting investors to the housing market, Freddie Mac provides mortgage lenders with continuous access to lower cost financing, which ultimately increases borrowers’ access to lower-cost mortgages. Freddie Mac is also enhancing the liquidity of its securities by seeking to increase demand for its debt securities in both the domestic and international capital markets, most recently through its introduction during 1998 and 1999 of several new debt financing programs: Reference NotesSM and Callable Reference NotesSM for long-term financing, and Reference BillsSM for short-term financing. As worldwide investor demand broadens for Freddie Mac’s debt securities, management believes these programs could produce a meaningful reduction in the corporation’s debt financing costs. In addition to maintaining the lowest possible cost of financing, Freddie Mac seeks to continually improve the mortgage origination process by helping to streamline this process for lenders and borrowers. Through Freddie Mac’s automated underwriting service, Loan Prospector®, mortgage lenders and borrowers benefit from the increased speed, reliability and ease of mortgage underwriting decisions. By launching Loan Prospector on the Internet in mid-1999, Freddie Mac is providing mortgage lenders with broader access to this underwriting tool. Freddie Mac will continually invest in innovative solutions that better assess mortgage credit quality and improve the overall process of underwriting residential mortgages. Freddie Mac expects continued growth, reflecting the corporation’s ongoing commitment to its key business strategies. Freddie Mac’s goal is to continue growing its total mortgage portfolio more rapidly than the rate of growth in total outstanding U.S. residential mortgage debt. The corporation believes there will be profitable investment opportunities to grow the retained portfolio in 2000, while adhering to its interest-rate risk management discipline. Furthermore, through a combination of strong house-price appreciation and Freddie Mac’s credit risk management capabilities, the corpo- ration expects continued improvement in credit performance, with lower credit losses anticipated in 2000 than experienced in 1999. Over the long term, Freddie Mac has consistently produced earnings growth. During the 10-year period ended December 31, 1999, the corporation’s diluted earnings per share grew at a compound annual rate of 17 percent. Through risk management and capital deployment strategies, management believes that Freddie Mac has built a foundation for mid-teens earnings growth over the next few years. The corporation’s ability to continue producing earnings growth is dependent upon factors such as total mortgage portfolio growth, retained portfolio growth, credit performance and other factors discussed in “FORWARDLOOKING STATEMENTS.” F O RWA R D - L O O K I N G S TAT E M E N T S Freddie Mac regularly communicates information concerning its business activities to investors, securities analysts, the news media and others as part of its normal operations. Some of these communications include “forward-looking statements” pertaining to management’s current expectations as to Freddie Mac’s future business plans, results of operations and/or financial condition. Forward-looking statements are typically accompanied by, and identified with, such terms as “anticipates,” “believes,” “expects,” “intends” and similar phrases. Management’s expectations for the corporation’s future necessarily involve a number of assumptions and estimates, and various factors could cause actual results to differ materially from these expectations. Management’s discussion and analysis includes forward-looking statements addressing the corporation’s prospects for earnings and mortgage portfolio growth, trends in credit losses and net interest yield, changes in capital position and other business and financial matters. Factors that could cause actual results to differ from the expectations expressed in these and other forward-looking statements by management include: substantial changes in interest rates, employment rates, house-price appreciation and the general economy; changes in the corporation’s strategies for and results of credit loss mitigation, interest-rate and other market risk management activities, and investment activities; the availability of debt funding in sufficient quantity and at attractive spreads to support continued growth in the retained portfolio; the availability of call options in the derivatives market comparable to those provided by callable debt; the availability of equity funding in sufficient quantity to support continued growth of the retained portfolio; the rate of growth in total outstanding U.S. residential mortgage debt; the size of the conforming residential mortgage market; borrower preferences for fixed-rate mortgages or FREDDIE MAC A-2 adjustable-rate mortgages (“ARMs”)/floating-rate mortgages; preferences of originators to sell mortgages into the secondary market; changes in investor preferences for mortgage-backed securities and debt versus other investments; competition in the purchase of mortgages and sale of mortgage-backed and debt securities; the corporation’s ability to implement innovative solutions to business processing systems issues; the occurrence of a major natural or other disaster in a geographic area in which the total mortgage portfolio is heavily concentrated; the degree to which the corporation’s business and financial forecasting methods accurately predict actual results; the impact of new accounting standards, particularly Statement of Financial Accounting Standards (“SFAS”) No. 133 on the accounting for derivative financial instruments, which Freddie Mac will implement effective January 1, 2001; and changes in the corporation’s regulatory environment, regulatory capital requirements or Congressional charter. M A R K E T O V E RV I E W Freddie Mac conducts business in two markets–the U.S. residential mortgage market and the global securities market. Freddie Mac’s participation in these markets serves to link America’s homebuyers and renters with the world’s capital markets. Fulfilling this role requires Freddie Mac to meet the challenge of improving access to low-cost mortgage financing while successfully managing its business risks. The U.S. residential mortgage market was more than $5 trillion at the end of 1999. This market is larger than the $3.5 trillion of U.S. Treasury securities and larger than the $2.4 trillion of U.S. corporate debt securities outstanding at the end of 1999. Freddie Mac forecasts that the residential mortgage market will grow 6 percent to 8 percent annually for the next several years, driven by strong demand for housing and house-price appreciation. The residential mortgage market consists of a primary mortgage market and a secondary mortgage market that link homebuyers and investors. In the primary market, financial institutions provide mortgage funds to borrowers for residential properties, and service mortgage loans. Residential mortgage lenders and servicers are generally commercial banks and their subsidiaries, mortgage companies, savings institutions, credit unions and other institutions. Mortgage lenders obtain mortgage funds in a variety of ways, often from deposits or by selling mortgages into the secondary market. The mortgage lending process begins with mortgage brokers or mortgage lenders. Mortgage brokers advise prospective homeowners about mortgage products and lending rates, and they connect borrowers with lenders. Mortgage lenders underwrite and originate mortgages. Mortgage ser- vicers administer mortgage loans, collecting payments of principal and interest from borrowers. These payments are ultimately passed through to secondary mortgage market investors. In addition, private mortgage insurance companies and other financial institutions sometimes provide thirdparty insurance for mortgage loans. Third-party insurance or other credit enhancements are required by law on certain loans sold to Freddie Mac and Fannie Mae. Freddie Mac operates within the secondary mortgage market. The secondary market encompasses institutions engaged in buying and selling mortgages and mortgagerelated investments. The magnitude of investment and trading activity in this market supports a continuous flow of funds to the primary market. Stable mortgage flows help moderate cyclical swings in the housing market. Secondary market participants include Freddie Mac and Fannie Mae, investment banking firms and others who trade and invest in mortgage securities. Freddie Mac and Fannie Mae are the largest participants in the U.S. secondary market, with a combined total mortgage portfolio of over $2 trillion (approximately 40 percent of all U.S. residential mortgage debt outstanding). Both companies are stockholder-owned, Congressionally chartered corporations with the public purpose of increasing the supply and availability of home mortgage financing. Distinct from Freddie Mac and Fannie Mae is Ginnie Mae, a wholly owned government corporation within the U.S. Department of Housing and Urban Development (“HUD”). Unlike Freddie Mac and Fannie Mae, Ginnie Mae’s guarantee is backed by the full faith and credit of the U.S. government. Freddie Mac competes primarily with Fannie Mae for the purchase of conventional residential mortgages–home loans that are not insured or guaranteed by agencies of the U.S. government. The corporation’s business is limited to the conforming mortgage market. Conforming mortgages cannot exceed prescribed dollar limits that are adjusted annually by Freddie Mac and Fannie Mae to reflect changes in the average purchase price of single-family conventionally financed homes, as reported by the Federal Housing Finance Board (“FHFB”). Effective January 1, 2000, the one-unit, singlefamily loan limit increased 5.3 percent to $252,700 from $240,000 in 1999. Freddie Mac estimates that approximately $1.09 trillion of conforming single-family mortgages were originated in 1999. Of that amount, $523 billion, or 48 percent, were sold to Freddie Mac and Fannie Mae compared to 50 percent in 1998. Freddie Mac also competes with other institutions that retain or securitize mortgages such as depository institutions, private-label issuers and Federal Home Loan Banks participating in FHFB-approved programs. Competition from A-3 FREDDIE MAC these entities can vary with economic, financial market and regulatory environments. Among other things, these factors may affect the degree to which these institutions sell mortgages in the secondary market rather than retaining them in their own portfolios. Freddie Mac competes in the global securities markets as an issuer of mortgage-backed securities (“Participation Certificates” or “PCs”) and debt. Under Freddie Mac’s Congressional charter and other federal laws and regulations, Freddie Mac securities have a number of special attributes, including: • Exemption from U.S. Securities and Exchange Commission registration requirements (although Freddie Mac is fully subject to the antifraud provisions of the securities laws); • The ability of financial institutions to invest in Freddie Mac mortgage-backed and debt securities essentially without limit; • Access to the Federal Reserve’s book-entry system for the issuance, transfer and payment of most mortgagebacked and debt securities and • The eligibility of Freddie Mac mortgage-backed and debt securities as collateral for certain Federal Reserve loans and accounts maintained under the Treasury Tax and Loan program. These attributes help Freddie Mac operate efficiently and on a large scale in both its securitization and debt financing activities. Freddie Mac competes in the mortgage securities market based on the relative strength of its security programs. Freddie Mac PCs are liquid securities that enable the corporation to finance large mortgage purchases quickly and opportunistically. In the global debt market, Freddie Mac issues a variety of callable and non-callable debt securities to meet the demand for investments and hedging vehicles that are large, liquid and highly rated. Through its innovative debt securities programs, Freddie Mac is continuing its efforts to reduce the costs of its debt financing. of PCs are an off-balance sheet contingency (referred to as “Total Mortgage Participation Certificates” or “Total PCs”). • Debt Financing. Under this method of financing, mortgages and mortgage-related securities held as on-balance sheet portfolio investments are financed principally with debt securities issued by Freddie Mac and, to a lesser extent, with equity and other liabilities. Mortgages and mortgage-related securities held as portfolio investments by Freddie Mac are referred to as the “retained portfolio.” Freddie Mac’s public mission requires it to provide a continuous supply of mortgage credit for U.S. homebuyers in all economic environments. Freddie Mac flexibly employs both of these financing methods on a daily basis to ensure that it fulfills this mission. Each of these methods of financing mortgage investments generates different sources and types of revenue, exposes the corporation to different types and degrees of risk and requires the commitment of different levels of capital. Freddie Mac’s total mortgage portfolio consists of Total PCs, net of PCs held in the retained portfolio, plus the retained portfolio. During 1999, the total mortgage portfolio grew 18 percent, from $733 billion at the end of 1998 to $862 billion at the end of 1999. Securitization Financing When Freddie Mac finances mortgage purchases through the securitization process, it issues PCs in exchange for mortgages or sells PCs to investors for cash. Each PC issued by Freddie Mac represents an undivided interest in a pool of mortgages. Principal and interest payments on the mortgages in the pool underlying PCs are passed through to PC holders by Freddie Mac on a monthly basis. Freddie Mac assumes the mortgage credit risk on the underlying mortgages (the risk that mortgage borrowers will default on their payment obligations) by guaranteeing the payment of principal and interest to holders of its PCs. Payments on the mortgages underlying a PC pool are remitted to Freddie Mac by mortgage servicers approved by Freddie Mac. Generally, the rate of interest payable by servicers to Freddie Mac on the mortgages in any PC pool will exceed the coupon rate of the related PCs, with the difference retained by Freddie Mac as a fee to compensate the corporation for enhancing liquidity, assuming mortgage credit risk and administering principal and interest payments on PCs. This fee income, recorded as “Management and guarantee income” over the lives of the mortgages underlying PCs, provides Freddie Mac with a steady source of revenue. Any interest payable by the borrowers on mortgages in a PC pool that exceeds the mortgage servicer’s required remittance to Freddie A-4 BUSINESS REVIEW Freddie Mac’s principal business activity is the purchase and financing of single-family and multifamily residential mortgages and mortgage-related securities. Freddie Mac uses two principal methods to finance its mortgage-related investments: • Securitization Financing. Under this method of financing, purchased mortgages are securitized in the form of guaranteed mortgage passthrough securities (referred to as PCs) issued to investors by Freddie Mac. Mortgage investments financed by the issuance FREDDIE MAC Mac is retained by the servicer as compensation for servicing the mortgages. The balance of Total PCs grew $103 billion, or 16 percent, from $646 billion at the end of 1998 to $749 billion at the end of 1999. The costs of securitization financing and Freddie Mac’s ability to compete for mortgage purchases may be affected by the price difference, or “spread,” between PCs and competing securities. Freddie Mac’s Gold PC® offers a faster remittance of mortgage principal and interest payments to investors than Fannie Mae securities. Management believes that this faster remittance cycle should be reflected in the market prices of Gold PCs, causing them to trade at higher prices than Fannie Mae securities with similar coupons and maturities. At times, however, factors such as differences in liquidity and temporary imbalances in supply and demand have caused the price premiums on Gold PCs to fall below the level that Freddie Mac believes reflects the full value of the Gold PC’s faster remittance cycle. This increases the costs of its securitization financing. In the current market environment, Freddie Mac believes that the faster remittance cycle of the Gold PC should cause both 30-year and 15-year Gold PCs to trade at a price between 5.5 and 7.0 thirty-seconds (one thirtysecond is equal to 3.125 basis points in price) above similar Fannie Mae securities. For 1999, 30-year Gold PCs and 15-year Gold PCs traded at an average of 2.8 and 3.2 thirty-seconds, respectively, above the price of similar Fannie Mae securities, compared to 3.5 thirty-seconds and 2.7 thirty-seconds, respectively for 1998. The price of Freddie Mac securities relative to Fannie Mae securities may strengthen or weaken Freddie Mac’s competitive position. Freddie Mac continues to support the market for its PCs through various activities, including the securities trading activities of its Securities Sales and Trading Group (“SS&TG”), participating with external money management firms to buy and sell PCs, marketing to dealers and investors the relative merits of trading and investing in PCs, participating in the dollar roll market, introducing new mortgagerelated securities products and related initiatives. Freddie Mac anticipates that it will continue its market support activities for both 30-year and 15-year Gold PCs, and initiate and expand new efforts in the future. Freddie Mac may increase, reduce or discontinue these or other related activities at any time. Debt Financing Freddie Mac principally issues debt securities to finance mortgage-related investments held in the retained portfolio. In financing mortgage-related investments with debt, Freddie Mac issues a mixture of short-term debt and long-term callable and non-callable debt. This funding mix enables Freddie Mac to manage its interest-rate risk effectively by giving it the flexibility to closely match the cash outflows from debt financing A-5 with the expected cash inflows from its mortgage-related investments. Freddie Mac more closely matches the cash flows associated with its debt financing by using derivative financial instruments that effectively modify the interest rate, maturity or callability of the corporation’s contractual short-term and long-term debt. The corporation recognizes net interest income earned on the retained portfolio, which is the interest income earned on these investments less the interest expense on the interestbearing liabilities funding them. Mortgage-related investments comprising the retained portfolio primarily include Freddie Mac PCs, but also include unsecuritized mortgage loans and non-Freddie Mac securities. During 1999, the retained portfolio grew $69 billion, or 27 percent, from $255 billion at the end of 1998 to $324 billion at the end of 1999. At December 31, 1999, the retained portfolio consisted of $56 billion in “Mortgages” and $268 billion in “Guaranteed mortgage securities” (including $211 billion of repurchased Freddie Mac PCs). Maintaining access to low-cost debt financing will be a key driver of future retained portfolio growth. Freddie Mac’s introduction of new debt financing programs is building liquidity in the market for its debt in an effort to drive down overall debt costs. In 1998, the corporation introduced its Reference Notes financing program under which the corporation regularly sells large issues of non-callable debt to provide investors with high-quality, liquid debt securities. In April 1999, Freddie Mac further enhanced its debt financing program by introducing Callable Reference Notes to improve liquidity in the callable debt market. Most recently, in November 1999, Freddie Mac introduced Reference Bills which are large issues of short-term debt that are auctioned on a regular schedule. Reference Bills with one-, two- and three-month maturities are auctioned weekly. Reference Bills with six- and twelve-month maturities are sold every four weeks. Freddie Mac anticipates that this program, which commenced in January 2000, will provide improved liquidity for Freddie Mac short-term debt due to the cycle of regular, standardized issuances. The corporation also announced a $65 billion Reference Notes financing calendar for 2000. The financing calendar provides clarity and transparency with regard to the timing of new debt issues and reopenings of prior issues, the anticipated size of individual offerings and exact settlement dates. As investor demand continues to grow, management believes these programs could produce a reduction in the corporation’s debt financing costs. Freddie Mac invests its capital to purchase investments only when the corporation can expect to achieve attractive long-term returns, and when it believes the related risks are acceptable. Freddie Mac has produced growth in net interest income in a wide variety of interest-rate environments FREDDIE MAC through its ability to increase the size of its retained portfolio and successfully manage interest-rate risk. RISK MANAGEMENT Freddie Mac is subject to two primary business risks: (i) credit risk and (ii) interest-rate and other market risks. Freddie Mac is also exposed to operational and other related risks. Management of these risks affects both the level and stability of the corporation’s long-term value and short-term earnings. Credit Risk Freddie Mac’s primary exposure to credit risk is associated with the mortgages it purchases (“mortgage credit risk”). The corporation is also subject to credit risk from the institutions with which it conducts business (“institutional credit risk”). Mortgage Credit Risk Mortgage credit risk is the risk that the corporation will not receive amounts due from mortgage borrowers because of borrower defaults, potentially resulting in a loss if Freddie Mac is unable to collect amounts due through restructuring of the mortgage, sale of the underlying property or other loss mitigation activities. Credit Risk Management Oversight: Freddie Mac’s Board of Directors (the “Board”) oversees the corporation’s credit risk management. Under the Board’s oversight, Freddie Mac’s senior management is responsible for the day-to-day management of the corporation’s credit risk activities. Freddie Mac maintains a credit risk oversight function that reports directly to the Chief Operating Officer. Its purpose is to independently monitor the corporation’s credit risk exposure and assess the effectiveness of the corporation’s credit risk management systems and processes. Credit Risk Management Strategies: Freddie Mac’s management of mortgage credit risk comprises three broad areas: • Establishing and enforcing sound underwriting standards, increasingly through the use of automated underwriting; • Obtaining credit enhancements on higher risk mortgages and • Executing loss mitigation activities to resolve non-performing loans. Underwriting Standards and Quality Control— Freddie Mac seeks to ensure that the mortgages it purchases are protected by the borrower’s willingness and ability to repay the mortgage obligation, and by adequate equity in the underlying property. Increasingly, automated underwriting tools such as Freddie Mac’s Loan Prospector and other quantitative credit risk management tools are used to evaluate and monitor credit risk for single-family mortgages. During 1999, 50 percent of Freddie Mac’s single-family purchase volume was evaluated prior to purchase using Loan Prospector, compared to 36 percent in 1998. Introduced in 1995, Loan Prospector combines loan-to-value (“LTV”) ratios and other loan and borrower characteristics to generate credit risk classifications that enable Freddie Mac and lenders to evaluate overall loan risk. The statistically based risk assessments provided by Loan Prospector increase the ability of Freddie Mac and mortgage lenders to distinguish between single-family loans based on their likelihood of default. The corporation also controls the quality of its singlefamily mortgage purchases by purchasing mortgages from seller/servicers that maintain approved underwriting and servicing standards as required by Freddie Mac. The corporation monitors seller/servicers’ compliance with its underwriting standards through quality control reviews and on-site audits and actively investigates situations involving possible fraud. As part of its post-purchase quality control review process, Freddie Mac uses Loan Prospector to evaluate the credit quality of single-family mortgages that were not evaluated by Loan Prospector prior to purchase. Particular focus is placed on reviewing purchases identified as high-risk mortgages. For multifamily mortgages, Freddie Mac relies primarily on a combination of intensive underwriting and strict requirements on the mortgage lenders that are eligible to participate in Freddie Mac’s multifamily programs. Credit Enhancements —Freddie Mac manages the credit risk related to higher LTV mortgages by generally requiring primary mortgage insurance for loans with original LTV ratios exceeding 80 percent. Primary mortgage insurance covers a portion of the loss experienced on those loans that default. For certain loans, Freddie Mac also obtains credit enhancements to supplement primary mortgage insurance coverage. For these loans, the lender or a third party has agreed to retain primary default risk by pledging collateral or agreeing to accept losses on loans that default. Freddie Mac benefits from credit enhancements to the extent that mortgages default at expected levels in a future period, typically resulting in the corporation’s receipt of collateral or cash proceeds that offset credit losses. In exchange for this potential future benefit, Freddie Mac receives a lower guarantee fee on securitized mortgages that are credit enhanced. Table 1 presents the composition of Freddie Mac’s credit-enhanced mortgage investments. FREDDIE MAC A-6 Table 1 – Credit-Enhanced Mortgage Investments December 31, (dollars in millions) 1999 Exhibit 2 – Total Mortgage Portfolio (At-Risk vs. Credit-Enhanced) 1998 $900 $800 (in billions) Credit-enhanced mortgages(1) Non-Freddie Mac securities Total $200,602 $170,390 56,569 29,817 $257,171 $200,207 Unpaid Principal Balance $700 $600 $500 $400 $300 $200 $100 $0 95 96 97 98 99 (1) Includes loans for which the lender or a third party has retained primary default risk by pledging collateral or agreeing to accept losses on loans that default. Freddie Mac retains secondary default risk on credit-enhanced mortgages to the extent losses exceed the level covered by the applicable credit enhancement. As shown in Table 1, the corporation’s credit-enhanced mortgage investments have two components: credit-enhanced mortgages and non-Freddie Mac securities. Non-Freddie Mac securities held in the retained portfolio are protected by the credit guarantee of various agencies, bond insurance policies or senior/subordinated structures (see “RISK MANAGEMENT—Credit Risk—Institutional Credit Risk” for further discussion of non-Freddie Mac securities). Pool insurance is the most prevalent type of credit enhancement protecting Freddie Mac’s mortgage portfolio. Pool insurance covers a large group of similar loans, in contrast to primary mortgage insurance which is obtained for individual loans. Pool insurance contracts expire after no fewer than eight years, and typically cover losses ranging between 0.80 percent and 1.50 percent of the original unpaid principal balance of the pooled loans at the time of purchase. For the pool insurance contracts that expire before the completion of the mortgage term, Freddie Mac ensures that the contracts cover the period of time during which it is most likely that the related mortgages may default. In addition to pool-insured loans, Freddie Mac’s credit-enhanced mortgages include loans protected by reinsurance, collateral (including cash or marketable securities) pledged by a lender or recourse agreements under which the lender repurchases loans that default. Since 1995, Freddie Mac has increased the creditenhanced portion of its total mortgage portfolio. The portion of the total mortgage portfolio not protected by credit enhancements, the at-risk portfolio, represents those mortgages for which the corporation has assumed primary default risk. As shown in Exhibit 2, 30 percent of the corporation’s total mortgage portfolio was credit-enhanced at December 31, 1999, compared to 27 percent and 16 percent at December 31, 1998 and 1997, respectively. At-Risk Portfolio Balance Credit-Enhanced Portfolio Balance While the use of credit enhancements reduces Freddie Mac’s exposure to mortgage credit risk, it increases the corporation’s exposure to institutional credit risk (see “RISK MANAGEMENT—Credit Risk—Institutional Credit Risk”). Loss Mitigation Activities—Mortgages may become non-performing despite the corporation’s underwriting standards due to changes in general economic conditions, changes in the financial status of individual borrowers or other factors. Table 2 summarizes the corporation’s non-performing loans and restructured and seriously delinquent loans. Table 2 – Non-Performing Loans, Troubled Debt Restructurings and Serious Delinquencies December 31, (dollars in millions) 1999 1998 1997 Non-accrual loans(1) Real estate owned Total non-performing assets Troubled debt restructurings(2) Serious delinquencies(3) Total $ 621 $1,068 $1,449 438 574 722 1,059 1,642 2,171 553 647 799 2,309 2,219 2,267 $3,921 $4,508 $5,237 (1)Includes loans for which interest income is recognized on a cash basis. For single-family loans, this population is determined using statistically based models. For multifamily loans, the population includes all loans 90 days or more delinquent. (2)Includes previously delinquent loans that have been modified and are performing in accordance with the modified terms. (3)Includes single-family loans 90 days or more delinquent, excluding all loans disclosed as non-accrual. For multifamily loans, the population includes all loans 60 days or more delinquent but less than 90 days delinquent. Loss mitigation activities are a key component of Freddie Mac’s strategy for managing and resolving non-performing assets and lowering credit losses. These activities influence the amounts recovered by the corporation on delinquent mortgages and real estate owned (“REO”). The corporation emphasizes early intervention in delinquencies and alternatives to foreclosure. Foreclosure alternatives are intended to reduce the number of A-7 FREDDIE MAC delinquent mortgages proceeding to foreclosure and, ultimately, reduce Freddie Mac’s total losses by eliminating a portion of the costs related to foreclosed properties. Loan modifications and pre-foreclosure sales are the two foreclosure alternatives most often carried out by servicers on behalf of Freddie Mac. A loan modification is an agreement that changes one or more of the original terms of a mortgage for qualifying borrowers, usually the loan’s interest rate or payment period. A pre-foreclosure sale is a transaction in which Freddie Mac accepts less than a full payoff of the amount owed on a defaulted mortgage in exchange for the sale of a home prior to foreclosure. In 1999, Freddie Mac executed foreclosure alternatives on a total of 5,517 loans, consisting of 3,830 loan modifications and 1,687 pre-foreclosure sales. Over the years, Freddie Mac has developed innovations that help servicers manage non-performing loans more effectively. These innovations include Early IndicatorSM, a system that determines the probability that delinquent loans will continue through to foreclosure, and Servicer Performance Profiles SM, which are confidential reports in which Freddie Mac evaluates the performance of its mortgage servicers based on their management of performing and non-performing loans. Credit Risk Profile: In addition to the corporation’s credit risk management practices, the credit risk profile of Table 3 – Total Mortgage Portfolio December 31, (dollars in millions) Total mortgage portfolio balances: purchased mortgages also influences Freddie Mac’s credit results. As discussed below, Freddie Mac monitors certain loan characteristics such as product mix, LTV ratio and geographic concentration, which may affect the default experience on the corporation’s mortgage portfolio. Product Mix—Product mix affects the credit risk profile of Freddie Mac’s total mortgage portfolio. Table 3 presents the distribution of Freddie Mac’s total mortgage portfolio by mortgage product type. LTV Ratios—The likelihood of mortgage default depends not only on the initial credit quality of the loan, but also on events occurring subsequent to origination. Accordingly, Freddie Mac monitors the LTV ratio at the date of mortgage origination, as well as the estimated current LTV ratio, which reflects changes in economic conditions (such as house-price appreciation) occurring after the date of mortgage origination. The estimated current LTV ratio compares the current unpaid principal balance of the mortgage to the estimated current market value of the property collateralizing the mortgage. Historical experience has shown that defaults are less likely to occur on mortgages with low estimated current LTV ratios. The distribution of Freddie Mac’s single-family portfolio by original and estimated current LTV range is presented in Tables 4 and 5, respectively. 1999 1998 Mortgages and Freddie Mac PCs 30-year single-family fixed-rate 15-year single-family fixed-rate ARMs/floating-rate Balloon/resets Total single-family Multifamily Total mortgages and Freddie Mac PCs Non-Freddie Mac securities(1) Fixed-rate ARMs/floating-rate Total non-Freddie Mac securities Total mortgage portfolio Credit risk distribution: $567,396 169,922 36,114 15,508 788,940 16,817 805,757 42,626 13,943 56,569 $862,326 $605,155 $257,171 66% 20 4 1 91 2 93 5 2 7 100% 70% 30% $481,592 152,785 38,708 19,486 692,571 10,972 703,543 22,982 6,835 29,817 $733,360 $533,153 $200,207 66% 21 5 2 94 2 96 3 1 4 100% 73% 27% Freddie Mac at-risk(2) Credit-enhanced(3) (1)Non-Freddie Mac securities held in the total mortgage portfolio are categorized based upon the product type of the mortgage collateral underlying the security. (2)Includes those loans for which Freddie Mac has assumed primary default risk. (3)Includes loans for which the lender or a third party has retained primary default risk by pledging collateral or agreeing to accept losses on loans that default. Also includes nonFreddie Mac securities such as securities guaranteed by Ginnie Mae and asset-backed securities and commercial mortgage-backed securities. In some cases, the lender’s or third party’s risk is limited to a specific level of losses at the time the credit enhancement becomes effective. FREDDIE MAC A-8 Table 4 – Original LTV Ratio Range December 31, 1999 Table 6 – Credit Performance 1998 1997 Year Ended December 31, (dollars in millions) 1999 1998 1997 0% to 70% Above 70% to 80% Above 80% to 90% Above 90% to 95% Above 95% Total 32% 42 15 10 1 100% 33% 42 15 10 — 100% 33% 41 16 10 — 100% Table 5 – Estimated Current LTV Ratio Range(1) December 31, 1999 1998 1997 0% to 70% Above 70% to 80% Above 80% to 90% Above 90% to 95% Above 95% Total 59% 19 16 2 4 100% 52% 21 18 3 6 100% 54% 19 16 4 7 100% (1) Current market values are estimated by adjusting the value of the property at origination based on changes in the market value of house prices since origination. Geographic Concentration—Freddie Mac mitigates the potential adverse effect of changing local and regional economic conditions on its credit results by maintaining a geographically diverse mortgage portfolio. The geographic distribution of mortgages purchased by Freddie Mac generally reflects the distribution of outstanding residential mortgage debt in the United States. Further information on geographic credit concentrations is provided in Note 9 to the Consolidated Financial Statements. Credit Performance: The effectiveness of Freddie Mac’s credit risk management is reflected primarily in the level of defaulted mortgages and the level of credit losses relative to the total mortgage portfolio. Effective risk management and favorable economic conditions, particularly house-price appreciation, were key drivers of these measures of credit performance in1999. Table 6 and the following discussion address the credit performance of Freddie Mac’s singlefamily and multifamily mortgage portfolios. Delinquencies, end of period(1) Single-family:(2) At-risk portfolio(3) 0.39% 0.50% 0.55% Total portfolio 0.43% 0.49% 0.56% Multifamily:(4) Net carrying value $ 23 $ 40 $ 80 Percentage 0.14% 0.37% 0.96% REO, end of period Single-family $437 $ 569 $712 Multifamily 1 5 10 Total $438 $ 574 $722 REO activity Properties in inventorybeginning of period 6,781 8,402 9,057 Properties acquired 11,474 15,490 19,326 Properties disposed (12,636) (17,111) (19,981) Properties in inventoryend of period 5,619 6,781 8,402 Net charge-offs Single-family: $ 58 $ 62 Foreclosure alternatives(5) $ 14 REO acquisitions 45 61 222 Total single-family 59 119 284 Multifamily (3) (3) 12 Total $ 56 $ 116 $296 Number of single-family foreclosure alternatives settled(5) 5,517 6,535 6,102 Credit-related expenses Provision for mortgage losses $ 60 $ 190 $310 REO operations expense: Single-family 99 151 213 Multifamily — 1 6 Total 99 152 219 Totalcredit-related expenses $159 $ 342 $529 Credit losses(6) Single-family $158 $ 270 $497 Multifamily (3) (2) 18 Total $155 $ 268 $515 Total Credit Losses/Average Total Mortgage Portfolio: Including nonFreddie Mac securities 1.9 bp 4.0 bp 8.3 bp Excluding nonFreddie Mac securities 2.0 bp 4.1 bp 8.4 bp Reserve for mortgage losses, end of period $772 $ 768 $694 (1) Includes mortgages purchased for Freddie Mac’s total mortgage portfolio. Excludes non-Freddie Mac securities held in the total mortgage portfolio. (2)Based on the number of mortgages 90 days or more delinquent. (3)Includes only those loans for which Freddie Mac has assumed primary default risk. Excludes loans for which the lender or a third party has retained primary default risk by pledging collateral or agreeing to accept losses on loans that default. (4)Based on net carrying value of mortgages 60 days or more delinquent. (5)Primarily consist of pre-foreclosure sales and loan modifications. (6)Equal to charge-offs plus REO operations expense. A-9 FREDDIE MAC Single-family—The single-family at-risk delinquency rate declined 11 basis points from year-end 1998 to 0.39 percent at December 31, 1999, improving in all regions of the country. REO properties in inventory continued to decline in 1999, both in terms of dollar amount and number of properties held, with dispositions outpacing acquisitions. The single-family REO balance was $437 million at December 31, 1999, down from $569 million and $712 million at December 31, 1998 and 1997, respectively. Acquisitions of single-family REO properties declined to their lowest level since 1992. Single-family credit losses totaled $158 million in 1999, a 41 percent and 68 percent decline from losses experienced in 1998 and 1997, respectively. The decline in credit losses was due primarily to lower loss severity rates on defaulted mortgages and declining REO acquisitions. Lower loss severities reflect continued strong home prices, as well as increased recoveries on credit enhancements. Table 7 presents the distribution of the singlefamily mortgage portfolio and at-risk delinquencies by year of origination. Based on the effectiveness of the corporation’s credit risk management, Freddie Mac expects continued strong credit performance. Freddie Mac has increasingly purchased or required credit enhancements on its mortgage portfolio since 1995. As shown in Table 7, mortgages originated in 1995 or later represented nearly three-quarters of the corporation’s single-family portfolio at December 31, 1999. These mortgages have significant credit enhancement protection, and therefore are expected to reduce Freddie Mac’s credit losses even as they move through their peak default years (generally, three to five years after origination) (see “FORWARD-LOOKING STATEMENTS”). Multifamily—The multifamily delinquency rate was 0.14 percent at December 31, 1999, down from 0.37 percent and 0.96 percent at December 31, 1998 and 1997, respectively. The decline from both December 31, 1998 and 1997 reflects decreases of $17 million and $57 million, respectively, in the net carrying value of non-performing multifamily mortgages. Multifamily net recoveries totaled $3 million in 1999, compared to net recoveries of $3 million in 1998 and net charge-offs of $12 million in 1997. Net recoveries in 1999 and 1998 resulted from the collection of certain amounts previously deemed uncollectible. Institutional Credit Risk Freddie Mac is subject to credit risk from institutional counterparties to the extent they do not fulfill their obligations to Freddie Mac under the terms of specific contracts or agreements. Freddie Mac’s primary institutional credit risk exposure arises from agreements with the following counterparties: • Mortgage servicers; • Mortgage insurers; • Guarantors of non-Freddie Mac securities held in the retained portfolio; Table 7 – Single-Family Mortgage Portfolio and At-Risk Delinquencies by Year of Origination(1) December 31, Dollars in Millions(2) 1999 1998 Dollars in Millions(2) At-Risk Delinquency Rate(3) Year of Origination At-Risk Delinquency Rate(3) Pre-1992 1992 1993 1994 1995 1996 1997 1998 1999 Total $ 35,897 37,475 96,961 39,289 35,660 56,252 71,715 248,673 167,018 $788,940 1.00% 0.45% 0.29% 0.66% 0.87% 0.77% 0.29% 0.09% 0.04% 0.39% $ 47,719 50,834 117,460 49,311 45,225 71,750 87,264 223,008 — $692,571 1.16% 0.49% 0.34% 0.70% 0.89% 0.76% 0.19% 0.02% — 0.50% (1)Excludes non-Freddie Mac securities held in the total mortgage portfolio. (2)Balance of total single-family mortgage portfolio (at-risk and non-at-risk mortgages combined) for respective period presented by year of origination. (3)At-risk delinquency statistics are based on loans 90 days or more delinquent plus foreclosures in process and approved, as a percentage of the total number of loans in the year of origination. Includes only those loans for which Freddie Mac has assumed primary default risk. Excludes loans for which a lender or a third party has retained primary default risk by pledging collateral or agreeing to accept losses on loans that default. In some cases the lender’s or third party’s risk is limited to a specific level of losses at the time the credit enhancement becomes effective. FREDDIE MAC A-10 • Issuers and guarantors of investments held in the liquidity and contingency portfolio and • Counterparties to derivative financial instruments entered into by the corporation. Freddie Mac is exposed to institutional credit risk arising from the insolvency of mortgage servicers that remit monthly principal and interest payments on mortgages to Freddie Mac. To protect itself against this risk, Freddie Mac requires servicers to meet minimum net worth, insurance and other eligibility requirements, and institutes remedial actions against seller/servicers that fail to comply with these standards. Freddie Mac also bears institutional credit risk relating to the non-performance of mortgage insurers that insure purchased mortgages. Freddie Mac manages this risk by regularly monitoring its exposure to individual mortgage insurers. Freddie Mac also performs periodic on-site audits of mortgage insurers to ensure compliance with its eligibility requirements and to evaluate their management and control practices. Substantially all mortgage insurers providing primary mortgage insurance coverage on single-family mortgages purchased during 1999 were rated “AA” or better by major credit rating agencies, with 70 percent rated “AA+” or better. In addition, mortgage insurers are regulated by state insurance authorities. Freddie Mac’s retained portfolio is exposed to institutional credit risk to the extent that guarantors of non-Freddie Mac securities held in this portfolio become insolvent. NonFreddie Mac securities in the retained portfolio consist of agency and non-agency mortgage-related securities. Agency mortgagerelated securities present minimal institutional credit risk exposure to Freddie Mac due to the high credit quality of issuers and guarantors such as Ginnie Mae. Ginnie Mae’s guarantee is backed by the full faith and credit of the U.S. government. Nonagency mortgage-related securities are exposed to both mortgage and institutional credit risk. The corporation mitigates the mortgage credit risk associated with these securities through the use of senior/subordinated bond structures, bond insurance or a combination of both. The institutional credit risk associated with non-agency mortgage-related securities arises from the insolvency of bond insurers that guarantee these securities. Freddie Mac manages this risk by only purchasing securities meeting the corporation’s investment guidelines, and by performing ongoing analysis to ensure the creditworthiness of bond insurers. Table 8 presents the composition of non-Freddie Mac securities held in Freddie Mac’s retained portfolio at December 31, 1999 and 1998 and their credit rating by product type. Table 8 – Non-Freddie Mac Securities December 31, 1999 1998 Dollars in % AAA Dollars in % AAA Millions Rated (1) Millions Rated (1) Agency Securities $19,860 Non-Agency Securities: Home equity 13,808 Commercial mortgagebacked securities(2) 7,822 Mortgage revenue bonds 5,690 Manufactured housing 4,693 Other mortgagerelated securities 4,696 Total $56,569 100% 96% 96% 79% 92% 91% 95% $8,207 100% 5,923 6,592 4,640 1,711 2,744 $29,817 86% 95% 78% 73% 93% 91% (1)Credit rating is designated by at least two nationally recognized statistical rating agencies. (2)Consists of securities backed by pools of loans that include significant amounts of multifamily mortgages. As illustrated in Table 8, 95 percent of non-Freddie Mac securities held by the corporation were rated “AAA” by independent credit rating agencies at December 31, 1999. With the exception of mortgage revenue bonds, substantially all of the remaining securities not rated “AAA” had an independent credit rating of “AA” or better. Mortgage revenue bonds, which are bonds issued by state and local municipalities, were rated “A” or better at December 31, 1999. Freddie Mac often obtains secondary bond insurance for securities that are not rated “AAA”. Institutional credit risk also arises from the insolvency of issuers or guarantors of investments held in Freddie Mac’s liquidity and contingency investment portfolio, which is used to meet both anticipated and unanticipated liquidity and working capital requirements (see “LIQUIDITY AND CAPITAL MANAGEMENT—Liquidity”). Instruments within this portfolio are investment grade at the time of purchase, primarily short-term in nature and diversified among various issuers, thereby mitigating to a significant extent the institutional credit risk inherent in this portfolio. As discussed later, Freddie Mac uses derivative financial instruments primarily in connection with its interest-rate risk management activities (see “RISK MANAGEMENT— Interest-Rate and Other Market Risks—Derivative Financial Instruments”). The use of over-the-counter derivative financial instruments exposes Freddie Mac to institutional credit risk that arises from the possibility that a counterparty will be unable to perform according to the terms of the derivatives contract. Exchange-traded derivative financial instruments, such as futures contracts, do not increase the corporation’s exposure to institutional credit risk since changes in the value of open exchange-traded contracts are settled daily. Freddie Mac mitigates its exposure to institutional credit risk related to over-the-counter derivative contracts by using master netting A-11 FREDDIE MAC agreements. These agreements provide for the netting of amounts receivable and payable under all transactions covered by the master netting agreement between Freddie Mac and a single counterparty in the event that the master agreement is terminated due to non-performance. In addition to using master netting agreements, Freddie Mac manages institutional credit risk associated with derivative financial instruments by limiting its selection of counterparties to only those institutions having credit ratings among the highest available from major rating agencies. The corporation also limits its exposure to any one counterparty, regularly monitors financial positions and, in many cases, requires collateral in order to manage institutional credit risk. At December 31, 1999, the four largest counterparties (based on notional or contractual amounts outstanding), each with an independent credit rating of “A+” or better, accounted for approximately 54 percent of the notional amount of the corporation’s outstanding over-the-counter derivative financial instruments. Freddie Mac’s management of credit risk related to derivative financial instruments is discussed further in Note 9 to the Consolidated Financial Statements. The corporation’s aggregate exposure to institutional credit risk for derivative financial instruments can be estimated by calculating the “net replacement value” of, or cost to replace, all outstanding non-exchange traded derivative financial instruments for each counterparty with which the corporation was in a net gain or “positive fair value” position, after taking into account the offsetting provided by master netting agreements. The corporation’s estimated exposure to credit risk, based on net replacement values, was $4.7 billion at December 31, 1999, compared to $1.1 billion at December 31, 1998. The increase in the corporation’s credit risk exposure reflects both the increased use of derivative financial instruments, as well as changes in interest rates which increased the net gain position on contracts with several of Freddie Mac’s largest counterparties. (see “RISK MANAGEMENT—Interest-Rate and Other Market Risks—Derivative Financial Instruments”). Freddie Mac’s exposure to institutional credit risk can fluctuate from period to period due to changes in interest rates and/or foreign exchange rates. Of the total estimated exposure to institutional credit risk on derivative financial instruments in a net gain position, $4.0 billion was fully collateralized at December 31, 1999. Substantially all of the corporation’s uncollateralized exposure of $0.7 billion at December 31, 1999 resulted from derivatives contracts with counterparties having an independent credit rating of “AAA”. Freddie Mac’s policy for requiring collateral from counterparties is based on independent credit ratings, estimated credit risk exposure on net replacement values and internal assessments of counterparty credit quality. In addition, it is the corporation’s policy to limit its uncollateralized riskadjusted credit risk exposure to any one counterparty from FREDDIE MAC all investment and derivative activities to less than 1 percent of “Stockholders’ equity.” To date, Freddie Mac has not incurred any credit losses on derivative financial instruments or set aside specific reserves for institutional credit risk exposure. Management does not believe such reserves are necessary, given the corporation’s collateral and counterparty policy requirements. Interest-Rate and Other Market Risks Although Freddie Mac’s mortgage-related investments financed with debt offer the potential for achieving higher returns than those likely to be achieved through mortgage securitization, they also expose the corporation to a higher degree of interest-rate and other market risks, and require the commitment of higher levels of capital per dollar of mortgages financed. Disciplined management of these risks is critical to Freddie Mac’s ability to manage its debt and securitization financing activities. Interest-Rate Risk Interest-rate risk is the risk that changes in the level of interest rates could affect adversely the market value or future earnings of Freddie Mac. Managing interest-rate risk includes consistently maintaining acceptable levels of interest-rate risk exposure while ensuring that investments meet the corporation’s thresholds for return on equity and achieving annual net interest income targets set by management. Sources of Interest-Rate Risk: Freddie Mac’s interest-rate risk exposure results largely from the uncertainty of when mortgages will prepay. Mortgage borrowers may prepay their mortgage loans, in most cases without penalty, before the scheduled maturity date of the loan (“prepayment risk”). This feature makes the timing and amount of mortgage prepayments very sensitive to interest rates. A significant decline in interest rates could lead to high prepayments which result in a shorter expected life for the mortgage than originally projected. Conversely, a significant increase in interest rates could lead to lower than anticipated prepayments and a longer expected life for the mortgage than originally projected. As discussed earlier, debt financing is Freddie Mac’s principal source of financing mortgage-related investments held in the retained portfolio. Investment, funding and hedging decisions made for the retained portfolio are sensitive to prepayment uncertainty. As a result, differences between prepayment estimates and actual prepayments could lead to mismatches in the expected cash flows between assets and liabilities. This risk is partially mitigated by Freddie Mac’s strategy of using a mix of short-term debt, callable and noncallable debt and derivative financial instruments to provide flexibility for adjusting the duration of the portfolio when these mismatches occur. A-12 The effects of interest-rate risk on Freddie Mac’s mortgagerelated investments and how well this risk is managed will be realized over time through reported net interest income. The potential variability of this income is driven by changes in interest rates and the resulting changes in mortgage prepayment rates which can create mismatches between the income on mortgagerelated investments in the retained portfolio and the expense on liabilities funding these investments. In a low interest-rate environment, higher mortgage prepayment levels reduce net interest income to the extent that mortgage-related investments are repaid and replaced with lower-yielding investments and the corporation’s funding costs cannot be correspondingly reduced. In a high interest-rate environment, lower prepayment levels can reduce net interest income to the extent that mortgage-related investments are repaid more slowly than expected, and the associated debt reprices and can only be replaced by higher-cost debt. tion, it is also exposed to prepayment uncertainty to the extent it buys mortgages at a premium or discount. These amounts (reported on Freddie Mac’s Consolidated Balance Sheets as “Purchase and sale premiums, discounts and deferred fees”) are deferred and amortized over the estimated weighted average lives of the underlying mortgages using the effective interest method. The rate of amortization of these deferred items is sensitive to large changes in interest rates and mortgage prepayments, and tends to be higher in periods when prepayment estimates are increased or when actual prepayments exceed expectations. The interest-rate risk associated with deferred items is mitigated, in part, by financial instruments that respond in an opposite manner to changes in mortgage prepayments (see Note 1 to the Consolidated Financial Statements). Interest-Rate Risk Management Oversight: Freddie Mac’s Board of Directors oversees the corporation’s interest-rate risk management process. Under the Board’s oversight, Freddie Mac’s senior management is responsible for the management of the corporation’s interest-rate risk management activities. Members of senior management serve on a Risk Management Committee responsible for setting risk thresholds, expected return on equity and net interest income targets and for reviewing the quality of actual results. A separate group within the portfolio management area is responsible for the day-to-day interest-rate risk management strategies and rebalancing activities. Freddie Mac also maintains a market risk oversight function that reports directly to the Chief Financial Officer. Its purpose is to identify all of the corporation’s interest-rate and other market risk exposures, and to provide senior management with an independent evaluation of whether these risks are effectively identified, measured, managed and controlled. Measurement of Interest-Rate Risk: As an investor in mortgage-related securities, Freddie Mac’s most significant market risk exposure relates to changes in the level of interest rates. To assess this risk, Freddie Mac measures, on a daily basis, its risk exposure resulting from an immediate, adverse 50-basispoint parallel shift in the current yield curve (the greatest loss that would result from an upward or downward 50-basis-point shift). Risk exposure is stated in terms of Portfolio Market Value Sensitivity (“PMVS”), which is the estimated percentage decline in the net market value of the corporation’s interestearning assets and liabilities (referred to as “portfolio market value”). This methodology includes the effects of derivative financial instruments on Freddie Mac’s assets and liabilities, treats preferred stock as a debt equivalent and takes into account the market value of projected future cash flows from mortgage securitization financing. Through the PMVS process, Freddie Mac is able to closely monitor and limit To a lesser degree, securitization financing of mortgage purchases also exposes Freddie Mac to interest-rate risk. Changes in interest rates and resulting changes in the rate of mortgage prepayments underlying PCs could decrease future earnings if the associated management and guarantee income is not replaced, or is replaced with new business that generates lower income. Additionally, the timing differences between when payments are received from borrowers and subsequently remitted to PC investors (referred to as the PC remittance cycle) can lead to significant interest expense, particularly in a rapidly declining interest-rate environment. If the interest rate paid to the PC investor is higher than the reinvestment rate for the cash received, then Freddie Mac bears the cost difference during the time from when the mortgage borrower pays Freddie Mac and when the payment is made to the PC investor. Overall, the level of exposure to interest-rate risk associated with mortgage securitization financing is lower than the level of risk associated with debt financing of mortgagerelated investments, because there is substantial matching between the prepayment patterns of the underlying mortgages and the PCs that finance the mortgages. Interest-rate risk associated with mortgage securitization financing is managed by the corporation in conjunction with its management of related risks associated with debt financing. Trading activities in support of the market for Freddie Mac Gold PCs are managed by Freddie Mac’s SS&TG unit and various external money managers. The primary goal of these activities is to improve the liquidity of Freddie Mac Gold PCs and strengthen relationships with key mortgage security investors. Gold PCs are traded actively, and daily changes in market value are recognized through “Other income, net.” These trading portfolios are subject to Freddie Mac’s risk measurement and management standards which minimize losses in periods of significant changes in interest rates. When Freddie Mac purchases mortgage-related investments through debt financing or mortgage securitizaA-13 FREDDIE MAC potential mismatches between the terms of assets and liabilities due to changes in interest rates. Freddie Mac supplements PMVS measurements with additional interest-rate modeling and tools such as stress tests that measure the effect on the corporation of more severe interest-rate and credit environments for purposes of evaluating the adequacy of the corporation’s capital (see “LIQUIDITY AND CAPITAL MANAGEMENT—Capital Management—Capital Adequacy”). Freddie Mac uses proprietary financial and risk models to estimate interest-rate risk. These models use a range of possible interest-rate scenarios to project estimated mortgage prepayments. The use of financial models to measure interestrate risk exposes Freddie Mac to certain operational and other related risks (see “RISK MANAGEMENT—Operational and Other Related Risks—Business and Financial Model Risk”). Interest-Rate Risk Management Strategies and Results: Freddie Mac issues debt and actively rebalances its funding mix to protect the corporation’s portfolio market value. Funding Transactions—For acquisitions of mortgagerelated investments, Freddie Mac obtains financing with a mix of debt and derivative financial instruments that provide the ability to closely match cash outflows from this financing with the cash inflows from the corporation’s investments. Freddie Mac uses a mix of short-term debt, long-term callable and non-callable debt and derivative financial instruments to maximize its ability to reprice debt when mortgages prepay faster than expected. Freddie Mac’s ability to maintain this flexibility depends on its ability to issue debt and enter into derivative financial instruments on acceptable terms. Rebalancing Transactions—Freddie Mac executes interest-rate risk management (or “rebalancing”) transactions to provide short-term and long-term protection. To provide short-term protection, Freddie Mac typically buys or sells derivative financial instruments, such as U.S. Treasury futures or interest-rate swaps, in order to closely match the expected life of its assets and liabilities. In addition, Freddie Mac obtains long-term protection from wider swings in interest rates by purchasing call options to change the characteristics of the debt used to finance the mortgages purchased. Through these transactions, Freddie Mac’s objective is to maximize the amount of debt that it has the option to reprice when interest rates are rapidly declining, and to minimize the amount of debt that must be repriced when interest rates are rapidly increasing. Risk Management Results—Exhibit 3 illustrates the percentage of business days PMVS was within certain ranges during 1999 as compared to 1998 and 1997. Exhibit 3 – Portfolio Market Value Sensitivity Ranges 50% Percent of Business Days Within the Range 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% <=1.00% 1.01% to 2.00% 2.01% to 3.00% 3.01% to 4.00% 4.01% to 5.00% >5.00% Portfolio Market Value Sensitivity (PMVS) 1999 1998 1997 As shown in Exhibit 3, PMVS was 3.00 percent or less for approximately 88 percent of the business days in 1999, compared to 4 percent and 51 percent of the business days in 1998 and 1997, respectively. Additionally, PMVS was 2.00 percent or less for 55 percent of the business days in 1999. At December 31, 1999, 1998 and 1997, each 1 percent of PMVS equated to a potential dollar value loss of approximately $128 million, $93 million and $82 million, respectively. The corporation also measures and monitors interestrate risk assuming more severe changes in interest rates. To quantify the potential effect of a more dramatic shift in interest rates, estimates of PMVS at the end of December 31, 1999, 1998 and 1997, assuming a 100 basis-point rather than a 50 basis-point adverse parallel shift of the current yield curve are presented in Table 9. Table 9 also provides the potential dollar loss in portfolio market value as a percentage of interest-earning assets. Table 9 – Portfolio Market Value Sensitivity (Assuming a 100 BasisPoint Parallel Shift of the Yield Curve) Potential Dollar Value Loss as a Percent of PMVS Interest-Earning Assets As of December 31, 1999 December 31, 1998 December 31, 1997 2.9% 14.0% 11.5% 0.1% 0.4% 0.5% Freddie Mac’s PMVS was generally lower throughout 1999 as compared to 1998. The decline in PMVS for 1999 reflects the corporation’s actions to protect its portfolio market value against rising interest rates. During 1998 and 1999, Freddie Mac executed funding and rebalancing actions which significantly reduced its interest-rate risk exposure for 1999. When short-term debt and derivative financial instruments were priced at attractive levels in 1998, Freddie Mac purchased substantial amounts of protection against rising interest rates, including purchases of derivative financial instruments to A-14 FREDDIE MAC reduce short-term funding exposure, and purchases of option-based derivatives designed to adjust future funding costs for purposes of offsetting mortgage lengthening. Freddie Mac further reduced its interest-rate risk exposure in 1999 by executing rebalancing transactions (including issuances of Reference Notes, sales of U.S. Treasury securities and the use of interest-rate swaps) that lengthened the duration of its debt portfolio to match the lengthened duration of its mortgage portfolio. Freddie Mac’s operating results for 1999 reflect the effects of the 1998 protection and the additional protection purchased in 1999 (see “CONSOLIDATED RESULTS OF OPERATIONS–Net Interest Income on Earning Assets”). For many mortgage investors in 1999, the market value of their portfolios decreased as a result of the increase in interest rates and the resulting reduction in mortgage prepayments. Because Freddie Mac maintained a low risk profile during 1999, and as a result of its risk management strategies, the portfolio’s overall value increased by $2.2 billion, from $10.3 billion in 1998 to $12.5 billion in 1999, on a pre-tax basis (see Note 13 to the Consolidated Financial Statements). The generally higher PMVS during 1998 as compared to 1997 was due to the lower mortgage interest rates that prevailed during 1998, as well as increased market volatility. Because of lower interest-rate levels, a greater proportion of the corporation’s mortgage portfolio was subject to refinancing during 1998. Despite the higher PMVS, the corporation’s interest-rate risk exposure in 1998 remained within acceptable levels in accordance with operating risk thresholds established by the corporation. Exhibit 4 – Cumulative Repricing of Effective Long-Term Debt 100% 90% Percent of Effective Long-Term Debt Outstanding 80% 70% 60% 50% 40% 30% 20% 10% 0% 00 01 02 03 04 05 06 07 08 09+ in each year. These early repricing opportunities provide substantial protection against prepayment risk. The bottom line shows the cumulative final maturity of the corporation’s effective long-term debt, assuming that no debt is called, but rather that each instrument remains outstanding until its final maturity. These long final maturities provide protection if prepayments are slowed and the lives of the corporation’s retained mortgage investments are extended. In 2000, approximately 9 percent of the effective long-term debt outstanding as of December 31, 1999 is scheduled to mature. However, an additional 24 percent, for a total of 33 percent, of effective long-term debt could be called by Freddie Mac should prepayments of mortgage-related investments accelerate. Other Market Risks In addition to parallel shifts of the yield curve, Freddie Mac also monitors and manages its exposure to other interest-rate and market risks. The following discussion describes these risks. Yield Curve Risk: To the extent that Freddie Mac cannot exactly match the durations of its assets and liabilities, the corporation’s portfolio market value may be exposed to non-parallel shifts in the yield curve, such as a flattening or steepening. Freddie Mac measures yield curve risk by monitoring the sensitivity of its portfolio market value to changes in interest rates along all points of the yield curve. Freddie Mac manages this risk by funding a significant portion of its mortgage-related investments with a mixture of effective short-term and long-term debt designed to match the expected cash flow characteristics of its investments. Mortgage-related investments funded in a steeper yield curve environment generally have higher initial spreads that decline over time as short-term debt matures. Mortgagerelated investments funded in a flatter yield curve environment generally have spreads that are initially lower (given smaller differences between the cost of short-term and longterm debt), but generate earnings in future periods that generally are more stable over the lives of the investments. Basis Risk: Basis risk is the risk that changes in the interest-rate spread between different financial instruments may cause changes in the corporation’s portfolio market value or net interest income. Freddie Mac is primarily exposed to basis risk as a result of the spread between the London Interbank Offered Rate (“LIBOR”) and Freddie Mac’s shortterm debt rate. Freddie Mac’s funding strategy includes using interest-rate contracts and other derivative financial instruments indexed to LIBOR to effectively lengthen the duration of short-term debt. Freddie Mac’s cost of effective long-term debt will decrease if spreads between LIBOR and short-term debt widen, and will increase if spreads tighten. Freddie Mac is also exposed to basis risk to the extent that U.S. Treasury-based Earliest Repricing Latest Repricing Exhibit 4 illustrates the cumulative percentage of Freddie Mac’s effective long-term debt outstanding at December 31, 1999 that will reprice in future years assuming that (i) all effective callable debt is repriced at the earliest possible call date and (ii) no debt is repriced until its scheduled maturity. The top line illustrates the cumulative amount of the corporation’s effective long-term debt that is available for repricing either through maturity or exercise of the call option A-15 FREDDIE MAC instruments are used to rebalance Freddie Mac’s portfolio. Freddie Mac enters into financing arrangements involving basis risk only when such arrangements are intended to enhance net interest income through reduced funding costs. Volatility Risk: Volitility risk is the risk that changes in market expectations regarding the volatility of future interest rates may cause changes in the corporation’s portfolio market value. This expectation, defined as implied volatility, is embedded in option prices. When Freddie Mac purchases mortgage-related investments, it implicitly sells a prepayment option to the mortgage borrower. Similarly, when Freddie Mac issues callable debt or uses certain derivative financial instruments, it implicitly buys a call option to match the cash flow characteristics of the prepayment option embedded in the mortgages. To the extent that increases in the implied volatility of interest rates have a greater effect on options embedded in mortgage-related investments than on the options embedded in callable debt or derivative financial instruments, Freddie Mac is exposed to increases in the level of volatility. The corporation’s portfolio market value may be reduced as a result of increased volatility or may grow due to decreased volatility. Freddie Mac monitors volatility risk by measuring exposure levels on a daily basis. Derivative Financial Instruments Freddie Mac enters into derivative financial transactions as an end user and not for trading or speculative purposes. The corporation uses derivative financial instruments in combination with underlying liabilities or assets to synthetically create debt instruments or interest-earning assets that achieve lower effective financing costs or higher effective asset yields than those available on alternative instruments. Additionally, through the use of derivative financial instruments, Freddie Mac is better able to match the expected durations of its assets and liabilities and reduce the corporation’s exposure to interest-rate and/or foreign currency risk than through the issuance of debt. The use of derivative financial instruments has become increasingly important in Freddie Mac’s overall strategy of managing interest-rate risk. Through derivative financial instruments, Freddie Mac hedges anticipated debt issuance transactions and changes the effective repricing date of outstanding short-term and long-term debt in rebalancing its mix of total outstanding debt. Of the total notional balance of derivative financial instruments outstanding at December 31, 1999, $417 billion were executed in conjunction with debt financing (“debt-linked”), and $7 billion were executed in conjunction with the purchase of mortgage-related investments (“asset-linked”). Freddie Mac typically uses derivative financial instruments to effectively convert short-term financing to long-term fixed-rate debt. Due to rising interest rates during 1999, Freddie Mac changed its mix of debt funding by shifting from short-term to effective long-term debt funding to match the lengthened duration of its mortgage-related investments. Through the use of derivatives, Freddie Mac converted 79 percent of its contractual short-term debt to effective long-term debt at December 31, 1999, as compared to 51 percent at December 31, 1998 (see “RISK MANAGEMENT—Interest-Rate and Other Market Risks—Interest-Rate Risk—Interest-Rate Risk Management Strategies and Results”). SFAS No. 133, which Freddie Mac will implement on January 1, 2001, will revise significantly the accounting treatment of derivative financial instruments. Among other things, the new standard requires derivative instruments to be recorded and carried on the balance sheet at their current fair value. The new accounting treatment may result in increased volatility in the reported earnings of corporations that use such instruments, including Freddie Mac (see “EFFECT OF NEW ACCOUNTING STANDARD” and Note 1 to the Consolidated Financial Statements). Table 10 summarizes the notional or contractual amounts of derivative financial instruments by type and their related net fair value. Freddie Mac estimates the fair value of derivative financial instruments using discounted cash flow models based on current market interest rates and estimates of interest-rate volatility. Table 10 – Derivative Financial Instruments December 31, 1999 1998 Notional or Net Contractual Fair Amount Value Notional or Net Contractual Fair Amount Value (dollars in millions) Interest-rate contracts: Interest-rate swaps Receive floating $101,243 $ 1,978 $ 41,464 $(1,212) Receive fixed 22,375 (385) 11,762 195 2,962 (2) 4,329 (30) Basis(1) Interest-rate caps 17,811 717 18,299 313 Interest-rate floors 403 3 1,603 9 Interest-rate corridors 1,722 25 1,943 5 Future and options(2) 267,737 2,674 220,832 1,119 Treasury-based 8,894 278 11,542 70 contracts(3) Foreign currency swaps 1,097 (82) 1,464 (42) Total $424,244 $ 5,206 $ 313,238 $ 427 (1)Interest-rate swaps in which Freddie Mac pays and receives a floating rate, but which are based on two different indexes. (2)All options held by Freddie Mac were options to enter into interest-rate contracts (or swaptions). (3)Excludes exchange-traded derivative financial instruments, such as Treasury-based futures contracts. FREDDIE MAC A-16 At December 31, 1999, the notional balance of Freddie Mac’s derivative financial instruments totaled $424 billion, compared to $313 billion at December 31, 1998. This increase in notional and contractual amounts reflects the increased use of interest-rate swaps, futures and options to lengthen the duration of Freddie Mac’s existing debt to match the lengthened duration of its mortgage portfolio. Additionally, at December 31, 1999 and 1998, the net fair value of the corporation’s derivative financial instruments was $5.2 billion and $0.4 billion, respectively. The increase in the net fair value of the corporation’s derivative financial instruments resulted from changes in interest rates, which increased the net gain position on contracts with several of Freddie Mac’s largest counterparties, as well as increases in the notional or outstanding contractual amounts of these financial instruments. While derivative financial instruments reduce Freddie Mac’s overall exposure to interest-rate and foreign currency risk, they increase the corporation’s exposure to institutional credit risk (see “RISK MANAGEMENT— Credit Risk — Institutional Credit Risk”). In addition, derivative financial instruments may also subject the corporation to operational risk (see “RISK MANAGEMENT—Operational and Other Related Risks—Hedging Risk”). Further information regarding derivative financial instruments is presented in Notes 1, 7 and 9 to the Consolidated Financial Statements. Operational and Other Related Risks Operational risk is the risk of loss due to human error, system failures, fraud, or circumvention or overriding of internal controls. Freddie Mac mitigates operational risk by following comprehensive financial and operating policies and procedures, and by regularly evaluating the effectiveness of its internal control structure. The corporation’s policies and procedures include controls to ensure that system-generated data are reconciled to source documentation in a timely fashion. Freddie Mac also performs reasonableness and validity tests to ensure the accuracy of its financial information. The corporation’s Internal Audit Department regularly monitors Freddie Mac’s compliance with established policies and procedures, and evaluates Freddie Mac’s internal control structure. In addition, Freddie Mac maintains a continuity plan for critical business processes and systems in the event of disasters. Hedging Risk: Hedging refers to the buying or selling of financial instruments to protect the corporation’s portfolio market value or future earnings from adverse changes in the level and shape of the yield curve, and the volatility of interest rates. Hedging risk is the risk that hedging transactions do not effectively meet their objectives. The effectiveness of the hedging strategy depends on Freddie Mac’s ability to execute hedging transactions when they are needed, at a reasonable price. To manage this aspect of hedging risk, Freddie Mac monitors market liquidity on a daily basis, and uses a variety of hedging instruments to reduce its dependence on the liquidity of any individual hedge market. Freddie Mac is also subject to the risk that hedging instruments do not provide effective protection. Freddie Mac manages this risk by adjusting its hedging strategies based on actual and expected market relationships. Business and Financial Model Risk: The business and financial models used by Freddie Mac also expose the corporation to risk. Freddie Mac’s proprietary mortgage prepayment model, a valuation tool for projecting expected levels of mortgage prepayments in differing economic environments, is a core model used in conjunction with other valuation models for measuring and managing the corporation’s exposure to credit and interest-rate risk. Operational failure related to the corporation’s mortgage prepayment model could adversely affect the value, or future earnings, of the corporation. Freddie Mac mitigates operational risk related to this and other valuation models by benchmarking its model results to market estimates of external parties. In the case of forecasting models, Freddie Mac mitigates operational risk by performing periodic comparisons of actual results to forecasted results and adjusting forecast models and assumptions accordingly. Year 2000 Risk: Freddie Mac’s efforts to prepare its business systems for the century date change have resulted in uninterrupted business processes and service to customers. Management is confident that Freddie Mac’s systems will continue to handle the year 2000 date change successfully throughout the year (see “FORWARD-LOOKING STATEMENTS”). Freddie Mac monitored the resources required and the costs incurred in preparing its business systems and facilities for the year 2000 date change since the inception of its readiness program in 1997. Additionally, the timing of certain investments to replace critical systems was accelerated due to year 2000 issues. These investments were likely to have been made within three years, even in the absence of the year 2000 deadline. Through December 31, 1999, costs totaling approximately $165 million were incurred with respect to the corporation’s year 2000 readiness program, which includes approximately $123 million of general year 2000 readiness costs and $42 million of accelerated systems replacement costs. L I Q U I D I T Y A N D C A P I TA L MANAGEMENT Liquidity Freddie Mac’s business activities present liquidity demands that are driven by maturities of debt, purchases of mortgages, payments of principal and interest to mortgage security holders A-17 FREDDIE MAC and general operations. The corporation’s sources of cash to meet these needs include short-term and long-term borrowings, mortgage prepayments and cash flows from operations. Because of its financial performance and its regular and significant participation as an issuer in the funding markets, the corporation’s sources of funding remain adequate to meet its liquidity needs. During 1999, Freddie Mac issued a total of $688 million in stock through three preferred stock offerings, and issued $1.678 trillion and $114 billion in short-term and long-term debt, respectively, to support its business activities and to provide the corporation with added liquidity leading up to the century date change. The corporation’s Reference Notes, Callable Reference Notes and Reference Bills programs enable the corporation to sell large issues of non-callable, callable and short-term debt (see “BUSINESS REVIEW—Debt Financing”). During 1999 and 1998, Freddie Mac issued $50 billion and $20 billion of debt, respectively, under its Reference Notes program, and issued $6 billion of debt in 1999 under its Callable Reference Notes program. Freddie Mac introduced its new Reference Bills program in November 1999. Issuances under this program commenced in January 2000. In addition to stock and debt issuances, the corporation maintains a liquidity and contingency investment portfolio used to manage recurring cash flows and meet other cash management needs, maintain capital reserves to meet mortgage funding needs, provide diverse sources of liquidity and help manage the interest-rate risk inherent in mortgage-related investments. The liquidity and contingency investment portfolio enables Freddie Mac to deploy fully its available capital and fulfill its purpose of providing a stable and reliable supply of mortgage credit nationwide. This portfolio is important to Freddie Mac’s financial management and its ability to provide liquidity and stability to the mortgage market. At December 31, 1999 and 1998, the liquidity and contingency investment portfolio totaled $42 billion and $49 billion, respectively, and principally consisted of cash and cash equivalents, reverse repurchase agreements and highly rated short-term and longer-term investments. The corporation recognizes net interest income on the liquidity and contingency investment portfolio. Further information regarding the liquidity and contingency investment portfolio is presented in Note 4 to the Consolidated Financial Statements. Capital Management Freddie Mac manages its capital resources to provide attractive returns on common equity while maintaining sufficient capital to satisfy internal capital adequacy standards and regulatory capital requirements, and to absorb unforeseen losses that might arise in fulfilling its mortgage guarantee obligations and conducting its business programs. Capital Transactions Table 11 summarizes the components of Freddie Mac’s capital base. Table 11 – Capital Base December 31, (dollars in millions) 1999 1998 1997 Common stock: Par value $ 152 Additional paid-in capital 474 Preferred stock (at redemption value): 6.72% preferred stock(1) — 1996 variable-rate preferred stock(2) 250 6.125% preferred stock(3) 287 6.14% preferred stock(4) 600 5.81% preferred stock(5) 150 5% preferred stock(6) 400 5.1% preferred stock(7) 400 1998 variable-rate preferred stock(8) 220 5.3% preferred stock(9) 200 5.1% preferred stock (10) 150 5.79% preferred stock(11) 250 1999 variable-rate preferred stock(12) 288 Retained earnings 9,736 Net unrealized (loss) gain on certain investments reported at fair value, net of taxes (1,166) Treasury stock, at cost (866) Stockholders’ equity 11,525 Reserve for mortgage losses 772 Primary capital base 12,297 Subordinated borrowings 130 Adjusted total capital base $12,427 $ 152 494 $ 152 51 300 250 287 600 150 400 400 220 200 — — — 8,083 300 250 287 600 150 — — — — — — — 6,830 120 146 (821) (1,245) 10,835 7,521 768 694 11,603 8,215 162 521 $11,765 $8,736 (1) Redeemed on February 12, 1999. (2) Variable-rate is equal to the sum of the three-month LIBOR rate plus 1 percent divided by 1.377 and is capped at 9.00 percent. Optional redemption on or after June 30, 2001. (3) Optional redemption on or after December 31, 2001. (4) Optional redemption on or after June 30, 2002. (5) Optional redemption on or after October 27, 1998. (6) Optional redemption on or after March 31, 2003. (7) Optional redemption on or after September 30, 2003. (8) Variable-rate is equal to the sum of the three-month LIBOR rate plus 1 percent divided by 1.377, and is capped at 7.50 percent. Optional redemption on or after September 30, 2003. (9) Optional redemption on or after October 30, 2000. (10) Optional redemption on or after March 31, 2004. (11) Optional redemption on or after June 30, 2009. (12) Initial dividend rate is 5.97 percent per annum through December 31, 2004. Dividend rate resets on January 1, 2005 and on January 1 every five years thereafter based on a five-year constant maturity Treasury rate which is capped at 11.00 percent. Optional redemption on December 31, 2004 and on December 31 every five years thereafter. FREDDIE MAC A-18 During 1999, the corporation added $694 million to its primary capital base, largely driven by earnings and three preferred stock offerings. The increase in the capital base through preferred stock issuances provided the corporation with the flexibility to respond to growth opportunities during 1999. In March 1999, Freddie Mac issued $150 million (or 3.0 million shares) of 5.1% non-cumulative preferred stock and, in July 1999, the corporation issued $250 million (or 5.0 million shares) of 5.79% non-cumulative preferred stock. Additionally, in November 1999, Freddie Mac issued $288 million (or 5.75 million shares) of variable-rate noncumulative preferred stock. During 1998, the corporation added $3.388 billion to its primary capital base which, in addition to earnings growth, reflects a common stock offering in November 1998 totaling $1.003 billion (or 17.1 million shares) and four preferred stock offerings totaling $1.220 billion. These stock offerings enabled the corporation to respond to growth opportunities during both 1998 and 1999. On February 12, 1999, Freddie Mac redeemed its 6.72% preferred stock. The corporation’s outstanding 5.81% preferred stock issue has been redeemable since October 27, 1998, and its 5.3% preferred stock issue will become redeemable on October 30, 2000. Freddie Mac’s capital structure may be influenced by the redemption and replacement of all or part of these preferred stock issues, which could result in changes in the corporation’s mix of common and preferred equity funding. Redemption of preferred stock in future periods will depend primarily on interest-rate levels. No other issue of Freddie Mac’s preferred stock outstanding at December 31, 1999 will become redeemable in 2000. Net unrealized losses in 1999 of $1.286 billion on certain available-for-sale securities partially offset increases in the corporation’s primary capital base, resulting in a net increase of $694 million in the primary capital base. Freddie Mac’s availablefor-sale portfolio consists of liquidity investments and certain structured mortgage securities, primarily non-Freddie Mac securities. Although the credit quality of these securities is high, their classification as available-for-sale allows Freddie Mac to manage the associated credit risk effectively by retaining the ability to sell the securities as appropriate. In accordance with the corporation’s overall risk management framework, it is management’s practice to fund available-for-sale securities on a duration-matched basis. Freddie Mac’s available-for-sale assets totaled $62 billion at December 31, 1999, up from $38 billion at December 31, 1998. In accordance with SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” availablefor-sale securities are marked to fair market value, with unrealized gains and losses reported through “Stockholders’ equity.” Under SFAS No. 115, the market value adjustment on availablefor-sale securities is limited to the securities themselves and therefore does not include the offsetting market valuation on the debt instruments funding these investments. Since available-for-sale securities are funded on a duration-matched basis, the decrease A-19 in the market valuation of these securities did not represent an economic loss for Freddie Mac in 1999 because it was offset by an increase in the market valuation of the related debt. The magnitude of the change in the mark-to-market valuation of the corporation’s available-for-sale portfolio is influenced primarily by the size of the portfolio, the general level of interest rates and credit risk premiums. Substantial increases in these factors could result in further market value declines (see “FORWARD-LOOKING STATEMENTS”). Freddie Mac actively manages capital to provide attractive returns on common equity by establishing a return on equity threshold for new investments and returning surplus capital to shareholders in periods when more capital is generated than can be deployed at acceptable returns. During 1999 and 1998, Freddie Mac returned capital to shareholders of $92 million and $85 million, respectively, through common stock repurchases pursuant to the corporation’s stock repurchase program. Common stock repurchases during these years were low relative to previous years, reflecting the availability of profitable investment opportunities during these periods. In addition to its corporate stock repurchase program, Freddie Mac repurchases common stock to satisfy obligations under its stock-based compensation plans. See Note 8 to the Consolidated Financial Statements for further information on the corporation’s stock-based compensation plans. Freddie Mac believes that common stock repurchases may be an important component of earnings per share growth in future periods. However, the amount of capital actually available to repurchase common stock will be affected primarily by mortgage portfolio growth opportunities, Freddie Mac’s assessment of the adequacy or sufficiency of its capital, as well as the implementation of regulatory risk-based capital standards (see “REGULATORY MATTERS— Capital Standards”). Capital Adequacy Freddie Mac regularly assesses the adequacy of its capital. Management believes that at any point in time, capital should be sufficient to ensure that Freddie Mac can satisfy its financial obligations in a timely manner with its own resources even if economic circumstances deteriorate unexpectedly and severely. Maintaining adequate levels of capital protects the value of Freddie Mac as a going concern. As discussed earlier, the major risks inherent in Freddie Mac’s securitization financing and debt financing of mortgage-related investments are (i) credit risk and (ii) interest-rate risk. The greater the exposure Freddie Mac has to these risks, the more capital it needs to withstand adverse credit or interest-rate environments. Freddie Mac assesses its capital adequacy using a stress test methodology, a type of scenario analysis used by many firms to evaluate their financial strength under adverse FREDDIE MAC business conditions. The customized stress test methodology employed by Freddie Mac is designed to estimate the amount of capital the corporation would need to satisfy its obligations over a 10-year period of extremely adverse economic conditions. Freddie Mac identifies six severe economic scenarios. Each 10-year stress scenario is defined by extreme changes in housing prices and interest rates, the two economic variables that give rise to Freddie Mac’s credit risk and interest-rate risk. Freddie Mac simulates the corporation’s financial performance under these stressful economic conditions using proprietary models of mortgage default and prepayments to predict cash flows on mortgage-related investments. An accounting model is also used to translate those cash flows, as well as simulated cash flows on liabilities and off-balance sheet obligations, into income statements and balance sheets during each of the 10-year stress periods. Freddie Mac’s standard for capital adequacy is to maintain capital equal to at least 130 percent of that necessary to satisfy all financial obligations under each of the six stress tests. The 30 percent additional capital beyond what is needed to cover credit risk and interest-rate risk captured by the stress tests is an additional cushion for other risks, such as operational risk. At December 31, 1999, Freddie Mac satisfied this internal capital adequacy standard, having capital of at least 130 percent of that required under each of the six stress scenarios. The stress tests that Freddie Mac uses to assess capital adequacy are illustrated in Exhibit 5. Exhibit 5 – Stress Test Ellipse Yearly House-Price Appreciation probability distribution of interest-rate and house-price shocks possible over 10 years, given the relationship between 10-year house-price and interest-rate changes observed in the past. As illustrated in Exhibit 5, house-price and interest-rate movements tend to be positively correlated over long periods of time. For example, large increases in interest rates tend to be associated with house-price appreciation at the national level. The stress tests selected around the ellipse to assess Freddie Mac’s capital adequacy are, in management’s judgment, approximately equally remote and include the points on the ellipse representing the greatest changes in interest rates (points A and D) and house-price depreciation (point C). Table 12 illustrates the house-price and interest-rate shock for each of the six stress test scenarios. Table 12 – Stress Test Economic Shocks Stress Test Scenarios 10-Year Economic Shock InterestRate (1) Change House-Price Appreciation (2) (average/yr.) A B C D E F High 1980s Style Depression Depression RefiRefiInflation Recession 1 2 Boom 1 Boom 2 +113% +75% +5% +1% -24% -3% -53% +1% -51% -43% +3% +5% (1) The change in interest rates is expressed as a percent of current interest rates. The interest-rate shock is assumed to occur in the first year of the 10-year simulation. For example, in the Depression 1 scenario (scenario C), the assumed 10-year U.S. Treasury rate of interest decreases by 24 percent during the first year of the stress period and remains at that level for the remaining nine years. (2) The figures in the table represent the average yearly house-price growth rate over each of the 10-year stress periods. However, the simulation actually concentrates the house-price shock in the first five years. For example, in the Depression 1 scenario (scenario C), house prices depreciate an average of 6 percent per year for the first five years of the stress period and remain unchanged for the remaining five years. In addition to an average house-price appreciation, the simulation assumes a fixed amount of dispersion around the national average to represent regional differences. Refi Boom High Inflation F E -53% -51% D -24% 5% A InterestRate Change 75% 1% B -3% 113% Depression C 1980s-Style Recession Note: The ellipse encompasses 99 percent of future 10-year economic scenarios. The stress tests represent extreme moves in interest rates and house prices. The axes in Exhibit 5 illustrate the principal underlying economic factors that affect the value of Freddie Mac’s total mortgage portfolio. As discussed earlier, house-price changes are important determinants of mortgage defaults, while interest-rate changes affect mortgage prepayment levels and Freddie Mac’s cost of funds. The ellipse represents the joint Management believes the stress test methodology allows Freddie Mac to capture the risks of the corporation’s total mortgage portfolio, as well as to determine an appropriate amount of capital to hold against such risks. The focus of the stress tests is on the risks embedded in the current book of business and current capital levels supporting this book of business; accordingly, these stress tests assume a “wind-down” mode with no new business or capital. In reality, Freddie Mac, as a going concern, has the ability to raise capital or reduce its risk exposure as economic conditions change. However, the stress test methodology is a conservative approach to assessing capital adequacy that does not take into account any dynamic responses to changing economic conditions. Management believes stress tests to be more effective than traditional capital-to-asset ratios in determining the adequate amount of capital for several reasons. First, a stress test is a portfolio approach to measuring risk and capital adequacy, capturing credit and interest-rate risks, as well as the interactions among those risks. Second, stress tests give credit A-20 FREDDIE MAC for risk-reducing strategies such as the use of callable debt, credit enhancements and capital market instruments such as swaps, options, swaptions, caps, floors and credit derivatives. Furthermore, stress tests are forward-looking and dynamic, capturing the effects of changes in economic conditions, as well as changes in the portfolio or off-balance sheet exposures. In addition to its internal assessment of capital adequacy, Freddie Mac ensures that capital is sufficient to comply with regulatory capital standards. The Office of Federal Housing Enterprise Oversight (“OFHEO”) has proposed a risk-based capital standard for Freddie Mac and Fannie Mae based on a stress test model (see “REGULATORY MATTERS—Capital Standards”). V O L U M E S TAT I S T I C S Table 13 summarizes Freddie Mac’s purchase, liquidation and securitization activity for the years ended December 31, 1999, 1998 and 1997. Table 13 – Volume Statistics Year Ended December 31, (dollars in millions) 1999 1998 1997 New business purchases(1) Single-family: 30-year fixed-rate 15-year fixed-rate ARMs/floating-rate Balloon/resets Total single-family Multifamily Total Credit risk distribution of purchases Freddie Mac at-risk(2) Credit-enhanced(3) Purchase market share(4) Percentage of refinance mortgage purchases Average LTV of purchases Refinance mortgages Purchase money mortgages Total purchases Mortgage liquidations Mortgage liquidation rate Original-issue securities settlements Single-family PCs Multifamily PCs Total Structured securitizations(5) $195,974 48,320 16,524 4,473 265,291 7,181 $272,472 $175,842 $ 96,630 43% 50% 70% 81% 75% $143,508 20% $230,986 2,045 $233,031 $119,565 72% 18% 6% 1% 97% 3% 100% 65% 35% $213,659 58,897 9,338 2,534 284,428 3,910 $288,338 $172,386 $115,952 42% 64% 70% 81% 74% $195,383 31% $249,627 937 $250,564 $135,162 74% 21% 3% 1% 99% 1% 100% 60% 40% $ 85,605 18,697 10,105 4,842 119,249 2,241 $121,490 $ 72,795 $ 48,695 42% 41% 70% 81% 76% $ 91,882 15% $113,758 500 $114,258 $ 84,366 70% 16% 8% 4% 98% 2% 100% 60% 40% (1)Includes mortgages exchanged for Freddie Mac PCs and purchased for cash, and non-Freddie Mac guaranteed mortgage securities. Excludes repurchased Freddie Mac PCs since repurchases do not affect the unpaid principal balance of the total mortgage portfolio. (2)Includes only those mortgages for which Freddie Mac has assumed primary default risk. (3)Includes loans for which the lender or a third party has retained primary default risk by pledging collateral or agreeing to accept losses on loans that default. In some cases, the lender’s or third party’s risk is limited to a specific level of losses at the time the credit enhancement becomes effective. Also includes non-Freddie Mac securities held in the total mortgage portfolio. (4) Based on mortgage purchase and PC issuance activity relative to Fannie Mae. (5)Includes issuances of mortgage-related securities in which the cash flows are structured into various classes having a variety of features, the majority of which qualify for treatment as Real Estate Mortgage Investment Conduits (REMICs) under the Internal Revenue Code. A-21 FREDDIE MAC Although Freddie Mac’s purchase volumes decreased relative to 1998, total purchases during 1999 represented the second largest level of purchases in Freddie Mac’s history. The overall decrease in purchase volumes in 1999 compared to 1998 resulted primarily from rising interest rates during 1999 and a corresponding decrease in mortgage refinance activity. In 1999, refinanced mortgages represented 50 percent of Freddie Mac’s total purchases, down from 64 percent in 1998 and up from 41 percent in 1997. Though interest rates trended upward in 1999, interest rates continued to be low compared to historical standards, and thus the supply of fixed-rate mortgages sold into the secondary mortgage market remained strong. Borrower preferences for fixed-rate mortgages continued during 1999 as spreads between fixed-rate mortgages and ARMs/floating-rate mortgages remained relatively narrow. Fixed-rate mortgages represented 90 percent of Freddie Mac’s purchases for 1999, down from 95 percent in 1998 and up from 86 percent in 1997. The increased proportion of ARMs/floating-rate purchases during 1999 reflects portfolio purchases of floating-rate, non-Freddie Mac securities for the retained portfolio (see “BUSINESS REVIEW—Debt Financing”). Freddie Mac’s credit-enhanced purchases were slightly down from 1998. This decline is the result of lower levels of pool insurance on purchases made during 1999 (see “RISK MANAGEMENT—Credit Risk— Mortgage Credit Risk-—Credit Risk Management—Credit Enhancements”), partially offset by the increased purchase of nonFreddie Mac securities for the retained portfolio. Total purchase volumes more than doubled in 1998 relative to 1997, primarily reflecting an increase in mortgage refinance activity in 1998. The corporation’s market share, as a percentage of the combined Freddie Mac and Fannie Mae purchases of both new originations and seasoned mortgages, increased to 43 percent for 1999 compared to 42 percent for both 1998 and 1997. As discussed below, this increase reflects the impact of increased business delivered under special business arrangements with certain large mortgage originators. Freddie Mac competes for mortgages primarily on the basis of the relative strength of its mortgage purchase programs, security products, customer service, ease of mortgage purchase processing and price. A significant portion of Freddie Mac’s mortgage purchase volume is generated from several key mortgage lenders that have entered into special business arrangements with Freddie Mac. These individually negotiated relationships characteristically involve a commitment by the lender to sell a high proportion of its conforming mortgage origination volume to Freddie Mac. The four most significant of these arrangements accounted for slightly over 35 percent of Freddie Mac’s volume; the largest of such agreements is with Norwest Mortgage, Inc. Freddie Mac is exposed to the risk that it will lose significant purchase volume that it may be unable to replace if, when the agreements terminate, one or more of these key lenders chooses to significantly reduce the volume of mortgages it sells to Freddie Mac. The liquidation rate on the total mortgage portfolio was 20 percent for 1999, compared to 31 percent and 15 percent for 1998 and 1997, respectively. The lower liquidation rate in 1999 compared to 1998 reflects a slowing of borrower prepayments due to rising interest rates. The rise in the liquidation rate in 1998 compared to 1997 reflects an increase in borrower prepayments due to declining interest rates. As part of its securitization financing activities, Freddie Mac engages in structured securitizations in which it resecuritizes PCs that qualify as real estate mortgage investment conduits (“REMICs”) under Internal Revenue Service (“IRS”) regulations. Structured securitization volumes vary based on market conditions which impact investor demand for REMIC securities. Freddie Mac’s structured securitization activity was $120 billion in 1999, compared to $135 billion and $84 billion in 1998 and 1997, respectively. AV E R A G E B A L A N C E S H E E T S A N D R AT E / V O L U M E A N A LY S I S Table 14 presents average balance sheets and information with respect to yields earned on assets and rates paid on liabilities for the years ended December 31, 1999, 1998 and 1997. Daily weighted average balances are calculated for interest-earning assets, interest-bearing liabilities and Total PCs. When daily weighted average balance information is not available, a simple month-to-month average balance is calculated. Table 15 contains a rate/volume analysis that details the changes to “Total revenues” during 1999, 1998 and 1997 resulting from changes in average balances, asset yields and funding costs. FREDDIE MAC A-22 Table 14 – Average Balances and Yields Year Ended December 31, Average Balance (dollars in millions) Assets 1999 1998 Average Balance Interest Income/ Expense Average Rate Average Balance 1997 Interest Income/ Expense Average Rate Interest Income/ Average Expense Rate Interest-earning assets Mortgages Guaranteed mortgage securities(1) Total retained portfolio Cash and investments(2) Securities purchased under agreement to resell Total interest-earning assets All other assets Total assets $ 54,577 $ 3,967 7.27% 239,285 293,862 53,085 15,747 6.58% 19,714 6.71% 2,751 5.10% $ 50,383 $ 3,736 7.41% 152,687 203,070 36,666 10,533 6.90% 14,269 7.03% 2,049 5.53% $ 45,626 $ 3,439 7.54% 105,096 150,722 26,378 7,591 7.22% 11,030 7.32% 1,563 5.84% 5,182 288 5.56% 352,129 $ 22,753 6.45% 6,359 $358,488 5,736 320 5.50% 245,472 $16,638 6.77% 5,016 $250,488 8,042 408 5.07% 185,142 $13,001 7.01% 4,177 $189,319 Liabilities and Stockholders’ Equity Interest-bearing liabilities Debt securities: Effective short-term debt $ 44,516 $ 2,199 4.87% Effective long-term debt 283,900 17,337 6.08% Subordinated borrowings 147 14 9.36% Total debt securities 328,563 19,550 5.91% PC variance: Due to prepayments(3) 9,299 658 7.08% Due to ARM/floating-rate adjustments(4) — 5 — Net cost of PC variance 9,299 663 7.13% Total interest-bearing liabilities 337,862 $ 20,213 5.95% All other liabilities 9,501 Stockholders’ equity 11,125 Total liabilities and stockholders’ equity $358,488 Net interest income/yield $ 2,540 0.75% Net interest income/yield (fully taxable equivalent basis) $ 2,721 0.80% Guarantees $ 74,032 $ 4,037 5.38% 147,810 9,724 6.56% 322 30 9.32% 222,164 13,791 6.17% 12,647 — 12,647 913 7.23% 7 — 920 7.28% $ 47,753 $ 2,609 5.40% 121,946 8,243 6.76% 505 48 9.50% 170,204 10,900 6.38% 6,385 — 6,385 477 7.46% (7) — 470 7.37% 234,811 $ 14,711 6.23% 6,909 8,768 $ 250,488 $ 1,927 0.81% $ 2,091 0.88% 176,589 $11,370 6.42% 5,659 7,071 $ 189,319 $ 1,631 0.89% $ 1,741 0.94% Total PCs (in basis points) $710,009 $ 1,405 19.8 bp $ 609,877 $ 1,307 21.4 bp $ 565,685 $ 1,298 22.9 bp (1)Rates calculated on a fully taxable equivalent basis were 6.64%, 6.97% and 7.29% for the years ended December 31, 1999, 1998 and 1997, respectively, based on related income of $15.892 billion, $10.645 billion and $7.660 billion, respectively. (2)Rates calculated on a fully taxable equivalent basis were 5.24%, 5.65% and 6.00% for the years ended December 31, 1999, 1998 and 1997, respectively, based on related income of $2.819 billion, $2.101 billion and $1.604 billion, respectively. (3)Mortgage liquidations on which interest continues accruing to the security holder. (4)Rate changes on ARMs/floating-rate mortgages for which the related security rate changes one month later. A-23 FREDDIE MAC Table 15 – Rate/Volume Analysis 1999 vs. 1998 Increase or (Decrease) Due To Rate (dollars in millions) Volume Total 1998 vs. 1997 Increase or (Decrease) Due To Rate Volume Total Interest-earning assets Mortgages Guaranteed mortgage securities Total retained portfolio Investments Total interest-earning assets Interest-bearing liabilities Effective short-term debt Effective long-term debt Total debt securities PC variance Total interest-bearing liabilities Net interest income Management and guarantee income Other income, net Total revenues (80) $ 311 (761) 5,975 (841) 6,286 (195) 865 $(1,036) $ 7,151 $ $ 231 5,214 5,445 670 $ 6,115 $ (62) (494) (556) (60) $(616) $ 359 3,436 3,795 458 $4,253 $ 297 2,942 3,239 398 $3,637 $ (272) $(1,566) $(1,838) (1,319) 8,916 7,597 (1,591) 7,350 5,759 (13) (244) (257) $(1,604) $ 7,106 $ 5,502 $ 568 $ 45 $ (116) $ 214 $ 613 $ 98 $ 7 $ 718 $ (11) (276) (287) (17) $(304) $(312) $ (92) $1,439 1,739 3,178 467 $3,645 $ 608 $ 101 $1,428 1,463 2,891 450 $3,341 $ 296 $ 9 $ 3 $ 308 C O N S O L I D AT E D R E S U LT S O F O P E R AT I O N S “Net income” for 1999 was $2.223 billion, a 31 percent increase over the $1.700 billion reported for 1998. Diluted earnings per common share for 1999 was $2.96, up 28 percent over the $2.31 diluted earnings per common share reported for 1998. The increases in “Net income” and diluted earnings per common share were primarily due to a $613 million, or 32 percent, increase in “Net interest income on earning assets,” coupled with a $183 million, or 54 percent, decrease in credit-related expenses. The increase in net interest income was due to growth of the retained portfolio, while improved credit performance reflects favorable economic conditions, particularly house-price appreciation, as well as the increasing influence of higher credit quality mortgage originations (see “RISK MANAGEMENT—Credit Risk— Mortgage Credit Risk—Credit Performance). Net income for 1999 includes a pre-tax extraordinary gain of $8 million on the retirement of debt. The debt retirement resulted in an aftertax extraordinary gain of $5 million, or $0.01 basic and diluted earnings per common share. Table 16 summarizes Freddie Mac’s results of operations for 1999 as compared to 1998, and 1998 as compared to 1997. FREDDIE MAC A-24 Table 16 – Summary of Results 1999 vs. 1998 1998 vs. 1997 Percent Change 1997 Dollar Change Percent Change Year Ended December 31, (dollars in millions, except per share amounts) 1999 1998 Dollar Change Net interest income on earning assets Management and guarantee income Other income, net(1) Total revenues Credit-related expenses Administrative expenses Housing tax credit partnerships(2) Total non-interest expense Net income Earnings per common share(3) Basic Diluted Retained portfolio (in billions) Total mortgage portfolio (in billions)(4) $2,540 1,405 110 $4,055 $ 159 655 80 $ 894 $2,223 $ 2.97 $ 2.96 $324.4 $862.3 $1,927 1,307 103 $3,337 $ 342 578 61 $ 981 $1,700 $ 2.32 $ 2.31 $255.0 $733.4 $ 613 98 7 $ 718 $ (183) 77 19 $ (87) $ 523 $ 0.65 $ 0.65 $ 69.4 $128.9 32% 7% 7% 22% (54)% 13% 31% (9)% 31% 28% 28% 27% 18% $1,631 1,298 100 $3,029 $ 529 495 41 $1,065 $1,395 $ 1.90 $ 1.88 $164.4 $640.4 $ 296 9 3 $ 308 $(187) 83 20 $ (84) $ 305 $ 0.42 $ 0.43 $ 90.6 $ 93.0 18% 1% 3% 10% (35)% 17% 49% (8)% 22% 22% 23% 55% 15% (1) Includes recognized gains (losses) on hedging transactions totaling $22 million, $(9) million and $5 million for the years ended December 31, 1999, 1998, and 1997, respectively. (2) Represents costs associated with Freddie Mac’s investment in housing tax credit partnerships. Tax credits generated by these investments reduce the corporation’s tax liability. (3) After payments of preferred stock dividends of $153 million, $121 million and $95 million for the years ended December 31, 1999, 1998 and 1997, respectively. (4) Equal to the retained portfolio plus Total PCs, net of Freddie Mac PCs held in the retained portfolio. Net Interest Income on Earning Assets “Net interest income on earning assets” totaled $2.540 billion in 1999 compared to $1.927 billion in 1998. On a fully taxable equivalent (“FTE”) basis, net interest income totaled $2.721 billion in 1999, a 30 percent increase over 1998 FTE net interest income of $2.091 billion. FTE net interest yield on earning assets was 0.80 percent for 1999 compared to 0.88 percent for 1998. Growth in FTE net interest income reflects a $91 billion, or 45 percent, increase in the average balance of the retained portfolio. The 8 basis-point decline in FTE net interest yield from 1998 primarily reflects the net effect of funding and rebalancing actions taken by Freddie Mac to protect the corporation’s portfolio market value. Over the course of 1999, Freddie Mac increased its proportion of higher-cost, longer-term funding to better match expected asset and liability durations in a rising interest-rate environment. In addition Freddie Mac increased its holdings of option-based derivatives, which provide protection against significant interest-rate movements. While these actions compressed net interest yield in 1999, they substantially reduced the corporation’s future interest-rate risk exposure. The cost of these actions was partially offset by benefits related to certain derivative transactions entered into in late 1998 to hedge against the effect of rising interest rates on Freddie Mac’s funding costs. Throughout 1999, as some of these derivative transactions matured or were terminated, related gains were recognized in “Net interest income on earnA-25 ing assets.” These benefits are not expected to recur in 2000 since these derivatives contracts either matured or were terminated by the end of 1999. FTE net interest income totaled $2.091 billion in 1998 compared to $1.741 billion in 1997, while FTE net interest yield on earning assets was 0.88 percent and 0.94 percent for these same years, respectively. The increase in FTE net interest income from 1997 to 1998 was due primarily to a $52 billion, or 35 percent, increase in the average balance of the retained portfolio compared to 1997. The 6 basis-point decline in FTE net interest yield during 1998 was primarily due to lower initial spreads on new mortgage-related investments purchased during 1998, as well as an increased level of high-cost PC variance funding of interest-earning assets due to high mortgage prepayment levels that occurred in 1998 as a result of lowered interest rates. Interest income on mortgages does not include interest deemed uncollectible on non-performing mortgages. If nonperforming mortgages had been fully performing, they would have contributed an additional $13 million, $65 million and $111 million to net interest income in 1999, 1998 and 1997, respectively. Management and Guarantee Income “Management and guarantee income,” the fee Freddie Mac earns on Total PCs, increased to $1.405 billion in 1999, a $98 million, or 7 percent, increase from $1.307 billion in 1998. FREDDIE MAC This increase was due to a $100 billion, or 16 percent, increase in the average balance of Total PCs, partially offset by a 1.6 basis point decrease in the average guarantee fee rate compared to 1998. The average guarantee fee rate for 1999 continued to be affected by portfolio turnover, reflecting: (i) fee rates on new PC issuances typically below the average fee rate on the Total PC portfolio and (ii) liquidations of existing PC balances having comparatively higher fee rates. Lower average guarantee fee rates on new issuances primarily reflect increased competitive pressures, the continued use of credit enhancements on mortgage investments and changes in the mix of mortgage products purchased by Freddie Mac. The impact of portfolio turnover was diminished relative to 1998 due to slowing mortgage prepayments experienced in a rising mortgage interest-rate environment during 1999. As liquidation rates continue to slow, average guarantee fee rates will increasingly be influenced by product mix, the use of credit enhancements and the competitive environment (see “MARKET OVERVIEW” and “RISK MANAGEMENT—Credit Risk—Mortgage Credit Risk–Credit Risk Management—Credit Enhancements”). The $9 million, or 1 percent, increase in “Management and guarantee income” from 1997 to 1998 was due to a $44 billion, or 8 percent, increase in the average balance of Total PCs, partially offset by a 1.5 basis point decrease in the average guarantee fee rate. “Management and guarantee income” does not include interest deemed uncollectible on non-performing mortgages underlying the Total PC portfolio. If non-performing mortgages had been fully performing, they would have contributed an additional $4 million, $17 million and $30 million to “Management and guarantee income” in 1999, 1998 and 1997, respectively. Other Income, Net As presented in Table 17, the primary components of “Other income, net” include fees earned from resecuritization activity (fees paid by underwriters for Freddie Mac’s issuance and management of structured securitizations), gains and losses associated with certain investment-related activities and gains and losses from certain hedging transactions. Also included are fees earned by Freddie Mac primarily for automated underwriting (Loan Prospector) and electronic network (GoldWorks®) services that provide seller/servicers with easier access to the secondary mortgage market. Table 17 – Other Income, Net Year Ended December 31, (dollars in millions) 1999 1998 1997 Resecuritization fees Miscellaneous income, net(1) Total $ 64 46 $ 68 35 $103 $ 56 44 $100 $110 (1) Includes recognized gains (losses) on hedging transactions totaling $22 million, $(9) million, and $5 million for 1999, 1998, and 1997, respectively. “Other income, net” for 1999 increased $7 million compared to 1998 primarily as a result of gains from certain hedging transactions that must be reported in “Other income, net” rather than in “Net interest income on earning assets.” These gains were partially offset by losses on certain investment-related activities and, to a lesser extent, lower fees earned from resecuritization activity. “Other income, net” for 1998 increased $3 million compared to 1997. This increase was primarily attributable to a $12 million increase in resecuritization fees due to higher volumes of structured securitizations during 1998, partially offset by lower miscellaneous income, net, due to losses in 1998 associated with certain investment and hedging transactions. Credit-Related Expenses Credit-related expenses (which consist of the “Provision for mortgage losses” and “REO operations expense” ) decreased $183 million, or 54 percent, from $342 million in 1998 to $159 million in 1999, and decreased $187 million, or 35 percent, from 1997 to 1998. These decreases were due to both reductions in the “Provision for mortgage losses” and declines in “REO operations expense,” which were driven primarily by strengthening house prices (see “RISK MANAGEMENT— Credit Risk—Mortgage Credit Risk—Credit Performance”). The “Provision for mortgage losses” is charged against income in an amount considered appropriate to maintain the corporation’s reserve for mortgage losses at a level management deems adequate to absorb estimated losses incurred on the total mortgage portfolio. Administrative Expenses “Administrative expenses” increased $77 million, or 13 percent, from $578 million in 1998 to $655 million in 1999, and increased $83 million, or 17 percent, from 1997 to 1998. These increases were due primarily to continued investment in business process improvements, as well as costs related to the corporation’s year 2000 readiness efforts (see “OPERATIONAL AND OTHER RELATED RISKS—Year 2000 Risk”). The ratio of administrative expenses to revenues on a fully taxable equivalent basis declined to 15 percent in 1999 from 17 percent in 1998. Administrative expenses as a percentage of the average FREDDIE MAC A-26 total mortgage portfolio also declined to 8.1 basis points in 1999 from 8.5 basis points in 1998. Housing Tax Credit Partnerships The costs associated with Freddie Mac’s investment in housing tax credit partnerships totaled $80 million in 1999, a $19 million and $39 million increase from 1998 and 1997, respectively. Housing tax credit partnerships develop multifamily low-income rental properties. While these investments create operating losses, they also generate tax credits that reduce the corporation’s federal income tax liability. R E G U L AT O R Y M AT T E R S Capital Standards Under the Federal Housing Enterprises Financial Safety and Soundness Act of 1992 (the “GSE Act”), Freddie Mac and Fannie Mae are subject to certain minimum and risk-based capital standards issued by OFHEO. Until a final risk-based capital regulation has been issued and in effect for one year, the capital levels of Freddie Mac and Fannie Mae are to be classified only against the minimum capital standard. At December 31, 1999, Freddie Mac’s estimated minimum capital requirement, as reported to OFHEO, was $12.3 billion, up from $10.3 billion at December 31, 1998. At December 31, 1999, Freddie Mac’s core capital, which consists of the par value of outstanding common stock (common stock issued less common stock held in treasury), the redemption value of outstanding perpetual preferred stock, additional paid-in capital and retained earnings, as measured under generally accepted accounting principles, was $12.7 billion, up from $10.7 billion at December 31, 1998. Capital surplus, the excess of Freddie Mac’s regulatory core capital over the minimum capital requirement, was estimated at $405 million at December 31, 1999, up from $383 million at December 31, 1998. In its most recent classification, the Director of OFHEO classified Freddie Mac as “adequately capitalized,” OFHEO’s highest classification. See Note 8 to the Consolidated Financial Statements for further information regarding regulatory capital standards. The Director of OFHEO has issued a proposed regulation to implement the risk-based capital standard, which would set forth capital requirements using a stress test model. In early March 2000, Freddie Mac submitted to OFHEO detailed, written comments on the proposal. Freddie Mac commented that it believes the basic framework proposed by OFHEO is sound, but a number of changes in the components of the stress test are necessary in order to align capital to risk as envisioned in the GSE Act. The corporation’s comments in this regard included recommendations regarding the measurement of the benchmark for regional credit loss experience for single-family mortgages, single-family and multifamily credit risk and prepayment models, treatment of non-borrower credit risk, projection of the Treasury yield curve and non-Treasury interA-27 est rates, and assumptions as to refunding and operation expenses. The comments emphasized the importance of implementing the infrastructure systems and procedures, including treatment of new activities, that are needed to make the stress test operational and the proposal workable. Freddie Mac’s comments also identified options to make the implementation of the proposed regulation accurate, predictable and timely. Copies of those comments are available upon request. OFHEO has stated that, after it considers all of the comments submitted, it will determine whether to re-propose or to issue a final regulation. Freddie Mac believes that a reasonable implementation of the risk-based capital standard, when finalized, would be consistent with the corporation’s internal assessment of capital adequacy. Housing Goals The GSE Act requires the Secretary of HUD to establish three mortgage purchase goals for Freddie Mac and Fannie Mae: a goal for the purchase of mortgages on housing for low- and moderate-income borrowers (the “Low- and Moderate-Income Goal”); a goal for the purchase of mortgages on housing located in central cities, rural areas and other underserved areas (the “Underserved Areas Goal”); and a special affordable housing goal for the purchase of mortgages on housing for low-income borrowers in low-income areas and for very low-income borrowers, including purchases of multifamily mortgages (the “Special Affordable Goal”). In December 1995, the Secretary issued regulations establishing affordable housing goals for the years 1996 through 1999. The goals provide that 40 percent of the total number of dwelling units financed by the corporation’s mortgage purchases meet the Low- and Moderate-Income Goal in 1996 and 42 percent in each of 1997, 1998 and 1999; 21 percent of the total number of dwelling units financed by the corporation’s mortgage purchases meet the Underserved Areas Goal in 1996 and 24 percent in each of 1997, 1998 and 1999; and 12 percent of the total number of dwelling units financed by the corporation’s mortgage purchases meet the Special Affordable Goal in 1996 and 14 percent in each of 1997, 1998 and 1999, including a target of at least $988 million in qualifying multifamily mortgage purchases in each year from 1996 through 1999. Freddie Mac met the Low- and Moderate-Income Goal of 42 percent in 1999, with low- and moderate-income purchases of 46 percent. Freddie Mac also met the Underserved Areas Goal of 24 percent in 1999, with underserved areas purchases of 28 percent. Finally, Freddie Mac met the Special Affordable Goal of 14 percent in 1999, with special affordable purchases of 17 percent, and met the $988 million multifamily portion of this goal with $2.3 billion of qualifying multifamily mortgage purchases. On March 9, 2000, HUD published a proposed rule that would establish new housing goals for Freddie Mac and Fannie Mae for calendar years 2000 through 2003. Public comments regarding the rule must be submitted to HUD on or before sixty FREDDIE MAC days after the March publication date. Freddie Mac is examining the proposed rule and will provide HUD with detailed comments during the public comment period. The proposed rule would increase the Low- and Moderate-Income Goal from the current 42 percent to 48 percent in the year 2000, and to 50 percent in years 2001 through 2003; it would increase the Underserved Areas Goal from the current 24 percent to 29 percent in the year 2000, and to 31 percent in years 2001 through 2003; and it would increase the Special Affordable Goal from the current 14 percent to 18 percent in the year 2000, and to 20 percent in years 2001 through 2003. The proposed rule also would clarify HUD’s guidelines for counting different types of mortgage purchases toward the housing goals. The proposed rule may not be adopted as currently written. Management believes that if the proposed rule were adopted as currently written, it would not have a material adverse effect on Freddie Mac’s results of operations or financial condition. Management views the purchases of mortgages benefiting low- and moderate-income families and neighborhoods as an integral part of Freddie Mac’s mission and business, and remains committed to fulfilling the needs of underserved borrowers and markets. Accordingly, Freddie Mac expects that it will continue to purchase the majority of the single-family and multifamily mortgages counted toward its performance under the housing goals through its standard purchase programs. EFFECT OF NEW ACCOUNTING S TA N D A R D In June 1998, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” which Freddie Mac will implement on January 1, 2001. Management anticipates that the adoption of SFAS No. 133 may increase earnings volatility for the corporation. As a result, implementation strategies are currently being evaluated in order to develop effective solutions that are consistent with business fundamentals, mitigate earnings volatility and accommodate growth and change in risk management strategies. Further information regarding this new accounting standard is presented in Note 1 to the Consolidated Financial Statements. RECENT EVENTS Executive Vice President and Chief Financial Officer John P. Gibbons resigned from Freddie Mac, effective March 31, 2000. Vaughn A. Clarke, Senior Vice President of Finance, is serving as Chief Financial Officer while Freddie Mac conducts a search for a successor. TA X M AT T E R S In February 1997, Freddie Mac formed two real estate investment trust (“REIT”) subsidiaries that issued a total of $4 billion in step-down preferred stock to investors. Under IRS regulations in effect when the REITs were formed, dividend payments to holders of the REITs’ step-down preferred stock are tax deductible. In 1997, subsequent to the formation of Freddie Mac’s REIT subsidiaries, the U.S. Department of the Treasury (the “Treasury”) announced its intention to propose regulations that would effectively eliminate the tax advantages of REITs that issue step-down preferred stock. On January 5, 1999, the Treasury issued proposed regulations and, on January 7, 2000, issued final regulations generally consistent with those it had proposed. These regulations deny certain of the tax benefits attributable to Freddie Mac’s REIT preferred stock for tax years ending on or after February 27, 1997. Notwithstanding the issuance of the final regulations, the tax treatment of preferred stock dividends paid to investors in the REITs remains uncertain. Accordingly, Freddie Mac has elected not to treat such dividends as fully tax deductible in its Consolidated Financial Statements. This treatment is subject to change once uncertainties related to the tax treatment of such dividends are adequately clarified. The preferred stock is redeemable by the REITs under certain circumstances where changes in applicable tax law could adversely affect the tax treatment of the REITs or preferred stock. FREDDIE MAC A-28 Freddie Mac Five-Year Financial Highlights December 31, (dollars in millions, except per share amounts) 1999 1998 1997 1996 1995 Balance Sheet Retained portfolio Total assets Debt securities, net Total liabilities Capital base: Stockholders’ equity Reserve for mortgage losses(1) Primary capital base Subordinated borrowings Adjusted total capital base Total PCs Freddie Mac PCs held in the retained portfolio Primary capital ratio(2) Adjusted total capital ratio(3) Total mortgage portfolio $ $ $ $ 324,443 386,684 360,581 374,602 $ 255,009 $ 321,421 $ 287,234 $ 309,978 $ 10,835 768 11,603 162 $ 11,765 $ 646,459 $ 168,108 1.45% 1.47% $ 733,360 $ 288,338 2,396,651 $ 250,564 $ 135,162 $ 164,421 $ 194,597 $ 172,321 $ 186,154 7,521 694 8,215 521 $ 8,736 $ 579,385 $ 103,400 1.23% 1.30% $ 640,406 $ 121,490 1,085,046 $ 114,258 $ 84,366 $ $ $ $ $ $ 137,755 173,866 156,491 166,271 6,731 680 7,411 490 7,901 554,260 81,195 1.15% 1.22% 610,820 $ 107,424 $ 137,181 $ 119,328 $ 130,297 5,863 683 6,546 633 $ 7,179 $ 515,051 $ 56,006 1.10% 1.20% $ 566,469 $ 98,386 934,890 $ 85,877 $ 15,372 $ 29,643 (11,082) $ 18,561 $ $ $ $ $ $ $ 1,298 1,185 2,541 1,586 1,091 1.42 1.41 $ $ 11,525 772 12,297 130 $ 12,427 $ 749,081 $ 211,198 1.33% 1.34% $ 862,326 $ $ $ $ New Business Purchase and Financing Activities New business purchases $ 272,472 New business purchases (# of loans) 2,058,330 PC issuances $ 233,031 Structured securitizations(4) $ 119,565 Long-term debt: Issued $ 113,600 Retired (23,568) Net $ 90,032 Income Statement and Performance Ratios Net interest income on earning assets $ 2,540 Management and guarantee income $ 1,405 Total revenues $ 4,055 Income before income taxes and extraordinary item $ 3,161 Net income $ 2,223 Earnings per common share:(5) Basic $ 2.97 Diluted $ 2.96 Weighted average common shares outstanding(in thousands):(5) Basic 696,042 Diluted 700,211 Dividends per common share $ 0.60 Dividend payout ratio on common stock 20.14% Return on common equity(6)(9) 25.5% Return on total equity(7)(9) 20.3% Return on average assets and contingencies(8)(9) 0.26% Ratio of earnings to fixed charges(10) 1.16:1 Ratio of earnings to combined fixed charges and preferred stock dividends(10) 1.14:1 (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) $ 128,565 1,232,540 $ 119,702 $ 34,145 $ 63,789 $ 35,091 $ 33,852 (54,708) (22,091) (20,819) $ 9,081 $ 13,000 $ 13,033 $ $ $ $ $ $ $ 1,927 1,307 3,337 2,356 1,700 2.32 2.31 $ $ $ $ $ $ $ 1,631 1,298 3,029 1,964 1,395 1.90 1.88 $ $ $ $ $ $ $ 1,542 1,249 2,875 1,797 1,243 1.65 1.63 679,790 684,937 709,453 721,288 684,658 691,701 714,878 725,114 $ 0.48 $ 0.40 $ 0.35 $ 0.30 20.65% 21.08% 21.26% 21.09% 24.1% 23.3% 22.2% 21.9% 19.4% 19.5% 19.7% 19.7% 0.24% 0.21% 0.20% 0.20% 1.16:1 1.17:1 1.19:1 1.23:1 1.15:1 1.16:1 1.18:1 1.22:1 “Reserve for losses on retained mortgages” plus the “Reserve for losses on Mortgage Participation Certificates. ” “Primary capital base” divided by the sum of “Total assets” and “Total PCs” less “Freddie Mac PCs held in retained portfolio.” “Adjusted total capital base” divided by the sum of “Total assets” and “Total PCs” less “Freddie Mac PCs held in retained portfolio.” Includes issuances of mortgage-related securities in which the cash flows are structured into various classes having a variety of features, the majority of which qualify for treatment as Real Estate Mortgage Investment Conduits (“REMICs”) under the Internal Revenue Code. “Earnings per common share-basic” are computed based on weighted average common shares outstanding. “Earnings per common share-diluted” are computed based on the total of weighted average common shares outstanding and the effect of dilutive common equivalent shares outstanding. Annual computation reflects the simple average of quarterly returns. Quarterly returns are computed as annualized “Net income” less preferred stock dividends divided by the simple average of the beginning and ending balances of “Stockholders’ equity,” net of preferred stock (at redemption value). Annual computation reflects the simple average of quarterly returns. Quarterly returns are computed as annualized “Net income” divided by the simple average of the beginning and ending balances of “Stockholders’ equity.” Annual computation reflects the simple average of quarterly returns. Quarterly returns are computed as annualized “Net income” divided by the simple average of the beginning and ending balances of “Total assets” and “Total PCs” less “Freddie Mac PCs held in the retained portfolio.” In 1999, annual return computations were changed to reflect the simple average of quarterly returns. All prior years presented have been restated to reflect this change. Earnings represent consolidated pre-tax income plus consolidated fixed charges, less interest capitalized. Fixed charges include interest (including amounts capitalized) and the portion of net rental expense deemed representative of interest. A-29 FREDDIE MAC Freddie Mac Consolidated Statements of Income Year Ended December 31, (dollars in millions, except per share amounts) 1999 1998 1997 Interest income Mortgages Guaranteed mortgage securities Investments and securities purchased under agreements to resell Interest expense on debt securities Short-term debt Long-term debt Interest expense due to security program cycles Net interest income on earning assets Management and guarantee income Other income, net Total revenues Provision for mortgage losses REO operations expense Administrative expenses Housing tax credit partnerships Total non-interest expense Income before income taxes and extraordinary item Provision for income taxes Income before extraordinary item, net of taxes Extraordinary gain on retirement of debt, net of taxes Net income Preferred stock dividends Net income available to common stockholders Earnings per common share before extraordinary item Basic Diluted Earnings per common share Basic Diluted Weighted average common shares outstanding (thousands) Basic Diluted See accompanying Notes to Consolidated Financial Statements. $ 3,967 15,747 3,039 22,753 (2,199) (17,351) (19,550) (663) (20,213) 2,540 1,405 110 4,055 (60) (99) (655) (80) (894) 3,161 (943) 2,218 5 $ 2,223 (153) $ 2,070 $2.97 $2.95 $2.97 $2.96 696,042 700,211 $ 3,736 10,533 2,369 16,638 (4,037) (9,754) (13,791) (920) (14,711) 1,927 1,307 103 3,337 (190) (152) (578) (61) (981) 2,356 (656) 1,700 — $ 1,700 (121) $ 1,579 $2.32 $2.31 $2.32 $2.31 679,790 684,658 $ 3,439 7,591 1,971 13,001 (2,609) (8,291) (10,900) (470) (11,370) 1,631 1,298 100 3,029 (310) (219) (495) (41) (1,065) 1,964 (569) 1,395 — $ 1,395 (95) $ 1,300 $1.90 $1.88 $1.90 $1.88 684,937 691,701 FREDDIE MAC A-30 Freddie Mac Consolidated Balance Sheets December 31, (dollars in millions) 1999 1998 Assets Retained portfolio Mortgages Reserve for losses on retained mortgages Guaranteed mortgage securities (GMS) Purchase and sale premiums, discounts and deferred fees Net unrealized (loss) gain on available-for-sale securities Retained portfolio, net Cash and cash equivalents Investments Securities purchased under agreements to resell Accounts and trading receivables Real estate owned (REO), net Other assets Total assets Liabilities and Stockholders’ Equity Debt securities, net Due within one year Due after one year Total debt securities, net Principal and interest due to Mortgage Participation Certificate (PC) investors Other liabilities Reserve for losses on Mortgage Participation Certificates Guarantees Total Mortgage Participation Certificates (Total PCs) Less Underlying mortgages Subordinated borrowings Stockholders’ equity Preferred stock, at redemption value Common stock, $0.21 par value, 726,000,000 shares authorized, 725,882,280 shares issued Additional paid-in capital Retained earnings Net unrealized (loss) gain on certain investments reported at fair value, net of tax (benefit) expense of $(628) million and $64 million, respectively Treasury stock, at cost, 30,791,274 and 30,703,151 shares, respectively Total stockholders’ equity Total liabilities and stockholders’ equity See accompanying Notes to Consolidated Financial Statements. $ 56,676 (345) 56,331 267,767 51 (1,580) 322,569 5,144 31,747 4,961 18,635 438 3,190 $ 386,684 $ 57,084 (322) 56,762 197,925 525 136 255,348 2,565 44,753 1,756 14,580 574 1,845 $ 321,421 $ 175,525 185,056 360,581 7,334 6,687 374,602 427 749,081 (749,081) — 130 3,195 152 474 9,736 (1,166) (866) 11,525 $ 386,684 $ 193,871 93,363 287,234 19,441 3,303 309,978 446 646,459 (646,459) — 162 2,807 152 494 8,083 120 (821) 10,835 $ 321,421 A-31 FREDDIE MAC Freddie Mac Consolidated Statements of Stockholders’ Equity Year Ended December 31, 1999, 1998 and 1997 Additional Paid-In Capital Net Unrealized (Loss) Gain on Certain Investments Reported at Fair Value, Net of Taxes Treasury Total Stock Stockholders’ at Cost Equity Preferred Stock (dollars in millions) Common Stock Retained Earnings Balance, December 31, 1996 Net income Change in net unrealized (loss) gain on certain investments reported at fair value, net of taxes Comprehensive income Cash dividends declared: Preferred stock Common stock Common stock issuance Common stock repurchase Preferred stock issuance Preferred stock redemption Balance, December 31, 1997 Net income Change in net unrealized (loss) gain on certain investments reported at fair value, net of taxes Comprehensive income Cash dividends declared: Preferred stock Common stock Common stock issuance Common stock repurchase Preferred stock issuance Balance, December 31, 1998 Net income Change in net unrealized (loss) gain on certain investments reported at fair value, net of taxes Comprehensive income Cash dividends declared: Preferred stock Common stock Common stock issuance Common stock repurchase Preferred stock issuance Preferred stock redemption Balance, December 31, 1999 $ 1,400 $ 152 $ 75 $ 5,804 1,395 $ (12) $ (688) $ 6,731 1,395 158 158 1,553 (95) (274) 47 23 (604) (604) 750 (563) $ (1,245) $ 7,521 1,700 (95) (274) (24) 750 (563) $ 1,587 $ 152 $ 51 $ 6,830 1,700 $ 146 (26) (26) 1,674 (121) (326) 581 1,024 (157) (157) 1,220 $ (821) $ 10,835 2,223 (121) (326) 443 1,220 $ 2,807 $ 152 $ 494 $ 8,083 2,223 $ 120 (1,286) (1,286) 937 (153) (417) 47 27 (92) (92) 688 (300) $ (866) $11,525 (153) (417) (20) 688 (300) $ 3,195 $ 152 $ 474 $ 9,736 $(1,166) See accompanying Notes to Consolidated Financial Statements. FREDDIE MAC A-32 Freddie Mac Consolidated Statements of Cash Flows Year Ended December 31, (dollars in millions) 1999 1998 1997 Cash Flows From Operating Activities Net income $ 2,223 Adjustments to reconcile net income to net cash (used in) provided by operating activities: Amortization of mortgage purchase and sale premiums, discounts and deferred fees 106 Amortization of discounts on short-term debt 8,847 Amortization of discounts on long-term debt 354 Extraordinary gain on debt retirement (pre-tax) (8) Provision for mortgage losses 60 Provision for REO disposition losses 66 Net change in payables and receivables (13,155) (3,730) Purchases of mortgages (78,908) PC issuances under Cash Program 68,012 Net cash (used in) provided by operating activities (12,403) Cash Flows From Investing Activities Purchases of mortgage investments (103,982) Repayments of mortgage investments 44,403 Proceeds from sales of REO 1,111 Net decrease (increase) in investments 12,770 Net (increase) decrease in securities purchased under agreements to resell (3,205) Net cash used in investing activities (48,903) Cash Flows From Financing Activities Proceeds from issuance of short-term debt 1,677,833 Repayments of short-term debt (1,703,733) Proceeds from issuance of long-term debt 113,600 Repayments of long-term debt (23,568) Proceeds from issuance of preferred stock 688 Redemption of preferred stock (300) Proceeds from issuance of common stock 27 Repurchases of common stock (92) Payment of cash dividends on preferred and common stock (570) Net cash provided by financing activities 63,885 Net increase in cash and cash equivalents 2,579 Cash and cash equivalents at beginning of period 2,565 Cash and cash equivalents at end of period $ 5,144 Supplemental Cash Flow Information Cash paid for: Interest $ 19,193 Income taxes 1,249 Non-cash financing activities: PCs issued under Guarantor program 165,019 Structured Securitizations 119,565 Giant PCs issued 14,341 Transfers to REO 1,041 See accompanying Notes to Consolidated Financial Statements. A-33 $ 1,700 $ 109 6,710 283 — 190 90 269 7,651 (100,287) 83,452 (7,484) (132,206) 56,970 1,541 (31,329) 5,226 (99,798) 1,395 59 3,951 142 — 310 108 5,071 9,641 (42,906) 37,313 5,443 (43,693) 20,936 1,662 5,352 (542) (16,285) 2,104,501 1,777,300 (2,005,813) (1,778,533) 63,789 35,091 (54,708) (22,091) 1,220 750 — (563) 1,024 23 (157) (604) (447) (369) 109,409 11,004 2,127 162 438 276 $ 2,565 $ 438 $ 14,757 $ 299 167,112 135,162 46,708 1,483 10,824 487 76,945 84,366 61,845 1,684 FREDDIE MAC Freddie Mac Notes to Consolidated Financial Statements Note 1 Freddie Mac (or the “corporation”) is a stockholder-owned government-sponsored enterprise (“GSE”) established by Congress in 1970 to provide a continuous flow of funds for residential mortgages. Freddie Mac performs this function by purchasing single-family and multifamily residential mortgages and mortgagerelated securities in the secondary mortgage market. Freddie Mac uses two principal methods to finance its mortgage-related investments: mortgage securitization financing and debt financing. Each of these two methods of financing provides different sources and types of revenue for Freddie Mac and also exposes the corporation to different types and degrees of risk. The obligations of Freddie Mac are not insured or guaranteed by the United States or any agency or instrumentality of the United States. Under securitization financing, Freddie Mac securitizes purchased mortgages in the form of guaranteed mortgage passthrough securities (referred to as “Mortgage Participation Certificates” or “PCs”), which are issued in exchange for mortgages or sold to investors for cash. The portfolio of mortgages underlying PCs is an off-balance sheet contingency (referred to as “Total Mortgage Participation Certificates” or “Total PCs”). Through securitization, Freddie Mac increases the liquidity of, and assumes mortgage credit risk on, the mortgages underlying the PCs. As compensation for enhancing liquidity, assuming credit risk and administering principal and interest payments, Freddie Mac receives fee income that is recorded as “Management and guarantee income.” Guarantee fees are earned over the lives of the mortgages underlying PCs, providing Freddie Mac with a steady source of revenue. Freddie Mac generates fee-for-service revenue through other activities related to securitization financing. This includes fees earned from the resecuritization of PCs and other mortgage securities primarily into multiclass PCs that qualify as real estate mortgage investment conduits (“REMICs”) under Internal Revenue Service (“IRS”) regulations, or into single-class Giant PCs. Also included are fees earned from seller/servicers primarily for automated underwriting (Loan Prospector®) and electronic network (GoldWorks®) services that provide seller/servicers with easier access to the secondary mortgage market. Income generated from fee-forservice activities is recorded as part of “Other income, net.” In addition, income is earned through trading activities conducted by Freddie Mac’s Securities Sales and Trading Group and various external money managers in support of the market for Freddie Mac PCs. Income generated from trading activities is recorded as part of “Net interest income on earning assets” and “Other income, net.” In financing mortgage-related investments with debt, Freddie Mac issues a mixture of short-term debt, and long-term callable and non-callable debt. Freddie Mac principally issues debt securities to finance mortgage-related investments held in the retained portfolio. The corporation recognizes net interest income earned on the retained portfolio, which is the interest income earned on these investments less the interest expense on the interest-bearing liabilities funding them. The retained portfolio is comprised of unsecuritized “Mortgages” and “Guaranteed mortgage securities.” Guaranteed mortgage securities primarily consist of Freddie Mac PCs, and non-Freddie Mac mortgage-related securities that include securities from agencies such as the Government National Mortgage Association (“Ginnie Mae”), and securities collateralized by products such as home equity loans. Freddie Mac maintains a liquidity and contingency investment portfolio that is also financed principally by debt. This portfolio is used to manage recurring cash flows and meet other cash management needs, maintain capital reserves to meet mortgage funding needs, provide diverse sources of liquidity and help manage the interest-rate risk inherent in mortgage-related investments. The liquidity and contingency investment portfolio enables Freddie Mac to deploy fully its available capital and helps the corporation fulfill its purpose of providing a stable and reliable supply of mortgage credit nationwide. As with the retained portfolio, the corporation recognizes net interest income on the liquidity and contingency investment portfolio. Further information regarding Freddie Mac’s operating results, as segmented on the basis of the two methods by which it finances mortgage-related investments, is presented in Note 12. Freddie Mac’s financial reporting and accounting policies conform to generally accepted accounting principles (“GAAP”). The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Certain prior year amounts have been reclassified to conform to the current year presentation. The following is a summary of the corporation’s significant accounting policies. S U M M A RY O F SIGNIFICANT ACCOUNTING POLICIES FREDDIE MAC A-34 Consolidation The Consolidated Financial Statements include the accounts of the corporation and its majority-owned subsidiaries, Home Ownership Funding Corporation, Home Ownership Funding Corporation II and West*Mac Associates Limited Partnership (“West*Mac”). All material intercompany transactions have been eliminated in consolidation. Freddie Mac is the majority owner of two real estate investment trust (“REIT”) subsidiaries, Home Ownership Funding Corporation and Home Ownership Funding Corporation II which, in 1997, issued a total of $4 billion in step-down preferred stock to investors to finance the purchase of mortgage-related investments. The preferred stock ownership interest in the REIT subsidiaries is reported in “Debt securities, net,” and the related dividends paid by the REIT subsidiaries are reported in interest expense on long-term debt. West*Mac is the owner and developer of Freddie Mac’s corporate headquarters buildings. The interests of the minority partners in West*Mac are immaterial in relation to the Consolidated Financial Statements and are reported in “Other liabilities.” Mortgages and Guaranteed Mortgage Securities Freddie Mac classifies mortgages as held-for-investment and mortgage-related securities as held-to-maturity, and reports them at amortized cost when the corporation has the intent and ability to hold them to maturity. Mortgages that Freddie Mac does not intend to hold for investment are classified as held-for-sale and are reported at the lower of cost or market value as determined based on outstanding forward sale commitments or current market prices. Substantially all of the mortgages held-for-sale at December 31, 1999 and 1998 were subject to forward sale commitments. The lower of cost or market value is calculated based on the aggregate of all mortgages held-for-sale. Mortgage-related securities that Freddie Mac does not intend to hold to maturity are classified as available-for-sale and are reported at fair value, with unrealized gains and losses reported in “Stockholders’ equity” on a net-of-tax basis. Interest income on “Mortgages” and “Guaranteed mortgage securities” is recognized on an accrual basis unless the collection of interest income is considered doubtful. For single-family mortgages, estimates of uncollectible interest are based on statistical models. For multifamily mortgages, interest income is recognized on a cash basis when the mortgage is 90 days or more delinquent. PCs repurchased by Freddie Mac are included in the retained portfolio as “Guaranteed mortgage securities” and are also included in “Total PCs.” Guarantee fee income on these PCs is recorded as part of “Management and guarantee income.” The total mortgage portfolio consists of Total PCs, net of PCs held in the retained portfolio plus the retained portfolio. Securitization and Resecuritization Activity Freddie Mac sells or issues single-class PCs representing undivided interests in conforming single-family and multifamily mortgages through the securitization process. From securitization, Freddie Mac recognizes fee income over the lives of the underlying mortgages as “Management and guarantee income.” Freddie Mac also resecuritizes PCs and other mortgage securities primarily into REMICs or Giant PCs. A majority of the fees received from issuing REMICs and Giant PCs is recognized as “Other income, net” in the period the fees are received. The remaining portion, which is equal to the estimated future costs of managing the REMICs or Giant PCs, is deferred and amortized over the weighted average lives of the securities to “Other income, net.” Purchase and Sale Premiums, Discounts and Deferred Fees Purchase and sale premiums and discounts arise when Freddie Mac purchases mortgage-related investments and issues PCs at a price above or below the par amount. Generally included are purchase and sale premiums and discounts related to the purchase and securitization of mortgages, and which primarily represent interestonly (“IO”)-like assets. Also included are purchase discounts and premiums on principal-only (“PO”) stripped securities and other mortgage-related investments. Deferred fees result primarily from various credit enhancements associated with PC issuances. “Purchase and sale premiums, discounts and deferred fees” are amortized principally to interest income on the retained portfolio over the estimated weighted average lives of the underlying mortgages using the effective interest method. The corporation uses actual prepayment experience and estimates of future prepayments to determine the constant yield needed to apply the effective A-35 FREDDIE MAC interest method. Weighted average life estimates and the rate of amortization are periodically reviewed and revised, as necessary, to reflect changes in expected prepayment rates. IO-like assets are subject to significant prepayment risk, which is largely mitigated by PO stripped securities held in the retained portfolio. These PO and IO-like assets are reported at estimated fair value, with unrealized gains and losses reported in “Stockholders’ equity” on a net-of-tax basis. Reserve for Mortgage Losses Management maintains the corporation’s “Reserve for losses on retained mortgages” and “Reserve for losses on Mortgage Participation Certificates” (collectively, “Reserve for mortgage losses”) at levels it deems adequate to absorb estimated losses incurred on the total mortgage portfolio. Reserves are increased through periodic provisions charged to expense and decreased by charge-offs, net of recoveries. Charge-offs are recognized when a mortgage is modified in a troubled debt restructuring or foreclosed, and are equal to the cost basis of the mortgage less the fair value of the mortgage or property acquired. In estimating losses incurred on the single-family mortgage portfolio, management utilizes a statistically based model that evaluates numerous factors including, but not limited to, general and regional economic conditions, expected future default experience and mortgage collateral values. Multifamily mortgages are individually evaluated for losses, with reserves established to cover collateral deficiencies based on the current fair value of the underlying properties, less estimated costs to sell and repair the properties and/or remove hazardous conditions. Management also considers uncertainties related to estimations in the reserve setting process. Cash and Cash Equivalents Freddie Mac considers highly liquid investment securities, generally with original maturities of three months or less and used for cash management purposes, to be cash equivalents. Cash equivalents are reported at cost, which approximates their fair value. Investments All investment securities were classified as either available-for-sale or trading at December 31, 1999 and 1998. Available-for-sale securities are reported at fair value, with unrealized gains and losses reported in “Stockholders’ equity” on a net-of-tax basis. Securities held for trading purposes are reported at fair value, with unrealized gains and losses reported in current period income. Interest income on investments is recognized on an accrual basis unless the collection of interest income is considered doubtful, in which case interest income is recognized on a cash basis. Real Estate Owned Real estate owned (“REO”) is carried at the lower of cost or fair value less estimated selling costs. Accordingly, provisions for estimated REO selling costs and for losses occurring subsequent to foreclosure due to changes in the fair value of the property are recognized through the REO valuation allowance, with a corresponding charge to “REO operations expense.” REO-related expenses incurred and income earned during the holding period are also included as part of “REO operations expense.” Debt Securities Debt securities are classified on the Consolidated Balance Sheets as either “Due within one year” or “Due after one year” based on their contractual maturity. Interest expense on debt securities is classified on the Consolidated Statements of Income as either short-term or long-term, based on the effective repricing dates when the debt securities are issued, giving effect to derivative financial instruments linked to contractual debt. Debt securities denominated in a foreign currency are translated into U.S. dollars using foreign exchange spot rates as of the date of the balance sheet. Interest expense amounts are translated into U.S. dollars using the average foreign exchange spot rate during the year. Gains and losses resulting from the translation of assets and liabilities are recorded in “Other income, net.” The corporation uses foreign currency swaps to hedge against the risk of changes in foreign currency exchange rates. FREDDIE MAC A-36 Debt issuance costs are deferred and amortized using the effective interest method over the period during which the related indebtedness is outstanding or, for callable debt, the period during which the related indebtedness is expected to be outstanding. Security Program Variances Timing differences between Freddie Mac’s receipt of principal and interest payments from seller/servicers and subsequent passthrough to PC investors results in the liability “Principal and interest due to Mortgage Participation Certificate (PC) investors” (“P&I due”). P&I due balances arising from the passthrough of prepaid mortgages are interest-bearing at the PC coupon rate from the date of prepayment until the date the PC security balance is reduced, and non-interest bearing from the date the PC security balance is reduced to the date of payment to the PC investor. Interest expense resulting from P&I due balances is reported as “Interest expense due to security program cycles,” and is recognized over the period between the date of prepayment and the date of payment to the PC investor, consistent with the corresponding period during which investment income is earned on the prepayment proceeds. Income Taxes Freddie Mac uses the asset and liability method of accounting for income taxes. Under the asset and liability method, deferred tax assets and liabilities are recognized based upon the expected future tax consequences of existing temporary differences between the financial reporting and the tax reporting basis of assets and liabilities using enacted statutory tax rates. To the extent tax rates change, deferred tax assets and liabilities are adjusted in the period the tax change is enacted. Deferred tax expense represents the net change in the deferred tax asset or liability balance during the year. This amount, together with income taxes payable for the current year, represents the total “Provision for income taxes” for the year. Derivative Financial Instruments Freddie Mac enters into derivative financial instruments as an end user and not for trading or speculative purposes. These instruments are combined with underlying liabilities or assets to synthetically create debt instruments or interest-earning assets that achieve lower effective financing costs or higher effective asset yields than those available on alternative instruments. Derivative financial instruments also are used to reduce the corporation’s exposure to interest-rate and/or foreign currency risk. When derivative financial instruments meet specific criteria, they are accounted for either as synthetic instruments or as hedges. When these financial instruments fail to meet such criteria, they are reported at fair value, with related gains or losses reported in “Other income, net.” Interest-Rate Contracts: Synthetic instrument accounting is applied to interest-rate contracts (which include interest-rate swaps, caps, floors and corridors) when the contract has been entered into, purchased or sold with the express intent of synthetically altering the characteristics of an underlying financial instrument. Interest-rate contracts may alter the interest rate, call feature or maturity date of the related asset or liability. When used for this purpose, the net differential received or paid under interest-rate contracts is recognized on an accrual basis as an adjustment to interest income or expense on the associated assets or liabilities. Net premiums paid for interest-rate contracts are deferred and amortized to interest income or expense over the terms of the contracts. Gains and losses on terminated interest-rate contracts are deferred and amortized over the remaining effective lives of the related underlying assets or liabilities. Freddie Mac also enters into interest-rate contracts to hedge against the adverse effects of movements in interest rates on existing debt or on anticipated issuances of debt. Gains and losses from these derivative transactions that are designated as hedges are deferred and, upon termination of these transactions, are amortized as adjustments to interest expense over the life of the underlying debt. A-37 FREDDIE MAC Futures: Freddie Mac enters into futures contracts to hedge against the adverse effects of movements in interest rates on existing debt or on anticipated issuances of debt. Futures contracts are exchange-traded agreements. All changes in the value of open futures contracts are settled in cash on a daily basis. Gains and losses from these derivative transactions that are designated as hedges are deferred and, upon termination of these transactions, are amortized as adjustments to interest expense over the life of the underlying debt. Options: Freddie Mac enters into options to hedge against the adverse effects of movements in interest rates on existing debt or on anticipated issuances of debt. The net option premium paid is deferred and amortized to interest expense over the life of the option. Intrinsic value gains or losses (representing the amount in excess of the strike price of the related option) from these derivative transactions that are designated as hedges are deferred and, upon termination of these transactions, are amortized as adjustments to interest expense over the life of the underlying debt. All other gains or losses associated with the terminated derivative transactions are recorded in “Other income, net.” Treasury-Based Contracts: Freddie Mac enters into non-exchange traded contracts using U.S. Treasury securities to hedge against the adverse effects of movements in interest rates on existing debt or on anticipated issuances of debt. Gains and losses from these derivative transactions that are designated as hedges are deferred and, upon termination of these transactions, are amortized as adjustments to interest expense over the life of the underlying debt. Foreign Currency Swaps: Synthetic instrument accounting is applied to foreign currency swaps that are entered into in conjunction with the purchase of assets or issuance of debt denominated in a foreign currency and that offset the foreign currency risk associated with such assets or debt. The net differential received or paid under foreign currency swaps is recognized on an accrual basis as an adjustment to interest income or expense on the related assets or debt. The net receivable or payable balances for each currency swap are presented in either “Other assets” or “Other liabilities.” All assets and liabilities denominated in a foreign currency are translated into U.S. dollars using foreign exchange spot rates as of the date of the balance sheet. Interest income and expense amounts are translated into U.S. dollars using the average foreign exchange spot rate during the year. Gains and losses resulting from the translation of assets and liabilities are recorded in “Other income, net.” Earnings Per Common Share “Earnings per common share-basic” are computed as net income available to common stockholders divided by the weighted average common shares outstanding (“Weighted average common shares outstanding-basic”) for the period. “Earnings per common share-diluted” are computed as net income available to common stockholders divided by the total of weighted average common shares outstanding and the effect of dilutive common equivalent shares outstanding (“Weighted average common shares outstanding-diluted”) for the period. Dilutive common equivalent shares reflect the assumed issuance of additional common shares pursuant to certain of the corporation’s stock-based compensation plans (see Note 8) that could potentially reduce or “dilute” earnings per share, based on the treasury stock method. Table 1.1 provides a reconciliation of “Weighted average common shares outstanding-basic” to “Weighted average common shares outstanding-diluted.” Table 1.1 Year Ended December 31, (shares in thousands) 1999 1998 1997 Weighted average common shares outstanding-basic Effect of dilutive common equivalent shares outstanding Weighted average common shares outstanding-diluted 696,042 4,169 700,211 679,790 4,868 684,658 684,937 6,764 691,701 FREDDIE MAC A-38 Comprehensive Income Comprehensive income represents net income plus other components of comprehensive income which, for Freddie Mac, include those changes in the fair value of certain investments that are currently reported as “Net unrealized (loss) gain on certain investments reported at fair value” in “Stockholders’ equity.” Table 1.2 presents the components of the change in the fair value of these investments. Table 1.2 Year Ended December 31, (dollars in millions) 1999 1998 1997 Net unrealized (losses) gains arising during the period, net of tax (benefit) expense of $(702) million, $(11) million and $82 million, respectively Reclassification of net realized losses (gains) to income, net of tax (expense) benefit of $9 million, $(3) million, and $3 million, respectively Change in net unrealized (loss) gain on certain investments reported at fair value, net of tax (benefit) expense $ (1,303) $ (20) $ 153 17 $ (1,286) (6) $ (26) 5 $ 158 Consolidated Statements of Cash Flows The Consolidated Statements of Cash Flows include supplemental cash flow information related to Freddie Mac’s non-cash financing transactions involving the securitization of mortgages, resecuritization of existing PCs and foreclosure on defaulted mortgages. Non-cash financing transactions related to mortgage securitization and PC resecuritization include: (i) the exchange of mortgages with a seller for a like amount of PCs (“Guarantor Program”); (ii) the exchange of existing single-class PCs with a seller for a like amount of multiclass PCs, backed by the identical single-class PCs (“REMIC Program”) and (iii) the exchange of existing Freddie Mac PCs with a seller for an interest in a Freddie Mac PC backed by a group of PCs (“Giant PC Program”). Newly Issued Accounting Pronouncement In June 1998, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 133, “Accounting for Derivative Instruments and Hedging Activities.” SFAS No. 133 supersedes all previous accounting and reporting standards for derivative financial instruments and hedging activities. The new standard requires all derivative financial instruments (including certain derivatives embedded in other financial instruments) to be recorded on the balance sheet as either assets or liabilities measured at their fair value. Specifically, for a derivative financial instrument qualifying as a hedge of the fair value of a fixed-rate instrument, fair value gains or losses on the derivative are to be reported in income, along with offsetting fair value losses or gains on the hedged instrument attributable to the risk being hedged. For a derivative financial instrument qualifying as a hedge of the cash flows associated with a variable-rate instrument or an anticipated transaction, fair value gains or losses on the derivative are to be reported as an adjustment to “Stockholders’ equity” as a component of other comprehensive income, and recognized in income over the period or periods during which the hedged instrument or anticipated transaction affects income. For a derivative financial instrument not qualifying as a hedge, fair value gains and losses on the derivative are to be reported in income. In May 1999, the FASB voted to delay the implementation date of this accounting standard for one year, changing Freddie Mac’s SFAS No. 133 implementation date to January 1, 2001. The cumulative effects of this implementation will be reported as a change in accounting principle. Management is continuing to assess the potential impact of this accounting standard on the corporation’s reported results of operations and financial position. A-39 FREDDIE MAC Note 2 M O RT G A G E S AND The retained portfolio includes “Mortgages” and “Guaranteed mortgage securities,” which are comprised of Freddie Mac PCs and non-Freddie Mac mortgage-related securities. Table 2.1 summarizes the mortgages and mortgagerelated securities in the retained portfolio by mortgage product type. Table 2.1 December 31, (dollars in millions) 1999 G UA R A N T E E D M O RT G A G E SECURITIES 1998 Mortgages and Freddie Mac PCs Single-family: 30-year fixed-rate(1) 15-year fixed-rate ARMs/floating-rate Balloon/resets Multifamily Total mortgages and Freddie Mac PCs Non-Freddie Mac Securities(2) Fixed-rate ARMs/floating-rate Total non-Freddie Mac securities Total retained portfolio(3) $ 200,137 50,989 3,162 1,231 12,355 267,874 42,626 13,943 56,569 $ 324,443 $ 168,788 43,276 2,999 2,151 7,978 225,192 22,982 6,835 29,817 $ 255,009 (1) Includes 20-year fixed-rate mortgages, second mortgages and mobile home loans. (2) Non-Freddie Mac securities held in the retained portfolio are categorized based upon the product type of the mortgage collateral underlying the security. (3) Excludes related unamortized purchase and sale premiums, discounts and deferred fees, reserve for losses on retained mortgages, and net unrealized (loss) gain on available-for-sale guaranteed mortgage securities. Table 2.2 summarizes the mortgage-related securities included in “Guaranteed mortgage securities” by security product type. Table 2.2 December 31, (dollars in millions) 1999 1998 Freddie Mac PCs Non-Freddie Mac securities: Agency securities Non-agency securities: Home equity Commercial mortgage-backed securities Mortgage revenue bonds Manufactured housing Other mortgage-related securities Total non-Freddie Mac securities Total guaranteed mortgage securities(1) $ 211,198 19,860 13,808 7,822 5,690 4,693 4,696 56,569 $ 267,767 $ 168,108 8,207 5,923 6,592 4,640 1,711 2,744 29,817 $ 197,925 (1) Excludes related unamortized purchase and sale premiums, discounts and deferred fees and net unrealized (loss) gain on available-for-sale guaranteed mortgage securities. FREDDIE MAC A-40 At December 31, 1999 and 1998, the retained portfolio included $0.6 billion and $3.3 billion, respectively, of mortgages held-for-sale. The fair value of mortgages held-for-sale at December 31, 1999 and 1998 approximated their carrying value. Table 2.3 summarizes the estimated fair value and corresponding gross unrealized gains and losses for mortgage-related securities held in the retained portfolio. Table 2.3 December 31, 1999 1998 Gross Gross Amortized Unrealized Unrealized Estimated Cost Gains Losses Fair Value(1) Gross Gross Amortized Unrealized Unrealized Estimated Cost Gains Losses Fair Value(1) (dollars in millions) Held-to-maturity Available-for-sale(2) Total $218,977 $ 258 $ (9,291) $ 209,944 49,008 195 (1,797) 47,406 $267,985 $ 453 $(11,088) $ 257,350 $171,830 $ 2,177 $(1,052) $172,955 26,756 503 (361) 26,898 $198,586 $ 2,680 $(1,413) $199,853 (1) Estimated fair value includes the fair value of asset-linked derivative financial instruments which totaled $(3) million and $(145) million at December 31, 1999 and 1998, respectively (see Notes 9 and 13). (2) Includes IO-like assets and certain related amounts reported in “Purchase and Sale Premiums, Discounts and Deferred Fees.” At December 31, 1999 and 1998, “Stockholders’ equity” included net unrealized (losses) gains on available-for-sale mortgage-related securities, net of tax, totaling $(1.040) billion and $93 million, respectively. In 1999, 1998 and 1997, Freddie Mac sold $1.214 billion, $227 million and $202 million, respectively, of mortgage-related securities from its available-for-sale portfolio, resulting in net realized gains (losses) included in income of $0.5 million ($0.3 million, net of tax), $5.4 million ($3.5 million, net of tax) and $(0.8) million [$(0.5) million, net of tax], respectively. The cost basis of the available-for-sale securities sold was determined using the specific identification method. Note 3 Freddie Mac maintains a “Reserve for losses on retained mortgages” and a “Reserve for losses on Mortgage Participation Certificates” (collectively, “Reserve for mortgage losses”) to provide for estimated losses incurred on the total mortgage portfolio. Table 3.1 summarizes the activity in the “Reserve for mortgage losses.” Table 3.1 Year Ended December 31, (dollars in millions) 1999 R E S E RV E F O R M O RT G A G E LOSSES 1998 1997 Beginning balance Provision Charge-offs, net of recoveries Ending balance $ 768 60 (56) $ 772 $ 694 190 (116) $ 768 $ 680 310 (296) $ 694 A-41 FREDDIE MAC The “Reserve for mortgage losses” consists of a general reserve and a specific valuation allowance related to impaired loans. The population of impaired loans includes multifamily loans for which it is probable that the corporation will not receive all amounts contractually due, as well as all troubled debt restructurings (both singlefamily and multifamily). The corporation’s recorded investment in impaired loans and the related valuation allowance are summarized in Table 3.2. Table 3.2 December 31, Recorded Investment (dollars in millions) 1999 1998 Net Investment Valuation Allowance Recorded Investment Valuation Net Allowance Investment Impaired loans with: Related valuation allowance No related valuation allowance Total $ 62 545 $ 607 $(11) — $(11) $ 51 545 $ 596 $ 90 611 $ 701 $ (17) — $ (17) $ 73 611 $ 684 For the years ended December 31, 1999, 1998 and 1997, the average recorded investment in impaired loans was $655 million, $806 million and $952 million, respectively. Interest income recognized on impaired loans was approximately $48 million, $53 million and $66 million for the years ended December 31, 1999, 1998 and 1997, respectively. Interest income on troubled debt restructurings is recognized on an accrual basis. Interest income on other impaired loans is recognized on a cash basis. Note 4 Table 4.1 summarizes the amortized cost and carrying value of the liquidity and contingency investment portfolio. The remaining contractual maturities of available-for-sale investments are summarized in Table 4.2. Table 4.1 December 31, 1999 INVESTMENTS 1998 Gross Gross Amortized Unrealized Unrealized Carrying Cost Gains Losses Value(1) Gross Gross Amortized Unrealized Unrealized Carrying Cost Gains Losses Value(1) (dollars in millions) Obligations of states and municipalities $ 3,530 Asset-backed securities 10,387 Corporate debt securities 3,344 Treasury securities — Auction-rate preferred stock 629 Other available-for-sale securities 127 Total available-for-sale investments $18,017 Mortgage-related securities held for trading purposes(2) Federal funds sold Eurodollar time deposits Commercial paper Accrued interest receivable Total investments $1 2 1 — 1 — $5 $ (18) $ 3,513 $ 2,834 (84) 10,305 7,144 (95) 3,250 3,493 — — 355 (2) 628 1,471 — $(199) 127 17,823 2,556 7,125 3,420 666 157 $ 31,747 121 $15,418 $ 9 13 53 2 8 — $ 85 $ (1) $ 2,842 (33) 7,124 (9) 3,537 — 357 — 1,479 — $ (43) 121 15,460 4,349 6,571 13,953 4,258 162 $ 44,753 (1) The carrying value for available-for-sale investments and mortgage-related securities held for trading purposes represents their estimated fair value. Estimated fair value includes the fair value of asset-linked derivative financial instruments which totaled $5 million and $(3) million at December 31, 1999 and 1998 (see Notes 9 and 13). The carrying value for Federal funds sold, Eurodollar time deposits, commercial paper and accrued interest receivable is amortized cost. (2) Net trading gains totaled $21 million and $23 million for the years ended December 31, 1999 and 1998, respectively. FREDDIE MAC A-42 Table 4.2 December 31, Amortized Cost (dollars in millions) 1999 1998 Estimated Fair Value Amortized Cost Estimated Fair Value Due within one year Due after one year through five years Due after five years through 10 years Due after 10 years Asset-backed securities(1) Total $ 528 3,673 1,464 1,965 7,630 10,387 $ 18,017 $ 527 3,636 1,406 1,949 7,518 10,305 $ 17,823 $ 1,910 2,649 2,090 1,625 8,274 7,144 $ 15,418 $ 1,917 2,665 2,124 1,630 8,336 7,124 $ 15,460 (1) The contractual maturities of asset-backed securities may not represent their expected lives as obligations underlying these securities may be prepaid at any time without penalty. At December 31, 1999 and 1998, “Stockholders’ equity” included net unrealized (losses) gains on available-for-sale investments, net of tax, totaling $(126) million and $27 million, respectively. In 1999, 1998 and 1997, Freddie Mac sold approximately $58 billion, $12 billion and $1 billion respectively, of availablefor-sale investments, resulting in net realized (losses) gains included in income of $(27) million [$(17) million, net of tax], $3 million [($2 million, net of tax)], and $(6) million, [$(4) million, net of tax], respectively. Note 5 SECURITIES P U RC H A S E D UNDER AGREEMENTS TO R E S E L L Securities purchased under agreements to resell (reverse repurchase agreements) are effectively collateralized lending transactions in that Freddie Mac purchases a security with an agreement to sell back exactly the same security. Table 5.1 summarizes information regarding the balances and maturities of reverse repurchase agreements. Table 5.1 1999 1998 (dollars in millions) Average outstanding balance during the year Maximum month-end outstanding balance Due within one year Due after one year through five years Balance, December 31 $ 5,182 $ 4,961 $ 4,951 10 $ 4,961 $ 5,736 $ 4,997 $ 1,693 63 $ 1,756 The amount that a Freddie Mac customer can borrow under a reverse repurchase agreement is generally limited to a maximum of 97 percent of the initial fair value of the securities collateralizing the agreement, depending on the type of collateral and/or the credit quality of the customer. The master agreements governing reverse repurchase agreement transactions provide for the delivery of securities collateralizing the agreements to Freddie Mac (or its custodian bank) and provide that Freddie Mac has the right to sell the collateral in the event of borrower default. All reverse repurchase agreements permit Freddie Mac to obtain additional collateral as margin if the fair value of the securities subject to the reverse repurchase agreement declines. As Freddie Mac does not maintain control over securities received as collateral, these securities are not recorded as assets on the Consolidated Balance Sheets. A-43 FREDDIE MAC Note 6 Table 6.1 provides a summary of Freddie Mac’s REO activity. Table 6.1 R E A L E S TAT E OW N E D REO, Gross (dollars in millions) Valuation Allowance REO, Net Balance, December 31, 1996 Additions Dispositions and write-downs Balance, December 31, 1997 Additions Dispositions and write-downs Balance, December 31, 1998 Additions Dispositions and write-downs Balance, December 31, 1999 Note 7 892 1,684 (1,786) 790 1,483 (1,641) 632 1,041 (1,185) $ 488 $ $ (84) (108) 124 (68) (90) 100 (58) (66) 74 $ (50) 808 1,576 (1,662) 722 1,393 (1,541) 574 975 (1,111) $ 438 $ DEBT SECURITIES AND S U B O R D I N AT E D B O R ROW I N G S Contractual Debt Table 7.1 provides information relating to debt securities and subordinated borrowings. Table 7.2 provides additional information related to amounts with original maturities of one year or less. Table 7.1 December 31, Balance, Net(1) (dollars in millions) 1999 1998 Effective Rate(2) Balance, Net(1) Effective Rate(2) Due within one year: Discount notes, medium-term notes and securities sold under agreements to repurchase Current portion of long-term debt Total due within one year Due after one year(3) Total $ 166,203 9,322 175,525 185,186 $ 360,711 5.42% 6.28% 5.47% 6.24% $ 183,256 10,615 193,871 93,525 $ 287,396 5.11% 6.38% 5.18% 6.58% (1)Net of unamortized discounts and hedging gains totaling $21.2 billion and $16.4 billion at December 31, 1999 and 1998, respectively. (2)Represents the weighted average effective rate at the end of the period, and includes the amortization of discounts or premiums, hedging gains or losses and debt issuance costs. (3)Includes subordinated borrowings of $130 million (8.93 percent effective rate) and $162 million (8.98 percent effective rate) at December 31, 1999 and 1998, respectively, net of unamortized discounts and fees totaling $0.4 billion at December 31, 1999 and 1998. FREDDIE MAC A-44 Table 7.2 1999 Balance, Net (dollars in millions) Average Balance Outstanding During the Year Effective Rate Maximum Balance Outstanding at Any Month End Discount notes Medium-term notes Securities sold under agreements to repurchase Total $ 157,439 8,764 — $ 166,203 $ 167,595 7,524 401 $ 175,520 5.41% 5.73% — 5.42% 1998 $ 176,118 10,002 1,283 Balance, Net (dollars in millions) Average Balance Outstanding During the Year Effective Rate Maximum Balance Outstanding at Any Month End Discount notes Medium-term notes Securities sold under agreements to repurchase Total $ 172,979 9,572 705 $ 183,256 $ 119,113 7,819 568 $ 127,500 5.09% 5.38% 5.64% 5.11% $ 174,192 9,571 2,213 Discount notes and medium-term notes are unsecured general obligations of Freddie Mac. Securities sold under agreements to repurchase are effectively collateralized borrowing transactions in that Freddie Mac sells PCs with an agreement to repurchase PCs that are substantially the same. These agreements require the underlying PCs to be delivered to the dealers who arranged the transactions. Subordinated borrowings, which are reported net of their unamortized discount, consist of capital debentures and zero-coupon capital debentures that are subordinate to all obligations of Freddie Mac, including obligations of others that have been guaranteed by Freddie Mac, whether existing at the date of issuance or thereafter. A significant portion of Freddie Mac’s long-term debt is callable. Callable debt gives Freddie Mac the option to redeem the debt security in whole or in part at either a specified call date or at any time on or after a specified call date. Table 7.3 summarizes the maturities, balances and effective interest rates at December 31, 1999 for callable debt by call period. Table 7.3 Call Period Inception Date (dollars in millions) Maturity Balance, Net of Discount Effective Rate 2000 2001 2002 2003 2004 Thereafter Total 2000-2028 2001-2029 2002-2029 2003-2019 2004-2022 2005-2029 $ 80,779 14,404 6,497 2,367 411 2,411 $ 106,869 6.31% 6.78% 6.84% 6.61% 7.20% 7.24% 6.44% A-45 FREDDIE MAC Table 7.4 summarizes the contractual maturities of short- and long-term debt securities and subordinated borrowings outstanding at December 31, 1999, assuming callable debt is (i) paid at scheduled maturity and (ii) redeemed at the initial call date. Table 7.4 Scheduled Maturity (dollars in millions) Assuming Callable Debt is Redeemed at Initial Call Date 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Thereafter Total $ 172,250 27,431 19,108 16,774 30,145 5,800 10,524 4,039 22,821 29,858 21,961 $ 360,711 $ 251,199 29,365 17,874 8,086 13,608 769 2,339 2,418 12,928 15,755 6,370 $ 360,711 In 1999, the corporation extinguished $821 million of debt prior to its scheduled maturity. As a result, Freddie Mac recognized extraordinary net gains totaling $8 million ($5 million, net of tax), or $0.01 basic and diluted earnings per common share in 1999. Synthetic Debt A significant portion of Freddie Mac’s debt financing is executed in conjunction with debt-linked derivative financial instruments (see Note 9). Debt-linked derivative financial instruments, when combined with the underlying debt instruments, synthetically create debt instruments that achieve lower effective financing costs than those available on alternative instruments, and/or reduce the corporation’s exposure to interest-rate risk. Debt-linked derivative financial instruments effectively convert short-term debt to long-term fixed-rate debt, or convert long-term fixed-rate debt to short-term debt, as illustrated in Table 7.5. Table 7.5 December 31, (dollars in millions) 1999 1998 Debt securities due within one year Fixed-rate debt due within one year Floating-rate long-term debt Derivative financial instruments converting short-term to long-term, net Effective short-term debt Effective rate Debt securities due after one year(1) Fixed-rate debt due within one year Floating-rate long-term debt Derivative financial instruments converting short-term to long-term, net Effective long-term debt Effective rate (1) Includes subordinated borrowings. $ 175,525 $ 193,871 (9,322) (10,615) — 640 (139,332) (99,243) $ 26,871 $ 84,653 5.64% 5.25% $ 185,186 $ 93,525 9,322 10,615 — (640) 139,332 99,243 $ 333,840 $ 202,743 6.11% 6.22% FREDDIE MAC A-46 Table 7.6 summarizes the effective maturity and the earliest effective repricing date of synthetic short- and longterm debt securities and subordinated borrowings outstanding at December 31, 1999. Table 7.6 Effective Maturity (dollars in millions) Earliest Effective Repricing Date 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Thereafter Total $ 57,660 41,950 34,134 36,227 50,987 9,864 12,021 3,259 31,622 57,940 25,047 $ 360,711 $ 136,791 45,937 35,550 27,977 35,859 1,993 3,934 8,827 18,414 37,837 7,592 $ 360,711 Note 8 S TO C K H O L D E R S ’ E QU I T Y Common Stock In November 1998, Freddie Mac sold 17.1 million shares of common stock from its treasury. The stock was sold at a price of $58.625 per share, resulting in net proceeds to Freddie Mac of $975 million. These shares were sold in an underwritten public offering. Costs incurred in connection with the issuance of common stock are charged to “Additional paid-in capital.” Preferred Stock Freddie Mac issued 3.0 million shares of 5.1% preferred stock on March 19, 1999, 5.0 million shares of 5.79% preferred stock on July 21, 1999 and 5.75 million shares of variable-rate preferred stock on November 5, 1999. All 11 classes of preferred stock outstanding at December 31, 1999 have a par value of $1 per share, and are redeemable (on specified dates) at the corporation’s option at their redemption price (or redemption value) plus dividends accrued through the redemption date. In addition, all 11 classes of preferred stock are perpetual and non-cumulative, and carry no significant voting rights or rights to purchase additional Freddie Mac stock or securities. Costs incurred in connection with the issuance of preferred stock are charged to “Additional paidin capital.” On February 12, 1999, Freddie Mac redeemed all outstanding shares of the 6.72% preferred stock at its $25 per share redemption price, plus accrued dividends. Table 8.1 provides a summary of Freddie Mac’s preferred stock outstanding at December 31, 1999. A-47 FREDDIE MAC Table 8.1 Issue Date Redemption Total Shares Shares Total Price Outstanding Authorized Outstanding Par Value per Share Balance(1) Redeemable On or After (shares and dollars in millions, except redemption price per share) 1996 Variable-rate(2) 6.125% 6.14% 5.81% 5% 5.1% 1998 Variable-rate(3) 5.3% 5.1% 5.79% 1999 Variable-rate(4) Total April 26, 1996 November 1, 1996 June 3, 1997 October 27, 1997 March 23, 1998 September 23, 1998 September 23, 1998 October 28, 1998 March 19, 1999 July 21, 1999 November 5, 1999 5.00 5.00 $ 5.00 $ 50.00 $ 250 5.75 5.75 5.75 50.00 287 12.00 12.00 12.00 50.00 600 3.00 3.00 3.00 50.00 150 8.00 8.00 8.00 50.00 400 8.00 8.00 8.00 50.00 400 4.40 4.40 4.40 50.00 220 4.00 4.00 4.00 50.00 200 3.00 3.00 3.00 50.00 150 5.00 5.00 5.00 50.00 250 5.75 5.75 5.75 50.00 288 63.90 63.90 $ 63.90 $ 3,195 June 30, 2001 December 31, 2001 June 30, 2002 October 27, 1998 March 31, 2003 September 30, 2003 September 30, 2003 October 30, 2000 March 31, 2004 June 30, 2009 December 31, 2004 (1) Amounts stated at redemption value. (2) The dividend rate resets quarterly and is equal to the sum of the three-month London Interbank Offered Rate (“LIBOR”) plus one percent divided by 1.377, and is capped at 9.00 percent. (3) Includes 1.4 million shares subsequently issued on September 29, 1998. The dividend rate resets quarterly and is equal to the sum of the three-month LIBOR rate plus one percent divided by 1.377, and is capped at 7.50 percent. (4) Initial dividend rate is 5.97 percent per annum through December 31, 2004. Dividend rate resets on January 1, 2005 and on January 1 every five years thereafter based on a five-year constant maturity Treasury rate, which is capped at 11.00 percent. Optional redemption on December 31, 2004 and on December 31 every five years thereafter. The dividend rate on the 5.1% (1998 issue), 1998 variable-rate, 5.3%, 5.1% (1999 issue), 5.79% and 1999 variable-rate preferred stock will increase if, prior to September 23, 2000, September 23, 2000, April 28, 2000, September 19, 2000, January 21, 2001 and May 5, 2001, respectively, the Internal Revenue Code of 1986 is amended to reduce the dividends-received deduction from the current 70 percent rate. The increase to the dividend rates will be equal to the amount necessary to offset the effect of the reduction in the dividendsreceived deduction. However, no additional adjustment will be made to the extent the dividends-received deduction is reduced below 50 percent. In the case of the 1998 and 1999 variable-rate preferred stock, such adjustment may result in a dividend rate in excess of 7.50 percent and 11.00 percent, respectively. FREDDIE MAC A-48 Dividends Declared Table 8.2 summarizes the cash dividends declared per share on Freddie Mac’s common and preferred stock. Table 8.2 Year Ended December 31, 1999 1998 1997 Common Preferred: 7.90%(1) 6.72%(2) 1996 variable-rate 6.125% 6.14% 5.81% 5% 5.1% (1998 issue) 1998 variable-rate 5.3% 5.1% (1999 issue) 5.79% 1999 variable-rate (1) The 7.90% preferred stock was redeemed on July 1, 1997. (2) The 6.72% preferred stock was redeemed on February 12, 1999. $ 0.60 — — 2.35 3.06 3.07 2.91 2.50 2.55 2.35 2.65 1.99 1.28 0.46 $ 0.48 — 1.68 2.46 3.06 3.07 2.91 1.92 0.69 0.65 0.46 — — — $ 0.40 0.99 1.68 2.48 3.06 1.77 0.51 — — — — — — — Common Stock Repurchase Program In September 1997, Freddie Mac’s Board of Directors (the “Board”) authorized the corporation to repurchase up to five percent, or approximately 34 million shares, of its common stock outstanding as of September 5, 1997. Under this authorization, Freddie Mac repurchased approximately 1.9 million outstanding common shares in each of 1999 and 1998. Stock-Based Compensation Freddie Mac has three stock-based compensation plans: the Employee Stock Purchase Plan (the “ESPP”), the 1995 Stock Compensation Plan (the “Employee Plan”) and the 1995 Directors’ Stock Compensation Plan (the “Directors’ Plan”). Freddie Mac applies Accounting Principles Board Opinion 25 and related interpretations in accounting for the ESPP and the Employee Plan. SFAS No. 123, “Accounting for Stock-Based Compensation,” is used to account for stock compensation granted under the Directors’ Plan. Employee Stock Purchase Plan: Freddie Mac has established an ESPP under which shares of common stock may be purchased by full-time and part-time employees continuously working 20 or more hours per week or on certain types of approved paid or unpaid leave. The maximum market value of stock available for annual purchase was $10,000 per employee in 1999. The purchase price under the ESPP in 2000 will be equal to 85 percent of the fair value of the stock on the subscription (grant) date, August 2, 1999, or the exercise date, July 31, 2000, whichever is lower. The ESPP is a non-compensatory plan and, as a result, no compensation expense is recognized for stock purchase options granted under the ESPP. On August 2, 1999, employees pledged to purchase 437,317 shares on July 31, 2000. Employees purchased 400,132 and 529,354 shares for the years ended December 31, 1999 and 1998, respectively. The per share weighted average fair value of stock purchase options granted under the ESPP in 1999 and 1998 as of the grant date was $15.00 and $11.64, respectively. A-49 FREDDIE MAC 1995 Stock Compensation Plan: Under the Employee Plan, Freddie Mac is permitted to grant to employees stock-based awards, including stock options, dividend rights, restricted stock and stock appreciation rights (“SARs”). All such awards are forfeitable for at least one year after the date of grant, and Freddie Mac has the right to impose performance conditions with respect to any awards under the Employee Plan. To date, no SARs have been granted under the Employee Plan. Stock options granted under the Employee Plan generally allow for the purchase of Freddie Mac’s common stock at a price equal to the fair value of the common stock on the grant date. Options generally may be exercised for a period of 10 years from the grant date, subject to a vesting schedule commencing on the grant date. The grant or exercise of such options does not result in compensation expense since the exercise price is equal to the fair value of the stock on the grant date. Dividend rights provide participants with the right to receive, at the time stock options are exercised or upon expiration, an amount equal to the dividends paid on the stock from the date the options were granted. Compensation expense associated with dividend rights is recognized when dividends are declared, based on the amount of dividends declared. Restricted stock entitles participants to all the rights of a stockholder, except that the shares awarded are subject to a risk of forfeiture and may not be disposed of by the participant until the end of the restricted period established by the corporation. The value of restricted shares awarded is amortized to compensation expense over the restricted or vesting period. During 1999, 259,980 shares of restricted stock were granted under the Employee Plan. At December 31, 1999, 789,299 shares of restricted stock granted under the Employee Plan remained outstanding. 1995 Directors’ Stock Compensation Plan: Under the Directors’ Plan, Freddie Mac is permitted to grant stock options with dividend rights, restricted stock and restricted stock units to non-employee members of the Board. The accounting for dividend rights and restricted stock granted under the Directors’ Plan is identical to that described above for the Employee Plan. Restricted stock units represent a contractual right to receive one share of common stock at a specified future date for each restricted stock unit. The accounting for restricted stock units is identical to that of restricted stock. During 1999, 14,196 restricted stock units were granted under the Directors’ Plan. At December 31, 1999, 35,578 shares of restricted stock and restricted stock units granted under the Directors’ Plan remained outstanding. Non-employee Directors are granted the option to purchase Freddie Mac common stock valued at $125,000 ($250,000 in the case of a newly elected or appointed Director). These options have an exercise price equal to the fair value of the common stock at the date of grant, and may be exercised for a period of 10 years from the grant date, subject to a five-year vesting period. The fair value of the options granted is deferred and amortized against income over the vesting period. The Directors’ Plan also provides for annual awards to each non-employee Director of restricted stock units valued at $65,000 ($130,000 in the case of a newly elected or appointed Director) on the date of grant. Awards of both stock options and restricted stock units become exercisable at the rate of 20 percent for each of five years following the grant date. Newly elected or appointed Directors who were granted the larger amount of stock options and stock units in their first year of service do not receive grants of stock options or stock units during their second year of service. Compensation Expense: Actual compensation expense related to stock-based compensation plans charged to income was $14.7 million, $10.4 million and $8.0 million for the years ended December 31, 1999, 1998 and 1997, respectively. Compensation expense is recognized for dividend rights and restricted stock for all plans and all stock option awards made under the Directors’ Plan. Table 8.3 summarizes the pro forma net income and related basic and diluted earnings per common share, had compensation expense for stock options granted under the ESPP and Employee Plan been determined based on their fair value at the grant dates (the fair value method as described in SFAS No. 123). FREDDIE MAC A-50 Table 8.3 Year Ended December 31, (dollars in millions except per share amounts) 1999 1998 1997 Net Income As reported Pro forma Earnings per common share–basic As reported Pro forma Earnings per common share–diluted As reported Pro forma $ 2,223 $ 2,211 $ 2.97 $ 2.96 $ 2.96 $ 2.94 $ 1,700 $ 1,690 $ 2.32 $ 2.31 $ 2.31 $ 2.29 $ 1,395 $ 1,385 $ 1.90 $ 1.88 $ 1.88 $ 1.86 For pro forma disclosure purposes, compensation expense was calculated as the fair value of the stock option awards issued as of the grant date, which was estimated using the Black-Scholes model. Table 8.4 summarizes the assumptions used in determining the fair value of options granted under Freddie Mac’s three stock-based compensation plans. Table 8.4 ESPP 1999 Employee and Directors’ Stock Compensation Plans 1997 1999 1998 1998 1997 Dividend yield(1) Expected life Expected volatility Risk-free interest rate 1.23% 1 year 37.56% 5.20% 1.18% 1 year 31.71% 5.21% 1.13% 1 year 29.63% 6.22% — 10 years 37.56% 5.34% — 10 years 31.71% 5.64% — 10 years 29.63% 6.89% (1) Dividend yield assumptions are not used for the Employee and Directors’ Stock Compensation Plans since the options under these plans provide for the accrual of dividend equivalents which is included in reported net income. Other Stock-Based Compensation Information: The maximum number of shares of common stock that may be granted to employees under the Employee Plan is 33.6 million shares. The maximum number of shares of common stock that may be granted under the Directors’ Plan is 2.4 million shares. At December 31, 1999, a total of 14.3 million shares remained available for grant under both the Employee Plan and the Directors’ Plan. The maximum number of shares of common stock that may be granted to employees under the ESPP is 12.0 million shares. At December 31, 1999, 5.3 million shares remained available for grant under the ESPP. The common stock delivered under these plans may be shares held in Freddie Mac’s treasury, authorized but previously unissued shares or shares purchased by Freddie Mac in the open market. No awards may be made under the ESPP or Employees’ Plan after December 31, 2004. No awards may be made under the Directors’ Plan after May 2008. A-51 FREDDIE MAC Table 8.5 provides a summary of activity related to stock options under the Employee Plan and the Directors’ Plan. Table 8.5 Year ended December 31, Stock Options 1999 1998 Stock Options Weighted Average Exercise Price 1997 Stock Options Weighted Average Exercise Price Weighted Average Exercise Price Outstanding, beginning of year Granted Exercised Canceled Outstanding, end of year Options exercisable at year-end Weighed average fair value of options granted during year 10,181,384 $ 18.75 1,075,290 58.64 (1,180,572) 12.27 (234,976) 51.53 9,841,126 $ 23.11 7,069,515 $ 14.89 $ 26.18 11,059,715 $ 15.56 892,867 46.69 (1,610,574) 11.30 (160,624) 20.56 10,181,384 $ 18.75 7,206,581 $ 13.07 $ 20.48 11,729,804 $ 13.38 1,002,110 34.52 (1,460,691) 10.12 (211,508) 21.11 11,059,715 $ 15.56 7,449,492 $ 11.68 $ 15.52 Table 8.6 provides additional information for stock options outstanding under the Employee Plan and the Directors’ Plan at December 31, 1999 by range of exercise prices. Table 8.6 Options Outstanding Range of Exercise Prices Weighted Average Remaining Contract Life Weighted Average Exercise Price Options Exercisable Weighted Average Exercise Price Outstanding at December 31, 1999 Exercisable at December 31, 1999 $ 6.25 to 14.99 15.00 to 24.99 25.00 to 34.99 35.00 to 44.99 45.00 to 54.99 55.00 to 64.10 3,359,825 3,735,757 990,101 94,600 878,607 782,236 9,841,126 2.56 5.68 7.41 8.49 8.74 9.27 5.38 $ 9.89 18.26 33.17 43.19 47.35 60.63 $ 23.11 3,359,825 3,399,277 275,329 19,359 11,019 4,706 7,069,515 $ 9.89 17.99 33.50 43.22 46.83 60.50 $ 14.89 Regulatory Capital The Federal Housing Enterprises Financial Safety and Soundness Act of 1992 (the “GSE Act”) established riskbased and minimum capital standards for Freddie Mac and Fannie Mae. The Director of the Office of Federal Housing Enterprise Oversight (“OFHEO”) has issued a proposed regulation to implement the risk-based capital standard which would set forth capital requirements using a stress test model. The risk-based capital standard, when finalized, will require Freddie Mac and Fannie Mae to maintain an amount of “total capital” sufficient for the corporation to maintain positive total capital for a 10-year period under highly stressful economic scenarios. Total capital includes “core capital” and general reserves for mortgage and foreclosure losses and certain other amounts available to absorb losses. Core capital consists of the par value of outstanding common stock (common stock issued less common stock held in treasury), the redemption value of outstanding perpetual preferred stock, additional paid-in capital and retained earnings, as measured under GAAP. The minimum capital standard is an amount of core capital equal to the sum of 2.50 percent of aggregate on-balance sheet assets, as measured under GAAP, 0.225 percent of average mortgage purchase commitments and, generally, 0.45 percent of other aggregate off-balance sheet obligations, including Total PCs, net of PCs held by Freddie Mac in its retained and trading portfolios. At December 31, 1999, Freddie Mac’s core capital totaled approximately $12.7 billion, which exceeded the minimum capital requirement under the GSE Act. FREDDIE MAC A-52 Note 9 OFF-BALANCE SHEET FINANCIAL INSTRUMENTS, C ONCENTRATIONS OF CREDIT RISK AND CONTINGENCIES Financial Instruments With Off-Balance Sheet Risk In the normal course of business, the corporation is party to transactions involving financial instruments with off-balance sheet risk. These financial instruments include Total PCs, net, commitments to purchase mortgages, commitments to sell PCs and derivative financial instruments. These instruments subject the corporation to credit risk and/or interest-rate risk in excess of the amounts reported on the Consolidated Balance Sheets. Table 9.1 summarizes financial instruments with off-balance sheet risk. Table 9.1 December 31, (dollars in millions) 1999 1998 Financial instruments whose notional amounts represent credit risk: Total PCs, net(1) Commitments to purchase mortgages Financial instruments whose notional amounts exceed the amount of credit risk: Commitments to sell PCs Derivative financial instruments $ 537,883 99,727 822 424,244 $ 478,351 79,911 5,067 313,238 (1) Excludes $211 billion and $168 billion at December 31, 1999 and 1998, respectively, of PCs held by Freddie Mac in the retained portfolio. Mortgage Participation Certificates Freddie Mac guarantees PC holders the timely payment of interest at the PC coupon rate, and the timely payment of principal on mortgages underlying Gold PCs or the ultimate payment of principal on mortgages underlying 75-day PCs. Several types of credit risk are associated with Total PCs, net. These include the risk of loss from: (i) borrower default on the mortgage; (ii) the failure of institutions holding monthly remittances payable to Freddie Mac and (iii) mortgage fraud. These credit risks are mitigated through Freddie Mac’s uniform underwriting and servicing criteria and, in certain instances, warranties obtained from sellers. Freddie Mac also requires collateral in the form of security interests in the underlying real estate supporting the mortgages backing the PCs, as well as mortgage insurance for mortgages exceeding certain loan-to-value (“LTV”) ratios. Certain transactions may also include other forms of credit enhancements provided by the seller. Management monitors the corporation’s credit exposure and provides for probable losses incurred through the “Reserve for losses on Mortgage Participation Certificates.” At December 31, 1999 and 1998, this reserve was $427 million and $446 million, respectively (see Note 3). As part of administering its PC programs, Freddie Mac is required to repurchase the mortgages backing PCs when certain events occur. Specifically, Freddie Mac may be required under certain conditions to repurchase balloon/reset mortgages, convertible adjustable-rate mortgages (“CARMs”) and mortgages in default. Under the balloon/reset and the CARM programs, the mortgagor has the option, if certain conditions are met, to reset or convert the mortgage to a market-based fixed-rate mortgage. If the mortgagor elects to reset or convert the mortgage rate, Freddie Mac is obligated to repurchase the mortgage from the security pool and may either place the mortgage in its retained portfolio or securitize and sell the mortgage as part of a pool underlying a new PC. Freddie Mac is also required to repurchase mortgages backing the PCs when the mortgages are deemed to be in default, as defined in the security offering documents. Commitments Under the Cash Program, Freddie Mac purchases mortgages for cash and subsequently sells PCs backed by those mortgages to third-party investors. The Cash Program subjects the corporation to interest-rate risk (the risk of adverse changes in fair value due to movements in interest rates) between the time it commits to purchase mortgages and the time it issues the related PCs. Freddie Mac manages this risk under the Cash Program by committing to issue PCs at approximately the same time it commits to purchase mortgages. Issuing PCs under the Guarantor Program does not expose the corporation to interest-rate risk because the purchase of mortgages and issuance of PCs occur simultaneously. A-53 FREDDIE MAC At the time a commitment to purchase is entered into, Freddie Mac is subject to credit risk similar to that described previously in “Mortgage Participation Certificates.” In addition, Freddie Mac is subject to loss if a party to a mandatory purchase commitment fails to deliver mortgages that Freddie Mac has committed to sell as PCs under a mandatory sale agreement. The loss in such an event is equal to the change in the market value of the mortgages to be delivered to Freddie Mac, and is offset by a pair-off fee payable to Freddie Mac by the mortgage seller. The maximum delivery period for mandatory purchase commitments is 90 days for fixed-rate mortgages and 105 days for adjustable-rate mortgages (“ARMs”). If a party fails to deliver mortgages under a mandatory purchase commitment, the corporation primarily fulfills its mandatory sale commitments with heldfor-sale mortgages in the retained portfolio. Table 9.2 summarizes Freddie Mac’s outstanding commitments to purchase mortgages. Table 9.2 December 31, (dollars in millions) 1999 1998 Cash Program Mandatory Optional Guarantor Program Mandatory Optional Master Commitments Mandatory Optional Total $ 758 6 53 238 $ 2,534 6 149 280 39,238 37,704 $ 79,911 63,006 35,666 $ 99,727 Under the optional commitment programs, lenders may or may not exercise their commitment option. Under the mandatory programs, the lender may buy back the commitment at any time by paying a pair-off fee. A master commitment is a contract between Freddie Mac and a mortgage lender that sets forth the terms and conditions under which Freddie Mac will purchase mortgages from approved seller/servicers. A master commitment may provide for the purchase of mortgages under one or more purchase programs with various product attributes, such as conventional fixed-rate or conventional ARMs. Derivative Financial Instruments Freddie Mac enters into derivative financial instruments as an end user and not for trading or speculative purposes. These instruments are combined with underlying liabilities or assets to synthetically create debt instruments or interest-earning assets, as well as to reduce the corporation’s exposure to interest-rate and/or foreign currency risk. Of the total notional balance of derivative financial instruments outstanding at December 31, 1999, $417 billion was executed in conjunction with debt financing (“debt-linked”) and $7 billion was executed in conjunction with the purchase of investments (“asset-linked”). Table 9.3 summarizes the notional or contractual amounts of derivative financial instruments and their related gross fair value. Freddie Mac estimates the fair value of derivative financial instruments using discounted cash flow models based on current market interest rates and estimates of interest-rate volatility. FREDDIE MAC A-54 Table 9.3 December 31, Notional or Contractual Amount (dollars in millions) 1999 1998 Notional or Contractual Amount Gross Gross Positive Negative Fair Value Fair Value Gross Gross Positive Negative Fair Value Fair Value Interest-rate contracts: Interest-rate swaps Receive floating(1) Receive fixed(2) Basis(3) Interest-rate caps(4) Interest-rate floors(5) Interest-rate corridors(6) Futures and options Treasury-based contracts(7) Foreign currency swaps Total $ 101,243 22,375 2,962 17,811 403 1,722 267,737 8,894 1,097 $ 424,244 $ 2,292 $ (314) 67 (452) 5 (7) 726 (9) 3 — 25 — 2,692 (18) 291 (13) 23 (105) $ 6,124 $ (918) $ 41,464 11,762 4,329 18,299 1,603 1,943 220,832 11,542 1,464 $ 313,238 39 $ (1,251) 219 (24) 1 (31) 315 (2) 16 (7) 9 (4) 1,227 (108) 95 (25) 31 (73) $ 1,952 $ (1,525) $ (1) The weighted average pay and receive rates were 6.31% and 6.20%, and 6.90% and 5.36% at December 31, 1999 and 1998, respectively. (2) The weighted average pay and receive rates were 5.99% and 6.44%, and 5.10% and 5.87% at December 31, 1999 and 1998, respectively. (3) Interest-rate swaps in which Freddie Mac pays and receives a floating rate, but which are based on two different indexes. (4) The weighted average strike rate (the rate above which the cap is in-the-money) was 6.94% and 6.84% at December 31, 1999 and 1998, respectively. (5) The weighted average strike rate (the rate below which the floor is in-the-money) was 6.39% and 5.32% at December 31, 1999 and 1998, respectively. (6) The weighted average floor and cap rates were 8.96% and 11.97% at December 31, 1999, and 7.39% and 11.63% at December 31, 1998. (7) Excludes exchange-traded derivative financial instruments, such as U.S. Treasury-based futures contracts. Interest-Rate Swaps: Interest-rate swaps are contractual agreements between two parties for the exchange of periodic payments based on a notional principal amount and agreed-upon fixed and floating interest rates. Freddie Mac enters into interest-rate swap agreements in conjunction with debt issuances or asset purchases. These swaps, when combined with the underlying liability or asset, synthetically create debt and asset yields that produce lower effective debt costs or higher effective asset yields than those available on direct debt issuances or asset purchases. The corporation is also a party to interest-rate swaps that adjust the effective costs or yields on shortterm debt and investment transactions related to the monthly mortgage and security payment remittance cycle. Freddie Mac also enters into interest-rate swaps to hedge against the adverse effects of movements in interest rates on existing debt or anticipated issuances of debt. Interest-Rate Caps, Floors and Corridors: Interest-rate caps and floors are agreements in which one party makes a one-time up-front premium payment to another party in exchange for the right to receive interest payments based on a particular notional amount and the amount, if any, by which the agreed-upon index rate exceeds a specified maximum (“cap”) or is below a specified minimum (“floor”) rate. Interest-rate caps and floors can be structured as corridors. A corridor combines a purchased and sold interest-rate cap or floor to effectively reduce the cost of the interest-rate cap or floor protection. Currently, all of the interest-rate corridors entered into by Freddie Mac involve interest-rate caps. Similar to debt- and asset-linked swaps, interest-rate caps and floors produce lower effective debt costs or higher effective asset yields when combined with short-term debt issuances and investments. Futures and Options: Futures contracts are exchange-traded agreements that obligate one party to sell and another party to purchase a specified amount of a designated financial instrument at a specified price and date. Options give the holder the right, but not the obligation, to buy or sell a specified asset or enter into a contract at a specified price during a specified period of time. Freddie Mac enters into futures and options to hedge against the adverse effects of movements in interest rates on existing debt or on anticipated issuances of debt. Treasury-Based Contracts: Freddie Mac enters into non-exchange traded contracts using U.S. Treasury securities primarily to hedge against the adverse effects of movements in interest rates on existing debt or anticipated issuances of debt. These transactions, under which securities are effectively sold or purchased for settlement at a future date, hedge debt issuance transactions by creating positions that offset changes in the future cash flows of the related debt. A-55 FREDDIE MAC Foreign Currency Swaps: Currency swaps are agreements that involve the receipt of a specified amount of a designated foreign currency and payment of a specified amount of U.S. dollars at various future dates. The currency swaps entered into by Freddie Mac are structured to hedge against the risk of changes in foreign currency exchange rates associated with the purchase of assets and issuance of debt denominated in a foreign currency. The amounts received under the terms of the currency swaps are equal to the interest and principal payments on the related foreign currency-denominated assets and debt. Table 9.4 summarizes changes in the notional amounts of derivative financial instruments and their remaining contractual maturities. Table 9.4 Notional or Contractual Amount (dollars in millions) 1999 1998 Change in notional balance Beginning balance New contracts Calls(1) Maturities and terminations Ending balance Contractual maturity(2) Under one year From one to five years From five to 10 years Over 10 years Total $ 313,238 515,335 (4,938) (399,391) $ 424,244 $ 160,761 160,751 93,983 8,749 $ 424,244 $ 95,547 508,212 (3,821) (286,700) $ 313,238 $ 206,646 56,192 46,507 3,893 $ 313,238 (1) All derivative financial instruments called during 1999 and 1998 were called at their par value, and no gains or losses were deferred or recorded to income. (2) Certain of the corporation’s derivative financial instruments contain provisions permitting termination prior to contractual maturity. In addition, derivative financial instruments generally may be terminated by mutual consent of the parties, or effectively canceled by entering into an offsetting transaction. Notional amounts generally serve only as a factor in determining periodic amounts to be received and paid and do not themselves represent actual amounts to be exchanged or directly reflect the corporation’s exposure to institutional credit risk. As such, notional amounts are not recorded as assets and liabilities in the Consolidated Balance Sheets. Instead, amounts receivable and payable related to derivative financial instruments (netted by counterparty) and the net unamortized balance of premiums paid (net of premiums received) are recorded as assets and liabilities. At December 31, 1999, the net receivable amounts resulting from derivative financial instruments totaled $126 million, and the net unamortized balance of premiums paid totaled $1.7 billion. Also recorded on the Consolidated Balance Sheets are unrealized fair value gains or losses on derivative financial instruments that are designated as hedges of debt instruments. At December 31, 1999, the net unrealized gain on these derivatives totaled $3.6 billion. See Note 1 for a more detailed discussion of Freddie Mac’s accounting policies related to derivative financial instruments. While derivative financial instruments reduce the corporation’s exposure to interest-rate and/or foreign currency risk, they increase the corporation’s exposure to institutional credit risk. Institutional credit risk arises from the possibility that a counterparty will be unable to perform according to the terms of the derivatives contract. Exchange-traded contracts, such as futures contracts, do not increase the corporation’s exposure to institutional credit risk since changes in the value of open exchange-traded contracts are settled daily. To limit its exposure to institutional credit risk on over-the-counter derivatives contracts, Freddie Mac uses master netting agreements. These agreements provide for the netting of all amounts receivable and payable under all transactions covered by the master agreement between Freddie Mac and a single counterparty in the event that the master agreement is terminated due to non-performance. In addition to using master netting agreements, Freddie Mac manages institutional credit risk associated with derivative financial instruments by limiting its selection of counterparties to only those institutions having credit ratings among the highest available from major rating agencies. The corporation also limits its exposure to any one counterparty, regularly monitors financial positions and, in many cases, requires FREDDIE MAC A-56 collateral in order to manage institutional credit risk. At December 31, 1999, the four largest counterparties (based on notional or contractual amounts), each with an independent credit rating of “A+” or better, accounted for approximately 54 percent of the notional amount of the corporation’s outstanding over-thecounter derivative financial instruments. The corporation’s aggregate exposure to institutional credit risk for derivative financial instruments can be estimated by calculating the “net replacement value ” of, or cost to replace, all outstanding nonexchange traded derivative financial instruments for each counterparty with which the corporation was in a net gain or “positive fair value” position, considering the offsetting provided for through master netting agreements. The corporation’s estimated exposure to credit risk based on net replacement values was $4.7 billion and $1.1 billion at December 31, 1999 and 1998, respectively. Freddie Mac’s exposure to institutional credit risk can fluctuate from period to period due to changes in interest rates and/or foreign exchange rates. Freddie Mac’s credit risk exposure based on net replacement values at each quarter-end during 1999 varied from $1.7 billion to $4.7 billion. Of the total estimated exposure to institutional credit risk on derivative financial instruments in a net gain position, $4.0 billion was fully collateralized at December 31, 1999. Substantially all of the corporation’s uncollateralized exposure of $0.7 billion at December 31, 1999 resulted from derivatives contracts with counterparties having a credit rating of “AAA”. The corporation’s policy for requiring collateral from counterparties is based on independent credit ratings, estimated credit risk exposure on net replacement values and internal assessments of counterparty credit quality. In addition, it is the corporation’s policy to limit its uncollateralized risk-adjusted credit exposure to any one counterparty from all investment and derivative activities to less than 1 percent of “Stockholders’ equity.” To date, Freddie Mac has not incurred any credit losses on derivative financial instruments or set aside specific reserves for institutional credit risk exposure. Management does not believe such reserves are necessary, given the corporation’s collateral and counterparty policy requirements. Concentrations of Credit Risk Table 9.5 summarizes the total mortgage portfolio by geographical concentration. Excluded from the total mortgage portfolio at December 31, 1999 and 1998 are $56.6 billion and $29.8 billion, respectively, of non-Freddie Mac mortgage-related securities held in the retained portfolio (see Note 2). Table 9.5 December 31, Amount (dollars in millions) By Region(1) 1999 1998 Percentage Amount Percentage West Northeast North Central Southeast Southwest $ 226,521 192,070 156,197 138,355 92,614 $ 805,757 $ 137,933 39,473 38,720 43,862 545,769 $ 805,757 28.11% 23.84 19.39 17.17 11.49 100.00% 17.12% 4.90 4.81 5.44 67.73 100.00% $ 199,038 172,145 137,722 114,219 80,419 $ 703,543 $ 126,623 35,204 34,949 36,725 470,042 $ 703,543 28.29% 24.47 19.58 16.23 11.43 100.00% 18.00% 5.00 4.97 5.22 66.81 100.00% By State California New York Illinois Florida All others (1) Region Designation: West (AK, AZ, CA, GU, HI, ID, MT, NV, OR, UT, WA); Northeast (CT, DE, DC, MA, ME, MD, NH, NJ, NY, PA, RI, VT, VA, WV); North Central (IL, IN, IA, MI, MN, ND, OH, SD, WI); Southeast (AL, FL, GA, KY, MS, NC, PR, SC, TN, VI); Southwest (AR, CO, KS, LA, MO, NE, NM, OK, TX, WY). A-57 FREDDIE MAC Contingencies From time to time, Freddie Mac may be involved as a party to certain legal proceedings arising in the normal course of its business. While litigation and claims resolution are subject to many uncertainties and cannot be predicted with assurance, it is management’s opinion that losses, if any, will not have a material effect on Freddie Mac’s Consolidated Financial Statements. A significant portion of Freddie Mac’s mortgage purchase volume is generated from several key mortgage lenders that have entered into special business arrangements with Freddie Mac. These individually negotiated relationships characteristically involve a commitment by the lender to sell a high proportion of its conforming mortgage origination volume to Freddie Mac. The four most significant of these arrangements accounted for slightly over 35 percent of Freddie Mac’s volume; the largest of such agreements is with Norwest Mortgage, Inc. Freddie Mac is exposed to the risk that it will lose significant purchase volume that it may be unable to replace if, when the agreements terminate, one or more of these key lenders chooses to significantly reduce the volume of mortgages it sells to Freddie Mac. Note 10 Table 10.1 presents the components of the corporation’s “Provision for income taxes.” Table 10.1 Year Ended December 31, (dollars in millions) 1999 INCOME TA X E S 1998 1997 Current tax provision Deferred tax provision: Amortization of debt discounts and issuance costs Amortization of mortgage purchase and sale premiums, discounts and deferred fees Provision for mortgage and REO losses (less than) in excess of deductions Deferred hedging gains Capitalization of development costs Other items, net Total deferred tax provision Total provision for income taxes $ 1,287 3 (201) 53 (124) (8) (67) (344) $ 943 $ 480 206 10 (27) 16 (7) (22) 176 $ 656 $ 512 24 (10) (24) 3 (6) 70 57 $ 569 Deferred tax assets and liabilities reflect the tax effect of temporary differences between the amounts of assets and liabilities for financial reporting purposes and the tax basis of those assets and liabilities. The net deferred tax asset is included in “Other assets.” Included in the net deferred tax asset is a tax (benefit) expense on the net unrealized (loss) gain on certain investments that are reported in “Stockholders’ equity” (see Note 1). Management believes that it is more likely than not that the total deferred tax asset will be realized in future periods. Table 10.2 summarizes the deferred tax asset and liability. FREDDIE MAC A-58 Table 10.2 December 31, (dollars in millions) 1999 1998 Deferred tax assets: Purchase and sale premiums, discounts and deferred fees Reserve for mortgage losses Other liabilities Net unrealized loss (gain) on certain investments reported at fair value Other Total deferred tax asset Deferred tax liabilities: Other assets Multiclass debt securities Other Total deferred tax liability Net deferred tax asset $ 633 145 287 628 107 1,800 $ 457 177 164 (64) 58 792 147 101 274 522 $ 270 147 97 259 503 $ 1,297 Table 10.3 reconciles the expected federal statutory tax provision to the effective provision for income taxes. Table 10.3 Year Ended December 31, (dollars in millions) 1999 1998 1997 Provision for income taxes at the statutory rate Tax-exempt interest and dividends-received deductions Tax credits Total provision for income taxes Statutory tax rate Effective tax rate $ 1,106 (79) (84) $ 943 35.0% 29.8% $ 825 (106) (63) $ 656 35.0% 27.8% $ 687 (72) (46) $ 569 35.0% 29.0% In 1998, the IRS issued a Statutory Notice to Freddie Mac asserting income tax deficiencies for the corporation’s first two tax years, 1985 and 1986. In first quarter 1999, Freddie Mac filed a petition in the U.S. Tax Court (the “Court”) to contest the deficiencies. In third quarter 1999, the IRS issued a Statutory Notice for Freddie Mac’s tax years 1987 to 1990, and Freddie Mac filed a petition in the Court on September 29, 1999. Subsequently, the Court combined the 1985 to 1990 tax years into one case. The IRS is currently examining Freddie Mac’s federal income tax returns for the years 1991 through 1997. In management’s opinion, adequate provision has been made for all income taxes and related interest. Management believes that additional tax liability, if any, that may arise for prior periods as a result of IRS adjustments will not have a material adverse impact on Freddie Mac’s Consolidated Financial Statements. Freddie Mac is exempt from state and local taxes, with the exception of real estate taxes. In February 1997, Freddie Mac formed two REIT subsidiaries that issued a total of $4 billion in step-down preferred stock to investors. Under IRS regulations in effect when the REITs were formed, dividend payments to holders of the REITs’ step-down preferred stock are tax deductible. In 1997, subsequent to the formation of Freddie Mac’s REIT subsidiaries, the U.S. Department of the Treasury (the “Treasury”) announced its intention to propose regulations that would effectively eliminate the tax advantages of REITs that issue step-down preferred stock. On January 5, 1999, the Treasury issued such proposed regulations and, on January 7, 2000, issued final regulations generally consistent with those it had proposed. These regulations deny certain of the tax benefits attributable to Freddie Mac’s REIT preferred stock for tax years ending on or after February 27, 1997. Notwithstanding the issuance of the final regulations, the tax treatment of preferred stock dividends paid to investors in the REITs remains uncertain. Accordingly, Freddie Mac has elected not to treat such dividends as fully tax deductible in its Consolidated Financial Statements. This treatment is subject to change once uncertainties related to the tax treatment of such dividends are adequately clarified. The preferred stock is redeemable by the REITs under certain circumstances where changes in applicable tax law could adversely affect the tax treatment of the REITs or preferred stock. A-59 FREDDIE MAC Note 11 E M P L OY E E BENEFITS Freddie Mac maintains a defined benefit pension plan covering substantially all of its employees. Benefits are based on years of service and the employee’s highest compensation over any three consecutive years of employment. It is Freddie Mac’s policy to contribute the maximum amount deductible for federal income tax purposes each year. Plan assets consist primarily of corporate bonds and listed stocks. In addition to the defined benefit pension plan, Freddie Mac maintains non-qualified, unfunded defined benefit pension plans for officers of the corporation. The related retirement benefits for the non-qualified plans are paid from Freddie Mac’s general assets. The corporation is required to accrue the estimated cost of retiree benefits, other than pensions, as employees render the services necessary to earn their post-retirement benefits. Freddie Mac maintains a defined benefit postretirement health care plan that provides post-retirement health care benefits on a contributory basis to retired employees age 55 or older who rendered at least five years of service after age 35 and who, upon separation or termination, immediately elected to commence benefits under the pension plan in the form of an annuity. The corporation’s post-retirement health care plan currently is not funded and therefore has no plan assets. Table 11.1 summarizes the components of consolidated net periodic benefit costs related to Freddie Mac’s defined benefit pension plans and post-retirement health care plan. Table 11.1 Pension Benefits Year Ended December 31, (dollars in thousands) 1999 Post-Retirement Benefits 1998 1997 1999 1998 1997 Service cost of current period Interest cost on benefit obligation Expected return on plan assets Recognized net actuarial (gain) loss Recognized prior service cost Recognized initial net asset being amortized over 17 years Net periodic benefit costs $ 10,747 $ 7,994 $ 7,801 9,721 7,809 7,211 (10,685) (9,843) (7,794) 292 (552) 41 14 14 14 43 $ 10,132 43 $ 5,465 43 $ 7,316 $ 2,444 $ 2,176 $ 1,676 1,315 1,010 852 — — — — (178) (134) — — — — — — $ 3,759 $ 3,008 $ 2,394 Table 11.2 summarizes the changes in the projected benefit obligation and plan assets for the defined benefit pension plans, and the change in the accumulated benefit obligation for the post-retirement health care plan. Table 11.2 Pension Benefits December 31, (dollars in thousands) Change in benefit obligation: 1999 Post-Retirement Benefits 1999 1998 1998 Benefit obligation—beginning balance Service cost of current period Interest cost on benefit obligation Net actuarial (gain) loss Benefits paid Benefit obligation—ending balance Change in plan assets: $ 145,122 10,747 9,721 (21,983) (2,082) $ 141,525 $ 119,806 19,868 88 (2,082) $ 137,680 $ 105,183 7,994 7,809 26,272 (2,136) $ 145,122 $ 110,397 11,457 88 (2,136) $ 119,806 $ 19,551 2,444 1,315 (3,270) (124) $ 19,916 $ 13,520 2,176 1,010 2,936 (91) $ 19,551 Plan assets at fair value—beginning balance Actual return on plan assets Employer contributions Benefits paid Plan assets at fair value—ending balance FREDDIE MAC A-60 Freddie Mac’s pension and post-retirement health care costs and the funded status of these plans for 1999, 1998 and 1997 were calculated using assumptions as of September 30, 1999, 1998 and 1997, respectively. Table 11.3 sets forth the funded status of the defined benefit pension plans and post-retirement health care plan, the assumptions used to calculate the funded status and amounts recognized in the Consolidated Balance Sheets. Table 11.3 Pension Benefits December 31, (dollars in thousands) 1999 Post-Retirement Benefits 1999 1998 1998 Benefit obligation in excess of plan assets $ 3,845 Unrecognized net actuarial gain (loss) 25,161 Unrecognized prior service cost (472) Initial unrecognized net asset being recognized over 17 years (1,177) Contributions made subsequent to measurement date — Net liability included in Other liabilities $ 27,357 $ 25,316 (6,295) (486) (1,220) — $ 17,315 $ 19,916 3,603 — — (36) $ 23,483 $ 19,551 333 — — (31) $ 19,853 Major assumptions: Assumed discount rate Rate of increase in compensation levels Consumer price index Expected long-term rate of return on plan assets 7.50% 4.50% 3.50% 9.00% 6.75% 4.50% 3.00% 9.00% 7.50% — — — 6.75% — — — The assumed health care cost trend rate used in measuring the accumulated post-retirement benefit obligation was 7.0 percent in 1999, gradually declining to 5.0 percent in the year 2003 and remaining at that level thereafter. Table 11.4 sets forth the effect on the accumulated post-retirement benefit obligation and the sum of the service cost and interest cost components of the net periodic post-retirement benefit costs that would result from a 1 percent increase or decrease in the assumed health care cost trend rate. Table 11.4 1 Percent Increase 1 Percent Decrease Effect on the accumulated post-retirement benefit obligation Effect on net periodic post-retirement benefit cost components 25% 28% (19)% (21)% Freddie Mac also offers a tax-qualified defined contribution pension plan (the “Savings Plan”) to all eligible employees. Employees were permitted to contribute from 1 percent to 15 percent of their annual salaries to the Savings Plan, up to $12,500 ($10,000 pre-tax and $2,500 after tax) in 1999 and 1998. Freddie Mac matches employees’ contributions up to 6 percent of their annual salaries; the proportion of the match depends upon the length of service. In addition, Freddie Mac is authorized to make discretionary contributions to a profit sharing account in the Savings Plan on behalf of each eligible employee, based on salary level. Freddie Mac made contributions to the Savings Plan totaling $15.3 million, $13.7 million and $12.4 million in 1999, 1998 and 1997, respectively. A-61 FREDDIE MAC Note 12 BUSINESS SEGMENT R E P O RT I N G Management assesses corporate performance and allocates capital principally on the basis of the two methods in which it finances mortgages and mortgage-related investments: securitization financing and debt financing. Freddie Mac separately manages the business activities associated with these two methods of financing, as each financing method generates different sources and types of revenue for Freddie Mac, exposes the corporation to different types and degrees of risk and requires Freddie Mac’s commitment of different levels of capital. Securitization financing of mortgage investments (the “Securitization Financing Segment”) involves securitizing mortgages the corporation has purchased, and selling them to investors in the form of PCs. Freddie Mac generates “Management and guarantee income,” representing the fee income it receives as compensation for, among other things, assuming the credit risk on Freddie Mac’s total mortgage portfolio. The Securitization Financing Segment therefore incurs all credit-related expenses as a consequence of assuming this credit risk. Since credit risk is also the primary risk exposure of multifamily mortgage-related investments, the revenues and expenses generated from these investments are included in the Securitization Financing Segment where this risk is managed. Through other activities related to securitization financing, Freddie Mac earns fees from the resecuritization of PCs and other mortgage securities (primarily into REMICs), as well as seller/servicerrelated fees. In addition, income is earned from trading activities conducted in support of the market for Freddie Mac PCs. Income generated from fee-for-service and trading activities is recorded as part of “Other income, net” or “Net interest income.” “Net interest income” for the Securitization Financing Segment also reflects interest earned on investments of capital allocated to this business segment. Also included is interest expense on PC variance balances (representing cash flows generated by timing differences between Freddie Mac’s receipt of payments on mortgages underlying PCs, and the subsequent passthrough of such amounts to PC investors), net of interest income from the temporary reinvestment of these balances. Debt financing of mortgage-related investments (the “Debt Financing Segment”) involves issuing debt securities (and, to a lesser extent, equity and other liabilities) to finance the purchase of unsecuritized mortgages and guaranteed mortgage securities, including Freddie Mac PCs and non-Freddie Mac mortgage securities, that are held by Freddie Mac as investments for the retained portfolio. Freddie Mac also maintains a liquidity and contingency portfolio that is financed principally by debt. The corporation recognizes “Net interest income” on both the retained and the liquidity and contingency investment portfolios, which is the interest income earned on these investments less the interest expense from the interest-bearing liabilities funding them. Most of the corporation’s consolidated total assets are financed with debt and other liabilities. Similar to Freddie Mac PCs held in the retained portfolio, purchases of unsecuritized mortgages reflect management’s decision to assume the credit risk on these mortgages through the Securitization Financing Segment, and to retain such mortgages as portfolio investments. Accordingly, income earned on unsecuritized mortgages is allocated between the corporation’s two financing segments, with the Securitization Financing Segment allocated a portion of this income as compensation for assuming the credit risk on these mortgages. “Management and guarantee income” for the Securitization Financing Segment includes a fee earned for the credit guarantee it provides on unsecuritized mortgages, and “Net interest income” of the Debt Financing Segment is correspondingly reduced by the cost of this credit guarantee. Revenues and direct expenses are allocated among the corportion’s two financing segments in accordance with the accounting policies set forth in Note 1, “Summary of Significant Accounting Policies.” Overhead expenses, such as administrative expenses, are allocated either directly to each segment or through estimates, based on factors such as revenues or portfolio volume, as applicable. There were no transactions with any single customer that accounted for 10 percent or more of consolidated total revenues. Table 12.1 details the corporation’s financial performance by financing segment for the years ended December 31, 1999, 1998 and 1997, respectively. FREDDIE MAC A-62 Table 12.1 Year Ended December 31, Securitization Financing (dollars in millions) Debt Financing 1999 Elimination(1) Consolidated Net interest income(2) Management and guarantee income Other income, net Total revenues Credit-related expenses Administrative expenses Housing tax credit partnerships Income before income taxes Provision for income taxes Income before extraordinary item, net of taxes Extraordinary gain on retirement of debt, net of taxes Net income Year Ended December 31, $ 214 1,558 135 1,907 (159) (547) (80) 1,121 (313) 808 — $ 808 $ 2,173 — (25) 2,148 — (108) — 2,040 (630) 1,410 5 $ 1,415 1998 $ 153 (153) — — — — — — — — — $ — $2,540 1,405 110 4,055 (159) (655) (80) 3,161 (943) 2,218 5 $2,223 Securitization Financing (dollars in millions) Debt Financing Elimination(1) Consolidated Net interest income(2) Management and guarantee income Other income, net Total revenues Credit-related expenses Administrative expenses Housing tax credit partnerships Income before income taxes Provision for income taxes Net income Year Ended December 31, $ 297 1,446 101 1,844 (342) (495) (61) 946 (267) $ 679 $ 1,491 — 2 1,493 — (83) — 1,410 (389) $ 1,021 1997 $ 139 (139) — — — — — — — $ — $1,927 1,307 103 3,337 (342) (578) (61) 2,356 (656) $1,700 Securitization Financing (dollars in millions) Debt Financing Elimination(1) Consolidated Net interest income(2) Management and guarantee income Other income, net Total revenues Credit-related expenses Administrative expenses Housing tax credit partnerships Income before income taxes Provision for income taxes Net income $ 193 1,421 90 1,704 (529) (431) (41) 703 (200) $ 503 $ 1,315 — 10 1,325 — (64) — 1,261 (369) $ 892 $ 123 (123) — — — — — — — $ — $1,631 1,298 100 3,029 (529) (495) (41) 1,964 (569) $1,395 (1) Reflects the elimination of fees earned by the Securitization Financing Segment for the credit guarantee it provides on unsecuritized mortgages retained by the Debt Financing Segment, and a corresponding elimination of the cost of this credit guarantee charged to the Debt Financing Segment for purposes of deriving consolidated amounts. (2) Net interest income for the Debt Financing Segment includes interest expense on debt securities and other liabilities that finance mortgage-related investments. Included in interest expense on debt securities is non-cash amortization of debt discounts totaling $9.2 billion, $7.0 billion and $4.1 billion for the years ended December 31, 1999, 1998 and 1997, respectively, which principally represents the contractual cost of funds associated with issuing short-term debt at a discount. This cost of funds is paid when the debt matures. A-63 FREDDIE MAC Note 13 FA I R VA L U E DISCLOSURES The Consolidated Fair Value Balance Sheets in Table 13.1 present Freddie Mac’s estimates of the fair value of the corporation’s assets and liabilities at December 31, 1999 and 1998. These balance sheets were prepared on the fair value basis of accounting, which is a basis of accounting other than GAAP, to provide relevant financial information that is not provided by the historical cost financial statements. These disclosures satisfy the guidelines of SFAS No. 107, “Disclosures About Fair Value of Financial Instruments,” which generally require disclosure of the fair value of financial instruments. Table 13.1 December 31, Carrying Amount (dollars in millions)(1) Assets 1999 1998 Fair Value Carrying Amount Fair Value Mortgages, net Guaranteed mortgage securities, net Retained portfolio, net Cash and cash equivalents Investments and securities purchased under agreements to resell Real estate owned (REO), net Other assets Off-balance sheet items: Guarantee fees on Total PCs Outstanding commitments to purchase and sell mortgages $ 56,400 266,200 322,600 5,200 36,700 400 21,800 (400) — $ 386,300 $ 362,400 7,300 6,800 (1,700) 374,800 — 3,200 8,300 $ 386,300 $ 55,000 257,400 312,400 5,200 36,700 400 21,800 2,400 100 $ 379,000 $ 354,700 7,300 6,800 (5,200) 363,600 1,400 2,900 11,100 $ 379,000 $ 56,800 198,500 255,300 2,600 46,500 600 16,400 (400) — $ 321,000 $ 288,900 19,400 3,400 (1,500) 310,200 — 2,800 8,000 $ 321,000 $ 58,200 200,000 258,200 2,600 46,500 600 16,400 200 100 $ 324,600 $ 289,000 19,400 3,400 (400) 311,400 800 2,900 9,500 $ 324,600 Liabilities and Net Fair Value Total debt securities, net Principal and interest due to PC investors Other liabilities Derivative financial instruments Estimated income taxes on differences between fair values and GAAP values Preferred stock Common stockholders’ net fair value after tax (1)Amounts have been rounded to the nearest $100 million. Limitations “Net fair value after tax” represents the difference between the estimated fair value of assets and liabilities reduced by the tax effect of the difference between the fair value and GAAP value of equity. This estimate does not attempt to present Freddie Mac’s value as a going concern or the value of anticipated future business. Therefore, net fair value does not represent an estimate of the aggregate fair value of Freddie Mac’s common stock or Freddie Mac as a whole. Valuation Methods and Assumptions The following methods and assumptions were used to estimate the fair value of Freddie Mac’s assets and liabilities at December 31, 1999 and 1998. FREDDIE MAC A-64 Mortgages, Net The fair value of unsecuritized mortgages is estimated using an option-adjusted spread (“OAS”) model. This estimation process involves calculating an OAS, a constant spread that, when added to each period’s U.S. Treasury rate used for discounting, equates the present value of the expected future cash flows to the market price of a benchmark Freddie Mac PC. The benchmark OAS is applied to the specific loans, calibrated to the market price of a benchmark security, to determine the estimated fair value. Guaranteed Mortgage Securities, Net The fair value of guaranteed mortgage securities is based on quoted market prices. Included are available-forsale mortgage-related securities that are reported on the historical balance sheet at their estimated fair value and, accordingly, their carrying amount is fair value. Cash and Cash Equivalents; Investments and Securities Purchased Under Agreements to Resell; Real Estate Owned (REO), Net; Other Assets; Principal and Interest Due to PC Investors and Other Liabilities These assets and liabilities are generally either short-term (in which case the carrying amount is a reasonable estimate of fair value), or are reported on the historical balance sheet at their estimated fair value and, accordingly, their carrying amount is fair value. Guarantee Fees on Total PCs The fair value of guarantee fees on Total PCs includes the expected guarantee fee income on Total PCs, net of the expected default costs on the underlying mortgages, float costs from remittance cycle cash flows and servicing-related administrative costs. The guarantee fee cash flows are estimated using benchmark interestonly stripped securities (“IOs”), calculated as a fixed percentage of the outstanding mortgage balance, as the cash flow pattern of IOs resembles that of guarantee fees. The value of these IOs is approximated using the OAS approach described above in “Mortgages, Net.” The present value of expected future default costs on the underlying mortgages is estimated using proprietary models. The fair value of the costs from remittance cycle cash flows is based on the estimated reinvestment income earned during the period between the remittance of mortgage principal and interest to Freddie Mac, and the disbursement of these funds to PC investors. The carrying amount of $(400) million at December 31, 1999 and 1998 represents the “Reserve for Losses on Mortgage Participation Certificates” which is reported as part of total assets for purposes of this presentation. Outstanding Commitments to Purchase and Sell Mortgages Outstanding commitments include commitments to buy and sell mortgages and mortgage-related investments. The fair value of mandatory commitments is estimated based on the pair-off fees the seller must pay if the mortgages are not delivered. Optional purchase commitments are assumed to have a fair value of zero. Total Debt Securities, Net and Preferred Stock The fair value of debt securities (including subordinated borrowings) and preferred stock is based on quoted market prices. Derivative Financial Instruments Freddie Mac estimates the fair value of derivative financial instruments based on discounted cash flows using market estimates of interest rates and volatility. For purposes of this presentation, the carrying amount and estimated fair value of asset-linked and debt-linked derivative financial instruments are presented separately from the carrying amount and estimated fair value of the associated assets and debt. Estimated Income Taxes on Differences Between Fair Values and GAAP Values The fair value balance sheet includes an estimate of federal income taxes by applying the statutory federal tax rate of 35 percent to the excess of net fair value over “Stockholders’ equity” measured under GAAP. This adjustment is made to the fair value of equity based on the assumption that income taxes will be paid on future earnings. A-65 FREDDIE MAC Additional Financial Information (unaudited) QUARTERLY RESULTS OF OPERATIONS 1999 1998 2nd 1st 4th 3rd 2nd 1st 4th (dollars in millions) 3rd Interest income on mortgages $1,015 $ 995 Interest income on guaranteed mortgage securities 4,354 4,120 Interest income on investments and securities purchased under agreements to resell 800 764 Interest expense on debt securities: Short-term debt (464) (338) Long-term debt (4,949) (4,793) Interest expense due to security program cycles (92) (138) Net interest income on earning assets 664 610 Management and guarantee income 362 356 Other income, net 23 34 Total revenues 1,049 1,000 Provision for mortgage losses (15) (15) REO operations expense (25) (21) Administrative expenses (167) (164) Housing tax credit partnerships (18) (22) Income before income taxes and extraordinary item 824 778 Provision for income taxes (238) (223) Income before extraordinary item, net of taxes 586 555 Extraordinary gain (loss) on retirement of debt, net of taxes 8 9 Net income $ 594 $ 564 Net income available to common stockholders $ 552 $ 525 Earnings per common share before extraordinary item(1) $ 972 $ 985 3,819 3,454 658 817 $ 964 $ 934 $ 927 $ 911 3,144 2,685 2,482 2,222 770 542 563 494 (473) (924) (4,146) (3,463) (190) (243) 640 626 349 338 20 33 1,009 997 (15) (15) (18) (35) (161) (163) (20) (20) 795 764 (238) (244) 557 520 (5) (7) $ 552 $ 513 $ 516 $ 477 (1,223) (952) (989) (873) (2,851) (2,516)(2,271) (2,116) (267) (213) (246) (194) 537 480 466 444 329 328 324 326 36 13 22 32 902 821 812 802 (40) (40) (50) (60) (29) (39) (40) (44) (169) (142) (135) (132) (15) (16) (15) (15) 649 584 572 551 (181) (159) (158) (158) 468 425 414 393 — $ 468 $ $ 430 $ — — — 425 $ 414 $ 393 396 $ 385 $ 368 Basic Diluted Earnings per common share(1) $ 0.78 $ 0.74 $ 0.75 $ 0.70 $ 0.78 $ 0.74 $ 0.74 $ 0.69 $ 0.79 $ 0.75 $ 0.74 $ 0.69 $ 0.79 $ 0.75 $ 0.74 $ 0.68 $ 0.63 $ 0.58 $ 0.57 $ 0.54 $ 0.62 $ 0.58 $ 0.56 $ 0.54 $ 0.63 $ 0.58 $ 0.57 $ 0.54 $ 0.62 $ 0.58 $ 0.56 $ 0.54 Basic Diluted (1) “Earnings per common share-basic” are computed based on weighted average common shares outstanding. “Earnings per common share-diluted” are computed based on the total of weighted average common shares outstanding and the effect of dilutive common equivalent shares outstanding. FREDDIE MAC A-66 Additional Financial Information (unaudited) TOTAL MORTGAGE PORTFOLIO LIQUIDATION ACTIVITY (annualized) Quarter Ended Year March 31 June 30 September 30 December 31 Annual 1999 1998 1997 1996 1995 25.8% 26.7% 11.7% 17.2% 8.1% 20.8% 27.8% 13.4% 15.8% 10.7% 15.3% 26.1% 16.0% 12.7% 15.0% 11.6% 35.8% 18.0% 12.4% 14.3% 19.6% 30.5% 14.7% 14.7% 12.2% MORTGAGE DELINQUENCY STATISTICS Single-Family Mortgages (based on number of mortgages) Date Total Number of Mortgages(1) Delinquent Three or More Payments(1) Foreclosures Approved and In Process(1) At-Risk Portfolio(1) Total Portfolio 12/99 12/98 12/97 12/96 12/95 6,879,620 6,420,915 6,668,745 6,755,817 6,437,804 0.16% 0.23% 0.22% 0.22% 0.26% 0.23% 0.27% 0.33% 0.36% 0.34% 0.39% 0.50% 0.55% 0.58% 0.60% 0.43% 0.49% 0.56% 0.60% 0.61% (1) Includes only loans for which Freddie Mac has assumed primary default risk. Excludes loans for which the lender or a third party has retained primary default risk by pledging collateral or agreeing to accept losses on loans that default. In some cases, the lender’s or third party’s risk is limited to a specific level of losses at the time the credit enhancement becomes effective. Multifamily Mortgages (based on net carrying value of mortgages) (dollars in millions) Date Total Dollars of Mortgages Delinquent Two or More Payments Foreclosures Approved and In Process Total Net Carrying Value of Non-Performing Mortgages 12/99 12/98 12/97 12/96 12/95 $ 16,817 $ 10,972 $ 8,364 $ 7,493 $ 6,665 0.12% 0.18% 0.52% 1.21% 1.12% 0.02% 0.19% 0.44% 0.75% 1.76% 0.14% 0.37% 0.96% 1.96% 2.88% $ 23 $ 40 $ 80 $ 147 $ 192 A-67 FREDDIE MAC Management’s Report on Consolidated Financial Statements and Internal Control Structure The management of Freddie Mac (or the “corporation”) is responsible for the preparation, integrity and fair presentation of the corporation’s annual Consolidated Financial Statements. The annual Consolidated Financial Statements presented have been prepared in accordance with generally accepted accounting principles and, as such, include amounts based on judgments and estimates made by management. Management also has prepared the other information included in this annual report, and is responsible for its accuracy and consistency with the Consolidated Financial Statements. The annual Consolidated Financial Statements referred to above have been audited by Arthur Andersen LLP, independent public accountants, who have been given unrestricted access to all financial records and related data, including minutes of all meetings of stockholders, the Board of Directors (the “Board”) and committees of the Board. Management believes that all representations made to Arthur Andersen LLP during the audit were valid and appropriate. In addition, management is responsible for establishing and maintaining an internal control structure over financial reporting, including controls over the safeguarding of assets. The objective of the internal control structure is to provide reasonable assurance to management and the Board as to the preparation of the financial statements in accordance with generally accepted accounting principles. Management has made its own assessment of the effectiveness of the corporation’s internal control structure over financial reporting, including controls over the safeguarding of assets, as of December 31, 1999, in relation to the criteria described in “Internal Control—Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this assessment, management believes that, as of December 31, 1999, the corporation’s internal control structure was effective in achieving the objective stated above. However, there are inherent limitations in the effectiveness of any internal control structure, including the possibility of human error and the circumvention or overriding of controls. Accordingly, even an effective internal control structure can provide only reasonable assurance with respect to the reliability of the financial statements. Furthermore, the effectiveness of any internal control structure can change with changes in circumstances. Management also recognizes its responsibility for fostering a strong ethical climate so that Freddie Mac’s affairs are conducted according to the highest standards of personal and corporate conduct. This responsibility is characterized and reflected in Freddie Mac’s Code of Conduct, which is publicized throughout the corporation. The Code of Conduct addresses, among other things, potential conflicts of interest, acceptable employee activities conducted outside of Freddie Mac, acceptable financial activities, confidentiality of proprietary information, ethical business conduct and compliance with the Code of Conduct. Freddie Mac maintains a systematic program to assess compliance with the Code of Conduct. The corporation has an Internal Audit Department whose responsibilities include monitoring compliance with established policies and procedures and evaluating Freddie Mac’s internal control structure. The Internal Audit Department is independent of the activities it reviews. Operational and special audits are conducted, and internal audit reports are submitted to appropriate management and the Audit Committee of Freddie Mac’s Board. The Audit Committee of the Board meets periodically with management, internal auditors and Freddie Mac’s independent public accountants to review matters relating to financial accounting and reporting policies and control procedures. Both Arthur Andersen LLP and the Internal Audit Department have full and free access, with and without management present, to the Audit Committee. Leland C. Brendsel Chairman & Chief Executive Officer Vaughn A. Clarke Senior Vice President, Finance & Chief Financial Officer FREDDIE MAC A-68 Report of Independent Public Accountants on Management’s Assertion About the Effectiveness of the Internal Control Structure Over Financial Reporting To the Board of Directors and Stockholders of Freddie Mac: We have examined management’s assertion that Freddie Mac maintained an effective internal control structure over financial reporting, including controls over the safeguarding of assets, as of December 31, 1999, included in the accompanying Management’s Report on Consolidated Financial Statements and Internal Control Structure. Our examination was made in accordance with standards established by the American Institute of Certified Public Accountants and, accordingly, included obtaining an understanding of the system of internal controls over financial reporting, testing, and evaluating the design and operating effectiveness of the system, and such other procedures as we considered necessary in the circumstances. We believe that our examination provides a reasonable basis for our opinion. Because of inherent limitations in any system of internal controls, errors or irregularities may occur and not be detected. Also, projections of any evaluation of the system to future periods are subject to the risk that the system of internal controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, management’s assertion that Freddie Mac maintained an effective system of internal controls over financial reporting, including controls over the safeguarding of assets, as of December 31, 1999, is fairly stated, in all material respects, based upon criteria established in “Internal Control—Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission. Vienna, Virginia January 13, 2000 Report of Independent Public Accountants on Consolidated Financial Statements To the Board of Directors and Stockholders of Freddie Mac: We have audited the accompanying Consolidated Balance Sheets of Freddie Mac, a federally chartered corporation (the “corporation”), as of December 31, 1999 and 1998, and the related Consolidated Statements of Income, Stockholders’ Equity and Cash Flows for each of the three years in the period ended December 31, 1999. These financial statements are the responsibility of the corporation’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform an audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Freddie Mac as of December 31, 1999 and 1998, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1999, in conformity with generally accepted accounting principles. A-69 We have also audited, in accordance with generally accepted auditing standards, the supplemental Consolidated Fair Value Balance Sheets of Freddie Mac as of December 31, 1999 and 1998. As described in Note 13, the supplemental Consolidated Fair Value Balance Sheets have been prepared by management to present relevant financial information that is not provided by the Consolidated Balance Sheets referred to above and are not intended to be a presentation in conformity with generally accepted accounting principles. In addition, the supplemental Consolidated Fair Value Balance Sheets do not purport to present the net realizable, liquidation or market value of the corporation as a whole. Furthermore, amounts ultimately realized by the corporation from the disposal of assets and settlement of liabilities may vary significantly from the fair values presented. In our opinion, the supplemental Consolidated Fair Value Balance Sheets referred to above present fairly, in all material respects, the information set forth therein as described in Note 13. Vienna, Virginia January 13, 2000 FREDDIE MAC