For the 4Q2014, Federal Home Loan Mortgage Corp (OTCBB:FMCC) net income came at $227million compared to $2.1 billion in 3Q2014. The sharp drop of 90% in net income was due to a $3.4 billion loss incurred on derivatives that were used to hedge against rising interest rates. At the end of 4Q2014, the company’s equity capital now stands at $1.8 billion.
Federal Home Loan will have to deal with the problem of hedging loss whenever interest rates will decline. In 4Q, the ’10-year treasury’ interest rate declined to 2.17% from 2.4% in the prior quarter. The interest risk always remains with the retained portfolios that are held by the company to boost financial results.
The Obama administration and Congress have called for such portfolios of each firm to be cut down. By holding retained portfolios, the mortgage companies are able to receive net interest income on the wide spread between their borrowing rate and the investment rate of return. However, the hedging of these portfolios subjects firms to huge potential losses in the future. If rates rise, the losses occurring from derivates hedge could be reversed.
Declining interest rates
Federal Home Loan equity capital can be at risk in the event of continued decline in interest rates. As per 10-K filing, it has $1.8 billion in reserves, and the hedging loss of $3.4 billion is greater than Federal Home’s equity capital reserves. If interest rate volatility continues, its entire reserve could be wiped out. In such a scenario, it had to turn to Treasury for assistance.
The future ahead
Federal Home stated that the Treasury might fail to provide the requested capital if it has already reached its borrowing limit. In such a case, its equity reserves can even enter into a negative zone. Therefore, Treasury should end the net worth sweep and permit the firm to retain capital. Also, additional steps should be announced to enable the mortgage firms to build capital through the equity segment.