Nazir Dossani's Speech to the Citigroup Agency Debt Investor Conference on May 20, 2004

Prepared Remarks for Nazir Dossani
Senior Vice President – Investments & Capital Markets
Freddie Mac

Citigroup Agency Debt Investor Conference
Napa Valley, California
May 20, 2004

Thank you, Dale [Horowitz], for that warm introduction and thanks to the folks at Citigroup for inviting me to spend a few minutes with you this morning to talk about the role that Freddie Mac and our investors play in the fixed-income markets in financing homeownership in the United States. I met a number of you already and hope to meet more of you later today.

I bring the regards of Dick Syron, our Chief Executive Officer, who regrets that last-minute scheduling issues prevented him from being here. Dick is driving many changes at Freddie Mac and has had a very positive and profound impact in a short period of time, in a number of areas that I will touch on shortly.

Today, let me discuss why you can continue to rely on Freddie Mac to be a strong and steady source of high-quality, highly liquid debt securities. We will remain a reliable business partner because the focus of our business – U.S. mortgage finance – is an essential engine driving the financial aspirations of millions of families and the largest economy in the world. Housing is a national priority in the United States, and we believe it will remain so. Moreover, the market-based model for financing housing – which exists through our partnership with you – provides the best means for funding home loans in diverse economic environments. I will spend the bulk of my time today describing how we manage the interest-rate and credit risks associated with the securitization and purchase of mortgages. Finally, I will conclude with a few thoughts about the political context in which we operate and why we are optimistic about the outcome of these discussions.

Putting Consumers First

At Freddie Mac, our work is driven by the housing needs of the American consumer. For most families in the United States, housing has been the dominant vehicle through which they have built net worth in an appreciating asset. The extremely favorable financing terms we provide, combined with strong home price appreciation over an extended time period, has made U.S. housing the primary means for low- and middle-income American families to create wealth and an equity stake that can be passed on to their children.

In many nations, housing is financed through adjustable or short-term mortgages with rigid terms, priced in a manner similar to other consumer products, like credit cards or auto loans. Across our northern border, in Canada, the typical fixed-rate mortgage has a seven-year term, requires a 25-percent down payment, and imposes a stiff penalty for refinancing. As Dick Syron likes to say, you can get a long-term, fixed rate, prepayable mortgage in Detroit, Michigan, but a few short miles away in Windsor, Canada, it's quite a different story.

In the United States, the loan of choice is the fixed-rate, pre-payable mortgage, with a term of up to 30 years. The long-term, fixed-rate mortgage protects consumers when mortgage rates go up and enables them to refinance or extract equity when rates go down. The product is essential to helping families make ends meet, put their children through college, and fund small businesses or retirement plans.

The fact that homeowners know that they do not face a significant increase in mortgage payments if interest rates move up translates into increased consumer confidence in America. This consumer confidence in turn drives enormous macro-economic benefits for the American and global economies. Indeed, it is now widely acknowledged that, during the most recent economic downturn, it was the strong housing market that provided the brightest spot in the sluggish U.S. economy.

How Freddie Mac Supports the U.S. Mortgage Market

As many of know, Freddie Mac finances mortgages in two ways: First, we securitize mortgages – that is, we package mortgages from lenders in exchange for mortgage-backed securities, and receive a credit guarantee fee for taking on the credit risk of consumer default. Lenders either hold these securities in their portfolios or, as they do in many cases, sell them in the capital markets. Our role in creating relatively homogenous, highly-rated mortgage securities promotes certainty, liquidity and stability in the mortgage market and allows lenders to lock in mortgage rates for consumers, because they can forward-sell the mortgage security and lock in their own funding costs.

We also purchase mortgages from lenders to hold in our own portfolio, financing these purchases by issuing a variety of debt security products in the global capital markets. We buy these mortgages either directly from lenders in the form of newly created mortgage-backed securities or we bid for mortgages from a wide range of investors in the secondary mortgage market.

I think it is important to point out that both of these activities directly assist us in fulfilling our statutory purposes as articulated by the U.S. Congress. In 1989, when the Congress modernized our charter to provide for fully private market funding of Freddie Mac, we were specifically instructed to use both of these types of activities to fulfill our mission. Here is a direct quote from the legislative record from that Congress:

A primary purpose [of Freddie Mac and Fannie Mae] is to provide stability in the secondary market for home mortgages including mortgages securing housing for low and moderate-income families. This can be accomplished through both portfolio purchasing and selling activities, as well as through the securitization of home mortgages. The continuous presence of the FHLMC and FNMA in the secondary market in bad as well as good economic times provides assurances of a dependable and substantial funding source for home mortgages.

We can't say it any better than the U.S. Congress has, and Congress reflects the will of the people. The Congress was absolutely correct that, to fulfill our purposes, Freddie Mac needs both to create mortgage securities and purchase mortgages and mortgage securities. Moreover, Congress was correct in stating that, to be effective in these two activities, we need to maintain a relatively "continuous presence."

Let me give you a good example from not so long ago. You may recall that, in the fall of 1998, in the market disruption following the Russian bond default and the dissolution of Long Term Capital Management, there was a broad-based liquidation of virtually all securities carrying credit risk – so-called "spread product." Investors engaged in a classic "flight to quality," seeking to dump all spread product in favor of U.S. Treasury securities.

During this extraordinary disruption, Freddie Mac, along with Fannie Mae, was able to maintain our access to worldwide debt markets. Our deep call on liquidity enabled us to stabilize the U.S. residential mortgage market, because we continued to purchase mortgages as a buttress against the rout occurring in every other sector. On many individual days that fall, and I recall it well, we, along with Fannie Mae, purchased literally billions of dollars of mortgages a day from lenders, dealers, hedge funds – you name it – because no one else was willing or able to provide liquidity. Our purchase activity was essential in maintaining market stability – which is one of our core, statutory purposes – and the refinancing boom that was then occurring continued on an uninterrupted basis.

Even when conditions are not at a crisis level, it is clear that our portfolio purchase activities help to stabilize markets and provide the type of continuous, competitive bid that keeps secondary mortgage markets highly liquid and the financing cost for the mortgages we purchase consistently as low as any consumer retail product. Studies that we and Fannie Mae have commissioned provide compelling empirical evidence of the beneficial effects that our portfolio purchase activities have on mortgage interest rates and the operation of the market as a whole.

It is through our debt security products and funding program that we have worked with you to create a significant, additional source of funding for U.S. housing that complements our mortgage securitization business.

Retained portfolio growth is opportunistic and disciplined
Note: 2001 and 2002 numbers are restated. Freddie Mac is presenting monthly balances for 2003 activity using restated December 31, 2002 balances for both the total mortgage portfolio and the retained portfolio as a beginning balance in order to roll forward the balances for 2003 activity. See March 2004 Monthly Volume Summary for further details. 2003 numbers are subject to change when 2003 financials are released. Source: Freddie Mac as of March 31, 2004 Source: Freddie Mac

The growth of our retained mortgage portfolio has been significant in the past decade, but this growth has been disciplined and responsive to prevailing conditions in the secondary mortgage market. For example, we have observed significant funding of mortgages from the depository sector in the past few years. Because of the currently steep yield curve, depository institutions have found it attractive to pay a low-rate of interest on short-term deposits and use this funding to place a large volume of mortgages on their balance sheets. But when rate conditions change, depositories will be less likely to engage in this activity and are very likely to sell some of their long-term mortgages to the GSEs.

In point of fact, we believe that the willingness of depository institutions to take on the risk of funding long-term, fixed-rate mortgage assets using short-term deposit liabilities is greatly dependent on the belief of the depositories and their regulators that a strong, take-out bid exists in the capital markets. We provide this bid with your help – we fund mortgage purchases in pursuit of our statutory mission by issuing high-quality debt products in which you invest. In this sense, the depository model and the capital-market-based model are mutually reinforcing, providing a strong funding source for mortgages regardless of prevailing market environments, just as Congress intended.

Managing the Risk of a Mortgage Portfolio

Still, there is no denying that both of Freddie Mac's core business activities create risks that we are obligated to manage carefully. Holding a large portfolio of largely fixed-rate, prepayable mortgages creates significant interest-rate risks. And our securitization business transfers credit risk from the mortgage lender originating the loan to Freddie Mac.

As the senior officer accountable for deploying capital against both of these types of mortgage risks, I spend the majority of my time thinking about how to manage these risks while providing a compelling long-term return to our shareholders. Let me briefly describe the framework under which we manage these risks and generate these returns.

On the portfolio investment side of the business, we apply a simple but rigorous framework. In determining whether to purchase a given mortgage asset for our portfolio, we adhere to two strict disciplines: Our objective is to provide a return on equity that we are reasonably confident of obtaining over the life of the mortgage asset regardless of changes in prevailing interest rates or changes in the volatility of interest rates. So, in designing our hurdle rate for mortgage purchases, we use an extremely broad set of assumptions about the possible path of interest rates and volatilities and the resulting cost to us in refunding and rebalancing our mortgage portfolio.

Freddie Mac's interest rate risk management process
Note: Portfolio Market Value Sensitivity (PMVS) is the estimated percentage decline in the net market value of the corporation's interest-earning assets and liabilities from an immediate, adverse 50 basis point parallel shift in the current yield curve. Source: Freddie Mac

Let me take you through a layer of detail down on this interest-rate risk management process. If we think of our balance sheet as composed of mortgage assets on one side and debt, derivatives and stockholders' equity on the other, we can manage the convexity risk that the mortgage assets present through a number of techniques:

• First, Asset Selection itself is critical. We believe we possess a core competency in identifying assets with desirable prepayment characteristics. By modeling the behaviors of mortgage cash flows over time, we can both select desirable mortgage assets and also restructure mortgage securities so that we retain those cash flows with more stable characteristics while selling off those cash flows that may provide an attractive short-term yield but that inherently possess more long-term prepayment risks.

• Second, our Funding Mix and Strategies are essential. By issuing a wide variety of debt products, combined with long-dated option-based derivatives, we are able to distribute a significant additional amount of convexity risk at the time we put the mortgage asset on our balance sheet. We have worked hard with Citigroup and our other dealer partners to develop a more transparent and liquid callable bond market. By developing this market, we have provided you with attractive debt instruments that also give us the funding that distributes a significant amount of duration risk. In addition, at the time of funding we also distribute a portion of convexity risk through our purchase of option-based derivatives.

Through these techniques of asset selection and restructuring, and callable debt and option-based derivative funding, we are able to manage the majority of the interest-rate risk of our mortgages at the time of purchase.

• Finally, the remaining interest-rate risk is managed on a daily basis through dynamic rebalancing. Every day, we obtain market- and model-based prices on each and every mortgage, debt and derivative instrument – we mark our entire portfolio to market – and we rebalance the portfolio to ensure that we can achieve our long-term return targets regardless of changes in the market environment.

We measure our exposure by estimating the value of stockholders' equity that is at risk. We call this estimate the "Portfolio Market Value Sensitivity" and each month we publish the preceding month's average of the daily percentage of stockholders' equity at risk on a couple of dimensions.

We use both an absolute interest-rate shock – an instantaneous increase or decrease in rates of 50 basis points – and a yield curve shock – an instantaneous non-parallel LIBOR curve shift of 25 basis points – and report on these to the market every month.

Portfolio market value sensitivity is consistently low
Note: 2003 figures subject to change when 2003 financials are released. These adjustments are not expected to change PMVS by more than 2 percentage points for any given month. Source: Freddie Mac

Our results are impressive by any measure. We consistently maintain a low level of stockholders' equity at risk, even in volatile interest-rate environments such as we observed in June and July of last year.

Freddie Mac maintains a low level of interest rate risk
Note: 2003 figures subject to change when 2003 financials are released. These adjustments are not expected to change duration gap by more than 1 month. Source: Freddie Mac

We also publish a monthly duration gap figure. Over the past year, our duration gap has basically remained with a range of plus or minus one month, indicating that our assets and liabilities are well balanced and well managed.

Derivative instruments play an integral role in our overall interest-rate risk management strategy. Now, of course, distributing interest-rate risk using derivatives creates another kind of risk – namely, exposure to the creditworthiness of the counterparty with whom we are doing business.

We have made extraordinary advances in the past few years in our management of derivative counterparty risk. We have a highly diverse, numerous set of counterparties, and the credit ratings of these counterparties are also quite high. We require collateral posting for all net exposures from all but the highest-rated counterparties, and for most of these parties we are obtaining collateral on a "T+1" basis, meaning our exposures are collateralized basically on an overnight basis. And, most important, we have synthesized our management of interest-rate and counterparty risks. We have developed our systems to the point that our operating managers and traders have a real-time understanding of our exposure to a given counterparty. This enables us to execute interest-rate trades in a manner that often permits us to reduce our net exposure to a counterparty at the same time.

Turning to the securitization side of our business, our primary exposure is in the form of mortgage credit risk. And in this area, our experience is equally impressive. Let's start from the fact that Freddie Mac deals almost exclusively with residential mortgage loans – one of the lowest risk asset classes financed today. We simply do not have the kind of diverse product lines that commercial banks have, and that has enabled us to develop significant expertise and experience in managing mortgage default risk.

Significant homeowner equity supports the credit quality of our single-family portfolio
Note: 2003 data subject to change when 2003 financials are released. Source: Freddie Mac

Second, our mortgage credit risk exposure is supported by very significant homeowner equity. The average loan-to-value ratio of our overall securitization portfolio stands at less than 65 percent, and the percent of loans having LTVs of 95 percent or greater is only two percent.

This very low loan-to-value average reflects current market valuations. And we recognize that annual home price appreciation figures in recent years have been extremely strong, to say the least.

But given our current portfolio composition, we are more than prepared for a circumstance in which house price appreciation reverts to a more traditional pattern and, indeed, we are quite prepared to see house prices declining in some regions of the country. And while nominal U.S. national home prices have grown in each of the past 50 years, we would also be well positioned in the very unlikely event that we observed an actual decline in national home prices across the board. We don't believe such an occurrence is likely, but it's our job to be prepared for such an eventuality.

All of our risk management activities are aimed at helping us to obtain an attractive return on the capital we deploy regardless of exogenous conditions. And our capital position is also extremely strong. Under our statutory and regulatory framework, we hold capital to meet leverage ratios for both on-balance sheet and off-balance sheet transactions. Moreover, we also hold capital to comply with a state-of-the-art risk-based regulatory capital standard. This standard applies a stress test that requires Freddie Mac to hold capital sufficient to survive 10 years of severe economic conditions. Under the risk-based test, both the credit and interest-rate risk of the GSE's mortgage holdings are stressed to historic proportions. Our current risk-based capital requirement is quite modest, reflecting the fact that we "manage the tails" on both the interest-rate-risk and credit-risk dimensions of our business.

In fact, our business model enables us to generate capital from operations on a consistent basis. I believe this fundamental balance sheet strength is an important reason why the rating agencies provide us with such strong evaluations and why Moody's this week affirmed our independent "Financial Strength" rating of "A-Minus," one of the strongest ratings for any financial institution in the world. Our current capital position reflects a significant surplus over our binding minimum capital requirement and we are confident that we can grow our balance sheet in accordance with the needs of the market while maintaining the target capital surplus that we have agreed to hold with our safety and soundness regulator.

GSE Regulation

Let me conclude with a few remarks about regulatory oversight and the current political environment surrounding our company. Continued support for the GSE model of housing finance does not imply that improvements to the GSE regulatory oversight structure are not needed. They are. Dick Syron, our new Chairman and CEO, was himself a regulator as President of the Federal Reserve Bank of Boston. He believes that world-class regulatory oversight is critical to the achievement of Freddie Mac's mission and to maintaining the confidence of the Congress, the public and financial markets. Freddie Mac strongly supports the enactment of legislation that provides strong, credible regulatory oversight.

I am sadly aware that Freddie Mac's accounting issues are the source of much of the current controversy regarding the role of the GSEs. However, as with any episode such as this, it is critical to get the ship back on course without overreacting at the wheel. Given the enormous benefits of the conforming mortgage market, which has proven its resiliency in all interest-rate and credit environments, zeal to improve this system must be tempered with an abundance of care. That is why Dick has urged in his testimony before the Senate Banking Committee that, in enacting regulatory reforms, the Congress should "measure twice and cut once."

Much of the rhetoric surrounding Freddie Mac and Fannie Mae appears to have taken on a life of its own. We understand that such headline risk and media noise is not comforting to long-term holders of our securities. But we are confident that a consensus is emerging and that sensible, bi-partisan regulatory reform legislation will be enacted. The question is not "if" but "when" we will see such legislation. And that is subject to exogenous events that are as easy for me to predict as the future path of interest-rate volatilities. We make it our business not to predict the latter, and I will leave it to you as well to predict the timing of the former.

Conclusion

With that, let me conclude my prepared remarks and take your questions. I hope that I have provided you with a useful summary of the value we bring and the careful approach we take to managing our risks. We look forward to continuing to fulfill our important housing mission and to continuing to provide you with liquid and attractive investment opportunities that help American families to achieve their financial dreams. Thanks for your time and attention.