Eugene McQuade's Speech at the 2005 Lehman Brothers Financial Services Conference on May 12, 2005

Prepared Remarks for Eugene McQuade
President & COO, Freddie Mac

2005 Lehman Brothers Financial Services Conference
London
May 12, 2005

Introduction

Thanks, Bruce, for that kind introduction. [Slide 1] It's great to be in London and I'd like to thank Lehman Brothers for giving me this opportunity to speak to you today about Freddie Mac.

Let me start with the standard disclosures. [Slide 2] My remarks may contain certain forward-looking statements regarding business results, which are based on a set of assumptions about key business drivers and other factors. Changes in these factors could cause our results to vary materially from our expectations. These assumptions are further described in our Information Statement posted on our web site.

Overview

[Slide 3] Anyone who has followed the papers knows that at Freddie we truly live in interesting times. We've had to restate our earnings, put a new management team together, and face major regulatory legislation. That said, we are emerging out of that long dark tunnel. We're looking at a strong earnings engine … an increase in market share … good improvement in funding costs … and a dynamic market – with strong housing sales, low inventories and good employment numbers.

To explain where we are, I want to focus with you on four topics:

• Our financial results for 2004;
  
  
• Our business activities and developments in 2004;
  
  
• Conditions in the U.S. housing market today and how these conditions will affect Freddie Mac's business and credit profile; and
  
  
• Finally, how events in Washington may affect The GSE's, with the U.S. Congress considering legislation to strengthen our regulatory oversight.

Financial Results

Let's start out by looking at our reported numbers. I'll begin by stating the obvious: Since we completed our financial restatement our reported results have become volatile from year to year and will continue to be so. [Slide 4] This slide shows our earnings as restated beginning in 2000 and, as you can see, our net income ranged from a low of $2.8 billion to a high of more than $10 billion. While our reported results under U.S. Generally Accepted Accounting Principles are important, we believe that the volatility associated with GAAP results is not indicative of the underlying stability of our business as they treat half the balance sheet on a mark-to-market basis and the other half on a historic cost basis – truly comparing apples to oranges.

[Slide 5] This next slide helps prove my point. It provides a summary of our financial results for the last three years. As you can see, our net interest income has been pretty stable, benefiting from the steep yield curve environment, but trending down somewhat as a result of lower retained portfolio growth in 2004. Our management and guarantee income also has remained on track. Jumping down to expenses, these have gone up, largely in response to restatement and remediation costs to put the organization in better operating shape. We're committed to getting that number under control in 2005.

The real driver of volatility has been the large swings in "other non-interest income" largely caused by mark-to-market gains and losses on our derivative instruments. As many of you know we use derivatives to manage our interest-rate risk, and the gains or losses represent only a partial view of our total economic returns. This is because both our mortgage portfolio and our debt, which, if marked to market through our income statement, would generally offset the marks on the derivatives.

Here's the good news: while year-to-year results are likely to remain volatile, we believe we produce long-term earnings that are attractive relative to other financial institutions.

Fair Value Growth

[Slide 6] A better way to view our long-term financial growth – and a measure on which we increasingly are focused – is to look at the growth in the fair value of stockholders' equity. We believe fair value measures provide a useful view of our business economics and risks, because fair value takes a consistent mark-to-market approach to the presentation of all financial assets and liabilities, rather than an approach that combines historic-cost and fair value techniques, as is the case with our GAAP-based financial statements.

Stable fair value of common equity growth

This slide shows the year-over-year growth of our fair value of common equity for the past three years. We averaged about $5 billion a year in fair value growth, before dividends, with much less period-to-period volatility than was exhibited in our GAAP earnings during these three years. We think this was a good, multi-year return, but we've also said these numbers – at about a 20% return on fair value equity – are above our expectations going forward, as our fair value results over the past few years have benefited from the tightening of mortgage to debt spreads. As you know, this year option adjusted spreads have widened, and, all things being equal, that implies fair value growth will be lower. But we still believe fair value is a good, long-term indicator of how we're doing.

Capital

Our multi-year earnings growth has given us a very strong capital position. [Slide 7] On the screen you can see we ended the year with regulatory core capital of almost $35 billion, which is about 4% of assets, exceeding our minimum regulatory capital requirement by $10.8 billion and our 30 percent regulatory target surplus by $3.5 billion. This leaves us with eleven percent capital above and beyond all of our requirements. In fact, this represents an even stronger position compared to year-end 2003, when our core capital of $33 billion exceeded our minimum requirement by $9.2 billion. We expect to be able to maintain a surplus over both our minimum requirement and the 30 percent target surplus, across a wide range of market conditions.

[Slide 8] Our ability to generate capital has enabled us to compile a strong track record of returning capital to shareholders, in fact over the past 5 years, we've returned over $4 billion to shareholders through dividends and repurchases. In 2004 alone, we paid out $836 million in common dividends. In March of this year, we raised our common dividend by 17 percent, to $1.40 per share annually, providing a current yield of about two percent on the stock, and we have had a cumulative 35 percent increase in the dividend since the beginning of 2003. The key issue for us going forward is the extent to which we can take advantage of the current strength of our capital position. This will depend on the outcome of the current legislative discussion in Washington, which I'll discuss at the end of my remarks, as well as our ability to get the company in better operating shape, and, in particular, return to timely financial reporting.

Strong capital payout record

Business Performance

Now let's turn to the state of our business – which in 2004 was largely a good news story.

• First, we've increased our attention on our lending customers – who sell us the residential mortgage loans that we securitize and purchase. [Slide 9] On this slide you can see an improvement in our market share relative to Fannie as of the end of 2004. Our share took a sharp fall during '03, and I'm pleased to say that last year we reversed that fall and brought Freddie back into a much more competitive position under Patti Cook's leadership. We're focused now on competing not only with Fannie Mae, but also the proliferating private-label mortgage securities market. Our goal is to grow our share within both the GSE market as well as the overall U.S. mortgage market.
  
  
• On the investment side of our mortgage activities, we saw much lower retained portfolio growth in 2004. [Slide 10] Behind me you can see our growth in 2004 was about $7 billion, or only a little over one percent of our retained portfolio. Flat growth in our investments was due to the strong bid for mortgages from other investors, particularly U.S. depositories whose strong capital positions gave them a large appetite for investing in mortgages in the so-called "carry trade." In addition, banks have also strongly bid for adjustable rate mortgages, which are easier to hedge on their balance sheets. Our growth year-over-year will be responsive to the relative demand of the mortgage market for liquidity and funding. In other words, I expect that we will be most active as an investor when spreads on mortgages become wide relative to our debt and when the market needs our bid to keep mortgage rates as low as possible. As we've said and done before, we are committed to maintaining a disciplined approach to grow our portfolio only when doing so meets both our mission and return objectives.
  
  

• As our portfolio growth has slowed and as the mix of floating rate mortgage assets increases, we have been able to meaningfully reduce the amount of derivative instruments that we hold to manage interest-rate risk [Slide 11]. This means that we now are able to maintain the same, very low interest-rate risk profile while reducing our dependence on derivatives. As this slide shows, in 2004 we reduced the notional amount of derivatives we hold by more than $300 billion which is also a decline of 36 percent from the high at year-end 2002.




Derivative balances have also declined

• On the funding side, we have seen great improvements as well. [Slide 12] As you can see on the screen our debt funding costs across all maturities improved substantially over the past 15 months. Based on the volume of our medium and long-term debt issuance during this period, and assuming an average improvement of seven-and-half basis points, we estimate that this saves us around $200 million a year in lower borrowing costs on these debt securities. We've experienced a similar positive development on our mortgage passthrough security, the Freddie Mac Gold PC. [Slide 13] Here you can see the price our mortgage security relative to Fannie Mae's improved over the year by 5/32nds of a point – which may not sound like much, but translates as well into much better credit guarantee fees when we exchange our securities with lenders for the mortgages they originate.

Debt funding costs improved

U.S. Housing Market

Having looked at the condition of our business, let's look at the condition of the U.S. housing market. [Slide 14] As we all know, the market in the United States has been terrific, and the question on a lot of people's minds is whether the rapid appreciation in home values is posing a serious risk to the economy and to financial institutions funding mortgages. To be sure, there are regions of the country, particularly along the East and West Coasts – where the rate of home price appreciation is not sustainable. This slide shows the annual rate of house price appreciation in each state for the past year. Some of the annual rate increases – California, Nevada, Florida – are fairly high.

Now, while some of these markets inevitably will cool off, our view is that the U.S. housing market generally is not experiencing a "bubble," or at least one that won't pop and fall to the ground. We believe the underlying economic fundamentals explain a good deal of the recent price appreciation in the U.S. housing market. Let me tell you why.

First, employment and interest-rate conditions remain very favorable. [Slide 15] Unemployment, as you can see on the slide, is holding steady at slightly more than 5 percent nationally, with generally good labor conditions in all regions. [Slide 16] And as this next slide illustrates, long-term interest rates – while they may be a "conundrum" to our personal investing – continue to remain very low relative to historic averages, which in turn makes housing in the U.S. very affordable. The Federal Reserve has been raising rates, but these are short-term rates, while most U.S. mortgages are priced using longer-term five- and ten-year Treasury rates, which, as you are aware, have been range bound for quite some time now. And, if long-term rates do end up rising, the fact that about 75 percent of American borrowers already have mortgages with a low fixed rate of interest means that most households are insulated from rate shocks that can cause credit defaults. Long-term fixed-rate mortgages – where Freddie Mac excels and has special value – help to stabilize the housing sector and the U.S. economy as a whole.

Second, housing market fundamentals also remain very solid and provide very little evidence that the market as a whole is overheated. [Slide 17] On the screen you can see that sales of new and existing homes are continuing at a brisk pace while the inventory of homes for sale remains very low. It's a straightforward case of supply and demand, fed by new households and new immigrants buying the "starter" homes that put a floor under house values.

[Slide 18] While we believe the current rate of home price appreciation will most likely revert to the mean, we can see in this slide that during the last half century the growth in overall U.S. housing prices has remained positive – at least on a nominal basis – in every year, even during some of our deepest recessions.

So where do we think prices go from here? A forecast by five leading housing economists in the U.S. has projected annual appreciation at five percent a year over the next decade. Coincidentally, this is very close to the average appreciation rate for homes over the past 50 years, and it's a pretty reasonable estimate of where things are likely to go. That doesn't mean we will flat line at five percent, particularly if the ten-year Treasury, or unemployment go up appreciably. My personal guess is that we'll move below that five-percent line at some point and might even see some price depreciation in those regions that have seen torrid price growth.

Freddie Mac Credit Profile

Even if market conditions don't end up being as benign as the previous fifty years suggest, Freddie is very well positioned in our exposure to the U.S. housing market. We start with a significant amount of homeowner equity supporting our single-family portfolio. [Slide 19] From this slide you can see that the average loan-to-value ratio in our portfolio has fallen throughout the late 90's and has leveled off in the past few years at around 60 percent. In 2004, this level fell even further, we estimate to around 57 percent.

Loan-to-value of our portfolio continues to improve

[Slide 20] In addition, as this slide illustrates, our portfolio of guaranteed mortgages enjoys substantial geographic diversification. This is beneficial for us on the credit risk side, since housing market problems – whether from too rapid an acceleration of prices or recessionary market conditions – tend to occur on a regional basis.

We also have a strong track record in managing credit risk. [Slide 21] On the screen you can see that total credit losses, illustrated by the blue line on the bottom of the chart, in 2004 were only to $137 million, slightly higher than one basis point of our $1.2 trillion mortgage portfolio. Ninety-day delinquencies on single family loans, shown by the green line, were less than one percent of our portfolio, and improved in 2004. Although we expect credit losses in 2005 to increase slightly from their recent low levels, we also expect credit losses to remain well below their historic levels, which have averaged around five basis points.

Finally, as house prices increase in certain markets, our concentration in those markets declines, due to what is known as the "conforming loan limit." Freddie Mac and Fannie Mae are statutorily limited to a loan principal amount that is currently capped at just below $360,000 dollars. Fewer than 40 percent of mortgages in California, for example, would even be eligible for a GSE loan.

In sum, while the house price situation bears watching, we are confident we are managing our credit risks appropriately and that we are well positioned to handle any adverse market conditions.

Legislative Outlook

Now, before wrapping up, let me spend a few moments touching on the approach we are taking on legislation. Management's highest priority is to do everything we can to obtain a positive outcome from the deliberations in Congress on legislation to strengthen our regulatory oversight. [Slide 22] From our standpoint keys to a positive outcome on GSE reform legislation are:

In his testimony before Congress last month, our Chairman and CEO Dick Syron explained Freddie's important role in expanding homeownership and supporting the broader American economy. Dick reiterated our strong convictions that we would like to see GSE regulatory reform legislation pass and he emphasized our continued commitment to work with the Administration and Congress on establishing a strong, effective regulator. He also made it clear that we would review each legislative proposal against the yardstick of whether it allows us to fulfill our housing mission while at the same time being responsible to our shareholders and debt investors.

Our management has adopted a very deliberate approach to our participation in public discussions about legislation: We are using the appropriate forums to articulate our views on the legislation, and avoiding detailed discussions in other, more public arenas. Frankly, we think it is in the best interests of the company's shareholders for us to avoid debating legislative matters in the newspapers. To be sure, the wrong legislative outcome could have an adverse impact on our future financial results and prospects. But we are hopeful that Congress will strike the right balance here – strengthening oversight while allowing us to continue serving U.S. homeowners and generating competitive returns for shareholders.

Conclusion [Slide 23]

In closing, we've made a great deal of progress in renewing and refocusing the company's energies to produce value for shareholders in the long term. And we're working hard to resolve the legislative issue that remains our biggest overall risk.

Freddie has a great franchise and a new management team who are committed to improving the execution of our mission and our business, which will benefit U.S. homeowners and our shareholders alike.

Thank you for the invitation to join you. Let me now open the floor to questions.