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Dick Syron's Speech to Lehman Brothers Financial Services
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Thanks, Bruce. And thanks to Lehman for this opportunity to speak to you today about Freddie Mac. [Slide 1]
It is a pleasure to return to the Lehman conference today, because it gives me an opportunity to report directly to our owners on the progress at Freddie Mac, and my views on our future. I think from any perspective, the last twelve months in the housing market and at Freddie Mac should be viewed as a transition period.
Since this time last year, the slowdown in the US housing market and concerns about deteriorating credit have grabbed news headlines. And some have continued to question the GSEs' future role in the housing market.
Despite these pressures, Freddie Mac has managed to increase shareholder value and sustain our guarantee portfolio market share of the GSE market, while keeping our traditional risks low.
In addition, we have made progress on enhancing our internal financial reporting infrastructure so that we will be able to return to timely, GAAP-compliant financial reporting. We are focusing on this priority, and we recognize that it's a critical and necessary step to operating with transparency and unlocking value for shareholders.
I know everyone's been waiting for this for a long time, but as you know, the problems were worse than we originally believed. As I will discuss shortly, we are pursuing a comprehensive plan for fixing these problems, and there is no higher priority at Freddie Mac today, than accomplishing this task.
While our strong capital position and market share are no doubt gratifying, clearly they reflect what we did for you yesterday. In contrast, our future success depends on our ability to improve on our current business by returning to timely financial reporting, and responding to changing conditions in the U.S. housing market.
Let me spend my remaining time focused on those items.
Housing market is in transition
I'll begin with developments in the housing market. The housing market has clearly slowed since mid-2005, and many homeowners, policy makers and market participants are wondering if we will achieve a soft landing, or perhaps experience something a little rougher.
| Housing Market Has Come Off Its Highs |
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[Slide 3] puts the recent period in perspective. As you can see, the rapid pace of home sales and price appreciation that we experienced from 2001 through 2005 has moderated. The chart on the left shows that as of the end of July, inventories of new and existing homes were higher than they have been in the past 10 years, and well above their average level from the early 90's, another transitional period.
Similarly, the chart on the right illustrates that while still positive, nominal home price appreciation has slowed significantly in the past 12 months, and is running at an average rate that is slightly below the long-term average.
Notwithstanding this clear slowdown, 2006, taken as a whole, is still shaping up to be a good year for the mortgage market in historic terms. As you can see from [Slide 4], we do expect home price appreciation to slow from double-digit growth last year, and for home sales and housing starts to follow suit. At the levels we anticipate, 2006 would come in pretty much like 2003, or about the third best year for housing ever.
| Housing Affordability Has Declined |
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But that doesn't mean we don't have challenges. [Slide 5] shows that, since 2003, the same growth in values that has benefited many homeowners has coincided with significantly reduced housing affordability overall. The combination of higher prices and rising interest rates has made housing less affordable today than it has been at any time since 1990.
We need to turn this trend of declining affordability around, but it won't be easy. I've said publicly that the solution to declining affordability depends on more than just changes to mortgage financing. It also requires us to look at changes on the supply side, such as zoning and building restrictions, among other factors.
As a GSE, Freddie Mac is chartered to promote liquidity, stability and affordability in the US mortgage market. This mandate creates our unique niche, and requires Freddie Mac to manage our business for long-term achievement of our mission, and long-term, not short-term returns on equity. Historically, this approach has enabled Freddie Mac to maintain a strong capital position and helped us to assure continued access to mortgage credit throughout difficult economic periods.
Freddie Mac plays a strong role
[Slide 6] shows that Freddie stands ready to play this supportive role today, as we have in the past. As you can see, Freddie Mac has steadily increased both our regulatory core capital and fair value over the past three years.
[Slide 7] bears this out. The chart on the left shows our duration gap – which is a key measure of sensitivity to adverse interest rate movements. At roughly zero months of sensitivity since 2003, it's pretty darned low. Keeping portfolio risk low gives us the capability to hold mortgages over a long investment horizon, without taking on significant directional interest rate risk.
On the credit side, on the right, you see that our exposure to a national house price decline is also very low. At the end of 2005, our sensitivity to a 5 percent national house price decline was about $600 million, or roughly 2 percent of our fair value of common equity. That's on a total guarantee portfolio of approximately $1.3 trillion which says something about the credit quality of our book of business.
We owe this low credit risk sensitivity to the combined effects of a strong loan-to-value ratio, and a broadly diversified national mortgage portfolio.
[Slide 8] shows that in the past 10 years, Freddie Mac's average LTV on our credit guarantee portfolio has fallen from 67 percent to 55 percent – a level that is lower than it has been since the beginning of 1990, and well below the average over that period.
If we get slower or negative growth in home prices, we would expect this LTV number, as well as our credit losses, to increase as they have in the past, but the point is that we are well diversified from credit shocks, and our guarantee business is positioned to weather even a harsh credit environment.
[Slide 9] shows that as of the end of 2005, our credit guarantee portfolio is geographically diversified throughout the US. As a result, even if we experience weak conditions in some regions of the country, the portfolio's overall value should be protected by continuing strength in other markets.
This is a good example of how succeeding nationally in our mission also makes our business stronger.
| Annualized House Price Growth for Second Quarter 2006 |
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[Slide 10] Shows a regional breakdown of US house price growth for the second quarter of 2006, which we released last week. As you can see from the areas shaded in red, home prices have stayed flat or actually fallen in a few parts of the US, directly tied to local economic performance.
In the East North Central region, for example, slow economic and employment growth are primarily responsible for price declines in parts of Ohio and Michigan.
New England has been affected by weak employment gains, a soft vacation home market, and a market correction to overvalued homes.
I should know – I sold one, and not at the peak.
Still, the US as a whole achieved moderate nominal house price growth for the second quarter.
Bottom line: We expect that the recent choppiness in regional house prices trends will continue, with some MSAs and local markets seeing year over year declines while others continue to chug along.
Because of our strong capital position, we think we are very well positioned to weather local and regional down turns, but as you'd expect, we are watching the situation very carefully. In addition, we will continue to be active across the entire US, throughout periods of weakness, and will not pull out of declining areas. This is a fundamental aspect of our mission, and we will continue to perform it.
Since I joined Freddie in 2003, I have made meeting our affordable housing goals a key component of our overall corporate objectives. Since then, we have integrated our mission into our every day activities, rather than approaching it as a "cost of doing business."
Business is strong
As you can see from [Slide 11], this attention has paid off, and we have continued to fulfill our goals in the past two years, despite their increasing difficulty. Fulfilling our increasing HUD affordable housing goals every year is a real achievement, particularly as affordability deteriorates nationally.
That's why despite our past success, we can never be complacent about our mission. It is why Congress chartered us. Rather, we need to adapt and innovate to meet increasing housing goals. Not incidentally, I believe these same efforts will also help us to hit our objectives for increasing our share of the total guarantee mortgage market.
[Slide 12] shows that through greater business flexibility, customer service and innovation, Freddie has been able to regain our traditional share of the GSE guarantee market over the past three years.
We have done this by increasing our historically low market share with several prominent lenders, focusing on achieving a minimum level of share with a broader group, and aggressively competing for continued high share with existing customers. In each of these areas, our willingness to extend our mortgage bid from the traditional GSE market into new products has enabled us to capture business.
Increasingly, these efforts have required Freddie Mac to utilize both our on-balance-sheet retained portfolio and our off-balance-sheet guarantee portfolio. This evolution in our business model has been in the works over the past three years, and is becoming more important to our financial returns as well as our public mission.
Since the end of the refinance boom in 2003, Freddie has increasingly purchased and guaranteed a higher percentage of variable-rate securities and alternative mortgage products, than we did historically.
Let me give you two examples. On the retained portfolio side, Freddie has increased our investment in highly rated variable rate securities to 40 percent of our portfolio as of June 30th, from about 29 percent at the end of 2004. These purchases have been essential to meeting our mission goals, and have also provided good financial returns.
In the guarantee portfolio, Freddie has also increased our activity in alternative mortgage products in 2006. As of the end of June, these products accounted for roughly 6 percent of our total guarantee book, up from less than 1 percent in 2003.
In both examples, our increased breadth of investment and guarantee activity has helped us to meet our mission and broader business objectives. But let me assure you that while we have made headway in expanding the types of mortgages we guarantee and purchase, we continue to manage our portfolios in a very prudent, balanced and responsible way.
[Slide 13] shows that continued innovation in our debt issuance has helped Freddie Mac to expand our already strong funding programs in the past several years.
As you can see on the left, our borrowing costs have richened significantly relative to LIBOR in the past two years, particularly in the 5- and 10-year segments. This has allowed us opportunistically to lengthen the maturities of our outstanding debt, thus reducing our rollover risk, without compromising our long-term returns.
In addition, the chart on the right shows that Freddie has significantly increased the amount of funding we source through issuance of callable debt. I think this is one place where the GSEs have a real comparative advantage. Through focused efforts to standardize pricing conventions and promote secondary market liquidity, Freddie has increased our callable debt outstanding to more than $300 billion over the past three years.
This growth in our callable debt balance has allowed us to fund more than 60 percent of our fixed rate mortgage portfolio, and cover more than 50 percent of its convexity risk. As a result, Freddie has diversified our hedging activities away from the top 10 broker dealers and into the hands of over 1,000 global debt investors. In this way, together with the derivatives market, callable debt serves as another tool for us to maintain safe and sound operations, and manage interest rate risk on a day-to-day basis.
Comprehensive Plan / financial reporting objectives
Increasingly at Freddie Mac, success in our mission and in our business is dependent on success in improving our internal systems and controls. This point is important to our customers, our investors and of course our regulators.
On the regulatory side, last month Freddie Mac announced a voluntary, temporary growth limit on our retained portfolio in response to a request from our regulator, OFHEO. Let me highlight two important points.
First, the letter sets a specific trigger for the expiration of this growth limit: namely, our return to quarterly financial reporting under GAAP.
Second, it provides for modest portfolio growth to support our mission, through the purchases of multifamily whole loans, private label asset-backed securities, commercial mortgage-backed securities, and other assets that are intended to help us meet our affordable housing goals or sub-goals.
I regulated banks for more than 20 years. And I believe it is very important for Freddie Mac to have a productive, open and mutually respectful relationship with our regulator. By taking this action, we safeguarded our mission, took the right step for our shareholders, and reduced an important source of uncertainty for the company.
| Financial Reporting Objectives / Comprehensive Plan |
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As our letter with OFHEO makes clear, now more than ever, getting our financial controls and reporting done right and in a timely fashion is the highest priority for senior management and every Freddie Mac employee. [Slide 14] shows the critical steps in our comprehensive plan and reporting timeline.
As you can see, our objective is to return to quarterly reporting, following the release of our full-year 2006 results. In terms of timing, our goal is to issue full-year 2006 results by late in the first quarter of 2007. Then our focus will shift to getting out the quarters for 2007.
As for our controls work, suffice it to say our approach is comprehensive. We are fixing known issues; implementing improvements to our close-the-books process; implementing critical systems initiatives; and finally, carrying out a control review to ensure that from end to end, our upgraded system is working as seamlessly as it should. We've made progress in several of these areas already, and will have more to tell you at our next market update call.
Capital management
| Increased Return of Capital to Common Shareholders |
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[Slide 15] shows that Freddie has significantly increased our return of capital to common shareholders in the past three years, largely through growth in our annual dividend.
Beginning in 2006, the increase also reflects common stock repurchases associated with our preferred for common swap transaction. Having spoken to many of you on this topic, I know it is an area of focus, so let me give you a couple thoughts on how I view our common dividend, and additional capital management activities.
While we have clearly taken significant steps to improve the dividend in the recent past, I am hopeful that over time, we can continue to increase our common dividend until we reach a payout rate that is closer to that of other large cap financials.
In addition, we have made significant progress on our preferred for common swap, having repurchased approximately 25.5 million shares, or $1.5 billion as of the end of August, and issued $1 billion of preferred in July. In addition, we feel we should be able to bring our total capital balance to a level that's closer to our long-term targets.
At the same time, as you know, Freddie Mac has a strong and deeply involved regulator. We will continue working with OFHEO and others to make it clear this company has a responsible and thoughtful approach to capitalization.
We will also continue to execute against our board authorizations and proceeding in consultation with our regulator to seek additional ones as appropriate.
While we do so, we will remain conscious of our potential uses of capital in planning for the future as is required under our charter. I can assure you, the management team at Freddie Mac is very focused on growing the business over the long-term and returning capital when it is efficient and appropriate to do so.
Conclusion
Today, with housing so sensitive to mortgage rates and the economy so sensitive to housing our company's role is more vital than ever.
The senior team of Freddie Mac is acutely aware of our obligations to our stockholders. We are grateful for your support, and we are working hard to keep earning your confidence.
Toward that end, Freddie Mac is meeting our mission and maintaining the momentum of our business. We have taken important steps to reduce regulatory uncertainty. And we are fiercely focused on completing our accounting and internal controls remediation, once and for all.
Thank you again for investing in Freddie Mac and for your attention here today. I'd be happy to take your questions.
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