Richard F. Syron's Speech to the Bank of America Securities Annual Investment Conference on September 20, 2004

Prepared Remarks of Richard F. Syron
Chairman and CEO, Freddie Mac

Bank of America Securities 34th Annual Investment Conference
San Francisco
September 20, 2004

Thank you, Robert [LaCourisiere]. And thank you all for being here. It's my pleasure to join you at one of the most important investment conferences of the year.

I spoke at a similar conference last week in New York. And even though we're trying to move pretty quickly these days at Freddie Mac, things have not changed that much in the three business days since my last such presentation.

But I'm not one of those people who think that the entire world is centered along the Amtrak corridor from Boston to Washington. You top people on the West Coast deserve the very same face-to-face discussion as the top people in New York. And I'm glad for the opportunity to do this with you today.

I‘ve done a lot of these talks in my past lives and I want to acknowledge at the outset that this one won't be typical. It feels a bit awkward, frankly, that our current situation does not make it possible for me to review our recent financial results with you. Nonetheless, I feel an obligation as CEO to put myself in front of the owners of the company; let you see the goods; and answer your questions as fully as I can.

I've been in this job for over eight and a half months now. What I'd like to do is tell you where we are today, where we're going and how we're going to get there. What you'll hear is basically a report on what I've done thus far to change things at the company and get our house in order, and why I believe we are now headed down the right track.

Let me begin by addressing one of the things that a number of you have wondered about, which is a fundamental question for this franchise going forward. And that is the focus I am putting on Freddie Mac's mission – and, more particularly, from your point of view as equity owners, what that renewed focus on mission means for our financial returns and long-term prospects.

It's a good question and one we've thought about a great deal in the past few months. Is the mission in conflict with the interests of shareholders? Or to the contrary, is our housing mission a source of strength for Freddie Mac? I am convinced that the harder you look at us, the more pleased you will be by our renewed focus on the mission set out for us in our charter – which is a core asset of this company.

Mission and Clarity of Focus

First off, everyone talks about our mission, but I think it helps to put a definition on the table. It's very simple, really: Freddie Mac's mission is to enhance the stability, liquidity and affordability of the U.S. residential mortgage market. That's the law – you can look it up.

Our statutory mission dictates everything we do – our market, our customers, our products. We are limited by the four corners of our charter to the residential mortgage market, plain and simple. To me, the clarity of our mission is a gift. I don't have to worry and you don't have to worry about where our business model is going – whether management is going to make a mistake with a new line of business or an expensive acquisition. We couldn't do it if we wanted to. So we're not going to morph into a financial conglomerate with operations in 50 countries. It's just not going to happen.

But while our mission is very specific, it's also suitably broad. Our charge is not limited to assisting only the “affordable” end of the market. Yes, that is an important and visible part of what we do – and it's an area where we need to do more, as I'll discuss a bit later. But doing better on affordability shouldn't undermine our overall mission of providing stability, liquidity and affordability to the broader residential mortgage market.

We're very clear on that. And it's how we run our business.

Now, I would submit to you that this is a great market to be in and that we are in a very attractive position. Let me show you some slides to demonstrate what I mean.

Our market is best measured by the amount of U.S. residential mortgage debt outstanding – what we call “MDO.” As many of you know, growth in MDO has been exceptional in the past decade. And as captured by my first slide, leading housing economists in the industry are projecting that this market will continue to grow at a rate of more than eight percent annually for the next decade.

Residential mortgage debt is projected to more than double by 2013
Source of 1990-2003 data: Federal Reserve Board; projections from Homeownership Alliance.

This growth will be driven by fundamental economic and demographic factors – including the expected rate of house price appreciation, the rate of household formation, the rates of homeownership growth and in overall mortgage borrowing.

I believe this is a terrific growth rate in what has proved to be a resilient and stable sector of the economy. It compares favorably to the growth rates in other large industries, as well. Specifically, my next slide shows how the expected ten-year MDO growth rate stacks up with the five-year revenue growth rates projected for a number of other industries. This isn't an apples-to-apples comparison: one number is raw volume growth, and the other number is projected revenue growth. But this context gives you a very good feel for how strongly our sector is growing.

Selected industry five-year growth rate estimates versus ten-year MDO growth rate
Source: Economy.Com industry growth estimates for 2003-2008. Homeownership Alliance estimate for 10-year future MDO growth through 2013.

You can see that several other sectors have higher growth rates projected. However, many of them are inherently more cyclical than housing. So we are very comfortable having a mission that dictates we focus on a particular sector that has very strong overall growth prospects.

But you know better than anyone that being in a good market is not enough. My next key point is that Freddie Mac is well positioned to grow along with our market.

Freddie Mac is well-positioned in a growing market
1 Freddie Mac as of December 31, 2003. Retained portfolio includes both Freddie Mac and non-Freddie Mac securities. 2 Freddie Mac as of December 31, 2003. Securitization portfolio includes Freddie Mac securities held in the retained portfolio. 3 Fannie Mae as of December 31, 2003. Securitization portfolio includes Fannie Mae securities held in their portfolio. 4 Federal Reserve Board (whole loans) and Inside MBS & ABS (MBS); assumes FHLBs hold only conforming mortgages.

As my third slide illustrates, measured by on-balance sheet holdings of total single-family mortgage assets, we only have 9 percent of the market. And our share of these mortgages that we have securitized or guaranteed stands at only 16 percent. I think that would give us excellent growth prospects even if we were to do nothing more than continue to keep pace with the growth of the market.

Now as I've told you, we expect growth in our retained mortgage portfolio to continue to be characterized by periods of relatively slow growth followed by periods of significant market activity. This is not only consistent with our mission; it's one of our mandates. We provide a continuous presence through our mortgage securitization activities, making mortgage investments liquid by creating a deep market that relieves investors of mortgage default risk. And when market conditions create a demand for us to significantly increase our mortgage investment activity, that's when we step in to stabilize the market and enhance liquidity. It's happened before during market disruptions and in periods when mortgages simply don't look like a good investment for other market participants who can choose to exit the mortgage sector whenever they want. Our mission says to step in and provide stability and liquidity. Fortunately, serving our mission in this way can generate profitable opportunities to deploy capital.

Being prepared for growth opportunities is one of the reasons we are committed to maintaining a strong capital position. Our strong capital base positions us extraordinarily well to support our mission, and, when conditions are appropriate, to consider dividend increases and other opportunities to return capital to shareholders.

Let me make one further point here related to our mission. Even when we are not experiencing significant balance sheet growth, our mortgage securitization and 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 as consistently low as any consumer financial product. In short, the market functions better because it knows we will be there when needed.

For example, we all have witnessed 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 own balance sheets.

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 depends at least in part on the confidence of the depositories that a strong, take-out bid exists in the capital markets. When rate conditions change, we expect that depositories will be less enthusiastic about engaging in the so-called carry trade and more long-term mortgage purchase opportunities are likely to become available to us.

Now, I'm no longer a member of the Federal Open Market Committee, so don't ask me how soon a flattening of the yield curve is likely to occur. My point is that in a broad sense, the depository model and the capital-market-based model that Freddie Mac represents are mutually reinforcing – providing a strong funding source for mortgages regardless of prevailing market environments, just as Congress intended.

Mission = Focus on Execution

Thus far you've heard a largely philosophical discussion that says, yes, Freddie Mac's mission puts us in a growing market and we have good opportunities in that market. But while we don't have numbers, let me get to the meat of where we are today. The truth is, there are plenty of companies in good markets. What separates the great companies from the also-rans is the focus and operating capability of the management team. That's what generates the long-term value we're determined to deliver to homeowners and shareholders.

When I began this job at the end of last year, I took a deep breath and decided to do something surprisingly simple: I listened. A lot. In fact, more than my wife would ever have dreamed possible.

I met with our lending customers, our debt-holders, our equity owners, the Board of Directors and the management and employees of the company. I met with key regulators, people in government and others with valuable perspectives. All this input helped me to learn where Freddie Mac executes well and where we've got room to improve. I developed an understanding of what your demands for the company are – what I think you are telling us to deliver – and what are the demands of our lending customers, the Congress and our other stakeholders. Based on this careful assessment, I have set priorities for the company – priorities dictated by the requirements of our charter and the demands of investors and customers.

My first priority was to recruit a senior management team that would help me deliver on the company's priorities. And I'm very happy to have found a group of executives with proven track records in achieving operating excellence and providing exceptional investor and customer service.

This month, Gene McQuade joined Freddie Mac as President and Chief Operating Officer. Gene is the former president of Bank of America and chief operating officer of FleetBoston Financial, and he brings a wealth of operating and financial reporting experience to Freddie Mac.

I also recruited Patti Cook, a 25-year Wall Street veteran of the fixed-income markets, to serve as Executive Vice President of Investments. Patti is likewise very highly regarded in the capital markets as a customer-focused professional. She will guide our retained portfolio operations, reporting directly to me.

Other key hires this year include bringing in Ralph Boyd from the Bush Administration as EVP and General Counsel, to manage our legal, government relations and communications functions. Hollis McLoughlin, with a dual background in business and the public sector, is bringing both strategic focus and process discipline to bear as my Chief of Staff. And we will continue taking every opportunity to build out a strong senior management team with a deep bench.

All of the key senior people I've hired have a couple of things in common. First, they are all highly motivated – they bring energy and intensity on to the field. Second, they all have track records of operational excellence: they get stuff done. Third, and this is just as important, we all like and respect one another.

You know, life is a short game; and it's too short not to work with people you like. It's not only more fun, it's a heck of a lot easier to get decisions made, develop a cohesive game plan and execute it effectively. And I can already tell, this is a senior team that is going to work together and make decisions relatively smoothly – with our shirtsleeves up and our arms linked, not our elbows out. I'm really looking forward to it.

Speaking of good things to look forward to, I'm pleased to make an announcement today that gives one more powerful sign that Freddie Mac is on the march. We are nominating today four very distinguished individuals to serve as new directors. Geoffrey Boisi is the former Vice Chairman and co-CEO of JP Morgan Chase. Bill Lewis is Managing Director and co-Chairman of Investment Banking at Lazard Freres. Barbara Alexander has held several key positions with UBS Warburg and is an Executive Fellow at the Joint Center for Housing Studies at Harvard. And Gene McQuade, about whom you've already heard, will join these three others on the slate that is up for election at our annual meeting November 4.

If elected, these four new board members will join me and two others who have come on to our board in the past year: Tom Johnson, Chairman and CEO of GreenPoint Financial; and Richard Goeltz, former Vice Chairman and CFO of American Express, who became chair of our Audit Committee.

Not incidentally, we are immensely grateful for the service of the directors who will be leaving our board. George Gould and Henry Kaufman have shown with their leadership and wisdom what being a good director is all about.

A lot of companies are finding, in the Sarbanes Oxley era, that recruiting directors and audit committee chairs is harder than ever. So I am frankly all the more delighted by the caliber, depth and diversity of the people Freddie Mac has been able to recruit. They share a commitment to our mission and have helped lead some of the world's most respected and sophisticated financial institutions. This kind of strong new blood bodes well for us. And it confirms that Freddie Mac is not just striding forward with a top-notch senior management team, but top-notch corporate governance, as well.

In any case, now that our management team is coming together, I've given them the playbook – my priorities – which are based on Freddie Mac's mission and what you have told me to focus on. Let me run through them.

First, we have to become a more mission-driven company. We need to refocus on our housing mission, particularly our obligations to the affordable sector of the overall market we serve. If we're not going to do a good job on every part of our statutory mission, we might as well give back the charter.

But let me also say that refocusing on mission and doing more on the affordable side does not mean our approach will be un-businesslike. Anyone who thinks that misunderstands what it means to be our unique kind of government-sponsored enterprise. You see, Congress told us not only what our mission is, but in effect how to accomplish it – by using private sector tools. We execute a public mission using private market discipline and private market resources. It's hard-wired into the DNA of this company to attract and retain private equity capital and private debt funding to accomplish the mission.

For me, becoming a more mission-driven company goes hand-in-hand with becoming more innovative and greatly enhancing our focus on the needs of our customers. You know we have terrific operational capability and expertise at the company. We have a reputation for being among the very best at interest-rate risk management and credit risk management. Having been at the company for the better part of a year, I'd say that reputation is well deserved. But we have been insular and somewhat closed off, both inside the company and in our dealings with our customers. Being more mission-driven means integrating and innovating and building on our capabilities to extract more value for homeowners at the margin. We can extend low-cost financing to more Americans and we can do it using private sector capabilities.

Here's one illustration of what I mean. There is a homeownership gap of some 25 percentage points between the homeownership rates of white and minority families in this country. The former is roughly 75 percent; the latter is about 50. That is not only a central truth for our mission. It is also a key opportunity for our business.

Another obvious priority for us is to get our financial reporting current. Our progress in building accounting systems and improving internal controls must accelerate and we have to finish the job. We have committed to getting our 2004 results to you by March 31st of next year. And we will be holding a conference call on November 1st in which you'll hear more about our timeline for quarterly reporting in 2005 and ultimately, getting current.

Third, we have to give you financial reporting that you can use to evaluate our financial performance. Our GAAP results reflect both historic cost measures of certain liabilities and assets and fair value measures of certain other items. Most prominently, our GAAP results reflect unrealized gains and losses on a large portion of our derivatives portfolio, which can swing significantly from period to period based on changes in interest rate levels and volatilities. This means that our GAAP results can be very volatile from quarter-to-quarter and year-to-year. We saw a very large increase in our retained earnings and capital position due to the restatement of our results through 2002. This same volatility could adversely affect our future GAAP results, due to market swings in the value of derivatives that we may never realize and do not regard as particularly meaningful to our underlying economics.

For these reasons, we recognize our need to deliver financial disclosures that will help you understand our performance better, so that you can compare Freddie Mac more easily to other large financial institutions. I know that's important to you. It's also important to me and the other members of the senior management team.

Fourth, we have to achieve greater integration and efficiency to drive down our expenses and execute more effectively. I know we are digging out of a big hole on our financial reporting and some of the required automation and other costs are unavoidable. But I'm still not happy with the way we've been spending money: our G&A is way too high. You won't see it immediately, but Gene McQuade and I are going to run a much tighter ship – for starters, by getting rid of at least a brigade or two from that army of consultants Freddie Mac has been using.

Fifth, we need to manage our capital account to execute our mission safely and soundly, but with the efficiency that allows us to deliver long-term value to our equity holders. We are extremely well capitalized today, but until our financial reporting improves, we will operate under the 30-percent surplus framework established by OFHEO. Part of our operating capability must be to manage this account with more rigor to deliver value to you while maintaining an adequate cushion for regulatory purposes and to take advantage of market opportunities when they arise.

Last but not least, we need to tackle the regulatory issues. There is nothing contradictory about being a company with private market discipline and transparency, and being a company with strong regulatory oversight. We compete in a highly-regulated financial market and the market wants to know that our regulators have the tools and capabilities to conduct proper oversight. As a former regulator myself, that strikes me as entirely sensible.

To help ensure proper oversight, we talk and meet with our regulators early and often. This is one area where too much communication is better than not enough. Such an approach reduces the possibility of surprises. It's in this kind of spirit that we look forward to working with Congress and the Administration to help determine what's required to put to rest any doubts about whether our regulators have what it takes and what they need to do the job right. And Freddie Mac will certainly come to the table and take part in that process in good faith.

So these are the priorities I have given to the new management team. I hope that you will understand the process I've been going through. In my first eight months, the priorities were more or less handed to me: clean up the accounting mess; repair our relationships on Capitol Hill and elsewhere; and find the right kind of senior talent to help revitalize our operating franchise. Now we're ready to turn the page and turn our focus to the business of our mission – to renewing and, indeed, in some respects, surpassing our business execution, operating capabilities and relentless customer focus. I am confident that the team I have assembled has the right mix of financial sector skills and the right, can-do approach to operating the company. I look forward to reporting to you on our progress.

Conclusion

You know, the most successful companies of all are those with a clear mission that they execute with ferocious focus. Such mission-driven companies have the ability to create greater shareholder value than firms that are purely financially driven. Freddie Mac has a mission that benefits our society, motivates our employees, and has the support of our nation. Our being mission-driven is not in tension with building shareholder value; rather, our charter is a source of shareholder value.

I said earlier that Freddie Mac was sometimes insular in the past, and that I'm determined to change that. Well, that's not just talk. It's why I came here today – and why I was on the road meeting with investors last week, as well. And after my new senior management team has a chance to really get established, it's why you can expect to see a lot more of us getting out to meet with investors and hear what you have to say.

So with that, let me open the floor to your questions.

Thanks very much.