Buddy Piszel's Speech at the Bank of America 37th Annual Investment Conference on September 17, 2007

Prepared Remarks of Buddy Piszel
Chief Financial Officer

Bank of America 37th Annual Investment Conference
San Francisco, CA
September 17, 2007

Good morning.  I want to thank Bank of America and Robert Lacoursiere for giving me the opportunity to speak this morning about the risks and opportunities in the markets today and how Freddie Mac is capitalizing on them.

[Slide 1] I’ll summarize the takeaways up front, then we’ll go into a little more detail.

• One, while market turmoil has forced many companies to retrench, we have benefited from expanded growth opportunities in both our guarantee and retained portfolios.
• Two, Freddie Mac’s low exposure to the riskiest mortgage products positions us for lower credit risk and lower future credit losses in basis points than practically any other company in this industry.
• Three, having made significant progress on our financial reporting and controls remediation, we are focusing next on improving our business capabilities and efficiency through several high-value, targeted investments.  
• Finally, the net of our reduced remediation expense and investment in our capabilities will yield a significant amount of absolute cost savings beginning in 2008, and continuing throughout 2009.

Taken as a whole, these facts give us confidence in our ability to produce compelling value for our equity investors over time.  

Guarantee business

[Slide 2]  Let’s start with growth in our guarantee business.  By any measure, it is strong. Through the second quarter, Freddie Mac increased the size of our credit guarantee portfolio by an annualized 16 percent – at a time when total U.S. residential mortgage debt outstanding is on track to grow at about 6 percent for the year. 

This shift has largely reflected the change in mortgage originations away from ARM products and back towards traditional fixed rate loans.  This is an about face from the past several years when high ARM production allowed private label mortgage security issuers to take significant volumes from us.  

During the first part of 2007, we also achieved higher fixed rate production and growth in our bulk purchase channel.  I’ll go into this last point at greater length in a couple minutes, but improvements in our bulk volumes are very important for Freddie Mac because they are an area where we have been able to achieve significantly better risk-based pricing in 2007.  

Since these trends towards fixed rate loans and bulk securitizations have increased recently, I would expect our total volumes to continue growing throughout 2007, and for our year-end 2007 penetration to be better than last year.

[Slide 3] Freddie Mac’s regional diversification in our guarantee portfolio is one reason that we have been able to continue growing, in a sound way, despite the recent softness in many of the largest regional housing markets.  This is a strategic differentiator for us. While many mortgage players have high concentrations in California, Florida or the weaker Midwest markets, our house price risk is spread throughout the U.S. as a whole.  

As the chart behind me shows, weakness in California, Florida and Michigan is mitigated by strength in other parts of the country.  Over time, this reduced house price risk has translated into significantly stronger credit performance at Freddie Mac compared to the market as a whole.

While there is no doubt that in general house prices are weakening, the effect on Freddie Mac’s total credit exposure is mitigated by two points.

• First, many of the regions shown in red actually benefited from significant house price appreciation in the previous three years.  
• Second, about 58 percent of our total guarantee portfolio is based in states that were still experiencing positive house price appreciation at the end of the second quarter – that is, those states shown in yellow or green.  

This is because states like North Carolina, Texas, Oregon and Washington have continued to benefit from improving house prices, as big regional industries such as financial services, energy, and technology as well as international trade have kept employment strong.  

Over the long term, employment has been the key factor in determining house price appreciation in the U.S.  As some of you may recall, it was a series of regional economic downturns and unemployment in New England, the Mid-Atlantic, Texas and California that produced the last significant house price correction in the U.S. in the early 1990s.

We don’t show it here, but in our second quarter earnings call we put out a slide that shows changes in regional delinquencies in the first and second quarters of 2007 compared to our book overall. The basic trend that emerges is exactly what you’d expect in looking at this map.

[Slide 4]  While we have started to see some increases in delinquencies in specific states, as you can see here with our total single-family serious delinquency rate at 42 basis points, we are an industry leader.

As we make our way through an increasingly difficult credit market, this delinquency advantage will translate into lower losses at Freddie Mac.  Through the end of the second quarter, we had total credit losses (that is charge-offs plus REO expense) of 1.7 basis points.

For full year 2007, I expect that number to come in below 3 basis points.  That compares to a historical average at Freddie of about 5 basis points.  While we do expect that number to go up in 2008, our current low level compared to other companies indicates that our credit risk is well-managed.

Since we need to increase our reserves ahead of charge offs actually occurring, it is likely that our provision for credit losses will front-load this pain, as it started to do in the second quarter. As you would anticipate though, once we come through the credit cycle the provision will decline.   

[Slide 5]  Another major reason for our strong credit performance relative to the market is that we have very low exposures to Alt-A and risk layered mortgage products. Taken together, these represent about 8 percent of our total single-family guarantee portfolio.

On the Alt-A side, as of the end of June, we guaranteed $120 billion of loans that were either identified by the originator as Alt-A or had reduced levels of documentation. As I discussed earlier, many of these loans were sourced through our bulk channel, and so their pricing was specifically tailored in light of their increased risk.

In addition, for the Alt-A book, we have significant credit enhancement, strong average current LTVs of 71 percent and FICO scores of 715.  Our experience tells us these attributes should limit the credit impact from these loans.

As to risk layered products with low FICOs and high LTVs, at the end of the second quarter, we had total guarantees of about $10 billion, or less than 1 percent of our portfolio.  Moreover, 94 percent of these loans had credit enhancements. So while we are not totally immune to these risks, when compared to other market participants, I think you’ll find ours to be very low.  

So again, whether you view our overall portfolio, or look to our Alt-A book, layered products, total single-family delinquencies, or charge-offs, we feel our credit position is near the very best in the industry.    

[Slide 6]  While we are being very deliberate in the credit risk we take on, I want to be very clear that the current credit market situation also presents us with the opportunity to regain some pricing power.  While this slide doesn’t make the point clear because of noise from amortization amounts, since mid 2006, our all-in guarantee fees have begun to improve. 

Most of this increase has come from a product shift out of ARM and 15-year products into more traditional 30-year loans – but increasingly, higher delivery fees on bulk guarantee volumes have helped as well.

Throughout this year, we have increased our guarantee fees on bulk channel purchases where we can more closely tailor rates to the risks we undertake.  Since bulk deals are executed from time to time as originators need liquidity, and often focus on adjustable rate products, the pricing tends to behave more like a spot market for credit risk.

In our more traditional flow channel – where guarantee volumes and terms tend to follow 6- to 12-month contracts, and guarantee fee pricing takes longer to adjust – this year we were able to begin increasing credit delivery fees on certain programs and also, when possible, to begin tightening credit terms.  

As house prices continue to remain flat to down in much of the country, it will become increasingly important for us to find ways to re-price our guarantee fees so that future returns in the business remain attractive throughout the credit cycle. Let’s turn to the retained portfolio. Here, the current portfolio investment opportunities are the best we’ve seen in years.  While in the near-term, mark-to-market effects will be choppy, the reality is we’re adding business today that will be profitable for many years to come.

Retained portfolio

[Slide 7] Through July of this year, Freddie Mac increased the size of our retained portfolio at an annualized rate of 4 percent.  Most of this growth followed substantial improvements in OAS margins. As you can see on the chart behind me, at the end of June, the average OAS on our portfolio was approximately 40 basis points – an improvement of about 10 basis points over the end of year level.

This trend continued in the month of July, with overall portfolio OAS widening by about another 10 basis points, due to the market turmoil we’ve experienced recently.

As OAS spreads have trended upwards throughout 2007, our net purchase commitments have increased accordingly.  As our large commitments from June settle, we will rely upon our restructuring activities to add incremental shareholder value to our portfolio.  Over time, we have developed industry-leading capabilities on this front, and as a result have generated stronger returns even in low growth periods.

Importantly, we were able to capitalize on this opportunity in 2007 because we reduced the size of our portfolio in 2006, in part to comply with our voluntary temporary growth limit.  

Since the majority of our recent commitments and growth has focused on fixed rate assets it is likely that GAAP net interest income and NIM will also both benefit from these investments.

Increased purchases of fixed rate assets in our retained portfolio in 2007 are a result of changes in the underlying origination patterns.  This reflects the relative widening of fixed rate OASs relative to our debt, which makes them an attractive investment for us.

In July and August, OASs have generally widened out from their end of June levels. This has resulted from a combination of the mortgage to LIBOR spread increasing (which implies mortgages cheapened), as well as the spread between Freddie Mac’s debt and LIBOR widening (which implies Freddie’s debt richened).

[Slide 8] shows this last trend.  Our continued ability to issue debt at very attractive levels is a big reason for the improvements in OAS that I just mentioned. While our funding curve was re-shaped a little in the past month, as you can see here, we are still funding at very attractive levels below LIBOR – even amid the recent market disruption.  

As recently as two weeks ago, we priced $4 billion of 2- and 5-year Reference Notes securities at prices of 24 and 18 basis points below LIBOR respectively.  This funding advantage allows us to continue investing in our retained portfolio through even the most difficult financial markets.  Over time, Freddie Mac has achieved this goal by targeting specific asset classes that further our mission and increase shareholder value.

One way we’ve done this is through our investment in AAA rated ABS securities. This has been an area of intense focus for the markets recently, so let me make a couple comments.

[Slide 9]  First, on our recent volumes.  Unlike in the agency market where we frequently buy seasoned securities, we have tended to purchase ABS securities almost exclusively through new securitization deals.  Between 2004 and 2006, this gave us the best pricing transparency and purchase volumes, as increasing, private label issuance produced more and more AAA rated tranches.  

Since the recent spread widening has produced significant illiquidity in the ABS market, there has been an almost complete shutdown of new issues.  Thus, while spreads appear very attractive, there is limited availability of ABS that we can buy.

Second, as we disclosed at the end of last month, Freddie Mac holds approximately $119 billion in AAA-rated securities backed by subprime mortgages.  None of these securities have any CDO exposure, and we benefit from an average subordination level of approximately 34 percent that protects our equity value from any credit problems on the underlying loans. Due to this protection, we have not yet taken any meaningful credit losses on this position, and we do not expect to take any in the future.

So there you have it — strong growth, industry-low credit exposure, improved pricing power and wider OAS margins.  Taken as a whole, the net revenues outlook for Freddie Mac is improving significantly.

One of the exciting things, and one of the main reasons I took the job at Freddie, is that in addition to our top line potential, I see the ability to realize a meaningful amount of very achievable cost savings over the next couple years.  

Administrative expense

One thing I’ve learned in managing financial institutions is that the focus on managing costs increases in tough markets. Since we have focused a lot of resources in 2007 on fixing our financial reporting and control issues, I expect that we will end the year with admin up roughly $100 million over 2006 levels.  Considering the growth in our business volumes, year over year, this makes us basically flat at about 9.2 basis points as a percentage of our total mortgage portfolio.

To be clear, there is leverage in our business model and over time, total administrative expenses will decline in absolute dollars.  Importantly, we will be able to achieve this goal while still investing in expanded business capabilities that will improve our security performance and our ability to more dynamically manage credit risk.  

You should get a down payment on these savings in 2008, and a more significant reduction in 2009.  I’ll have better clarity on the timing and amounts later in this year, once we have finalized our analysis and planning, and we’ll update you as to the specifics at that time.  But make no mistake, Freddie’s G&A will come down meaningfully in the next two years.

Capital and financial timeline

Finally, let me briefly touch on capital and our financial reporting timeline. 

First, capital. As we discussed on our call late last month, during the third quarter, we completed our $1 billion preferred for common swap by repurchasing $250 million in common shares, and issuing an additional $500 million of preferred. 

Given the current level of spreads in the market and growth opportunities in both our guarantee and investment areas, we are balancing capital returns with our ability to invest in the business in ways that will provide attractive long-term returns.  

While the mark-to-market effects of credit spreads and interest rate moves can potentially impact our retained earnings, it’s important to note we have very good ability to source additional capital should we need it to fund profitable growth.

On our timeline, with our release of second quarter results in 61 days, we have accelerated our financial release process. Given this success – and our commitment to keep improving with each release – we’re targeting the release of third quarter results by Thanksgiving.

[Slide 10] Let me make a few closing points before Q&A.

First, as I’ve discussed, while the current unrest in the financial markets is causing turmoil for many mortgage companies, the underlying trends are benefiting Freddie Mac.

Second, in contrast to the sharp reductions in volumes and changed business plans that many weaker players in the mortgage industry have been forced to address, we are continuing to grow our business, to capitalize on our funding advantage and to maintain our disciplined credit exposure.  In this way, we are exploiting our core strengths to strengthen our long-term strategic position. 

Finally, the market events of the past two months have pointed out very visibly the ongoing role that Freddie and Fannie play in the mortgage market.  Far from representing an uneconomic subsidy, the GSEs are designed to provide liquidity, stability and affordability to the market.  That’s what we do – in good times and bad. This serves both our mission and our shareholders.  

Thanks to sound risk management and a high quality book of business, we are playing our vital role in the markets once again today – and we stand ready to do even more.

Thanks, and now let’s turn to your questions.