Patti Cook's Speech at the Lehman Brothers 10th Annual Financial Services Conference on May 17, 2007

Prepared Remarks of Patti Cook
EVP – Investments & Capital Markets

Lehman Brothers 10th Annual Financial Services Conference
London
May 17, 2007

Good afternoon. I want to thank Lehman Brothers and Bruce Harting for inviting me here to talk about Freddie Mac and our long-term role in the U.S. housing and mortgage market.

[Slide 1] Everyone has seen softness in the housing markets lately. Despite that, I believe Freddie Mac is a good way for investors to participate in the long-term growth of the U.S. housing and mortgage market.

What are the facts underlying this belief?

I'll begin by sharing a fair amount of information about the housing markets, the broader U.S. economy, and the demographic trends that will shape demand for housing in the coming years.

Next, I'll turn to Freddie's solid fundamentals – including our high quality assets, low cost funding, and the growth in our customer volumes.

I'll talk about the subprime problem, and the role Freddie is playing to help solve it – aided by these same solid fundamentals.

You'll get a look at how Freddie's interest rate and credit risk profiles remain low, notwithstanding the short-term mark to market effects with which many of you are familiar.

Finally, I'll touch on the continued improvement of our capital structure through increasing dividends and share repurchases.

My overarching thesis is that, notwithstanding current market conditions, Freddie is in a strong position not only to weather a housing downturn, but also to keep serving our mission and building shareholder value.

After my presentation, I look forward to answering your questions.

[Slide 2] It may seem counterintuitive for me to talk about strength in the housing market, but by most measures, the long-term outlook is good even though near term adjustments are beginning to restore the balance between supply and demand.

Home building and prices outran long-term demand in recent years. After this current adjustment period passes, the housing and mortgage markets should resume their growth in keeping with long-term trends. And in many ways, we are fortunate that the rest of the economy – driven by corporate profits, consumer spending and stable interest rates – is fueling growth during this period.

The net result of this is that GDP growth excluding housing has been running at 2.1 percent over the past four quarters, while housing has reduced this by about 1 percent. While I am generally optimistic, I think that given this data, most economists would even agree with my belief that this underlying economic strength will keep us from slipping into a recession.

[Slide 3] Make no mistake; we are in a housing downturn. This chart shows that house prices were flat to down throughout most of the U.S. for the twelve months ending in March, with particular weakness in the most recent quarter. As you can see, most of this weakness is on the coasts and in the East North Central states being offset by strength in the Southeast and oil-producing states.

While this picture looks bleak, it is important to remember that these price declines come after a period of unprecedented appreciation between 2003 and 2005, when the average home in the U.S. gained approximately 27 percent in value.

These facts, together with continued low unemployment, give me reason to believe that this is not the beginning of a collapsing housing market, or the leading edge of a broad economic downturn but rather a working off of some of the excesses from recent years.

[Slide 4] Here you can see that as I indicated earlier, inventories of existing homes increased significantly in 2006.

While the current months-of-supply is high by recent experience, it remains well below the levels seen in prior downturns.

As would be expected, many of these problems are focused in the condo market, where vacancies are roughly four times that in the single family detached market, and in previously-hot areas like San Diego, Boston and Miami.

[Slide 5] Increased supply in markets such as these will clearly cause a continuing drag on prices in periods to come. But again, this isn't surprising given the level of price appreciation we experienced in the past few years, and the fact that home prices so significantly outpaced wage growth.

While this trend benefited many homeowners, in recent years, accelerating prices reduced affordability – making it more difficult for first time homebuyers.

Despite these near term declines, the breather we're currently experiencing is a healthy development for the long term, in that it will give incomes a chance to catch up with prices, and improve affordability.

[Slide 6] Over the long term, growth in housing and mortgage markets should mirror the underlying fundamentals. Here you can see that through the first quarter of 2007, jobs in the U.S. remained relatively plentiful.

This strength in employment is critical for the housing and mortgage industry, since historically, job loss or unemployment has been the primary reason for delinquencies.

Since homeowners tend to pay their mortgage if they are employed, and have sufficient income, it looks like job losses do not pose a significant near-term risk to housing. Again, I'm speaking nationwide, outside of areas in the Rust Belt.

[Slide 7] Just as important for the long term, demographic trends also favor housing.

First, as you can see here within the rectangle, the 55 to 74 year age cohort represents peak home ownership at about 80 percent. 

[Slide 8] And as seen on the next slide, this is exactly the cohort that will expand the most over the next 20 years, as the baby boomers replace the previous generation.

Second – and I think more important than this "baby boom effect" – is that over the next decade, demographers expect there to be some 15 million new households in the United States. Approximately 10 million of them will be minorities, and recent immigrants will likely account for 5 million. Many of these will be first time homeowners.

Providing financing for these families is a big part of our public mission, and should help our long-term growth.

[Slide 9] As you can see here, since 1970, mortgage debt has grown at an average rate of almost 10 percent.

Going forward, we expect a growth rate of about 8 percent, which would double the amount of mortgage debt in the next decade, a level that should provide good growth opportunities for Freddie over the long-term.

As an aside, this is a long-term growth rate that most industries and companies would be ecstatic to see in their underlying market.

So there you have it: a growing economy, low unemployment, and favorable demographic trends all point to attractive long-term growth rates in mortgage debt outstanding. Now let me turn to our business.

[Slide 10] This slide shows that since 2005, Freddie has managed to increase the growth rate of our guarantee business. This has been a strategic priority for us, and we have made significant strides in improving our customer relationships and broadening our mix of business across customers and mortgage products.

We have achieved this growth by maintaining a disciplined approach in underwriting the credit risk we take on, and by enhancing the value proposition we bring to our customers.

It is important to note that our business volumes will vary over time, and we will not imprudently chase growth at the expense of long-term shareholder returns. The most significant market trend in the first quarter has been the deterioration of subprime mortgage credit.

I don't have to tell you the short-term market impact that this has had, since practically every day there seems to be another news story on the subject. For many homeowners and financial institutions, making it through this period is a real challenge.

As a GSE, during periods of market disruptions, we are called on to increase activity to provide stability, liquidity and affordability to the U.S. mortgage market.

As others have noted in the policy arena, while the GSEs didn't create the current subprime problem, we are taking significant steps to help solve it.

Our recent subprime commitment is a good example of how we fulfill our mission.

[Slide 11] Freddie's disciplined approach to credit underwriting and our high asset quality has put us in the position to make this commitment.

As we've discussed in the past, at the end of 2006, Freddie had basically no subprime exposure in our guarantee business, and about $124 billion of AAA rated subprime exposure in our retained portfolio.

As you can see here, the vast majority of our guarantee portfolio continues to focus on long-term fixed-rate mortgages.

All that is no reason for complacency, however. I am deeply concerned about the dilemma facing subprime borrowers, and I believe we have an opportunity here to serve our mission and generate shareholder value.

Last month, we announced that we will purchase up to $20 billion in fixed-rate and hybrid ARM subprime products structured to limit payment shock on borrowers.

In doing this, we will focus on the higher quality segments of the market, and will stay away from the riskier loan products, and those with no documentation. This is an area where if we handle it right, what's good for our mission will be good for our business, as well.

[Slide 12] Our credit discipline has also helped Freddie Mac to demonstrate significantly lower delinquency rates than the broad market – and to do so not for a quarter or two, but over a sustained period.

As you can see, through February of this year our own single-family delinquency rates have stayed very low at about 53 basis points, although I would expect this to increase with the slowdown in coming months.

[Slide 13] Part of the reason for our continued strength is the fact that Freddie Mac has a diversified national portfolio. This helps to mitigate the impact on our total results of regional weakness due to economic slowdowns or inventory overhang.

Thus, through low delinquency rates and our diversified regional exposure, Freddie Mac is better positioned than most market competitors to withstand this period of heightened credit risk. Particularly since the amount of our business coming from California and other high-cost states is lower than most market participants.

[Slide 14] This low risk advantage extends to our interest rate exposures as well – where as you can see, our PMVS and duration gap levels have stayed very low over the past year.

Charts like these and the ones we just looked at make it clear to me that – far from posing unique risk to the market – Freddie Mac appropriately manages our interest rate and credit risk to levels that allow us to support the market in times of need.

One reason for this continued stability is that Freddie Mac economically hedges far more of the interest rate risk of our portfolio through the use of callable debt than most financial institutions, including our large bank competitors.

This track record has served us well over time – and has enabled us to argue our case that our capital requirements should be based upon the underlying risk in our business.

While work on the legislative and regulatory front is ongoing, our low interest rate and credit risk and improvements we are making in our financial reporting and controls will make us a stronger company over time, and should help us make our case with the appropriate parties.

[Slide 15]  While Freddie Mac has historically kept our credit and interest rate risks very low, our financial results have continued to display significant quarterly volatility.

To a large extent, this is due to the effect of asymmetric mark to market items on our GAAP financials and widening of certain spreads on fair value disclosures.

Having managed fixed income portfolios for most of my career, I do believe that markets generally price financial assets and risks more efficiently than model based methodologies.

However, as can be seen in the chart, often times, short-term disruptions in interest rates, option adjusted spreads or credit spreads have had a significant quarterly impact in our financial results.

Since Freddie is a longer-term guarantor and investor in the mortgage market, these short-term impacts don't entirely reflect our long-term results.

This dynamic can be seen in the contrast between these two charts. The chart on the left shows that over the past two years, our quarterly financial results have varied widely, with some negative periods, while the chart on the right shows that on a full year basis, our returns have been positive, and more stable.

Given the weaker housing market at the end of last year, some of the reduction in fair value you see in the third and fourth quarters of 2006 is associated with a higher present value of future default costs, which we would expect to realize over time. However, we feel that a sizable portion is due to increased risk premiums in the market, which we would not expect to recognize through credit losses.

Over the past several years, we have expanded our disclosures to help clarify these issues, and we are continuing to work on this topic so that the short-term sources of volatility and long-term sources of value creation are more evident in our financial reporting.

[Slide 16] Notwithstanding this volatility from period to period, continued growth and profitability in our underlying business and low risk levels have allowed Freddie to increase our returns of capital to common shareholders in the past several years.

Here you can see that between 2003 and 2006, we significantly increased our common dividend and repurchased $2 billion in common shares. In 2006, these two activities totaled more than $3.3 billion in returned capital – the most ever for Freddie Mac.

While we'll provide specific details during our earnings call in June, I can tell you that we have made significant progress on our commitment to repurchase $1 billion in common shares in conjunction with the issuance of preferred stock.

As we continue to make progress on our financial reporting and controls remediation, we will make every effort to continue this trend of returning capital to our shareholders.

So there you have it. A market that will be growing by roughly 8 percent. And doing business squarely within it, a company with low levels of interest rate and credit risk, growing customer volumes, improving operations, and increased return of capital to our shareholders.

Even if things were to get considerably worse for housing Freddie is strongly positioned to ride out the storm. As housing emerges from its current slowdown, we will remain a very sound long-term investment in the growing U.S. mortgage market.

I know we threw a lot of slides and information at you today. We're very grateful for your interest in Freddie Mac and I'm happy to answer your questions.