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Fannie Mae (FNM)

Q4 2006 Earnings Call

August 16, 2007 1:00 pm ET

Executives

Dan Mudd - President and CEO

Enrico Dallavecchia - EVP of CRO

Mary Lou Christy - SVP of Investor Relations

Bob Bakely - CFO

Peter Niculescu - EVP

Tom Lund - SVP Single Family Mortgage Business

David Berson - Chief Economist

David Hisey - SVP

Analysts

Paul Miller - FBR Capital Markets

Bruce Harting - Lehman Brothers

Eric Wasserstrom - UBS

Brad Ball - Citigroup

Ken Bruce - Merrill Lynch

Fred Cannon - KBW

Steve Sherowski - Banc of America

Presentation

Operator

Ladies and gentlemen, thank you for standing by and welcome to the Investor Analyst Conference Call. At this time all participants are in a listen-only mode. Later we will conduct a question-and-answer session, with the instructions being given at that time. (Operator Instructions).

Let me remind you that this call is being recorded by Fannie Mae and is copyrighted material. No recording, broadcast or other distribution of this call, in whole or in part is permitted without Fannie Mae's permission. Your continued participation on this call implies your consent.

I would now like to turn the conference over to our host Mary Lou Christy. Please go ahead.

Mary Lou Christy

Thank you. Good afternoon and welcome to today's investor analyst conference call. I am Mary Lou Christy, Senior Vice President of Investor Relations. Dan Mudd, Fannie Mae's President and Chief Executive Officer will lead off today's call. Our prepared remarks will be followed by a question-and-answer session where we will be joined by other members of senior management.

In addition to the 2006 10-K and the press release released today, we have provided an additional summary, which is a detailed discussion of our credit book of business and an investor summary, which provides current business highlight, as well as a summary of our 2006 financial performance and key drivers. All these documents are available on our website. The conference call will include forward-looking statements regarding, statements regarding our future plans, performance capital position, administrative expenses, credit losses, SEC filings, as well as trends for our industry. Actual results could differ materially from what is described in these statements as a result of a number of factors including those described in the risk section of our 2006 Form 10-K.

Now I'll turn the call over to Dan.

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Dan Mudd

Thanks, Mary Lou, and thanks to everybody for joining us today. As you know our 2006, 10-K is out and I can reaffirm for you our expectation that we will file 2007 on time and as has been our habit when we hit a milestone to kind of identify the next milestone, we expect to file our Forms 10-Q for the first, second and third quarters of '07 by December 31st of this year. So we are making good progress there and we have good momentum.

Today, I want to cover three areas. My part, to walk through the results for 2006, which as you all know, was our big remediation and rebuilding year. To discuss what I am sure is on everybody's mind the current environment and also to give you a forward look in terms of both the marketplace and Fannie Mae's role. Secondly, our Chief Risk Officer, Enrico Dallavecchia, will talk about our overall credit profile and then Bob Blakely who led the completion of today's filing as our Chief Financial Officer will discuss the drivers for our 2006 results.

So let me start, looking back, 2006 was a tough year for the financial results. Net income was down to $4.1 billion, which was at $6.3 billion in '05. Net interest income was down to $4.8 billion as our average portfolio balance dropped about 9% and we had 46 basis points of net interest yield compression. That was the year also that our administrative expenses peeked, going up by almost a $1 billion, because of the cost of the restatement. And credit related expenses went up by $355 million, as the housing market began its decline. Our credit loss ratio therefore rose albeit from historical lows going from 1.9 basis points in '05 to 2.7 in '06.

Losses on certain guarantee contracts that's an accounting classification we will talk more about that on the call. Those items went up by $293 million and Bob will get into more details there on. Amidst all that I also want to point out some of the brighter spots, the total book of business grew 7% to $2.5 trillion. The loss of market share to private label securities and other alternatives began to reverse, went from 23.5% in '05 had reached nearly 25% by the fourth quarter of '06 and by July of this year was a little bit above 38%. So we are seeing a huge restoration of share here as the market turns. Our guarantee fees through that period held up well with an average effective guarantee fee rate of almost 22 basis points.

Stockholders equity was up $2.2 billion for a total of $41.5 billion. The fair value of net assets at year end '06 was up $702 million to nearly $43 billion and excluding the $1.5 billion of net capital transactions during the year, the total fair value increase was $2.2 billion. Core capital held steady at $42 billion, which was also $30.8 billion above the OFHEO directed 30% surplus.

A little bit about the current environment where we are, our conventional single family book of business as of June 30th was holding solid with a weighted average mark-to-market LTV of about 57%, weighted average FICO score of 722. In my view these are indicators of a high quality book, which is exactly where you want to be going into a cycle like this.

In our press release today we provided a credit supplement that provided a bevy of additional disclosures related to that credit book and I would refer you to that as well, Enrico. You all know that the market is very choppy, there are pockets of illiquidity throughout the credit markets and from where we sit the situation is changing daily or in fact even hourly.

The Fannie Mae MBS, the Fannie Mae TBM, MBS remains very liquid and we are seeing continued strong demand for our debt. On the balance sheet side our risk management measures are where we want to be, duration for example, plus one month. We are managing all of our counterparty exposure and we are in constant communication with all of our counterparties.

That said, we are the largest player in the mortgage market so as the market adjusts I would expect, you should expect that we will take some lumps, but that is what we get paid for. On a relative basis our risk position is excellent and even on an absolute basis the numbers are very sound. So, what I see here is that the cycle is going to be challenging, we are transitioning from a world of high liquidity and low volatility to a world of high volatility and relatively low liquidity. We see home prices going down on a national basis across all the markets, jumbo all the way down through subprime we see the housing market down about 2% this year and about 4% in 2008.

We see across the spectrum higher credit losses and they are focused somewhat geographically, the Midwest, Ohio, Michigan, Indiana principally job related and in places like California and Florida where the home price run ups got over extended somewhat. The price performance in the middle part of the housing market, where we are most active should be better than the overall market, probably with a small gain this year and relatively smaller declines overall next year.

The market, I made a couple of comments about share, the market is returning in the direction of Fannie Mae’s historical quarter with tighter underwriting and more rational pricing, more demand really for the traditional fixed rate products that we specialize in.

And we also see spreads on mortgage investments widening out pretty much across the spectrum. So we see opportunities ahead for growth in our business and for gaining market share. But again, as I said and I reiterate, we are not immune to the stress in the housing market, so we do expect to see our credit loss ratio move into our more normal historic range of 4 to 6 basis points.

Overall, I would assess that the company is in better shape, we are more than adequately capitalized. We are regaining market share, we rebuilt most of the company from floor to ceiling and that includes, as you know from these calls our accounting, our controllers, our audit, our compliance, our risk management organizations. And we have made substantial progress in remediating our accounting and our internal controls as today's filing marks another milestone on that. We will be a current and timely financial filer soon.

All that said right now, we are focused on working with our customers to provide liquidity and stability to the market, which is one of the most serious parts of the mission that we are in a business to serve.

So let me turn to Enrico Dallavecchia, our Chief Risk Officer to give you a little color on the risk side. Enrico?

Enrico Dallavecchia

Thank you, Dan. Well in light of the credit environment that Dan has described, I would like to focus my remarks on four main topics. Topic number one, the credit characteristics of our single family credit book. First, I want to reiterate part of the conclusion for my remarks in our conference call in February, that is, I believe that the credit characteristics of our local business position us well right up into the broader market as the credit story continues to unfold.

Along with our press release this morning, we issued a credit related supplement that includes a great deal of incremental information on our credit book of business. The supplement provides an update on many more credit measures to June 30, 2007.

And let me hit some of the key points. Our conventional single-family mortgage credit book of business as Dan mentioned earlier had a really average FICO score of 722, which has remained essentially unchanged over the last few years. Fixed rate mortgages accounted for approximately 88% of our book, an important point given that extensive concerns in the market relating to the resetting of shorter marks and the weighted average loan to value ratio work book was approximately 71% and on a mark-to-market basis that figure is currently 57%.

Now let me move to my second topic today, our exposure to some of the product types and [loan] characteristics they are of the greatest concern in the market. On subprime and Alt-A, first I will address our loan holdings and then I will address private label securities in our portfolio, which are backed by this product.

We hold or guarantee $5.1 billion of subprime loans on our book or approximately 0.2% of our single-family mortgage credit book. Over 60% of them are fixed rate loans and about 88% of these loans are [credit enhancements]. We have relatively low exposure to high LTV ratio loans within the segment and specifically our weighted average of regional LTV ratio is 79% with 8% above 90% LTV.

Moving to Alt-A, we have or guaranteed approximately $310 billion in Alt-A loans at June 30th. That is about 12% of our total book. Importantly we generally acquire loans originated at Alt-A from our traditional lender partners. We will review and then approve lenders underwriting guidelines and are very familiar with the origination practices. The Alt-A mortgages originated by these lenders will typically follow an origination path similar to that used for originating prior mortgages. So believe that the Alt-A loans will guarantee, have a more favorable credit characteristic than the overall market of Alt-A loans, including a weighted average FICO score of 720 and low exposure to high LTVs.

Let me move on to private-label securities. We hold approximately, $47.2 billion in private-label securities backed by subprime loans, that's about 2% of our total single-family book. A full $46.9 billion of that total is currently rated AAA by at least two rating organizations and all of the securities has been put on negative watch. The weighted average subordination of these securities holding is 32%, which reflect the amount of credit losses that would have to occur in the underlying loss before Fannie Mae will take a loss.

And lastly, we hold no CDO. We also hold $34.5 billion in private-label securities backed by Alt-A loans, these securities have a weighted average subordination of nearly 20%. An important point for both our subprime and Alt-A backed security is our use of stress testing to assess potential losses under multiple scenarios. We include the scenarios as severe as two consecutive years of 10% declines in home prices, coupled with two consecutive years of 2% increase in interest rates. And the outcome of this scenarios project very little loss in cash flow even under the diverse scenario.

Our credit supplement will also give some details on other product types and borrower characteristics that are causing concern in the market right now. So let me address quickly a few of those. Mortgage loans represent 1% of our book and are heavily credit enhanced. [Secular] loans represent 0.1% of our book. High LTV loans where the original LTV exceeded 90% were 9% of our credit book. These loans carry credit enhancements and acquisition. Loss, the FICO scores below 620 accounted for 5% of our book. This loss of 30% [credit] and have a weighted average mark-to- market LTV of 64%.

Now, let me to move to my third topic what is our view of the market. From a prior perspective we believe that we will see a broader cyclical decline continue in the overall credit market at least to the later part of 2008. Some particular items of concerns are inventory on sold homes is approaching record levels. We project that home prices will decline by a total of about 2% over this year and by an additional 4% in 2008.

Subprime delinquencies have trended upward for the past few quarters and they are likely to begin dropping until after the housing market starts to recover. Recent problems in the non-agency segment of the mortgage market subprime, Alt-A or Jumbo have pushed rates for such loans upward and will likely further delay the start of our housing market recovery. And lastly, we see continued economic weakness in certain regions of the country, particularly in the Midwest.

Making things worse, a significant value of Subprime ARMs are scheduled to reset over the remainder of this year and in 2008. Even the lenders have dramatically tightened their lending standards. Borrowers may find that they are unable to refinance and avoid the resulting prepayment shock. This could have a cascading effect in the market leading to increases in foreclosures, higher inventories of unsold homes and increased credit losses for mortgage investments. This is clearly a market poised for more severe overall credit losses in the near to intermediate term. The loss of severity of individual institutional however, would vary widely.

So let me close with my fourth topic, our view on how Fannie Mae is positioned and our general expectation for credit losses. The increase in credit losses we experienced in 2006 was largely driven by the combination of weak economic conditions and weak to negative home price appreciation over the last year, centered in the mid-western state of Michigan, Indiana and Ohio.

We are currently seeing also other regions experiencing increases in delinquencies and foreclosures, specifically, Florida, California, Arizona and Nevada. These sates have relative robust economies, but are now seeing notable home price declines after steep run ups in recent years. We are also seeing weakness in Massachusetts. Given this, we expect to see increased credit losses from these states in 2008.

Again, to be clear, we will experience higher credit losses. We believe our losses in 2007 will fall within what we believe is a more normal historical range of 4 to 6 basis points. Looking forward over the long-term, as you would expect, in some period our losses was higher than average in our result.

Based on what I have addressed today, I believe the strength of our credit book puts Fannie Mae in a good position relative to other market participants. I encourage you to read the credit discussions attached to our press release.

Now, I would be happy to answer any questions you have later in the call. With that I thank you and let me turn over to Bob Blakely who will talk about the 2006 financial results.

Bob Blakely

Thank you, Enrico. Dan noted that the key drivers of net income in 2006 and what I would like to do is drill down on some of the more significant items that relate to these drivers, including the more pronounced impact of certain accounting treatments in the results. First, our net interest income, which Dan mentioned, declined by approximately $4.8 billion or 41% to $6.8 billion in 2006.

So, let me address the two key drivers. Our first and most significantly our net interest yield declined by 46 basis points to 85 basis points in 2006. As our borrowing cost increased at a faster rate than the interest we earned on our assets. You remember the federal reverse rates, the FED funds target rate by 100 basis points in 2006 to 5.25% driving this increase in our borrowing cost and the yield curve remained flat to invert it throughout the year. A decline in our net interest yield accounted for $3.3 billion or 68% of the total decline in net interest income.

Second, our average balance of interest earning assets declined by 9% compared to 2005. The decline in our average balance accounted for $1.5 billion or 32% of the total decline in net interest income.

Based on the decrease in the volume of our interest earning assets and the decline in the spread between the average yield on these assets and our borrowing costs, we expect as we indicated in the 10-K a continued downward trend in our net interest income the net interest yield in 2007 at a rate somewhat below the rate of decline in 2006.

Second key item, administrative expenses, which rose to $3.1 billion from $2.1 billion in 2005, this increase as Dan noted is primarily due to cost associated with our efforts to return to timely filing. In addition, we saw daily operating costs rise as we worked to enhance our risk governance framework and strengthen internal controls. These costs are allocated, all these cost are allocated to each of our three businesses and a significant impact on business segment results. Takeaway on expenses they are going down in 2007 and it will be substantially lower in 2008, as we complete our turnaround efforts and work to achieve a normalized run rate for administrative expenses of $2 billion.

I'd now like to move into two accounting treatments that had a significant impact on our results in 2006. Clearly our derivative mark-to-market will have the significant impact on our net income and the volatility of our net income from period-to-period. Rates have generally risen since the end of 2004, and the value of our pay-fix swap position has followed that trend with losses of $10.6 billion in 2004, gains of $549 million in 2005 and gains of $2.2 billion in 2006. The 2006 gains in our pay-fix swaps were more than offset by decreases in the value of our option base derivatives driven by time decay and decreases in applied volatility. So, we are still recording a net loss in our derivatives mark-to-market.

The total losses were $2.7 billion lower than in 2005, and through the first six months of 2007 as rates have continued to trend upward, we recorded fair value gains. I would add, however, that in light of current market conditions and uncertainty about how long the markets will remain volatile, we may experience an increased level of volatility in the fair value of our derivatives for the remainder of 2007. Because the fair value of our derivatives are affected my market fluctuations that cannot be predicted, we cannot estimate the impact of changes in the fair value of our derivatives for the full year 2007.

The second topic I would like to address. Losses on certain guarantee contracts, which increased from $146 million in 2005 to $439 million in 2006, and we expect will be higher in 2007. This issue is discussed in more detail in consolidated results of operation section of the 10-K. I want to briefly walkthrough the mechanics; since this is a new line on the face of our income statement.

The accounting for guarantee related assets and liabilities, this is the MBS issuant or CUSIP level. Importantly, while we negotiate contracts based on overall economics, this accounting application requires that we look in granular detail within each contract that individual securities. A single contract can create several Fannie Mae MBS securities. If a guarantee has a negative fair value at the time of the contract, we record that at the time of the acquisition.

Even at the positive fair value the gain is recognized overtime. We expect that the vast majority of our MBS guarantee transactions to generate positive economic returns. The key point is that the day-one losses are about the estimated fair value of the credit guarantee, not the projected losses on the security. For most CUSIPs with day one losses, expected losses are still less than expected revenues. So even if we record a day one loss on a CUSIP, we still expect to make money on that guarantee.

In closing, before handing it back to Dan, let me say that it has been a privilege to serve as Chief Financial Officer here during a period of certainly significant challenge and also a great deal of progress. And I look forward to working closely with the management team through the balance of 2007 as we continue to move towards getting current and reintroducing the company in the investment community.

And with that let me turn this back to Dan.

Dan Mudd

Hey, thanks Bob. We promised everybody a smooth transition on the Chief Financial Officer front from Bob Blakely to Steve Swad, that's happening. Many thanks to Bob and to Steve and to David Hisey, our Controller and the whole finance team both for that and for getting us here today. Steve Swad is on the call and he's ramped up quickly and I have got terrific confidence in his ability and the team's ability to get us back to current filing and to move forward from there.

Let me look ahead quickly to 2007 and 2008, it is impossible to guess exactly how this credit crunch and the ensuing market volatility is going to play out, but we do, as we sit here now expect the housing market correction to continue through next year.

Some of that is a correction, the market is to returning to more rational products and pricing and that in and of itself creates new growth opportunities for our guarantee business. Specifically we see much more potential volume in straightforward fixed rate products, in ARMs, as well as the higher quality segment of Federal underwritten non-prime and non-traditional products.

On the portfolio, on the balance sheet front, after years of tight mortgage investment spreads and relatively few opportunities for us to purchase assets profitably, spreads are now widening. That would create opportunities for our portfolio of business. And particularly, we see the opportunities in CMBS and multifamily loans, affordable loan products, where we remain one of the limited number of buyers. We can do more there and we will continue to address the issue of the cap on our mortgage portfolio.

As noted we do expect that credit losses will increase in 2007 and for the third time believe that those losses will be within our more normal historical range of four to six basis points. Finally, Mike Williams, the Chief Operating Officer and his team have done a terrific job of whittling down administrative costs. They will come down from their 2006 peak and head toward that targeted run rate of $2 billion a year for '08.

Going forward, we see lot of opportunities to provide value to lenders and to other industry partners to do a strong business in our affordable housing segment and to provide overall liquidity to the housing market. So I like where we are, a tough market and more to come. And with that let me go our first question.

Question-and-Answer Session

Operator

Thank you Ladies and Gentlemen financial you like to a question you may (Operator Instructions). And our first question from the line of Paul Miller with FBR Capital Markets. Please go ahead.

Paul Miller - FBR Capital Markets

Hi, thank you very much. Yeah, the question I have Dan, is that normalizing credit losses go four to seven basis points. Can you talk about a little bit where do you think the ROEs in your GT business is with the normalized credit losses of four to six basis points. And also, does that change at all, your plans for capital management, once you become current filers?

Dan Mudd

Well. Let me address them both and probably a little bit too generally for your case. We are not rolling out ROE quite yet as a measure. As we roll though this '06 filing to get in current, we got a pretty broad suite of metrics that should provide a lot of healthy wall in terms of value in the company. And we are going to do our best to perfect those and to roll those out. We think, by the way the number was four to six, not four to seven, just for the record. We do believe that the assets that we are acquiring continue to be of a very high quality.

And the guarantee business is producing the returns in the target zone. The business itself is very strong. It's a capital efficient business. It absorbs less capital than the portfolio side. From the capital management standpoint, the dividend, the return of capital continues to be on my list and on the Boards list. So we haven't lost sight of that and we'll continue to address it going forward.

Paul Miller - FBR Capital Markets

And in your target zone, can you give me your target zone on that GT business?

Dan Mudd

No. But I can have Tom Lund give you some qualitative comments in terms of how we are thinking about pricing and particularly how we are thinking about pricing in an environment with the anticipation we've got around losses going forward. Tom.

Tom Lund

Great thank you. First, I would say as we've reiterated over and over that the credit loss ratios that we talked about are in a more normalized range of what we expect for this business. So, I think that ought to give you a sense of where they are relative to how we think about pricing the business. Secondly, as we look forward opportunistically, as you heard I think Dan say, our market penetration has grown dramatically. We are able to come back and you've heard me talk in last couple of years about the standards in the marketplace. We believe, we are going to be able to reset some appropriate standards in this market, both from an underwriting and a pricing perspective and as the risk in the market moves up we think we'll be able to read price to the risk. So, we feel confident about the position that we've sit in the marketplace today as we look forward.

Paul Miller - FBR Capital Markets

Okay, thank you very much gentlemen.

Operator

And our next question from the line of Bruce Harting with Lehman Brothers. Please go ahead.

Bruce Harting - Lehman Brothers

Yes, thank you. The conventional wisdom historically has been that residential mortgages are one of the safer asset classes based on 30 or 50 years of data. It seems like we have collapsed under totally new waters here over the course of 2007, and we always thought that the GSEs would play a huge role but who would have expected this kind of an environment yet? You can't grow so, couple of questions. One is, what kind of growth rate could you potentially see in the MBS market given that they are still have regulatory constraint on your retained long growth. Number one what kind of growth rate do you think you'll need to step up.

Secondly, I don't know if Peter is there, but what steps do you think are needed right now to restore some semblance of normality to this market that seems to be turned upside down what normally people would want to hold residential mortgage assets probably next in line after treasuries, but right now people cannot get rid of them fast enough and in a market where we have AAA paper trading at $0.88 on the dollar, just curious what is FED using or what is your view on what will be returns in semblance of normality or liquidity of this marketplace. And clearly this is all good for you but just wondering if you could comment on that, thanks.

Dan Mudd

Yeah, thanks Bruce, thanks very much. With being in the process of a return to timely filing, I am going to wait a little while before opining on FED policy if you forgive me. I'll dodge that question. But on the others, I think what we are seeing is an acceleration of our ability to grow that probably is a little bit in excess of certainly of the market growth rate in excess of what we have seen in the past couple of years. Because we just haven't seen the investment opportunities. I don't think the conventional wisdom ceases to apply here. I think what you saw was a cycle. Maybe two cycles put together with no down cycle in the middle if you go all the way back to 2000 where home prices had basically outstripped their historical growth rate and the range and the array and the layers of products you could get.

Basically, we are intended to get many, many, many more people qualified without necessarily folks having the modeling or the historical experience in those products. When the markets cease to expand and start to decline from a home price standpoint, the folks that had the least equity got caught out first. So, if you are an individual consumer with subprime loan that started their 100%. 4% home price depreciation now you are at 104% you have a problem if you are holding the BBB sludge of a private label security and you don't have whole lot of equity in that., you have also got a problems, so and if you are a company that specialize in those layer of products and you didn't have another leg to stand on, you have also got kind of a corporate problem when you see five or six out of the top ten specialist "subprime originators" go out of business.

So that part of the shakeout has happened and it's caused, as you point out, spreads to widen all way through the stack here. But that said, investing in a home or investing in a company that's involved in the home industry remains a very good investment. The fundamental supply demand dynamics in the longer term are very attractive from a immigration standpoint, from an investment standpoint, from all those, all those factors.

And we are continuing to see a very solid conventional conforming market where we sit. So some of that conventional wisdom applies, I think some of the people that had convinced themselves of course the past couple of years that there was a secular shift and all that type of language, you know turned out to be wrong. But, with that, let me get Peter to dive into the very latest current market in liquidity conditions and so forth. Peter?

Peter Niculescu

Yeah, thank you Dan. And Bruce, thank you for the question. I think Dan covered the first part what's going on, which is the, it's really the underlying credit and mortgages. And we are unquestionably in the middle of the correction here. Investors who are exposed to mortgage defaults and delinquencies will see their losses rise and that will go on for a period of time and that inevitable. There is not pretty much that's going change that, but on top of that something else has happened and that is a reduction of liquidity in the mortgages, in the mortgage market generally over the last two or three weeks and that reduction of liquidity has gone worse even this week.

That is a pullback from people who have previously invested in mortgages, who are not prepared to invest in mortgages anymore and that's happening on top of whatever happened to credit condition. There's simply less funding available in the marketplace today for mortgages than was the case recently.

Now, we have seen that show up first in those securities that are generically less liquid and they may include, multi-family securities and adjustable rate mortgages and ironically even affordable mortgage product. They have certainly seen some of the largest and earliest widening. But as we sit here today and look even at the most liquid products I think I have to update our CEOs remarks earlier on the call and note that over the last three or four days you've started to see some widening in yield spreads betweens even the most liquid mortgage backed securities and other fixed income instruments. They have really started to see some widening, some of that, some of the largest part of the widening even occurred today although the market conditions are very volatile. But over the last three or four days we've seen anywhere from 15 to 25 basis points of yield spread widening between mortgages and other fixed income instruments, that's unusual among the most liquid sectors and really I think points out to a significant reduction in liquidity.

How has that result? Obviously nobody here knows, what the Fannie is going to do, that's not an issue for us to speak about. I do think what we need here is a long-term injection of liquidity into the marketplace. We need to find long-terms investors, long-term investors, who will buy mortgages, hold those mortgages and keep them through their lives. That's what needed here, you need significant balance sheet commitment from some set of investors that come into mortgages and help provide more funding for American homeowners. Bruce do you have a follow-up.

Bruce Harting - Lehman Brothers

Right, thank you very much. I'm just curious and I know its very sensitive time in terms of regulators neglect that but was the, is it simply an issue of waiting for you be timely before the growth limit can come off and basically defaulting to the original agreement, and then my last question is simply on these AAA subprime or Alt-A that you own. Those are -- can you just talk about the accounting on those, as you are not subject to a mark on those and can you just talk about that. How do you value those on the balance sheet? Thanks, on a go forward basis? Thank you.

Dan Mudd

The OFHEO agreement contemplated addressing issues in the of market dislocation. We're having a constructive and respectful conversation, but conversation all the same, that we think that disruption is here and we think this is what the company was built for and that this would be right time Fannie Mae. And I guess, I have to include Freddie Mac in that equation even though it's our investor call, include the agencies in terms of providing liquidity, while that's in the marketplace. As far as the accounting treatment in the market, let me ask our Controller David Hisey to touch on that for you, Bruce.

David Hisey

Thanks Dan. Bruce, the -- all of our securities are either unavailable for sale, which would mean they are marked through equity or they are in trading. The majority of these are unavailable for sales, so they get marked through equity. And I think as Enrico mentioned, we do a lot of stress testing of the cash flows and that is concerted and looking at any impairments and because of the strong cash flows that he mentioned, we don't see any impairments of those asset classes.

Bruce Harting - Lehman Brothers

Thank you.

Operator

Our next question comes from, Eric Wasserstrom with UBS. Please go ahead.

Eric Wasserstrom - UBS

Thanks. Dan this question is about your credit outlook. And I guess my question is given that we've seen massive deterioration of underwriting standards that's causing -- in some cases a catastrophic level of loss and riskier mortgages, but its occurring at a 4.5% unemployment environment, and what has generally been a pretty robust economic environment? And now that there is this issue that Peter just addressed about liquidity, why couldn't it be that the losses end up at the higher end or beyond that range closer to what we've seen in past more severe housing downturn? Because I think you guys keep somewhere around 10 or 12 basis points in New England downturn? Why couldn’t you be closer to something like that?

Dan Mudd

Well, I've given you our sense of where it's going to be and to my taste that's a significant change from where we've been in recent years, but more and more inline with what we've seen through the period of time. I would -- let me ask Enrico to step in, in a just a second here. But I would make couple of observations Eric about the environment. Throughout the period our underwriting, our seller service standards, our due diligence, our audit of these firms has remained the same. There was a period of time, starting in '04 blowing out through '05 and most of '06, where the market went out well beyond those standards. That said, we fundamentally held our standards where they were and to that point a huge amount of the business, went away from us. When those alternative executions began to fall apart or the operator fall victim to liquidity, our standards were still there and that business instead of being underwritten to our standards. So, the business that we brought on as indicated by some of the numbers that I gave and some of the numbers that Enrico gave have remained Fannie Mae quality works. So, we feel pretty good about that. That said, we are the largest player in the US mortgage industry and I am not going to stand here and tell you that we are immune from broader national trend, I just feel relatively better about where we are.

The other observation Eric that I would make is that, this adjustment is going to play itself out fairly unevenly. So, as you rightly point out, job growth, unemployment, broader economic factors land in different places in the nation here. So, what you see in the upper Midwest, Nevada, California and Florida for sets of reasons are going to tell a fundamentally different story than what you are seeing in Oklahoma or the North East Pacific North West picture spot. And that’s where I think that the local trends, both from the home price standpoint. If home prices are down somewhat but job growth is somewhat, you are probably okay, but if you get two or three trends moving in a similar direction in a similar place then you have a broader problem and even on that score I feel that we've got resources in place, we've built up the back end of our business that does work outs for closures, restructures and all that to be able to handle an increase volume. We normally benefit more than half of these loans are headed for closure, wind-up getting worked out and staying current. So, we are reasonably good at that, but we will get a test here. And Enrico is shaking his head saying I'd said everything that he was going to say. So, why don't I stop there and go to next question?

Eric Wasserstrom - UBS

Thanks.

Operator

Thank you. We go next to the line of Brad Ball with Citigroup. Please go ahead.

Brad Ball - Citigroup

Thanks. Dan, you've said that Fannie Mae would be willing to provide $20 billion or tens of billions to support the non-prime marketplace through this challenging period? Can you give us any indication as to whether you've begun the process of investing there? And if that's the case then, how would you characterize the kind of business you are doing? What it looks like? I know that you are very early on in highlighting your concerns about maturing of risk in the market. Could you describe what you are willing to do in this marketplace?

Dan Mudd

Yeah. Thanks Brad, it's a great question. And I'll do my usual thing and start, and then ask Tom Lund to follow-up a little bit. The last time that I looked at the number, we had done about $5.4 billion of financing of folks who had either been in sub-prime or whether qualify through sub-prime into conventional conforming mortgages. So, we are moving along that road.

We have worked with individual lenders to extend our standards and provide them with appropriate and careful variances to enable them to qualify more business and depending on the particular needs of their footprint or their product set or their capital structure to provide them with products and opportunities to help do those refinancings. We think as a general matter as of a couple of months ago, the top third maybe a little bit more than that of the folks in sub-prime could have qualified on a credit basis for a conventional conforming loan. As rates have stacked up a bit and as the credit rug has gotten pulled out from underneath, some of those on the upper edges of sub-prime, that number may have gone down a little bit and those folks that are below that level are probably going to need a little bit of restructuring in order to get through.

The other thing that we have done and then I will turn over to Tom is, we bought several other state housing rescue bond, I think about $500 million worth of those bonds, which at its initial session were not the most liquid products out there on the market, but we were really pleased to be able to work with the states to provide those and therefore kind of a meliorate some of the foreclosure issues in the tougher states. Tom?

Tom Lund

Thanks Dan. Brad, thanks for the question. You've heard us talk in the past a little bit about what we call the HomeStay initiative and really that was an effort across Fannie Mae, to figure out what services we could bring to support this segment of the market. Part of that was having consumers know that there were other possibilities out there for them and the kind of products that Fannie Mae could offer and working with services across that spectrum. Dan mentioned the fact that, we think we've done about $5 billion in product associated with that. And having said that, there are number of those consumers who probably out of the gate could have qualified for loan and didn’t necessarily get into a Fannie Mae product. There were those that have been in those loans who've made 24 months of payments, who have demonstrated credit capability as we underwrite them through our underwrited automating technology and look at their history, determine that these borrowers have access to the kind of products that we can bring in markets.

So part of it is education, part of it is a product spread that we’ve been able to bring to the marketplace. We've also given some grants out to some counseling agencies to make it more known out in the marketplace. And then even on the backend, we've tried to work with people lost mitigation things of that nature and tools around that. So, its been a very wide ranging set of tools that we tried to bring in the marketplace as Dan said. It can tend to get more challenging as rates move up a little bit or we see markets that there is more difficultly, but we continue to push down that path the and we're seeing good results so far.

Dan Mudd

Let me just conclude that part Brad and just say, there has been a little bit of over inflation here in terms, we can play a very important role and we can play a very important role in terms of what we know and what we do. We are doing everything we can on the securitization side. We can be doing more on the portfolio, on the balance sheet, investing side where there is specific areas like this then we can target we are good at. We are not the only answer to this problem. There are lots of different organizations that can play a role and we think the best way for us to do it is to play our proper part for what we are good at in the industry to help mitigate the down that you are not going to avoid the trough of the cycle, but you can certainly mitigate what it looks like when it hits bottom and I think we have a role to play there.

Brad Ball - Citigroup

Well, so actually I had a follow up to Peter's comments earlier, which segregates from that Dan. When Peter says that we need long-term investors in mortgages, who is that going to be, obviously you guys and Freddie are the obvious candidates, but who else is out there ready to bring capital to the mortgage market? And maybe just to help answer that could Peter talk about who exactly you are competing with in the market today bidding for securities and what the implications have been recently for OAS? Thanks.

Peter Niculescu

Sure. Thanks Brad for the question, this is Peter. I think the issue here is, one, confidence in markets, its one of confidence in investments. As you see investors pull back in size from mortgages, other investors have less confidence about where they can sell their investments in the future or how they will be marked. What needs to happen is an injection of long-term liquidity, long-term investment interest. As that happens, you bring other investors, more traditional investors back into the marketplace. That's what is the key.

I will tell you right now that to vary many sectors of the mortgage market Fannie Mae and Freddie Mac are really the two major and in some cases the two only bidders. There are other areas where as always we've had significant ownership from pension funds, insurance companies, non-US buyers, that the issue in the case of all of that ownership is that every investor is subject and sensitive to mark-to-market, they are sensitive to where securities will price in the future. They need to have confidence that there will be an adequate balance between demand and supply, and right now, we need to add a little bit more to the demand side of the equation. Thank you.

Brad Ball - Citigroup

Oh I am sorry, real quickly on OAS, Peter. Could you comment on recent OAS?

Peter Niculescu

What happened to it?

Brad Ball - Citigroup

Yes.

Peter Niculescu

I think I indicated earlier, we've seen spread widening of anywhere from 15 to 25 basis points this week among really a most liquid securities out there. As you go out into some of the less liquid areas, multi-family, commercial mortgage-backed securities, even adjustable rate mortgages, as well as on the AAA sub-prime you've seen spread widenings in the 40 to 70 basis point range, speaking very broadly.

Brad Ball - Citigroup

That's helpful. Thank you.

Operator

And our next question is from the line of Ken Bruce with Merrill Lynch. Please go ahead.

Ken Bruce - Merrill Lynch

Good afternoon. Clearly Fannie Mae is taking the steps that it needs to, in order to provide liquidity into this market. Peter obviously identified that the gaps, or the pockets of liquidity are kind of widening here. Is it your opinion that when you talk to OFHEO or just regulators in Washington, that they understand the gravity of the situation? And separately, is there any solution or assistance that Fannie Mae can provide in terms of helping lenders clear their inventory faster, whether that be in essence providing wet funding or otherwise being able to pull loans out the warehouse lines sooner in order to help them free up their existing capital. Clearly lenders are quite nervous, and any matter of assistance would probably be very much appreciated.

Dan Mudd

Okay. Ken, thanks for your question. Either you are trying to get me fired or actually killed. The first question, our conversations at the policy and the regulatory level kind of happen in two stages. One is being part of the general conversations about market color, what's going on, where we are, where we see things headed. And we've always tried to kind of play the role as a responsible market participant, those conversations continue.

The other part of the conversations are on the more specific regulatory matters, and I do think that it's in the best interest of Fannie Mae and therefore our shareholders to have those conversations whether with OFHEO, HUD, SEC, Treasury or anybody else in an appropriate confidential way and when there is something to announce we will certainly do that. So, I've got that one.

And the other question, we do have a set of products that provide for some degree of accelerated funding. As we offer those products, obviously they've got a bit more processing risk if you will attach to them, and so, we need to engage in those only with lenders that we know very well, we've got good experience with, in many cases we actually have Fannie Mae employees co-located in the shops and there has been a burgeoning of demand for that type of service or that type of product. And we are being careful to make sure that it goes out where it can be used, where it will matter and where we will get paid for it.

Ken Bruce - Merrill Lynch

And I am not trying to get you fired or killed actually. Yes, that's right, just to follow-up on Peter's comment, if AAA spreads are widening 60-70 basis points, does that present any mark-to-market implications for your book of business in the sub-prime in all day AAA area or is there any external markets that you have to basically go to in order to basically verify your own internal valuations of those securities, please?

Peter Niculescu

Yeah, thanks for the question, this is Peter, again. The answer is clearly straight forward, we rely on external marks to value our book. We really try and avoid anything other than that and we have a fairly careful process established to get marks from every vendor out there who will mark bonds and to check them. And we have put in place is clearly an elaborate process to do that its external to my unit its not part of what I do of this price verification group. So, we go through that with fairly careful controls and balances. And then I can tell you that, that is a group that is experiencing some challenges now in this marketplace. We get prices from vendors, we get prices from a wide variety of sources, with the market in the sort of shape it is. We have to work with people to get to accuracy there, what we are helped with, what really helps us compared to most other people is the vast majority of our balance sheet is relatively liquid and relatively easily valued. So, even on things like sub-prime and commercial mortgage-backed securities we have some of those liquid pieces and we have some of the things that is the easiest to value in the marketplace. So, I think in contrast to a lot of other mortgage investors out there, I think our problems are relatively mild but as with anybody who invest in mortgages right now getting adequate pricing is more challenging than it was three or four months ago.

Enrico Dallavecchia

We are going to try to do two more very quick ones because there are few more folks in the queue and hard for me they will try to answer yes or no, next one.

Operator

Thank you. Our next question will be from the line of Fred Cannon, with KBW. Please go ahead.

Fred Cannon - KBW

Thanks and thanks for the time on the call. I have just one follow-up I think most of my questions have been answered. You are forecasting a 4% price decline nationally for home prices. However, we all know, real estate markets are local and that has to be made up of a lot of different movements regionally. I was wondering if you could give us some idea of what you are expecting for home prices in the major markets in California and Florida that go into that 4%?

Enrico Dallavecchia

We've got David Berson, our Chief Economist here, so let me have him take a shot on.

David Berson

Good question. The areas that are going to have the weakest prices, are those that have the weakest job growth numbers. So, continuing places like Michigan and Ohio, but in the major markets of California, we probably will see some fairly big declines, but after years of huge run ups, so the net impact is still going to be most of the houses of those areas are still well above the values where people bought them. But we should expect some big decline, just as we saw in the early 90s and perhaps some double-digit declines in some of those areas.

Fred Cannon - KBW

So in that 4% you do have some expectation for double-digit declines in California?

David Berson

Well, in certain markets there will be some declines, it's not going to be the whole state, it’s not going to be entire cities, but parts of the market that are the weakest, or they have the biggest run-ups because of investor activity are likely to see the biggest declines.

Fred Cannon - KBW

Allright. Thanks very much.

Enrico Dallavecchia

Thank you, Fred. Can we do one more?

Operator

Yes, that will be in a line of [Steve Sherowski] with Banc of America. Please go ahead.

Steve Sherowski - Banc of America

Hi. I was just wondering, over the past couple of years, you have lost a lot other market share in MBS issuance. And over the past couple of months you have seen lot other market share gains. I was just wondering are there any steps you can take or do you see any opportunities to insure that this recent market shares gains you are seeing are on a more permanent basis? Not relinquished when and if these exotic mortgage products come back in a period?

Dan Mudd

Yeah, it’s a terrific question, which makes it kind of challenge to answer. I don't think the infrastructure that was created in some sense to compete with us in the private label securities market is going to go away so we have to be on our game to be able to compete against that. I think that some of the weaknesses in those structure are showing up as lenders face the down side of either holding the residual piece or taking buybacks or realizing that some of the private label security structures are really kind of have a boomerang feature and when they come back as contrast to an MBS, which they sell into the marketplace and then it carried our guarantee forward.

I also think that there is an opportunity for us in this market to show up as a strong and true partner to our customers. We’ve had various questions on this call about things that we can do to be helpful to individual lenders and we really sort of had our frontline crew fan out across the country to try to able understand those needs and do anything we can to help the lenders move through the crises.

The other thing that we doing is as our arrangements, the partnership agreements and pricing structures come up with customers, they are also looking for stability and they are also looking for some predictability in terms how we offer product and price and to the extent that we can stretch those out and provide a little bit more longevity we will. With all that said, the caveat is we are not immune from competitive forces, but I think we built a pretty competitive company here. So, we'll come out of this in pretty good shape.

Steve Sherowski - Banc of America

Okay, great. Thank you.

Dan Mudd

Thanks. Let me just summarize. Thanks for listening. A summary of everything we talked about today. I think our remediation is nearly complete. You'll see some quarters by the end of this year. We kind of think it as it being a long night's journey in today from an accounting standpoint, but we are well positioned to navigate through a pretty challenging market and to manage this company through the bottom of the cycle.

I continue to believe that the housing market is going to remain a good place to invest for the long-term. And I mean that both for our shareholders and for home owners. So, we'll keep working for you in that regard. We'll keep you informed. We look forward to talking with you when we have our next set of data out and let me close and just say thanks for your investment and thanks for your interest in this company. Mary-Lou?

Mary Lou Christy

Operator, do you want to give the details of the replay?

Operator

Yes. A replay of the call will be available for two weeks, starting at 4:30 pm eastern time from August 16 through midnight eastern time on August 30th. The replay number for this call is 1-800-475-6701 or for international callers 320-365-3844. The confirmation code is 883169.

Ladies and gentlemen, that does conclude our conference call for today. Thank you for your participation and for using AT&A executive teleconference service. You may now disconnect.

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