Freddie Mac Q2 2007 Earnings Call Transcript

| About: Freddie Mac (FMCC)

Freddie Mac (FRE) Q2 2007 Earnings Call August 30, 2007 10:00 AM ET

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Executives

Ed Golding - IR

Dick Syron - Chairman, CEO

Buddy Piszel - CFO

Patti Cook - CBO

Don Bisenius - SVP

Analysts

Paul Miller - Friedman Billings Ramsey

David Hochstim - Bear Stearns

Fred Cannon - KBW

Bob Napoli - Piper Jaffray

Brad Ball - Citigroup

Bruce Harting - Lehman Brothers

Howard Shapiro - Fox-Pitt Kelton

Moshe Orenbuch - Credit Suisse

Thomas Mitchell - Miller Tabak

Presentation

Operator

Welcome to the Freddie Mac second quarter 2007 financial results conference call. (Operator Instructions) I would like to turn the conference over to Mr. Ed Golding. Please go ahead, sir.

Ed Golding

Thank you and good morning. Welcome to our investor presentation and conference call, where we are pleased to present to you our financial results for the second quarter. Speaking today are Freddie Mac's Chairman and Chief Executive Officer, Dick Syron and our Chief Financial Officer, Buddy Piszel. Also joining us for the Q&A portion will be our Executive Vice President and Chief Business Officer, Patti Cook, and our Senior Vice President, Don Bisenius.

As we begin, let me make two important points: first, we have posted on our website a slide presentation and tables which include additional details of our second quarter results. You may want to have these available as Buddy walks through them. Second, please note that today we are making certain forward-looking statements regarding our business results. These statements are based upon a set of judgments and assumptions that are key business drivers and other factors. Changes in these factors could cause our actual results to vary materially from our expectations. You'll find a complete discussion of these factors in today's information statement supplements and the information statements in 2006 annual report, which are also posted on our website. We strongly encourage you to carefully review these factors.

One final note, we would like as many people as possible to be able to ask a question. Therefore, if you would please limit yourself to one question and a follow up, I would be grateful. As time permits, we will come back for a second round.

Thanks, and now let me introduce our Chairman and CEO, Dick Syron.

Dick Syron

Thanks, Ed. Good morning, everyone and thank you for your time. The second quarter presented Freddie Mac with significant opportunities and challenges, obviously amid an evolving housing and credit environment. As in the first quarter, housing prices declined in many areas, access to mortgage credit ebbed for some borrowers and credit and mortgage debt spreads widened. While we achieved improved profitability with net income of $764 million and a fair value increase of $800 million, we were not immune to market forces and we continue to take a cautious view of the housing market.

Now, ironically, while these forces have impacted our near-term profitability, over the longer run, the likely return to more reasonable levels of risk pricing will obviously benefit us. In the second quarter, Freddie Mac's net interest income stabilized, our guaranty income grew, our mission value became very visible and our shareholder value increased. There's no doubt that our quarterly data continue to be extremely bumpy, but it's also clear that our forward-looking opportunities to deploy capital effectively in the business look good.

In addition, we continue to accelerate our financial reporting by releasing results two weeks faster than in the last quarter. Throughout the long housing market boom, mortgage industry participants were largely protected from credit risk by significant annual house price gains. Today, we expect nominal house prices to be flat to slightly negative this year and next, and are preparing to conduct business in that environment.

While I was an early bear on the housing market, I was not bearish enough giving the degree to which housing prices were outstripping income growth. In contrast, I do think some of the most negative forecasts out there today are too severe and that many of the recent problems will be worked off in the next 18 months or so, as in the neighborhood of 1.5 million additional households will be formed to take up some of the current inventory overhang. Over the next decade, we expect this growth in demand to total about 13 to15 million households. So as long as liquidity is provided to the housing market, this cycle will be manageable for adequately capitalized companies. It will, however, place ever more of a premium on the quality of our credit underwriting process and the strength of our customer relationships.

Throughout the second quarter, we have grown our guaranteed volumes by an annualized rate of about 15% as higher fixed rate production and opportunistic growth amid market dislocations have improved our share of the total conforming market. We have achieved this growth while maintaining a disciplined approach to achieving attractive mortgage asset to guarantee spreads. In particular, we have done this in our expanded bulk purchase activities, an area where we can more closely tailor rates to the risks we undertake and promote stability by doing so in the U.S. mortgage market, and by modifying also the terms of business in our flow contracts.

Importantly, we have also taken steps to fulfill our mission and exert leadership by insisting on improved underwriting standards for sub-prime mortgages. It seems like a long time ago, but in February we became the first major secondary market participant to announce that we would no longer buy sub-prime loans that posed an unacceptable risk of excessive payment shock and possible foreclosure. In April, we followed up by announcing we would purchase up to $20 million in fixed rate and hybrid ARM products in the sub-prime space that are being developed to limit payment shock and provide lenders with more and safer choices. I'm pleased to report that in July, we settled our first purchase of sub-prime mortgages under this new guideline and we are witnessing a significant shift in production volumes towards products that we feel offer sustainable financial options for homeowners and attractive values for our shareholders at the same time.

The events of the last two months have also highlighted the need for smooth and uninterrupted liquidity flows in the mortgage market. We have also committed to purchase Alt A products that fall within our credit box on a 90-day forward basis. This program provides stability and certainty of execution for our originators. It is one more way that Freddie Mac is providing liquidity and stability in a tumultuous market. We're far from the total answer, but we're doing everything we can to help the markets and homeowners, and we want to maximize our ability to do even more in the future.

The various steps we are taking clearly foster our congressional charter and public mission. We are confident they also serve our business objectives. As you know, we are still operating under our voluntary temporary portfolio growth limit and we do have some dry powder left, but we're constrained from playing a fuller role in stabilizing the market as long as we are subject to portfolio limits and capital surpluses. There is still a need, in our mind, for long-term committed investment from the mortgage market that will help the growing inventory of assets to clear. Freddie can help fill this role, and in fact, that's what we're designed for. As is appropriate, we are discussing these issues on an ongoing basis with our regulators.

So those are the headlines: our return to profitability, very tangible execution of our mission in a tough time, improved controls and accelerated financial reporting. This all happened in a decent quarter and with a strong platform to build on.

With that, let me turn things over to our Chief Financial Officer, Buddy Piszel.

Buddy Piszel

Thanks and good morning, everyone. I'm going to take a few minutes to provide a high level review of our second quarter 2007 financial results and current business trends. We posted a package of slides that I'll refer to in my remarks, but given the current market environment, let me first give you a summary of where we stand on credit risk. We have provided you with a much expanded view of credit data that focuses on the riskier portions of our portfolio. A few takeaways:

(1) our overall exposure to higher-risk products is low relative to our competition. (2) we have a limited and a manageable exposure to all risk-layered products, such as loans with both high LTV and low FICO scores. (3) delinquencies are low, but they are trending upward, particularly in California and Florida and finally, our overall credit profile equips us to weather this downturn better than other market participants.

I'll briefly discuss the delinquency data and the exposure to risk-layered products, which are in the disclosures, and then I'll make a comment on our counter-party credit risks. First, delinquencies. While our single-family portfolio delinquency rates remain very low, we are seeing some regional increases. Over the past couple years, much of this experience has reflected economic weakness in Michigan and Ohio. More recently, the biggest changes come from California and Florida, where house price declines have led to sequential quarter increases in delinquencies of about 30%.

Consistent with this recent deterioration, loans supporting 2006 PCs have exhibited significantly higher early delinquency rates through their first 18 months certainly than we experienced in recent years. For example, the 2006 serious delinquencies are approximately double the average we experienced in the 2000 to 2005 books. This is in part driven by the weaker house prices and a higher percentage of loans that have secondary financing.

On mortgage product concentrations, we have low exposure to alt A and risk-layered loans, and when taken together, these represent about 8% of the total single-family guaranteed 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.

Importantly, we have been able to price for this higher risk, because we source most of these loans through bulk purchases. In addition, for the alt A book, we have significant credit enhancement, strong average current LTVs of 71%, and FICO scores of 715. 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% of our portfolio, and nearly all of this had credit enhancement.

Lastly, let me give you my views on counter-party credit risk. We believe we manage this very well. In periods like this, we're even more vigilant on these risks. We analyze and stress test a lot of detailed information in order to better anticipate and monitor potential deterioration in the credit quality of mortgage insurers and the seller services that we do business with. Our evaluation of the MIs is that they are adequately capitalized. While some of them may fare better than others in the current market, in the long term we're comfortable with our position is.

On the seller services side, we maintain a comprehensive watch list for those companies where we believe risks are elevated and take risk reduction actions to lower our exposures. Over the last nine months, some of our services have run into trouble, but we have taken the appropriate steps and have not incurred any material losses. In addition, in the event of a significant disruption, we have provisions to protect our risk positions and insure servicing by capable counter parties.

When we put all this together on the credit front, from a regional exposure, product concentration and counter-party credit risk respective, we are well positioned in the current environment.

With that, let me now turn to the second quarter results. As we announced this morning, Freddie Mac earned net income of $764 million in the second quarter, down from $1.4 billion a year ago. On a pre-tax basis, practically all of this decline resulted from an increase of $592 million in credit-related expenses and credit-related mark-to-market items.

Outside of credit, many aspects of the business improved. Net interest income and margins stabilized sequentially. Management and guarantee fee income continued its good growth rate. Our interest rate risk metrics remain very low. We continue to improve our internal control environments in several areas, and as Dick noted, we have accelerated our financial reporting timeline by two weeks over last quarter.

With that, let's turn to the GAAP results shown on slide 2. Let me start with net interest income. Line 1 shows that we had a reduction in net interest income of $199 million compared to the second quarter of 2006. As we discussed in June, our net interest margin declined throughout last year, as the flattening of the yield curve and replacement of the significant amounts of lower yielding and long-term debt reduced our GAAP margin. Since this activity occurred throughout 2006, we are still seeing the effectiveness in our year-over-year comparisons. If you look at NIM compared to the first quarter of 2007, you can see that it's stabilized. This has occurred as debt refinancings have slowed, our portfolio grew, the mix shifted towards fixed rate assets, and the yield curve steepened.

Moving to the guarantee business shown on line 2, year-over-year management and guarantee income increased by $85 million to $474 million, as improved customer volumes and higher contractual guarantee fee rates improved our results. Thus far in 2007, we have grown our guarantee portfolio significantly, as shifting origination patterns back towards fixed rate mortgages and increased bulk purchase transactions have boosted our total market share and top line G fees.

Turning to expenses, line 6 shows that administrative expenses increased by $37 million to $442 million, as we continued making investments that have accelerated our financial reporting timeline and allowed us to make good progress on fixing our internal controls. As we're now about two-thirds of the way through 2007, we're better positioned to give guidance on our full-year costs, and we would expect to end the year with administrative costs of about $1.7 billion, or an increase of roughly $100 million over our 2006 levels. Given that total admin was up from the '06 levels, year-over-year will be basically flat at about 9.2 basis points as a percentage of our total mortgage portfolio.

Make no mistake, though, there is leverage in our business model and over time, this ratio of total administrative expenses will decline. Over the long-term, we believe that we should be able to reduce administrative expenses on an absolute basis and you should start seeing some of that in 2008, once we complete some of the financial remediation and start the benefits of our new technology investments.

Finally, line 7 shows credit-related expenses, which included our provision and REO expenses, increased $336 million. We recognized this expense in response to a deteriorating house price environment, higher delinquency to foreclosure transition rates and increased average UPB levels in the 2006 and 2007 books. On the basis of total credit costs, and that I'll define as charge-offs plus REO expense, we realized $79 million of credit loss in the second quarter, or 2 basis points of our total managed portfolio. That's up from 1.3 basis points a year ago. Now, given the current credit trends, we would expect full year 2007 credit losses to increase, but to come in at less than 3 basis points, a level that is below our historical average of 5. This positions us well in a market that has not yet hit bottom and as such, we would expect the 2008 credit losses on this basis to increase from the 2007 levels.

Let me now take you through the GAAP mark-to-market items on slide 3, since they have continued to be volatile. Line 10 shows the total mark-to-market impact in the second quarter was a gain of $430 million. I should note that unlike previous periods, the mark-to-market effects of our portfolio of derivatives had a relatively small impact on the results. Rather, most of these gains resulted from the changes in the fair value of our guarantee asset, shown on line 2, which recorded an increase of $1.1 billion. As we indicated in June, higher long-term interest rates in the second quarter caused the GA to increase in value.

Moving down to line 8, increased market concerns over mortgage credit risk produced mark-to-market losses of $392 million in the quarter. These marks were largely associated with increased market discounts on the delinquent loans we buy out of PCs and higher market implied default costs on certain pool purchases underlying new securitizations. Just a reminder, we use market-based prices in valuing these items and in times of stress, these prices can overshoot the actual risks. Accordingly, these marks imply higher future default costs than we ultimately expect to incur. Nevertheless, given the recent credit market deterioration, we have witnessed through July and August, it is likely that we'll report significant mark-to-market losses on these items in our third quarter GAAP results.

Turning to fair value on slide 4, fair value of net assets increased by about $800 million in the second quarter, as gains on the fair value of the guaranteed asset and the underlying returns generated from investments and guarantee activities more than offset losses due to mortgage to debt OES widening. As you can see in line 1, investment activities in our retained portfolio reduced fair value by about $800 million in the second quarter, as compared to an increase of about $1 billion a year ago. Line 2 shows that most of the year-over-year decline is related to widening in the mortgage-to-debt option adjusted spreads. Aside from this reduction, fair value returns in the retained portfolio have remained solid, as rate income has increased year-over-year, as a result of wider OESs and new portfolio purchases.

In our guarantee activity, shown in line 3, the change in fair value was a positive $1.8 billion in the second quarter compared to a gain of about $1.2 billion a year ago. Notwithstanding the interest rate and credit-related marks on lines 4 and 5, underlying results in the business improved year over year due to increased customer volumes and moderately higher total guarantee fees. Again, given the market turmoil in July and August, with both OES and credit spreads gapping out wider, unless market conditions change, we would expect to record a significant reduction in fair value in the third quarter related to these items.

I'll close by discussing our progress on our capital management, financial reporting and internal controls. First, capital. Following the release of our 2006 financials, we initiated our preferred-for-common swap under our $1 billion authorization. Through the end of the second quarter, we bought back $750 million in common shares, and issued $500 million in preferred stock. During the third quarter, we repurchased the remaining $250 million under the common stock plan and issued an additional $500 million of preferred. Given the current level of spreads in the market and profitable growth opportunities in both our guaranteed business and our investment area, we are balancing capital returns with our ability to invest in the business in ways that provide attractive long-term returns. It's important to note that we have a very good ability to source additional capital, should we need it to fund profitable growth.

On the control front and timeline, let me make a couple points. First, with today's release in 61 days, we have meaningfully accelerated our financial release process. As a reminder, our target for the third quarter was 60 days, so we're basically a quarter ahead of schedule. Given the success and our commitment to continue to improve with each release, we are targeting the release of the third quarter results by Thanksgiving. That would represent a further improvement of 10 days.

Second, as we've just advanced the timeliness of our financial reporting, we are also making progress on new and more understandable results presentation. I would expect to roll that out with a full set of presentation and disclosures in early 2008 in anticipation of SEC registration.

Lastly, in this quarter we've addressed two more significant efficiencies in our financial reporting process. The first related to tightening of our GAAP policies and the second related to improved oversight of our financial and business models. So we are making very good progress on our overall remaining issues, and I'm optimistic that we will have the bulk of our control issues behind us by year end.

With that, let me turn it back to Dick.

Dick Syron

Thanks, Buddy. Let me make three points and then get to your questions. First, we've told you in previous calls that the underlying economics of our business matter more than the swings due to accounting. We think today's call confirms the enduring strength of our core franchise. It's worth keeping that in mind as we move forward, particularly in the current environment.

Second, we've set forth in prior calls the investment thesis that Freddie is a very sound way to participate in the long-term growth of housing in this country. To the extent this environment, which I think it does, says this company is built for the long run, we believe it plays to our demonstrated strength.

Finally, we all know that Freddie is easy to take for granted when times are good, but our value becomes very clear when the market runs into trouble. That is exactly what's happened again. The housing finance system almost immediately recognized this and to an increasing extent, the political and regulatory system has been facing that fact as well. We're doing everything we can today to help the market and homeowners and we want to maximize our ability to do even more.

The genius of the GSE model is that by doing more for our mission at a time like this we don't detract from our shareholders; in fact, we help them. We serve both our mission and our shareholders.

With that, let me now ask to turn to questions.

Question-and-Answer Session

Operator

Your first question comes from Paul Miller - FBR Capital Markets.

Paul Miller - Friedman Billings Ramsey

My question has to do with the MI companies. One of the things that's happened over the last three months is that the MI companies have come under risk of being downgraded from their double A status to their single A status. These guys provide a lot of reinsurance support for a lot of the loans above 80% LTV in your portfolios. What is the contingency plan if a bulk of these guys, like a Triad gets downgraded to single A, can they still write business for you? If they can't, is there enough capital in the MI space to continue with writing loans in the 80% LTV levels, or would you have to back off on taking some of those loans?

Patti Cook

We continue to believe that the MIs are well capitalized. So despite a potential rating decline for that industry, we look at the institutions closely and in every case we think they are adequately capitalized for the book of business that we have on with them at this time and that we would expect to do in the future.

Paul Miller - Friedman Billings Ramsey

So, even if they got downgraded to single A, that really wouldn't interrupt the business flow?

Patti Cook

No, it wouldn't.

Operator

Your next question comes from David Hochstim - Bear Stearns.

David Hochstim - Bear Stearns

Buddy, could you provide a little more color on how to think about the increase in the loss provision and the building of reserves, with so far the very modest increase in single-family charge-offs and somewhat modest increase in overall credit losses, and then the mark-to-market adjustments on the repurchased loans and how one can think about what your true credit loss exposure is on all of that?

Buddy Piszel

In the first quarter, David, we increased our reserves; we took a provision for $191 million, and we said at the time that a lot of that was due to our early experience on the '06 book. When we started the '07 year, we got into the first quarter of '07, we were thinking the '07 book was going to look more like the average of a couple of years versus the '06 book. And the early read now, as we look at the credit quality of what we've originated, plus the very, very early read on delinquencies, is that '07 looks a little bit more like '06. So we prudently have booked up our reserves in the second quarter, a little bit of catch-up on the '07 book and then a continued reflection of where we see the '06 book going. So that gives you some color for where the provision is.

When we think about the way to look at this, because there is a big difference between where the provision is and where the charge-offs are. The charge-offs, two points there. One, the provision only covers the off-balance sheet exposure, so it's not the full picture. The charge-offs, however, are the full picture and they are the most all-in indicator of where our actual credit losses have settled down.

After the mark-to-market items, we take that in two places. One is when we repurchase loans out of the PC pools that are more than 120 days delinquent and pricing has gotten worse with every sequential quarter, and we call these LEAH loans. These loans are now in prices that from in the $70 million range compared to we started the year in the high $90 million, it deteriorated to $80 million in the first quarter. It's now into the $70 million, and that's creating some exacerbation of the reported losses that were reflecting there.

Likewise, when we're issuing securities, certainly the pools may have losses embedded in them if you use the market view of potential default costs. And again, that's gone up in the second quarter really because of the market's view of where default costs are and both of these could be a reaction. But we'll have to see when that settles out.

David Hochstim - Bear Stearns

When you finally realize the actual losses, what happens? You would have an offset or recovery against those expense items in future periods?

Buddy Piszel

Right. Exactly. You'll have a recovery the fair value side and the real loss will ultimately find its way through the charge-off line. So at the end of the day, everything goes through the charge-off line.

Operator

Your next question comes from Fred Cannon - KBW.

Fred Cannon - Keefe, Bruyette & Woods

I just wanted to follow up on the comments on current market conditions on fair value. The comments were quite cautionary and I just wondered if we could get a bit more color? I believe the increase in OAS that we've seen would have a negative impact on the investment activities and deteriorating credit would have a negative aspect on the fair value of the GO. I was wondering about current market conditions on GAs. Would that also be a net negative given what's occurred since the end of the quarter?

Buddy Piszel

Interestingly, we had an increase in GA in the second quarter because rates were going up. With the rates rallying in the third quarter, that would be another negative. So it's a little bit like a triple storm.

Fred Cannon - Keefe, Bruyette & Woods

And so the issue on rates on the GA is driven by treasuries rather than the mortgage market rates, is that right?

Buddy Piszel

And spreads, but you're generally correct.

Operator

Your next question comes from Bruce Harting - Lehman Brothers.

Bruce Harting - Lehman Brothers

I wasn't totally clear on the answer to David's question about the 8 basis point provision rate versus the 2 basis point charge-off in the quarter. Is the provisioning level in this quarter anything near, should we expect that to be a run rate? I know you're getting out ahead of rising delinquencies or transition rates and higher severity, but can you give any further guidance? I think you said in your prepared remarks this year might be going more towards like 3 basis points and next year higher. If you could firm that up any more, that would be great. Thanks.

Buddy Piszel

Couple points, Bruce. There is an element of catch-up in the second quarter provision for first quarter '07 book. That's in the zone of about $60 million. As to the balance of the year, I wouldn't be surprised if our provisioning stays at the first half level, but it depends on whether what we're seeing in the '06 and '07 books is really just a draw-forward of losses versus a likely increase in the overall tail. So we'll be watching that carefully.

When we think about the provision, the provision covers about two-and-a-half years of losses, so there is a built-in lag in the way this will emerge, and we'll just see how things emerge on the overall credit story. But that gives you some more color. I don't know if there's anything more that we can share with you.

Dick Syron

Just let me add in a color sense to this, is that when we look at the likely evolution of the housing market and the economy, we have elected to be on the cautious or bearish side of that, feeling that it is better for us to err in that direction than making our estimates in the other direction.

Operator

Your next question comes from Bob Napoli - Piper Jaffray.

Bob Napoli - Piper Jaffray

I would like to take the MI question maybe theoretically a little bit further, and I understand your view that they are well capitalized and that the stock market isn't agreeing with you at the moment. Theoretically, if one or two of the MIs were to have ongoing problems and were not able to meet their obligation, can you maybe just walk through what you think the exposure would be to Freddie Mac and how that might work?

Don Bisenius

One of the ways we think about our MI exposure is we look at the amount of product that's actually covered and what types of losses could be experienced in a stress-type scenario. When we run those scenarios, we find that the amount of capital, as well as future premium income that the MIs earned is more than adequate to cover the exposure that we have there. So even if there is some downgrades and things like that, they're existing capacity to cover the losses they have to us is more than adequate.

Bob Napoli - Piper Jaffray

But if they were not, then is there an insurance fund that makes up the difference, or does that come onto the GSEs?

Don Bisenius

There is the capital that the insurance companies have themselves that we believe is more than adequate to cover it. In the event you got into a particularly stressful environment, there is also the future earnings capacity on the premiums on those books that can be used to offset losses.

Operator

Your next question comes from Brad Ball - Citigroup.

Brad Ball - Citigroup

Buddy, you mentioned a couple of times the likely negative impact of current market conditions on the mark-to-market and fair value results for the third quarter. I wonder if you could talk about what, if any, are the fundamental implications of that? What are the implications for your capital and your regulatory capital adequacy, but perhaps more importantly, and maybe Patti could chime in, what are the implications for the OAS and your G fee rates? I wonder if you could give a little more color on what you're seeing on the bulk side in G fees. Thanks.

Buddy Piszel

Let me take the capital question first. Brad. We have projected out where our capital could be on any kind of a stress scenario through the balance of the year, and we feel that we're adequately capitalized and we have actions that we can take on the balance sheet to be able to continue our growth rates in the G fee business and grow our retained portfolio to the cap. So we're not concerned at this point. It will be a negative, but it's a manageable negative to our overall GAAP capital, as we've currently estimated it.

Patti Cook

Brad, you raise the right issue, which is always at first blush a little confusing. When you look at the retained portfolio and you see a substantial drawdown in fair value because OAS has widened, you flip that around and you look at the opportunity that it creates for us to purchase. It's also important to remember that as we mark the portfolio down, because OASs have widened, we earn that back over time in a higher OAS or accrual rate on the portfolio going forward. So if you look at the total mark-to-market loss we've realized in the retained portfolio for the first six months of the year, that's translating into 20-plus basis points of higher OAS in the portfolio going forward.

I think as it relates to bulk G fees, which you also referenced, you're also raising an interesting point which is the difference between our capacity to respond to the market changes in bulk space versus flow space. In bulk space, which operates as a spot market, if you will, as prices change we can change the price that we bid for those portfolios. On the other hand, within flow space, it's more difficult. While we do have some delivery fees, the risk-based pricing aspect of flow is not nearly as good as it is in bulk.

Operator

Your next question comes from Howard Shapiro - Fox-Pitt Kelton.

Howard Shapiro - Fox-Pitt Kelton

I wanted to ask you another question on your fair value methodology. I understand that we are going to see a decline in fair value next quarter due to wider spreads. The question really is to Patti, tell us how much of your valuation methodology is model-driven, how much is market-driven, and in the market environment like we have now, where it's basically liquid and not very much price discovery, how exactly do you depend on the market to drive valuation?

Patti Cook

On both our G fee business and on the retained portfolio, we use market-based pricing to mark those portfolios to market. On the retained portfolio side, since the vast majority, basically everything we own is quite liquid we are not seeing any issues, if you will, in getting prices on that part of the portfolio.

On the G fee business I think there the possibility for continued wider spreads in this particular market exists for that book to continue to get marked down. So in both cases, it's a credit environment that exists today persists, risk premiums are high. Both those books could continue to be marked down.

I want to make a couple of observations. The way to think about the cumulative mark on the retained portfolio is that you then have a higher accrual rate, if you will, that you earn in your core spread going forward. The way to think of it on the credit guarantee business is a little different. If you look at the accumulated mark in GO, one way to think about is the implied house price path that would justify that kind of mark in GO? I think that we would say as of today, even through August, that the implied house price path in our GO mark-to-market is more severe than any that we are likely to realize.

Howard Shapiro - Fox-Pitt Kelton

One follow up on the portfolio limits. Your letter to OFHEO clearly states that in an environment where there's a liquidity issue, you would no longer be bound by the voluntary cap. If there's ever an environment that calls for corporate statesmanship, it seems like this is the environment. I'm a little surprised and perhaps you could explain to us why you haven't chosen to be more active and grow your portfolio in this crisis situation.

Dick Syron

Two or three observations. First, we are growing our portfolio and we're trying to do things judiciously so that we have the greatest impact obviously jointly on our mission objectives and on shareholders.

Second observation is that we are in continuous discussions with our regulator, as are other people, about what will happen with the caps, and the outcome there is yet to be determined. But the interpretation of our regulator so far -- and I think we may disagree on the term voluntary to some extent -- is that the caps are binding at this point in time. That has to be resolved. I think the regulator is examining what's going happen with the caps, and we don't think, as I've said before, that in this immediate environment it's advisable for our shareholders to get into protracted conflicts with our regulator.

Operator

Your next question comes from Moshe Orenbuch - Credit Suisse.

Moshe Orenbuch - Credit Suisse

A follow-up on that comment and a couple of others. I mean, I think the fact the company has $1.8 billion of excess capital at June 30, it sounds like on a GAAP basis you probably swing back to a loss in the third quarter. There was a reference made to capital available to you. I guess, I just want to understand that whole concept as to how you take advantage of this current environment if in fact the capital seems to be a bit constrained, and reference that and kind of combine it with the fact that your commitments at the end of July were down over 90%?

Dick Syron

Let me just start this. First of all, we do have a surplus in this period. Second, on the 30% surplus issue, when that arrangement was first contemplated, it was contemplated on a basis which I think makes sense for most things in life, that it wouldn't be a death trigger, but rather it would be something that would be considered over an averaging period. We're having some discussions with our regulator on that, and there are a variety of mechanisms that could be employed to give us more space, which we think would be desirable obviously not only from our perspective, but from the perspective of the markets.

Patti Cook

I just want to address what we are doing within the constraints of the cap. I think you've got to look at us providing liquidity to market in two fundamental ways, both on the prime side in the primary market and the secondary market. In the primary market, we are trying to provide liquidity via the sub-prime model offering and also our more recent disclosure on alt-A, where we'll commit to up to 90 days for a particular credit box so both of those activities are a way to continue to provide liquidity.

I think in the retained portfolio, where the cap is an issue, we are trying to optimize our purchases, both against the cap and again run-off. So when you look at the monthly run-off in our portfolio of $12 billion to $15 billion a month, we are trying to be very selective and optimize where the market could use the redeployment of that liquidity, if you will, most advantageously. For us right now, that's going to be a combination of agency passthroughs when they need it, which is the case in June, where you saw $40 billion of commitments, but then also supporting the non-agency aspect in the secondary market. So I think it's important to remember that we do have a fair amount of run-off that we can optimize against, as well as up against the cap.

Dick Syron

Moshe, the reason we said that the way we did, if the cap were lifted and we were given no relief on the mandatory 30%, we would consider issuing preferred to take advantage of our unlimited portfolio of market conditions to say we could make money by doing it.

Moshe Orenbuch - Credit Suisse

Did you ask OFHEO specifically?

Dick Syron

We don't have to ask them to issue preferred stock.

Moshe Orenbuch - Credit Suisse

No, no, I'm talking about on the cap. There were press reports that Fannie Mae asked for an increase so that didn't seem comparable.

Dick Syron

We were not involved in the exchange of letters, but we have made clear in numerous venues as we're making clear now, that we think from a public policy perspective there would be a benefit for lifting both the caps and the $417,000 limit on what we can buy, obviously given the disruptions in the jumbo market and we are in continuous discussions with our regulator on that process.

Operator

Your next question comes from David Hochstim - Bear Stearns.

David Hochstim - Bear Stearns

Actually two parts. Buddy, you were talking before about poor performance in the 2007 book than you had anticipated. Is it possibly you really haven't seen a lot of 2007 production, and that what's been called 2007 so far in the early part of the year was really slopping over from '06?

Buddy Piszel

That clearly is the case, and we're going through analyzing right now exactly how much of '07 is ’07 originations versus '06 spillover. So that is the case. What we're reacting to is not so much the early read on the performance of the book, but really the attributes of the book, which look a lot like '06, but that makes sense, since a lot of it was originated in '06.

David Hochstim - Bear Stearns

And then the follow-up I had is for Patti. If you could just give us maybe some additional color on what you're seeing today and the end of August or the beginning of September in terms of opportunities or relative spreads without being too specific in disposing what you really plan to do? But are there opportunities to maybe more aggressively sell some assets and then buy others, if you're seeing $0.70 prices on certain assets now, wouldn't those be things that would in some cases be more attractive than some of the PCs you've got?

Patti Cook

I think we have and have already exercised the opportunity to be able to sell when the market corrects. The way we think about the products area, you've got the very liquid TBAs, you've got less liquid agencies and then you've got non-agencies. Really trying to maximize the impact we have on the market through both sales and purchases is clearly something we're trying to do.

David Hochstim - Bear Stearns

Can you give us a sense of the relative change in OAS, or maybe even tell us what you think OAS averaged on the portfolio in the second quarter?

Patti Cook

What I would do is take the mark-to-market loss that we disclosed to you in OAS for the first two quarters and look at that on the overall portfolio and you'll see that spreads have widened on the portfolio by 20 to 25 basis points. If you think about the portfolio as being somewhat representative of the assets we can purchase, it's telling you something about the opportunity, although obviously it is a distribution around that 25 basis points.

Operator

Your next question comes from Bruce Harting - Lehman Brothers.

Bruce Harting - Lehman Brothers

Yes, in the event that a number of economists now are looking for a couple of [fed easings] between now and the end of the year, do you have any data on the coupon distribution that could be helpful in our understanding of the speed with which 50, 75 or 100 basis points impact that would have in terms of refi volumes and would it actually be helpful to your efforts in the sub-prime remediation in terms of moving some of those resets into fixed? So any help you can be in terms of that data.

Buddy, you talked about the margin having stabilized and gave a number of reasons that you listed, mix shift, steeper curve, etc. I wondered if you could just go through each of those factors as you see them impacting the margin for the next six to 12 months. Thanks.

Patti Cook

First of all, on your economic outlook and the likelihood, or the result of fed easing, I think you would have to look at that as a positive for the underpinnings of the mortgage market overall. So I think you're on sort of the right path to think about would it make it easier for current sub-prime borrowers to refinance into a fixed? I haven't really thought about what that would do to volumes, but, yes, I think at the end of the day that would certainly be helpful.

Buddy Piszel

Add to the factors a stabilizing NIM, most of what contributed to NIM stabilizing in the first quarter should continue for the balance of the year. I think the shift to fixed rate product, we see that continuing. Your guess is as good as mine what's going to happen with the yield curve. The amortization of the deferred cash flow hedge is stable for the entire year, so you're not going have the higher levels that we experienced in 2006.

The one wild card is what happens with rates, because in the second quarter, we've got a little bit of positive lift from rates being up and the premium amortization was reduced as a result of that. That could move around $50 million or so, but it's not a big driver. So our sense is that we should continue to see a stabilization of NIM over the balance of the year, and if the book continues to grow, you would expect to see some growth there, too.

Patti Cook

I might add to that, the other underlying fundamental is that the economic margin in the business is improving and over time, that will play through, or should, with NIM.

Operator

Your next question comes from Paul Miller - FBR Capital Markets.

Paul Miller - Friedman Billings Ramsey

I just had a quick follow up on the MI question again. You said it doesn't really matter if they get downgraded to single A if you allow them the right business, but does it impact your risk-base ratios at all? Because I remember way back when there was a discussion between holding different capital levels between triple As and double As, and that got waived. Are there different capital levels between a single A underwriter versus a double A underwriter?

Patti Cook

Small difference in the capital charge.

Paul Miller - Friedman Billings Ramsey

Small difference?

Patti Cook

Yes.

Paul Miller - Friedman Billings Ramsey

The other question is the Sarbanes-Oxley, the last time I asked this question I think was three months ago. You said that you still plan on signing a Sarbanes-Oxley letter by late '08. Has that timeframe changed at all?

Buddy Piszel

No, that's not. It would be in conjunction with our year-end ’08 financial statements. You sign that once a year in conjunction with your annual audit literally we will not have to be Sarbanes compliant by the end of '08, but we would intend to be.

Paul Miller - Friedman Billings Ramsey

Why wouldn't you have to, just out of curiosity?

Buddy Piszel

Because there's a new SEC registrar, we've got a one-year waiver, so we literally don't have to be compliant until the end of '09, but we think it's in the best interest and our shareholders to be compliant earlier.

Paul Miller - Friedman Billings Ramsey

So if you file current financials next summer, if that timeline's still correct, you have one year before you got to sign the SOX letter?

Buddy Piszel

Right, but our intention would be to sign it with our year-end financials for '08.

Operator

Your final question comes from Thomas Mitchell - Miller Tabak.

Thomas Mitchell - Miller Tabak

In looking at your mix of business, is there a way for us to estimate going forward the changes that are taking place in your risk profile? That is as you meet your obligation under your charter, undoubtedly you're going to increase the risk profile of the assets that you guarantee and hold. Where will we see that appear?

Patti Cook

I think our additional disclosure over the last couple of months, both around sub-prime holdings and the retained portfolio, and then with this release, the additional disclosure we've given to you around our Alt A purchases, we will continue to highlight those differences. I mean that is the right place to look. So look at our sub-prime purchases. Look at the disclosure we gave you today in terms of alt A, which supplement the other information that we give you on the portfolio overall.

Buddy Piszel

Tom, this is not a one-shot deal on this disclosure. We're going to be providing the expanded credit disclosure each quarter going forward.

Dick Syron

Well, I want to thank all of you for your time. If there are any follow-up questions, obviously we would be anxious to take them. It's a testing time for all of us, but we think it is also a time of great opportunity for us. To reiterate what I said before, it's in this kind of market that you really do see what the value of the GSEs is. Thank you.

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