Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

Executives

Ed Golding - SVP of Equity Investor Relations

Dick Syron - Chairman and CEO

Patti Cook - Chief Business Officer

Buddy Piszel - CFO

Ray Romano - Credit Risk Oversight

Analysts

Paul Miller - FBR Capital Markets

Gary Gordon - Portales Partners

David Hochstim - Bear Stearns

Howard Shapiro - Fox-Pitt, Kelton

Eric Wasserstrom - UBS

Moshe Orenbuch - Credit Suisse

Robert Lacoursiere - Banc of America Securities

Fred Cannon - KBW

Brad Ball - Citi

Ken Posner - Morgan Stanley

Bruce Harting - Lehman Brothers

Claudie McPhearson - HSBC

George Sacco - JP Morgan

Thomas Mitchell - Miller Tabak

Freddie Mac (FRE) Q3 2007 Earnings Call November 20, 2007 10:00 AM ET

Operator

Ladies and gentlemen, thank you for standing by. And welcome to the Freddie Mac Third Quarter 2007 Financial Results Conference Call. At this time, all lines are in a listen-only mode. Later, there will be a question-and-answer session and instructions will be given at that time. (Operator Instructions). As a reminder, today's call is being recorded.

At this time, I would like to turn the conference over to Senior Vice-President of Equity Investor Relations, Mr. Ed Golding. Please go ahead, sir.

Ed Golding

Thank you Kent, good morning. Welcome to our investor presentation and conference call, where we present to you our financial results for the third quarter. Speaking today are Freddie Mac's Chairman and Chief Executive Officer, Dick Syron, our Chief Business Officer Patti Cook and our Chief Financial Officer, Buddy Piszel. Our SVP of Credit Risk Oversight, Ray Romano will join us for Q&A. As we begin, let me make two important points. First, we have posted on our website a slide presentation and core tables, which include additional information on our results. You may want to have these available, as Buddy walks through the numbers.

Second, please note that today we may make certain forward-looking statements regarding our business results. These statements are based on 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 full discussion of these factors in today's Information Statement Supplements and the Information Statement in the 2006's Annual Report, which are also posted on our website. We strongly encourage you to carefully review these factors. And 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. We will comeback time permitting for a second round. Thanks, and now let me introduce our Chairman and CEO, Dick Syron.

Dick Syron

Thanks, Ed, and good morning to all of you. I know everyone has had the chance to review the press release we posted early this morning. As you know, the third quarter continued to represent a very difficult environment as falling housing prices, deteriorating mortgage credit and continued volatility in the fixed income market all contributed to a net loss of $2 billion. Even the continuation of the same market trends that produced these results through October, November is likely that the fourth quarter will prove difficult as well.

These results are not surprising, given the vagaries of our accounting that were tied to the housing accounting to the housing economy and we are taking strong steps to improve our business and our future financial results. We do not believe it would be wise to be sanguine about the intermediate term housing market. Thus we are determined to take strong steps and be in front of whatever happens. We are all very strong believers in both the long-term opportunities for shareholders and in our obligations in times like this to meet our charter by stabilizing markets.

The actions that Buddy and Patti will discuss are aggressive, forward-looking and financially prudent. And they will show that we are able to propel our mission into and meet our responsible release to our shareholders at the same time. Not withstanding, the extremely tough market in the third quarter, Freddie Mac benefited from our traditional strengths as net interest income in guaranteed fees continued to grow.

Buddy will discuss these trends, and will take to you through our financials. In particular, he will focus on how credit impacted the results. In addition we have taken some steps, since early 2007 to advance our mission, improve our credit exposure and enhance our long-term profitability.

As a result, through the third quarter our credit position has remained among the strongest in an admitably troubled industry. And the conventional conforming market with the vast majority of our exposure is -- has held up well. Patti will review how we've managed our credit position. And will discuss some of the current opportunities we're seeing in the business.

Before I turn it over to Patti, I want to reiterate to everyone on the call that the GSEs were set up for times like these. Over time Freddie has prospered by committing capital needs [to buying this] managing credit and interest risk to expectable levels and earning attractive long-term results. Given the current opportunities said in both of our businesses, we feel that we should remain focused on the fundamentals of our business. As a result, the right thing for us to do now is to take steps to bolster our capital position in order to strengthen our franchise and better position us for the future and that's exactly what we're doing.

With that, I'll turn it over to Patti.

Patti Cook

Thanks, Dick. These are certainly volatile and challenging times in the US housing and financial markets. I will address how this environment is affecting our current business and the prospect for our future business. I will touch on the credit quality and expected profitability of our guarantee fee business, the credit quality of the asset-backed securities in the retained portfolio and the outlook for profitability in both.

In summary though, I would say that what is bad for current profitability is good for the longer term prospects of Freddie Mac. As you will hear, we are clearly more relevant and needed today than even we were a year ago, which is creating opportunities for us to improve our longer term profitability. But first what have we done to address the current market environment.

We continue to support our customer's liquidity needs and it helps stabilize the conforming mortgage markets. In this period of illiquidity the GSEs are the primary liquidity provider for mortgages. This is evidenced in our annualize growth rate of 16%, which compares to estimated MDO growth of about 6.

As demand for mortgages has declined the share of originations being securitized by the GSEs has increased to approximately 65% in the third quarter of '07, some about 40% in 2006. As a result, the agency mortgage market has continued to function relatively well. Let's turn to current market environment and its impact on our [G-fee] business. On slides 8 and 9 we have updated the information we provided on our second quarter call. As in June, our current credit position remains relatively strong across our total portfolio. In aggregate Freddie Mac benefited from a low current LTV ratio of 60%, high average FICO scores on 724 and a serious delinquency rate of just 51 basis points, a level that is roughly half of the market average.

However, our 2006 and 2007 books are expected to realize higher expected default costs than prior books for two reasons. First, the recent weakening in the house price -- of house prices have increased expected default costs for the 2006 and 2007 books compared to prior years. Second, there was an increase with risk layering mortgages, for example mortgages with FICO scores less than 620 and original LTVs greater than 90 are more concentrated in the 2007 book and represent about 1% of purchases.

On the guarantee fee business, we use market prices to mark all credit related exposures. In the third quarter the market prices for credit deteriorated significantly and I believe that the market is putting a big risk premium into the price they quote, especially on prime conventional mortgages. Let me put this in perspective. We guarantee obligation including related items with $16.8 billion at the end of September.

For this value to represent the present value of future default costs on our guarantees, we would need to see default rates in the 4% to 5% range and severities around 30%. A more reasonable assumption might be defaults of 3% to 3.5 % and severities of 30% resulting in total present value of default costs of $10 billion to $20 billion over the life of the portfolio. This is with some areas such as California experiencing declines in house prices of 25% to 30%.

To put this in perspective, our worst performance was the portfolio we held as of 1991, which went on to experience a 2.6% default rate and a severity of about 30%. So we would need to experience a scenario approximately twice as severe as the 1990s to see the GO realized. Also a note of caution, when comparing these life time numbers to charge-offs, this type of analysis includes not only charge-offs but also REO expense and lost interest.

So to summarize, the difference between the $10 billion to $12 billion that I quoted, and $16.8 billion can be thought of as an expression of the market’s uncertainty about the future, which manifests itself in wider spreads. So, unless the conventional conforming default rate, rises to a level of 4% to 5%, we would expect to earn some of the GO mark back overtime. And remember, as of now we are seeing single family serious delinquencies as of September 30, 2007 of 51 basis points. To address the declining profitability that results from the decline in the housing market we have taken steps throughout 2007 to increase prices and limit our credit exposure.

In our bulk purchase channel we were able to response quickly to the changing market dynamics. Early in the year we began restricting the credit terms and increasing prices for purchases through bulk. G-fees in this space have nearly doubled for similar products since beginning of the year, dramatically improving expected ROEs.

While this bulk channel accounts for only about 15% of our total purchases, it accounts for a disproportional share of our lower credit quality purchases. This contributed to the increase our new purchases in our average G-fee up to the mid 20s for the third quarter of 2007. This number includes contractual G-fees and amortization of delivery fees, but does not include non-cash items such as accrual of day one differences.

Through our [slow] purchases given the prevalence of long-term contracts that govern our purchases in that space, implementing credit and prices changes is more challenging. However, we have taken two significant steps. In August we raised prices for loans with higher risk characteristics. And last week we expanded our delivery fees to include fees on LTVs greater then 70% and FICO scores below 680. This would have the effect of increasing fees on our current deliveries by 3 to 5 basis points depending on delivery mix.

We are also discontinuing the purchase of no income no asset or NINA loans and reinforcing our declining market's requirement. We will continue to review all of our pricing on an on-going basis, in some while the housing market remains challenging. We are comfortable with our ability to adjust prices in term of business to enhance the profitability of our securitization business going forward.

Let's turn to a discussion of the risk profile and profit outlook for the retained portfolio.

The credit profile of our retained portfolio remains of the highest credit quality with 57% in agency mortgages and 33% in non-agency securities, of which 97% is AAA rated and does not include any CDOs. These assets [facts] are critical to our ability to meet our affordable lending objectives and allowed us to invest in non-prime markets with substantial credit enhancements.

Despite the continued deterioration of the housing market, and increases in non-prime delinquencies, we remain comfortable with our risk position on these assets. For the subprime securities while we have experienced some downgrades, we have high levels of subordination that support these investments as shown on slide 10.

Even at a 50% cumulative default rate at a 50% severity assumption no losses are projected on these securities. There are also about $26 billion of Alt-A and $21 billion of [MD&A] asset back securities in the portfolio, which we've grouped together in the slide with average subordination levels up 16% and 22% respectively. While the overall book should have sufficient subordination to withstand continued deterioration in housing and performance, there are some chances of losses although unlikely on a few individual bonds given the variation in subordination levels.

Let me turn to OAS and fair value. Despite its high credit quality the retained portfolio has experienced significant spread widening during 2007. In the third quarter alone the portfolio was marked down by $8 billion on a fair value basis as spreads widened bringing the year-to-date write down to about $9 billion. This represents about a 40 basis point widening on the entire portfolio. There is always some good news and bad news in these marked downs. The bad news is the fair value mark-to-market write down it creates, the good news is the higher spread income that will accrue going forward, coupled with improved opportunities.

At the beginning of the year, the spread in the portfolio was about 25 to 30 basis points. At the end of September it was about 65 to 70 basis points. That's the spread the portfolio was earning going forward is about 2.5 times higher. While capital constrains are currently restricting our purchase activities, we are optimizing our purchases and select sales against one-off to maximize the OAS on the portfolio.

Two examples during the third quarter were first, the purchase of AAA bonds against the sale of agency [pass throughs] and second the purchase of cheap agency [REMs] in August against fixed rate pass through. Both transactions resulted in significant option adjusted in spread pick up.

We will continue to look for these kinds of opportunities and also add responsibly to the portfolio as we address our capital situation. So there you have it. From a business perspective, even in this difficult business environment we continue to benefit from a relatively strong credit position. We will have higher core spread income in the retained portfolio. We have taken steps to continue our mission and improve our business and we are experiencing significant growth and pricing power in our G-fee business. All of these business drivers will contribute to improved returns over the long-term.

With that, I'll turn it over to Buddy.

Buddy Piszel

Thanks Patti, and good morning everyone. I am going to take a few minutes to provide a high level review of our third quarter 2007 GAAP in fair value results shown on slide 2. I will keep this brief because I want to focus most of my comments on credit.

Let's begin with the GAAP results. The key takeaways here are that while we have continued to experience improvements in net interest income and guarantee fees, the combination of negative marks on our derivates in credit related items as well as higher provisions for credit losses produced a quarterly net loss of $2 billion or $3.29 per share.

Let's look first at net interest income. As you can see here on line one for the third quarter we continue to benefit from improved net interest income. The combination of improved contractual spreads between our assets and debt, continued yield curves steepening and the diminishing effect of the 2006 debt refinancing, lifted our net interest income to $987 million or 52 basis points of net interest margin up from $973 million or 51 basis points in the second quarter.

Moving to our management guarantee income. Line two shows that we experienced good growth in revenues on third party owned PCs which brought our top line guarantee revenues to $520 million or 16.6 basis points up from $474 million or 15.7 basis points in the second quarter. This line includes only contractual G-fees on third party PCs. Amortization of deferred fees would have added 1.4 basis points yielding an overall G-fee of 18 bps. As a reminder, we do not include any contribution from non-cash accretion of day one losses in our guarantee fees.

During the third quarter, we recorded $1.5 billion in interest rate related mark-to-market losses shown here on line three. Remember, we manage our interest rate exposures to very low levels. The reported losses on derivatives are economically offset by gains on our debt funding programs and retained portfolio securities. These offsetting gains are not reflected in the GAAP income statement. So again for another quarter, our reported results have been significantly depressed by mark-to-market effects.

This GAAP accounting depresses our regulatory core capital, which is necessary for growth. It’s also made it more difficult to communicate our results externally. While the work is incomplete, I can tell you that we are taking two steps to address this problem. First, I have asked my team to start building a framework for reinitiating hedge accounting on our portfolio of derivatives. That, plus selective adoption of the fair value option will dampen some but not all of this noise. Second, as we have discussed with many of you we have also made good progress on developing segment reporting and an adjusted GAAP measure that will present our company’s resolves more clearly.

As part of this presentation, we are currently planning to adjust out unrealized derivative mark-to-market items and simply recognize realized gains and losses as they would emerge over the life of the portfolio. Delivering this presentation requires a re-measurement of past results with an accompanying MD&A. We are doing our utmost to roll out this presentation by year end. But if this work jeopardizes our release results in 60 days it would be provided after the year end release.

We will meet our 60-day year end commitment. Moving to lines four and five, the total credit impact on our GAAP results in the third quarter totaled $3.5 billion. On a year-to-date basis we have absorbed $4.9 billion of total credit costs. I will discuss that thoroughly in a minute.

Let me now turn to our fair value results on line six. You can see we recorded a net reduction in our fair value of common equity before capital transactions of $8.1 billion after-tax in the third quarter. Included in this result was OAS widening in the retained portfolio, which contributed a pre-tax reduction of approximately $8 billion, $3.5 billion of which, was associated with a widening of OAS on our portfolio of ABS securities. As Patti discussed, we believe that little if any of this fair value loss will result in cash losses.

So, we expect most of this mark will be timing differences, as improved core spread income in the retained portfolio during the quarter and going forward will reverse these losses. Our guarantee fee business experienced a $7 billion per-tax reduction in value due to significant declines in the market value of the net guarantee assets and guaranty obligation and widening credit spreads and the lower market prices on our portfolio of delinquent loans. This resulted in the GO that Patti referred to of approximately $17 billion, which over states what we expect to become realized credit losses. A more reasonable outcome is $10 billion to $12 billion. I think there was a glitch in Patti's script when she gave the words she gave 10 to 20 she meant 10 to 12.

I have given a high level of review of our GAAP and fair value results. Let me now turn to credit beginning with slide three. This slide frames the way the company currently accounts for credit costs. In the upper box line one is our credit provision, which for the most part addresses our off balance sheet single family credit exposure. Year-to-date we took approximately $1.7 billion in provision expenses with the bulk of that recorded in the third quarter. I will explain that third quarter increase in the minute.

GAAP allows you to provide for incurred losses that have already manifested themselves in delinquencies, as well as, in estimates for losses related to credit events which have occurred such as job loss that will emerge as delinquencies within the foreseeable future. For us that foreseeable future is one year. GAAP does not allow you to expense your projected ultimate default cost nor does it allow you to expense future REO cost or lost interest. These are recognized on a pay-as-you-go basis.

In the lower box is our mark-to-market credit cost that covers two situations. First, in general, when assets are moved on balance sheet we record our credit exposure by booking -- looking to the markets view of how they would price credit risk for these investments, and then booking that. That market price is a much different measure of credit, it not only covers ultimate expected default, but also covers REO and lost interest as well as a significantly -- at a significant uncertainty premium.

So, that measure has all the potential overshooting issues that Patti covered in discussing the fair value of the GO. Year-to-date on line six we recorded approximately $2.2 billion of net market write downs. When we think about the quarter earnings of the business, we believe a provisioning approach better measures the emergence of credit costs, as opposed to the mark-to-market approach and we will be presenting our results on the provisioning basis in our adjusted GAAP frame work.

What we presented on the slide, is the provision we would have incurred in lieu of these mark-to-market items. On the upper right box you can see that year-to-date provisioning for these essentially on balance sheet credit costs would have resulted in an additional provision expense of $494 million as opposed to a market price adjustment of $2.2 billion. For the third quarter standalone the additional provision expense was $263 million as opposed to a market price adjustment of $1.7 billion.

So adding that on balance sheet provision to our off-balance sheet provision generates an adjusted provision in total of approximately $2.2 billion year-to-date and establishes an adjusted gross reserve of $2.6 billion.

The last mark-to-market item on this page is line eight, which are losses we record when the markets pricing of the value of loan guarantees for an individual pool exceeds the value of the fees. When this happens, we report a loss today and at the same time defer revenue of an equal amount that will amortize into the P&L overtime. When amortization is complete there is a zero impact on results. However, as the market view of credit worsens initial reported losses have increased, more revenue is deferred and that's what happening. That said we don't think of this as an incremental credit cost of credits over the long-term. So I know that that's a complicated explanation, but I hope it's clear.

In summary, we've taken $4.6 billion of credit costs year-to-date through our P&L. We believe an adjusted provision of approximately $2.2 billion is a more reasonable measure of credit costs. On a provisioning basis our credit costs have gone up significantly in the third quarter and the next two slides [cater], to what's behind this.

We've said in past calls that our 2006 and 2007 books had worse credit attributes than previous year vintages and right out of the blocks were hit by negative price declines. As a result early delinquency in transition rates on these recent books are out sized compared to historical patterns. We have chosen to give creditability to these observe trends and have made a number of changes to our reserving methodology in response. These changes for the 2006 and 2007 books are the biggest driver in our provision increase.

On slide four, you can see that year-to-date charge-offs, which are the most lagging credit indicator include a small percentage from the ’06 and ’07 books. However for our serious delinquencies, the ’06 and ’07 books account for 23% of the total, which is much higher than historical early performance. We had experienced down cycles before in the credit markets and in hindsight we always wish we would have reacted more quickly .We have done that, as a result [57%] of our adjusted reserve is attributable to our 2006 and 2007 books.

On slide five, we give you a forward look of charge-offs. Remember at the end of the day no matter what the book keeping method, our credit losses emerged in this charge-off line. The total credit costs in dollar shown here assume that the ’08, ’09 purchases do not contribute to losses in ’08 or in ’09. So on line one you can see charge-offs continuing to rise through the end of the year and end the year at approximately $350 million.

Adding REO expense that equates to a full year total credit cost of roughly $500 million or 3 basis points of the portfolio in line with our expectations. For projecting forward we are using the less severe realization and severity rates and house prices [paths], Patti referred to earlier, which equate to about $10 billion of total expected future GAAP credit costs for this book.

For 2008 and 2009, total credit losses grossed significantly rising from 8 basis points in ’08 to 11 basis points in 2009. We have not provided the [out years] but I can tell you that 2009 is the peak charge-off year for the closed book and then charge-off starts sloping down. What's important here is that when we think about our adjusted reserve, it's based on our view of the forward looking charge-offs for incurred losses. You can see here that at $2.6 billion our adjusted reserve will cover roughly the next two years of charge-offs.

Let me close the credit story on slide six with a discussion of our losses on loans purchased or LIA loans. When we buy 120-day delinquent loans out of our securities, we put them on the balance sheet at the market’s view of fair value. We have always used the market’s view versus our models view. And you can see that as credit conditions have worsened the market's pricing for these loans have declined dramatically. These prices again reflect a severe market sentiment that Patti discussed.

Down below we show you what the historical trend has been for the way these loans have played out. And roughly speaking in the past, around 60% to 65% [cure], which means they resumed payments on the mortgage or they paid off. Now the older books did benefit from rising house price paths so the more recent books could behave worse but so far the ’06 book looks in line with our long-term experience.

Since we started with this accounting last year we recaptured a cumulative 53% of the total dollar discounts on loans purchased out of securities during 2006. At this point we have no reason to believe that the ’07 LIA purchases will behave any differently. The last points on LIA are for the roughly 35% of LIA loans that go to foreclosure. One it takes a number of years to get there, and two, today’s LIA prices overshoot the charge-off amount.

So, let me summarize our credit story. Credit has clearly worsened. We have taken over $4.6 billion in the credit costs year-to-date, which is almost 50% of the $10 billion we expect ultimately incur. The mark-to-market items have been extreme. We believe an adjusted provision is the right way to look at credit and our actions there have been responsive to what we have seen and prudent.

Before I turn to capital, let me provide some insight into the fourth quarter. And as Dick said, so far, in the quarter market conditions are [worsening] against us. Loan rates have rallied and OAS in credit spreads have continued to widen. So unless market conditions improve, fair value returns will be negative and with no changes in our accounting, our GAAP result will also be negative. At this point, we're projecting fourth quarter performance about in line with the third quarter, which brings me to capital.

As of September 30th, we had $8.5 billion of capital over the statutory minimum capital. But only $600 million over the 30% mandatory capital surplus target. Given the opportunities to deploy capital, and uncertainty of our GAAP results and credit conditions, as well as uncertainties on the relief of 30%, we are planning on taking several actions to bolster our capital. Firstly, we have engaged Lehman Brothers and Goldman Sachs to help us consider capital raising alternatives in the very near-term.

Second, we are seriously considering a 50% reduction in our common dividend. These actions, coupled with other management steps, should provide sufficient capital flexibility for us to manage the company for our shareholders and meet our charter through the balance of this credit downturn. When things return to normal we are committed to returning the excess capital to our shareholders. With that, let me turn things back to Dick.

Dick Syron

Thanks, Buddy, we’ve given you a lot of information today in context. I just won't leave you with the couple of very short comments that are hopefully straightforward. Our situation is, we have a 30% mandatory capital requirement and we are committed to meeting that. At the same time our accounting is volatile to say the least. And net drives much of what we have been talking about.

Having said that, one, we've taken the challenges that Freddie faces extremely seriously, as I know you believe we are. And we're focused on them intensely and we believe very realistically. Two, we're putting in place a very active capital management plan that will allow us to manage our business consistent with the needs of the market environment, benefit our shareholders and put this situation behind us. Three, we've identified a clear path to improve our financial results, and we're moving down that path very aggressively. Clearly the most important part of this call is your questions and let's turn to those.

Question-and-Answer Session

Operator

Great. Thank you very much. (Operator Instructions). And our first question then comes this morning from the line of Paul Miller with FBR Capital Markets. Please go ahead.

Paul Miller - FBR Capital Markets

This is a question for Patricia Cook. On the 17, can you go over the GO. The GA -- GO write down. I think there is a lot of numbers going out there. And you said that you were expected $10 to $12 billion of losses. But you had written down that asset by $17 billion and to realize that loss you would need to double the severity rate, which we saw in the early 90's. Can you just go over some of that a little more slowly?

Patti Cook

Sure. Although its sounds Paul like you've pretty much got it. The total value of the GO on the balance sheet as of September 30th was $16.4 billion, all right? That is a present value estimate of total future default costs. Now when we evaluate that number against what we think are some reasonable expectations call it 3% to 3.5% default and severities 28% to 30%. We will only expect to realize on a present value basis $10 billion to $12 billion of that 16. And even now I want to put in historical context and say the 3% to 3.5% defaults and the 28% to 30% severities are high numbers. They are much higher than our 1991 book of business realized.

Having said that, if we're right about that number, the 10 to 12, it means the difference: the 16.4 minus that number, would accrue back to us in the form of income or increased fair value overtime. I want to go a step further and say that behind the 3% to 3.5% defaults are pretty significant house price declines, call it peak to trough nationally or something like 5% or 6% and various regions that are experiencing some deterioration in house prices, lows of 25% to 30%. So I hope that's helpful.

Paul Miller - FBR Capital Markets

Yeah. And just one quick follow-up, but 5% to 6% national decline, what if we get 10% declines I mean would -- is that what's factored into that $16 billion number?

Patti Cook

You know what rather than think about it from just a house price decline because there is a lot of ways to new ones to the house price decline.

Paul Miller - FBR Capital Markets

Yes.

Patti Cook

The answer would be if you saw at a 10% national house price decline led to 4% to 5% default and 30% plus severities in our conventional conforming space then you could realize $16 billion. So I would encourage you to connect a house price outlook with what you think that means in terms of default in severities and to put it in historical context; go back and look at what Freddie experienced with their 1990, 1991 book of business.

Paul Miller - FBR Capital Markets

Okay thank you every much Patricia.

Patti Cook

Yeah, sure.

Dick Syron

This is Dick Syron. Can I just add quickly on to this? There is lot of housing price decline numbers thrown around. There are four major different indices that we use. We -- the index that we are using tends to understate compared to other areas, in other words it would be worse –if you would have put it on the some basis, same basis as the other indices because it’s a repeat sales index that has to do with the space that we sell in. So it’s important to understand that and it has no [jumbos] in it.

Paul Miller - FBR Capital Markets

Okay. Thank you very much.

Operator

Great. Thanks and we have a question in from the line of Gary Gordon with Portales Partners, please go ahead.

Gary Gordon - Portales Partners

Okay. Thank you. Just the definitions of these accounting charges are mind boggling, but on page three you announced the credit related items, the first, the second and third item, losses on loan purchased in PC residual. May be you could just add a little color to what they are? I understand a new business charges the line eight. What are two and three?

Buddy Piszel

Losses on loan purchases, what I refer to as the LIA loans, and these are situations where we purchase a delinquent loan greater than 120 days delinquent add it to the portfolio and put it on the balance sheet at the market's view of fair value. The next line, which is the PC residual, that’s a big number and this gets to the current accounting model where -- when -- if we have an off-balance sheet guarantee we are provisioning for it. If we buy that security, so we buy a Freddie security and put it on our balance sheet, we stop provisioning and we mark the credit to market. So it has the same measurement underpinnings, as the GO that Patti just spoke to, and creates a much more radical view of the measurement of credit.

Gary Gordon - Portales Partners

Okay. Following up on the line eight losses on certain credit guarantees: Basically, as we speak, you put on new business, you take a hit to earnings, and, therefore, the capital?

Buddy Piszel

Right.

Gary Gordon - Portales Partners

You just re-priced a lot of your products: if we are looking at the fourth quarter has the re-pricing considering the way credit spreads have changed has the re-pricing allowed you to offset this or you basically continue to lose business -- lose money every time you add a new piece of business?

Buddy Piszel

Well remember this is a timing difference. When we book that loss today [I defer our incoming amortization]. So it does stress our GAAP capital, but it's not a long-term capital issue for the company. Secondly, the price increases that we have announced will go effective in April so you really won’t see the improvement on the day one difference for new purchases until that point in time. We think that those price increases will tend to mute some of the day one loss. It also depends on where the markets are pricing credit at that point in time because we use the markets to price that day one difference.

Gary Gordon - Portales Partners

Okay I guess the reason it was issued today is you put on a new business you lose money and now you have got issues with capital potentially cutting the dividend having to raise capital so there would be I think a trade-off as we speak of. Do I go out and raise new equity or do I do that next piece of business and how would you think -- how are you making these, thinking about these trade-offs?

Buddy Piszel

Yes unfortunately the way this is done the -- we would contract with one of our originators in total and we know in total that business is profitable, but in the way they deliver individual pool our accounting has to react to individual pools even when in total there is a profitable overall contract. So yes, it's unfortunate the way accounting model works. But we don't see it as a trade-off in doing new business because we can at this point determine which of these pools are delivered with a gain and which are delivered with a loss.

Gary Gordon - Portales Partners

Okay. Can you just literally just have to take a new business even if it means being forced to raise capital to finance it?

Patti Cook

One thing I would add about it, I mean we believe that the long-term returns on the G-fee business are attractive and to echo some of Buddy's discussion we are looking at ways to mute the affect of that day one difference.

Gary Gordon - Portales Partners

Okay.

Patti Cook

And sort of the way we would actually pool those loans into securities.

Gary Gordon - Portales Partners

Okay. Thank you.

Operator

Thanks and our next question then comes from the line of [Mike Benise] with Bear Stearns. Please go ahead.

David Hochstim - Bear Stearns

Yeah. Hi its, actually David Hochstim. I was wondering: could you just address the idea that your basically suffering from wider credit spreads through reductions in GAAP or you can't take advantage of those wider spreads solely because your capital has been eroded and you can't buy those high return assets and you have got $8.5 billion of surplus capital above statutory minimum? Why isn't the best thing for the shareholders to get relief from that arbitrary 30% cushion that the regulator has imposed you are virtually compliant with the agreement in fact you have been in compliance with the original agreement you had in June? So why should -- why shouldn't there be some adjustment to that supposedly temporary capital restrictions?

Dick Syron

Well, David you have addressed a very key issue, obviously. And the issue you have addressed has underneath it, that we have the opportunity now, to put profitable business on the books. But we are constrained by capital and that is a major fact to look. I mean we don’t think this is a very pleasant thing to say that what we are doing here, right in terms of major capital actions considering dividend reductions. But we wouldn't be doing it, unless we thought we were going to make money on it. And that's the motivation for it. With respect to the 30% itself the 30% is the decision of the regulator. This is as you know for the GSE sector as a whole, are highly regulated business. And they are the ones that have to determine that. Now, looking forward we are making strong progress towards our compliance plan. As our compliance plan is completed and we have a 60 day timeframe on that. We would expect and we get some other things done to become more aggressive, and we do expect to get the 30% back overtime, which will obviously both give us more opportunities and put us in a situation where the capital that we've raised now, won’t be as necessary (inaudible).

David Hochstim - Bear Stearns

Okay. A follow up question for Buddy, that the, I mean the guidance on the fourth quarter looking similar to the third quarter from a GAAP earning stand point is that suggest that some of the accounting changes that you've talked about implementing that would reduce some of this GAAP noise and distortions in capital won't be effective for the fourth quarter or could they be and that would kind of help diminish the affect to those?

Buddy Piszel

They well-- may well could be, David and we're doing everything that we can to get those implemented and they would certainly mute things and probably the biggest thing it had do is that PCR mark that we take which is an effective GO mark for the on-balance sheet Freddie securities. We're trying to do a number of things but we're trying to do everything and we don't want to make a commitment at this point that we can deliver all of it.

So my guidance was on the same basis as we reported third quarter. Fourth quarter would look the same we're working to get the accounting changes if we do the fourth quarter will improve.

David Hochstim - Bear Stearns

Okay. Thanks.

Operator

Thank you. And our next question then comes from lines of Howard Shapiro with Fox-Pitt, Kelton. Please go ahead.

Howard Shapiro - Fox-Pitt, Kelton

Hi. I just wanted a follow-up on David's question and ask you point blank: did you go to OFHEO and ask for at least on the 30% capital surcharge? You are purposing to dilute shareholders, so please don't tell us that it’s a question you do not want to answer on a corporate call.

Dick Syron

Well, we respect and abide by our regulators, which is and how we deal with these things. We have had discussions with them on the 30% that obviously is a key issue and I would expect that we would be having those discussions as time goes forward.

Howard Shapiro - Fox-Pitt, Kelton

But did they say now.

Dick Syron

You can interpret the answer I think.

Howard Shapiro - Fox-Pitt, Kelton

So the regulators said now. Okay, great. And next question I guess it would be for Patti, on your sub-prime exposure the securities where you have got some are [B29] and plus subordination. Can you tell us how those securities might differ from the sub-prime collateral that's in the marketplace as a whole specifically to sub-prime collateral that's in the ABX [index] that's marked at substantial discounts to par?

Patti Cook

The biggest difference between our sub-prime ABS and the ABX index is around the

Between our sub prime ABS and ABX index is around the average life of the securities. So the ABS has setback the ABX index, much longer and that has several implications the first of which as spreads widen, [DBO one] is greater so the price goes down harder and may be more importantly they don’t benefit like we do on the increased subordination and the yearly cash flows, going to increase the subordination of the shorter ABSs that we own that’s the primary difference.

Howard Shapiro - Fox-Pitt, Kelton

Okay, great. Thank you very much.

Patti Cook

You are welcome.

Operator

Thanks and our next then comes from the line of Eric Wasserstrom with UBS. Please go ahead.

Eric Wasserstrom - UBS

Thanks, I mean just to circle back to just some of things that have been said, I mean given that there is a very, very high likelihood that the trends we have seen so far through the quarter will cause you to violate the 30% excess capital standard in the absence of any other [exogenous] factor. Can you help us prioritize what course of action you would take and put some magnitude around that?

Dick Syron

Well at the time 30% was first put into place, it was put into place with the idea that this is something that one could go through and then come back above and manage on an average basis, so we are not handling this on the basis of you know "gee", we want to avoid being 29.98 at the end of one month. But our cushion and as you know, we have talked about this extensively and our regulator has commented on it extensively the need for a cushion above the 30% is sufficiently [thin] now that when you combine that with the opportunities that would be foregone not to be undertaking business we think the course that we are considering discussing with our directors is the capital is the right one. One quick point: There are two basic approaches we could take now. We could sort of go to [fortress] Freddie, right, shrink the business which I don’t think would be in the interest of the shareholders and certainly not in our interest of our obligation statutorily and under our charter to the US mortgage market. But we could do that, we could not do anything on stock and just shrink the business and wait for it through or we could take these actions, which we think are consistent with the best interests of the mortgage market and with the interest of the shareholders and do it quickly get in front of the situation and do it with a magnitude that we think we can get behind us.

Eric Wasserstrom - UBS

Okay and in terms of given that the, I respect that and I understand that. I am just trying to get…

Dick Syron

I am sorry fro my -- if I am too intense about it.

Eric Wasserstrom - UBS

No, no. I can understand why. But I guess given that the dividend cut is actually in the scheme of thing of a very small number I am trying to get a sense of how else you would prioritize the actions and what the potential magnitude of them could be?

Dick Syron

You know we have, I think we have indicated we are talking about doing things in the preferred space, okay. We have not talked this fully through with our Board. We have obviously talked to our Board but we haven’t gone through the full governing process in a formal sense, so in all due respect I don’t want to get too precise about this. Let me put it this way. We are not happy about this. We don’t expect you to be happy about it. But we are trying to do this in a way that’s either least worst or most friendly to our existing common shareholders.

Eric Wasserstrom - UBS

Great. Thanks very much.

Operator

Thank you and we have a question then from the line of the Moshe Orenbuch with Credit Suisse. Please go ahead.

Moshe Orenbuch - Credit Suisse

Thanks, I guess I was trying to understand the context of how we should think about the potential from write downs in the fourth quarter and its wasn't clear you said similar sized to the third quarter but are they driven by the same factors and do those update in the first quarter then? I mean presuming that the two factors number one that home price declines are continuing and both the rate of increase in delinquencies is continuing, it would seem that would continue and also could you address whether the sub-prime securities will have to be written down through earnings on other than temporary impairment basis and how that would effect the capital which you need to raise?

Buddy Piszel

Moshe, let me take that in two pieces. On the credit side, if you think about our reserve covers about roughly two years out, of charge-offs and we said that beyond '09 charge-offs start to decline assuming that our house price [pay off] and assumptions hold you would some decline of the provision that will start to happen and it really depends on what those out year charge-offs look like. But if we had base it on the way we are looking at things, as '10 and 2011 charge-offs decline, the provisioning will be declining also. In regards to the marks that we are taking there's two factors there. How much gets purchased out of the portfolios, and at what price? And that’s the biggest wild card in trying to project forward so we are assuming for the fourth quarter purchases are going to continue to rise and prices are going about be holding. They are not, this is on the [legal] side they are not going to be going up. Now the other factor is the reversal of the markdowns we've already taken for LIA, you can see that started to play into the results and against the pace at which the LIA performance online. And those are the three determining factors. So, that would imply that, '08 will continue to be a difficult credit year. And it's hard to estimate at this point relative to '07 where that will be. And then things should clearly abate moving into 2009.

Patti Cook

Moshe, I want to add on the sub-prime in terms of impairments, because of the view it's to our expectation that we don’t realize losses on that portfolio. We therefore don’t need to impair them.

Buddy Piszel

Right. We can tell you, Moshe, we've done significant cash flow testing, we've actually got very little of the portfolio that you get into the impairment calculation, because it has to go below $0.90 of a dollar, before we would consider it for impairment and then even for the little bit that's gotten there, it's even roughly $150 million there is no losses that we would expect taking.

Moshe Orenbuch - Credit Suisse.

That's a frame. That 90% is a Freddie Mac policy, it is not consistent with the way I understood it, but…

Buddy Piszel

That is our internal policy that before we consider things for impairment, especially, because we hold our portfolio it has to move below 90% and then, we're subject to whatever the cash flow test would indicate whether there is a loss to be realized.

Moshe Orenbuch - Credit Suisse

Okay. Thank you. I guess, just to get (inaudible) back on the first part then because it doesn't seem like, it would flip completely around by the first quarter, which seems that there is going to be additional, in other words, the capital plan have to encompass more than just the loss in the fourth quarter.

Buddy Piszel

Our capital plan does contemplate a difficult credit environment in our reported results for 2008. This does not abate in the first quarter of 2008.

Moshe Orenbuch - Credit Suisse

Okay. Thanks.

Operator

Thank you. And our next question then comes from the line of Robert Lacoursiere, with Banc Of America Securities. Please go ahead.

Robert Lacoursiere - Banc Of America Securities.

Yeah. I just wondered if you could just help me understand: how you come up with the valuations for the LIA loans? There is obviously not a market. So, what are you using like a level to approach and where do you get the inputs from?

Patti Cook

No, actually we do get LIA mark from the street. And you're right and part of that is probably reflected in the price. It is in a liquid market. It certainly not trading as many of the other securities that we are on trade but we do go to the street for any independent mark.

Robert Lacoursiere - Banc of America Securities

But you never actually trade? You don't actually sell these things? Are you just asking them to quote your figure, right?

Patti Cook

Right. But you are on to a good point Robert, because I think that same thing is in evidence when we priced the overall GO. If you think about it our mortgages that we're guarantying in our GSE business really don't trade in securitize in a AAA senior sub sort of structure. So, we've been there, the fact that we take that structure, we go to the market, we ask for a price on something that really doesn't trade. I think supports the notion that the uncertainty and the credit risk premium that's embedded in those marks is likely to overshoot in a cautious credit environment.

Robert Lacoursiere - Banc of America Securities

That is precise, I am just wondering why you have to rely on those quotes when there is no market, why can't you do a Level III approach and put your own assumptions like other institutions do?

Patti Cook

This is -- you want to take it Buddy?

Buddy Piszel

We have been there in the past and the feedback that we've received from our auditors is the market is a more reliable source of pricing and accordingly even in 10 markets, that should be our first line of defense whether it contradicts or models or not. Since we've made this change, we've only look to the market wherever possible, and we've always been able to get market prices. So, whether we like them or not, they are out there and if they are out we are using them to measure because the accounting literally says that you're supposed to use that what some one would pay you to take the obligation off your hands and if there is a market price out there, that is an indicator of the price that you would have to pay to have it taken off your hands.

Robert Lacoursiere - Banc of America Securities

If I could just bother you with one follow-up: if they are quoting, if these institutions are quoting you those prices, are they not obligated to reflect those valuations on their own positions on their own books?

Buddy Piszel

That's an interesting question, but we are not going go there.

Robert Lacoursiere - Banc of America Securities

Thank you.

Operator

Thanks. And our next comes from the line of Fred Cannon with KBW. Please go ahead.

Fred Cannon - KBW

Thanks. A follow up on couple of issues: One is, when you said earlier that the results in the fourth quarter would be in line with the third quarter, does that include the fair value loss that we saw in third quarter are you projecting the similar fair value decline in the fourth quarter?

Buddy Piszel

It’s hard to project, month of October was a not a good month when that closed out. You know, the fair value results are highly subject to where the market is at the end of the quarter. Through November, things haven’t improved much as far as credit spreads or where OASs have gone, so, this assumes that nothing improves if nothing improves, it may not be as bad as the third quarter, but it’s not going to be pretty.

Fred Cannon - KBW

Okay. So, it could be again $10 or so head--? It is kind of follow up to obviously a number of us who trying to get a handle on the size of the capital raised and I know it’s difficult for you guys to discuss that directly. I was wondering though in terms of just by math if I am often magnitude, I was thinking that, if we have a similar loss, and you don’t get the accounting change in the fourth quarter, you had about 600 million over your 30% cap number, if you had a $2 billion loss you probably want to make that up and then add another billion or so for potential growth. So, would I be off in a huge magnitude if I was thinking in $2 billion to $4 billion in terms of the capital needs of the company?

Buddy Piszel

Well, let me just say a couple of things, without giving you a number. Fred, we are looking to raise capital to get beyond the first quarter, really to get through '08 and to the end of the credit cycle. And secondly, this will be a large transaction. Third, we are not looking to do common. And fourth, we will be doing something assuming our Broad supports in a very, very near-term.

Fred Cannon - KBW

Okay, great. Thanks, very much. I know you can't say exactly, so that's helpful.

Operator

Great. Thank you. And our next question then comes from the line of Brad Ball with Citi. Please go ahead.

Brad Ball - Citi

Thanks, Buddy. I just had a follow-up on the question about your reserve relative to your guidance. So, you are looking for eight basis points of losses in '08 and another 11 basis points in '09 and it peaks in '09. You've got 2.6 billion of reserves today and you are projecting something like 2.9 billion of losses over the timeframe the '08, '09. So, on that basis it looks like there isn't a significant need for increase provisioning or is there where am I wrong and at the end of '09 when credit begins to improve what level of reserving do you expect to hold into the future, in others words, what do you expect your normalized loss rate to be? When we get back to the sort of mid single digits or we get back as those three basis points? Thanks.

Buddy Piszel

Remember the way this works Brad is that you are provisioning based on a forward look of incurred losses, so, you are right. At this point, the reserve covers most of the '08, '09 charge-offs, but as we are provisioning on the going forward basis, we are looking into 2010 and those charge-offs will be coming down on a going forward basis. And so that would be imply that assuming that our assumptions are right our provisioning would be going down accordingly. So, that's the way that works, I believe I said that we trying to cover in total some $10 billion of total credit cost that could got through the GAAP numbers. So, if we provided right now with the mark-to-market, we've gotten a long way there, I think we are almost 50% of way there already through this year but on a provisioning basis that will emerge overtime some thing on the six to seven years.

Brad Ball - Citi

And what about normalized loss rates?

Buddy Piszel

Normalized loss rates as we get through the rest this should return to some thing I think in the four to six range then three. If you look back historically, we were expecting about four to six and assuming stable times, what we are realizing is what we would be provisioning for and that’s the way to think about the business.

Patti Cook

One thing to add and remind ourselves as when we talk about the 10 to 12 that include REO expenses in loss interest. And not just charge-offs.

Brad Ball - Citi

Okay. Thank you.

Operator

Thanks. And our next question then comes from the line of [William Wong] with Morgan Stanley. Please go ahead.

Ken Posner - Morgan Stanley

Hi. it's actually Ken Posner. I wanted to ask a clarifying question about the 30% capital surcharge. Rationale for that surcharge has to do with a variety of operating and control issues. And I am wondering if you can give us sort of a punch list of things to be checked off at which point, I know you can speak for (inaudible) but at which point you go to (inaudible) and say we have, corrected every thing that you've pretty much point to?

Buddy Piszel

Well, we know that the critical things that are on the path are getting back on time and reporting, which we keep on closing the distance every quarter. We were pleased that we got this in a quarter out in the timeframes that we have. We have been taken that time in every quarter, yearend, we will be on time, and we will be continuing that in 2008. So, timeliness is one.

Secondly, it's re-mediating our material weakness, and that goes with the execution and the comprehensive plan. We are on track to have substantial remediation of our material weakness and our significant efficiencies by the end of the year. It will take a little time I think for someone to observe it. In fact, these are working as well as we would assert. But we are on track to get the bulk of this done by the end of the year.

The third is becoming an SEC registrant. We said that we would be an SEC registrant by mid-2008. We have actually started the engagement with the SEC as we speak. Those are three clear points.

So, there could be a question, clearly the regulator has discretion here and that we've not gotten a clear statement that if you do these things, that 30% cuts off. So, we are in discussions about what other considerations could be made, but at least those three points, without getting those done, we know that there is really no discussion. Thank you.

Operator

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

Bruce Harting - Lehman Brothers

I guess, I am not completely clear on the difference between, Patti, what you were talking about on the GO mark-up in terms of expectations and the assumptions underlying that, say, 4% to 5% versus the more realistic scenario. And then, overwhelming, that on top of the graph on 11 basis points of loss. So, is the 11 basis points out '09 is the actual cash incurred loss and the GO is more of a marking process that will be realized overtime or is one of component of the other?

And then in the exercise, we try to do each quarter in reconciling GAAP to operating, I'll leave some of those alone. But it sounds like if OAS, which is sort of gapped out here from, say, 30-40 basis points to almost 70 in the space at last quarter, continues to worsen. That will obviously impact fourth quarter.

But at some point and say, '08 or '09, will there be a windfall as OAS tightens where the GAAP numbers will be going dramatically in the other direction on both the OAS adjustment as well as the GO, Guarantee Obligation adjustment that you're talking about?

Patti Cook

All right. We're going to go backwards and answer the OAS question first. There are two observations about the substantial widening in OAS. One is, we've started to realize, if you will, core spread income over the retained portfolio at a much higher rate, when the whole portfolio is marked at 70 basis points versus 30; that in and of itself gives you more cushion, if you will, around subsequent widening.

So, for example, if you had 40 basis points widening this year and it resulted in X amount of fair value loss, a 40 basis point widening next year on much higher core spread income has a very different outlook. So, my point would be, even if spreads just stayed the same, you have the wind at your back from a fair value perspective.

Now, if you're right and the market were to correct, then you would have -- you referred to it as a windfall, you would have a substantial mark-to-market gain in fair value that would support returns from that perspective.

Bruce Harting - Lehman Brothers

But the OAS widening has a less impact on the GAAP results, right, because GAAP is a name that deals with a different emergence of profits. So, it's not as bigger driver, and you don’t get a windfall on the way GAAP emergence compared to fair value, if in fact OAS just start to tighten.

Bruce, I think the question on how do you toggle between the GO conversation and the table that we showed on expected defaults, I think you are right when you say that the expected defaults are a component of the GO. We are using in underlying data the same expected defaults emerging in the measurement of the GO base case, the $10 billion to $12 billion, as we reflected on this table. But the difference is that when you measure the GO, you are running out through the end of time and then you present value it.

The other two elements that the GO has in it is an REO cost, which again goes through measure out in time and present value and it also has lost interest, which is strung out in [TVT]. So, the numbers are by themselves different, but if you call Ed Golding, he could walk you through that, because we are able to move between the two models at this point. And the information we disclosed is a sub-component of the GO.

Next question, please.

Operator

Great Thank you. Yes and next question comes from the line of [Claudie Mcphearson] with HSBC. Please go ahead.

Claudie Mcphearson - HSBC

Good morning, thank you for taking my call. I am trying to figure out what all the news that’s in the press right now around bond insurers and mortgage insurers and the potential for down grades and then just negative ratings pressure on these types of companies: can you help us understand what a downgrade or a potential failure of a company like this would mean for Freddie Mac and around what kind of capital call would you face may be charges? And then just give us the sense of the impact of just downgrades versus may be an absolute failure of a company? Thank you

Ray Romano

This is Ray Romano. Let me first say that we aggressively manage our counter party risk and have a long track record of being proactive in managing these risks. Having said that, we have examined all of our mortgaging insurance for writers, as well as our financial guarantors, on an individual basis, and in on whole. We are comfortable with our exposure to these sectors. At the same time, we do have within our tool chess that our disposal ways in which we can manage those risks and we have executed on that throughout 2007 and we will continue to do so to manage that kind of exposure.

Buddy Piszel

Do you have any further questions?

Claudie Mcphearson - HSBC

Can you give us a sense of what exactly are these tools that you are utilizing?

Ray Romano

For example, in some of the financial guarantors we've actually taking proactive steps to receive premium payments or recoveries now versus expected losses at some time in the future for weaker identified counter parties and that’s just some examples we do have other tools as well, we maintain a very aggressive set of standards for all of our mortgage insurance providers. We are very clear what happens in the event of a downgrade. And what actions we could take such as requiring a plan for returning to a healthy position, measuring their remediation progress and also impose other restrictions to firm up their capital positions.

Claudie Mcphearson - HSBC

Okay. Thank you.

Operator

Thanks. And our next question then comes from line of George Sacco with JP Morgan. Please go ahead.

George Sacco - JP Morgan

Hi. First, with regards to the loans purchased from your PCs did the market values reflect credit enchantment you've purchased on those loans?

Buddy Piszel

I do not believe so--

George Sacco - JP Morgan

Okay. So--

Buddy Piszel

That's a straight price.

George Sacco - JP Morgan

Okay. So, in mortgage insurance any pool insurance that you may have purchased would actually be an offsetting recovery against some of that at some point?

Ray Romano

Yes. I would just add also, we have other contractual obligations associated with our purchasing environment so, those are also available.

George Sacco - JP Morgan

Okay. And just second question as related to the accounting changes you talked about the different things you are looking at potentially to smooth out GAAP earnings a little bit are any of these changes continued on a trigger then such as SEC registration or in theory could you implement all of the changes you are looking at as soon as you have that systems in place and are comfortable that you are prepared to do it?

Ray Romano

The changes its mix, some of the changes we would be able to do because that we think they are clearly profitable and that’s the guideline for making and change. Some of them, what we think are we are doing more for comparability and ease of understanding of the results and they do require approval and commission by the SEC and we've begun that dialog with them.

George Sacco - JP Morgan

Okay. And would you be applying or at least have discussions about applying any of these changes retroactively?

Buddy Piszel

The changes that we would be making if we are successful would be applied retroactively, so that we would have a consistent comparability of future results against historical results.

George Sacco - JP Morgan

Great. Thank you.

Operator

Thanks. And our next question then comes from line of Thomas Mitchell with Miller Tabak. Please go ahead.

Thomas Mitchell - Miller Tabak

In sort of marking this out I guess one way to look at your loss provision for the third quarter was that you were getting ahead of the curve and you put up a 25 basis point provision. Just in the short-term in the next two or three quarters can we expect to continue trying to push to get ahead of the curve or would we expect the provision to move closer to the actual expected losses that you described as 8 and 11 basis points in 2008 and 2009.

Buddy Piszel

Well. I wouldn't say we were pushing to get ahead of the curve. What we were doing is responding to what we have observed in the '06, '07 book. So there was in the current provision a certain amount of catch up for the '07 book and the '06 book as we change the way or methodology responding to the emerging trends.

So we would not expect in the next quarters to be again making further tightening because I think we have tightened as much as you are allowed to go, and giving recognition to what you will observe the patterns are. As far as the long-term 8 to 11 basis points, the provision in generally will lead your default costs. So we are not going to give guidance here as to when that will occur and at what degree it will occur in '08 but in general provisions going to come first, the defaults are going to come second.

Thomas Mitchell - Miller Tabak

And then in terms of this immediate markdown kind of business, is there any sense that you have -- I am trying to think how to phrase it. Are there any mechanisms in the market place that indicate to you that that changes any time soon? And then the second question goes to this other thing about OAS. If treasury bond yields stay the same they just stop moving and if the OAS stops moving then all these marks go away. Is that true or not?

Patti Cook

Actually there's two aspects, two answers whether you are talking about GAAP or fair value. In GAAP phase, because of mark-to-market there is an interest rate component to our GAAP results that doesn't have any economic component and you're right if rates didn't change it will eliminate that volatility from GAAP. On an option adjusted spread basis the fair value change is a direct of fund, it’s a direct function of those changes in OAS. A 1 basis point change in the overall portfolio can be as worth as much as $300 million plus. So stabilization in both interest rates and in spreads would yield the volatility of both GAAP and fair value in different ways.

Thomas Mitchell - Miller Tabak

Thank you.

Ed Golding

Operator, can we take two more questions please.

Operator

Certainly, The first of those two will be from the line of Paul Miller with FBR. Please go ahead.

Paul Miller - FBR Capital Markets

Yeah, thank you very much. I know a lot of you have been talking about these credit spreads widening out we know in the fourth quarter just getting worse but is it, I mean do you think that after the new year that these credit spreads will start to come back as a lot of these $400 billion of assets sitting out there that is a buyer strike out here relative to anybody buying any of these assets. Can you just give some market color on what do you think credit spreads are going go into the New Year?

Patti Cook

Thanks, Paul, if I had a crystal ball and I could speak to that conclusively we had all be in sort of great shape. If you look at where spreads are today and how wide they are and how far they have moved, I mean I know I am an optimist but I would certainly hope that we would see some stability as we begin the New Year. Having said that though, if house prices were to continue to decline and capital for a lot of larger financial institutions remains dear, it's hard for me to put my finger on when the turnaround actually occurs.

Dick Syron

Paul, its Dick. Just a quick addition to what Patti says we purposely have as a policy in the company that we do not try to engage in any element of market timing.

Paul Miller - FBR Capital Markets

Okay and then the other question I had on these OAS spreads that are I think you published that in the graph on your table that is like is 60 to 70 basis points?

Patti Cook

Yes.

Paul Miller - FBR Capital Markets

And then you also talked about your [name] almost doubling in the quarter. With the new product you are bringing on are you getting [to quote] on your basis points now on new products which you are -- that you are able to bring on to your books?

Patti Cook

That’s a good question. The OAS in the portfolio also in part reflects substantial widening on the AAA asset backed by sub prime that we have alluded to several times in the call, unfortunately because of those wide spreads not much is been originated, so at the margin our ability to add those types of securities to the portfolio really does not exist. Having said that there was one trade that we did in the third quarter that took advantage of those spreads but may be more importantly even on the agency side we are seeing enough widening in option adjusted spreads that the returns to deploy capital into that market are very attractive.

Paul Miller - FBR Capital Markets

Okay. When you say attractive I mean can you just give me a feeling on the agency stuff -- [a rough] like where can you put the new stuff on?

Patti Cook

You know from an economic perspective ROEs that are above our long-term expectations.

Paul Miller - FBR Capital Markets

Okay. Thank you very much.

Operator

Thanks. And our last question then comes from the line of Howard Shapiro with Fox-Pitt, Kelton. Please go ahead.

Howard Shapiro - Fox-Pitt, Kelton

Hi. Dick I was wondering if I could ask you may be a more general question on kind of implications of all this for the mortgage market. You've sold almost $50 billion of your portfolio into the marketplace in the last two months, which by my understanding means that $50 billion less of liquidity available for borrowers out there. If you couldn’t raise money or if it was too expensive to raise money or if you are growth constrained in general what would you say the general implications are for the down turn we are seeing in the mortgage market right now?

Dick Syron

Well, Howard, actually you raised a very, very important point its kind of [dear to my heart as an ex-fed person or regulator]. Clearly, it is not productive in this market for the mortgage markets or the macro-economy for us to be selling into the markets. And I think that's implicit in your question. And that is why we have made the decision painful as it may be that we want to be able to both satisfy our shareholders -- [okay, more] satisfy and to address our charter responsibilities to provide stability and liquidity given the capital requirements we have the only way we can do that, is not by necessarily shrinking the organization, but by going out and taking the steps that we will be talking to you about in the almost immediate future, and being able to be a valuable contributor of the market.

Howard Shapiro - Fox-Pitt Kelton

Thanks.

Dick Syron

Let met just finish by saying look this is a very, very difficult time. This is not happy news we realized that but we finished on this note. We will work through this. We have a difficult situation in front of us but we are confident and we are committed that we can work through it in a way that benefits both our shareholders in our mission to the mortgage market and the US economy and thank you very much for all the time that you have taken.

Patti Cook

Thank you

Ed Golding

Operator, could you give us the replay number.

Operator

I certainly can and thank you. And ladies and gentlemen this conferences will be available for replay starting today Tuesday, November 20th, at 1:30 PM Eastern Time and it will be available through Monday, December 3rd, at mid night Eastern Time and you may access the executive playback service by dialing 1800-475-6701 for within the United States or Canada or from outside the US or Canada, please dial 320-365-3844, and, and then enter the access code of 891911. Those numbers once again are 1800-475-6701 for within the United States or Canada or 320-365-3844, from outside the US or Canada and again enter the access code of 891911. And that thus conclude our conference for today. Thanks for you participation and for using AT&T's executive teleconference. You may now disconnect.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: Freddie Mac Q3 2007 Earnings Call Transcript
This Transcript
All Transcripts