Freddie Mac Q3 2007 Earnings Call Transcript

Nov.20.07 | About: Freddie Mac (FMCC)

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

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

Operator

Ladies and gentlemen, thank you for standing by. And welcometo the Freddie Mac Third Quarter 2007 Financial Results Conference Call. Atthis time, all lines are in a listen-only mode. Later, there will be a question-and-answersession 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 toSenior Vice-President of Equity Investor Relations, Mr. Ed Golding. Please goahead, sir.

Ed Golding

Thank you Kent,good morning. Welcome to our investor presentation and conference call, wherewe present to you our financial results for the third quarter. Speaking todayare Freddie Mac's Chairman and Chief Executive Officer, Dick Syron, our ChiefBusiness Officer Patti Cook and our Chief Financial Officer, Buddy Piszel. OurSVP 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 slidepresentation and core tables, which include additional information on ourresults. You may want to have these available, as Buddy walks through thenumbers.

Second, please note that today we may make certainforward-looking statements regarding our business results. These statements arebased on a set of judgments and assumptions that are key business drivers andother factors. Changes in these factors could cause our actual results to varymaterially from our expectations. You'll find a full discussion of thesefactors in today's Information Statement Supplements and the Information Statementin the 2006's Annual Report, which are also posted on our website. We stronglyencourage you to carefully review these factors. And one final note, we wouldlike as many people as possible to be able to ask a question. Therefore, if youwould please limit yourself to one question and a follow-up, I would begrateful. We will comeback time permitting for a second round. Thanks, and nowlet me introduce our Chairman and CEO, Dick Syron.

Dick Syron

Thanks, Ed, and good morning to all of you. I know everyone hashad the chance to review the press release we posted early this morning. As youknow, the third quarter continued to represent a very difficult environment asfalling housing prices, deteriorating mortgage credit and continued volatilityin the fixed income market all contributed to a net loss of $2 billion. Eventhe continuation of the same market trends that produced these results throughOctober, November is likely that the fourth quarter will prove difficult aswell.

These results are not surprising, given the vagaries of ouraccounting that were tied to the housing accounting to the housing economy andwe are taking strong steps to improve our business and our future financialresults. We do not believe it would be wise to be sanguine about the intermediateterm housing market. Thus we are determined to take strong steps and be infront of whatever happens. We are all very strong believers in both thelong-term opportunities for shareholders and in our obligations in times likethis 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 topropel our mission into and meet our responsible release to our shareholders atthe same time. Not withstanding, the extremely tough market in the thirdquarter, Freddie Mac benefited from our traditional strengths as net interestincome in guaranteed fees continued to grow.

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

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

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

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

Patti Cook

Thanks, Dick. These are certainly volatile and challengingtimes in the UShousing and financial markets. I will address how this environment is affectingour current business and the prospect for our future business. I will touch onthe credit quality and expected profitability of our guarantee fee business,the credit quality of the asset-backed securities in the retained portfolio andthe outlook for profitability in both.

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

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

As demand for mortgages has declined the share oforiginations 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 agencymortgage market has continued to function relatively well. Let's turn tocurrent market environment and its impact on our [G-fee] business. On slides 8and 9 we have updated the information we provided on our second quarter call.As in June, our current credit position remains relatively strong across ourtotal portfolio. In aggregate Freddie Mac benefited from a low current LTVratio of 60%, high average FICO scores on 724 and a serious delinquency rate ofjust 51 basis points, a level that is roughly half of the market average.

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

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

For this value to represent the present value of futuredefault 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 bedefaults of 3% to 3.5 % and severities of 30% resulting in total present valueof default costs of $10 billion to $20 billion over the life of the portfolio.This is with some areas such as Californiaexperiencing declines in house prices of 25% to 30%.

To put this in perspective, our worst performance was theportfolio we held as of 1991, which went on to experience a 2.6% default rateand a severity of about 30%. So we would need to experience a scenarioapproximately twice as severe as the 1990s to see the GO realized. Also a noteof caution, when comparing these life time numbers to charge-offs, this type ofanalysis 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 expressionof the market’s uncertainty about the future, which manifests itself in widerspreads. So, unless the conventional conforming default rate, rises to a levelof 4% to 5%, we would expect to earn some of the GO mark back overtime. Andremember, as of now we are seeing single family serious delinquencies as ofSeptember 30, 2007 of 51 basis points. To address the declining profitabilitythat results from the decline in the housing market we have taken stepsthroughout 2007 to increase prices and limit our credit exposure.

In our bulk purchase channel we were able to responsequickly to the changing market dynamics. Early in the year we began restrictingthe credit terms and increasing prices for purchases through bulk. G-fees inthis 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 ourtotal purchases, it accounts for a disproportional share of our lower creditquality purchases. This contributed to the increase our new purchases in ouraverage G-fee up to the mid 20s for the third quarter of 2007. This numberincludes contractual G-fees and amortization of delivery fees, but does notinclude non-cash items such as accrual of day one differences.

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

We are also discontinuing the purchase of no income no assetor NINA loans and reinforcing our declining market's requirement. We willcontinue to review all of our pricing on an on-going basis, in some while thehousing market remains challenging. We are comfortable with our ability toadjust prices in term of business to enhance the profitability of oursecuritization business going forward.

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

The credit profile of our retained portfolio remains of thehighest credit quality with 57% in agency mortgages and 33% in non-agencysecurities, of which 97% is AAA rated and does not include any CDOs. Theseassets [facts] are critical to our ability to meet our affordable lendingobjectives and allowed us to invest in non-prime markets with substantialcredit enhancements.

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

Even at a 50% cumulative default rate at a 50% severity assumptionno losses are projected on these securities. There are also about $26 billionof Alt-A and $21 billion of [MD&A] asset back securities in the portfolio, whichwe've grouped together in the slide with average subordination levels up 16%and 22% respectively. While the overall book should have sufficientsubordination to withstand continued deterioration in housing and performance,there are some chances of losses although unlikely on a few individual bondsgiven the variation in subordination levels.

Let me turn to OAS and fair value. Despite its high creditquality the retained portfolio has experienced significant spread wideningduring 2007. In the third quarter alone the portfolio was marked down by $8billion on a fair value basis as spreads widened bringing the year-to-datewrite down to about $9 billion. This represents about a 40 basis point wideningon the entire portfolio. There is always some good news and bad news in thesemarked 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 portfoliowas about 25 to 30 basis points. At the end of September it was about 65 to 70basis points. That's the spread the portfolio was earning going forward isabout 2.5 times higher. While capital constrains are currently restricting ourpurchase activities, we are optimizing our purchases and select sales against one-offto maximize the OAS on the portfolio.

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

We will continue to look for these kinds of opportunitiesand also add responsibly to the portfolio as we address our capital situation.So there you have it. From a business perspective, even in this difficultbusiness environment we continue to benefit from a relatively strong creditposition. We will have higher core spread income in the retained portfolio. We havetaken steps to continue our mission and improve our business and we are experiencingsignificant growth and pricing power in our G-fee business. All of thesebusiness 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 takea few minutes to provide a high level review of our third quarter 2007 GAAP infair value results shown on slide 2. I will keep this brief because I want tofocus most of my comments on credit.

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

Let's look first at net interest income. As you can see hereon line one for the third quarter we continue to benefit from improved netinterest income. The combination of improved contractual spreads between ourassets and debt, continued yield curves steepening and the diminishing effectof the 2006 debt refinancing, lifted our net interest income to $987 million or52 basis points of net interest margin up from $973 million or 51 basis pointsin the second quarter.

Moving to our management guarantee income. Line two showsthat we experienced good growth in revenues on third party owned PCs whichbrought our top line guarantee revenues to $520 million or 16.6 basis points upfrom $474 million or 15.7 basis points in the second quarter. This lineincludes only contractual G-fees on third party PCs. Amortization of deferredfees would have added 1.4 basis points yielding an overall G-fee of 18 bps. Asa reminder, we do not include any contribution from non-cash accretion of dayone losses in our guarantee fees.

During the third quarter, we recorded $1.5 billion ininterest rate related mark-to-market losses shown here on line three. Remember,we manage our interest rate exposures to very low levels. The reported losseson derivatives are economically offset by gains on our debt funding programsand retained portfolio securities. These offsetting gains are not reflected inthe GAAP income statement. So again for another quarter, our reported results havebeen 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 communicateour results externally. While the work is incomplete, I can tell you that weare taking two steps to address this problem. First, I have asked my team tostart building a framework for reinitiating hedge accounting on our portfolioof derivatives. That, plus selective adoption of the fair value option willdampen some but not all of this noise. Second, as we have discussed with manyof you we have also made good progress on developing segment reporting and an adjustedGAAP measure that will present our company’s resolves more clearly.

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

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

Let me now turn to our fair value results on line six. Youcan see we recorded a net reduction in our fair value of common equity beforecapital transactions of $8.1 billion after-tax in the third quarter. Included inthis result was OAS widening in the retained portfolio, which contributed apre-tax reduction of approximately $8 billion, $3.5 billion of which, wasassociated 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 cashlosses.

So, we expect most of this mark will be timing differences,as improved core spread income in the retained portfolio during the quarter andgoing forward will reverse these losses. Our guarantee fee business experienceda $7 billion per-tax reduction in value due to significant declines in themarket value of the net guarantee assets and guaranty obligation and wideningcredit 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 morereasonable outcome is $10 billion to $12 billion. I think there was a glitch inPatti'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 fairvalue results. Let me now turn to credit beginning with slide three. This slideframes the way the company currently accounts for credit costs. In the upperbox line one is our credit provision, which for the most part addresses our offbalance 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 thirdquarter. I will explain that third quarter increase in the minute.

GAAP allows you to provide for incurred losses that have alreadymanifested themselves in delinquencies, as well as, in estimates for lossesrelated to credit events which have occurred such as job loss that will emerge asdelinquencies within the foreseeable future. For us that foreseeable future isone year. GAAP does not allow you to expense your projected ultimate defaultcost nor does it allow you to expense future REO cost or lost interest. Theseare recognized on a pay-as-you-go basis.

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

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

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

So adding that on balance sheet provision to our off-balancesheet provision generates an adjusted provision in total of approximately $2.2billion 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 loanguarantees for an individual pool exceeds the value of the fees. When thishappens, we report a loss today and at the same time defer revenue of an equalamount that will amortize into the P&L overtime. When amortization is completethere is a zero impact on results. However, as the market view of credit worsensinitial reported losses have increased, more revenue is deferred and that'swhat happening. That said we don't think of this as an incremental credit costof 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 costsyear-to-date through our P&L. We believe an adjusted provision ofapproximately $2.2 billion is a more reasonable measure of credit costs. On aprovisioning basis our credit costs have gone up significantly in the thirdquarter and the next two slides [cater], to what's behind this.

We've said in past calls that our 2006 and 2007 books hadworse credit attributes than previous year vintages and right out of the blockswere hit by negative price declines. As a result early delinquency intransition rates on these recent books are out sized compared to historicalpatterns. We have chosen to give creditability to these observe trends and havemade a number of changes to our reserving methodology in response. Thesechanges for the 2006 and 2007 books are the biggest driver in our provisionincrease.

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 booksaccount for 23% of the total, which is much higher than historical earlyperformance. We had experienced down cycles before in the credit markets and inhindsight 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 2007books.

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, ourcredit losses emerged in this charge-off line. The total credit costs in dollarshown 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 risethrough the end of the year and end the year at approximately $350 million.

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

For 2008 and 2009, total credit losses grossed significantlyrising from 8 basis points in ’08 to 11 basis points in 2009. We have notprovided the [out years] but I can tell you that 2009 is the peak charge-offyear for the closed book and then charge-off starts sloping down. What'simportant here is that when we think about our adjusted reserve, it's based onour view of the forward looking charge-offs for incurred losses. You can seehere that at $2.6 billion our adjusted reserve will cover roughly the next twoyears of charge-offs.

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

Down below we show you what the historical trend has beenfor 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 orthey paid off. Now the older books did benefit from rising house price paths sothe more recent books could behave worse but so far the ’06 book looks in linewith our long-term experience.

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

So, let me summarize our credit story. Credit has clearlyworsened. 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-marketitems have been extreme. We believe an adjusted provision is the right way tolook at credit and our actions there have been responsive to what we have seenand prudent.

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

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

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

Dick Syron

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

Having said that, one, we've taken the challenges that Freddiefaces extremely seriously, as I know you believe we are. And we're focused onthem intensely and we believe very realistically. Two, we're putting in place avery active capital management plan that will allow us to manage our businessconsistent with the needs of the market environment, benefit our shareholdersand put this situation behind us. Three, we've identified a clear path to improveour 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 turnto those.

Question-and-AnswerSession

Operator

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

Paul Miller - FBRCapital Markets

This is a question for Patricia Cook. On the 17, can you goover the GO. The GA -- GO write down. I think there is a lot of numbers goingout 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 youwould need to double the severity rate, which we saw in the early 90's. Can youjust go over some of that a little more slowly?

Patti Cook

Sure. Although its sounds Paul like you've pretty much gotit. 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 futuredefault costs. Now when we evaluate that number against what we think are somereasonable 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 $12billion of that 16. And even now I want to put in historical context and saythe 3% to 3.5% defaults and the 28% to 30% severities are high numbers. Theyare much higher than our 1991 book of business realized.

Having said that, if we're right about that number, the 10to 12, it means the difference: the 16.4 minus that number, would accrue backto us in the form of income or increased fair value overtime. I want to go astep further and say that behind the 3% to 3.5% defaults are pretty significanthouse price declines, call it peak to trough nationally or something like 5% or6% and various regions that are experiencing some deterioration in houseprices, lows of 25% to 30%. So I hope that's helpful.

Paul Miller - FBRCapital Markets

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

Patti Cook

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

Paul Miller - FBRCapital Markets

Yes.

Patti Cook

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

Paul Miller - FBRCapital 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? Thereis lot of housing price decline numbers thrown around. There are four majordifferent indices that we use. We -- the index that we are using tends tounderstate compared to other areas, in other words it would be worse –if youwould have put it on the some basis, same basis as the other indices because it’sa repeat sales index that has to do with the space that we sell in. So it’simportant to understand that and it has no [jumbos] in it.

Paul Miller - FBRCapital Markets

Okay. Thank you very much.

Operator

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

Gary Gordon -Portales Partners

Okay. Thank you. Just the definitions of these accountingcharges are mind boggling, but on page three you announced the credit relateditems, the first, the second and third item, losses on loan purchased in PCresidual. May be you could just add a little color to what they are? Iunderstand 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 120days delinquent add it to the portfolio and put it on the balance sheet at themarket's view of fair value. The next line, which is the PC residual, that’s a bignumber and this gets to the current accounting model where -- when -- if wehave an off-balance sheet guarantee we are provisioning for it. If we buy thatsecurity, so we buy a Freddie security and put it on our balance sheet, we stopprovisioning and we mark the credit to market. So it has the same measurementunderpinnings, as the GO that Patti just spoke to, and creates a much moreradical view of the measurement of credit.

Gary Gordon -Portales Partners

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

Buddy Piszel

Right.

Gary Gordon -Portales Partners

You just re-priced a lot of your products: if we are lookingat the fourth quarter has the re-pricing considering the way credit spreadshave changed has the re-pricing allowed you to offset this or you basicallycontinue to lose business -- lose money every time you add a new piece ofbusiness?

Buddy Piszel

Well remember this is a timing difference. When we book thatloss today [I defer our incoming amortization]. So it does stress our GAAPcapital, but it's not a long-term capital issue for the company. Secondly, theprice increases that we have announced will go effective in April so you reallywon’t see the improvement on the day one difference for new purchases untilthat point in time. We think that those price increases will tend to mute someof the day one loss. It also depends on where the markets are pricing credit atthat 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 anew business you lose money and now you have got issues with capital potentiallycutting the dividend having to raise capital so there would be I think atrade-off as we speak of. Do I go out and raise new equity or do I do that nextpiece of business and how would you think -- how are you making these, thinkingabout these trade-offs?

Buddy Piszel

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

Gary Gordon -Portales Partners

Okay. Can you just literally just have to take a newbusiness 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 thelong-term returns on the G-fee business are attractive and to echo some ofBuddy's discussion we are looking at ways to mute the affect of that day onedifference.

Gary Gordon -Portales Partners

Okay.

Patti Cook

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

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 - BearStearns

Yeah. Hi its, actually David Hochstim. I was wondering:could you just address the idea that your basically suffering from wider creditspreads through reductions in GAAP or you can't take advantage of those widerspreads solely because your capital has been eroded and you can't buy thosehigh return assets and you have got $8.5 billion of surplus capital abovestatutory minimum? Why isn't the best thing for the shareholders to get relieffrom that arbitrary 30% cushion that the regulator has imposed you arevirtually compliant with the agreement in fact you have been in compliance withthe original agreement you had in June? So why should -- why shouldn't there besome 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 theopportunity now, to put profitable business on the books. But we areconstrained by capital and that is a major fact to look. I mean we don’t thinkthis is a very pleasant thing to say that what we are doing here, right interms of major capital actions considering dividend reductions. But we wouldn'tbe doing it, unless we thought we were going to make money on it. And that'sthe motivation for it. With respect to the 30% itself the 30% is the decisionof the regulator. This is as you know for the GSE sector as a whole, are highlyregulated business. And they are the ones that have to determine that. Now,looking forward we are making strong progress towards our compliance plan. Asour compliance plan is completed and we have a 60 day timeframe on that. Wewould expect and we get some other things done to become more aggressive, andwe do expect to get the 30% back overtime, which will obviously both give usmore opportunities and put us in a situation where the capital that we'veraised now, won’t be as necessary (inaudible).

David Hochstim - BearStearns

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

Buddy Piszel

They well-- may well could be, David and we're doingeverything that we can to get those implemented and they would certainly mutethings and probably the biggest thing it had do is that PCR mark that we takewhich 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 wedon'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 thirdquarter. Fourth quarter would look the same we're working to get the accountingchanges if we do the fourth quarter will improve.

David Hochstim - BearStearns

Okay. Thanks.

Operator

Thank you. And our next question then comes from lines ofHoward 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 askyou point blank: did you go to OFHEO and ask for at least on the 30% capitalsurcharge? You are purposing to dilute shareholders, so please don't tell usthat 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 andhow 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 thosediscussions 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 Iguess it would be for Patti, on your sub-prime exposure the securities whereyou have got some are [B29] and plus subordination. Can you tell us how thosesecurities might differ from the sub-prime collateral that's in the marketplaceas 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 ABXindex is around the

Between our sub prime ABS and ABX index is around theaverage life of the securities. So the ABS has setback the ABX index, muchlonger 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 importantlythey don’t benefit like we do on the increased subordination and the yearlycash flows, going to increase the subordination of the shorter ABSs that we ownthat’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 Wasserstromwith UBS. Please go ahead.

Eric Wasserstrom -UBS

Thanks, I mean just to circle back to just some of thingsthat have been said, I mean given that there is a very, very high likelihoodthat the trends we have seen so far through the quarter will cause you toviolate 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 putsome magnitude around that?

Dick Syron

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

Eric Wasserstrom -UBS

Okay and in terms of given that the, I respect that and Iunderstand 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 thedividend cut is actually in the scheme of thing of a very small number I amtrying to get a sense of how else you would prioritize the actions and what thepotential magnitude of them could be?

Dick Syron

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

Eric Wasserstrom -UBS

Great. Thanks very much.

Operator

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

Moshe Orenbuch -Credit Suisse

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

Buddy Piszel

Moshe, let me take that in twopieces. On the credit side, if you think about our reserve covers about roughlytwo years out, of charge-offs and we said that beyond '09 charge-offs start todecline assuming that our house price [pay off] and assumptions hold you wouldsome decline of the provision that will start to happen and it really dependson what those out year charge-offs look like. But if we had base it on the waywe are looking at things, as '10 and 2011 charge-offs decline, the provisioningwill be declining also. In regards to the marks that we are taking there's twofactors there. How much gets purchased out of the portfolios, and at whatprice? And that’s the biggest wild card in trying to project forward so we areassuming for the fourth quarter purchases are going to continue to rise andprices are going about be holding. They are not, this is on the [legal] sidethey are not going to be going up. Now the other factor is the reversal of themarkdowns we've already taken for LIA, you can see that started to play intothe results and against the pace at which the LIA performance online. And thoseare the three determining factors. So, that would imply that, '08 will continueto be a difficult credit year. And it's hard to estimate at this point relativeto '07 where that will be. And then things should clearly abate moving into2009.

Patti Cook

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

Buddy Piszel

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

Moshe Orenbuch - Credit Suisse.

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

Buddy Piszel

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

Moshe Orenbuch - Credit Suisse

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

Buddy Piszel

Our capital plan does contemplatea difficult credit environment in our reported results for 2008. This does notabate in the first quarter of 2008.

Moshe Orenbuch - Credit Suisse

Okay. Thanks.

Operator

Thank you. And our next questionthen comes from the line of Robert Lacoursiere, with Banc Of AmericaSecurities. Please go ahead.

Robert Lacoursiere - Banc Of America Securities.

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

Patti Cook

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

Robert Lacoursiere - Banc of America Securities

But you never actually trade? Youdon't actually sell these things? Are you just asking them to quote yourfigure, right?

Patti Cook

Right. But you are on to a goodpoint Robert, because I think that same thing is in evidence when we priced theoverall GO. If you think about it our mortgages that we're guarantying in ourGSE business really don't trade in securitize in a AAA senior sub sort ofstructure. So, we've been there, the fact that we take that structure, we go tothe market, we ask for a price on something that really doesn't trade. I thinksupports the notion that the uncertainty and the credit risk premium that'sembedded in those marks is likely to overshoot in a cautious creditenvironment.

Robert Lacoursiere - Banc of America Securities

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

Patti Cook

This is -- you want to take itBuddy?

Buddy Piszel

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

Robert Lacoursiere - Banc of America Securities

If I could just bother you withone follow-up: if they are quoting, if these institutions are quoting you thoseprices, are they not obligated to reflect those valuations on their ownpositions 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 fromthe line of Fred Cannon with KBW. Please go ahead.

Fred Cannon - KBW

Thanks. A follow up on couple ofissues: One is, when you said earlier that the results in the fourth quarterwould be in line with the third quarter, does that include the fair value lossthat we saw in third quarter are you projecting the similar fair value declinein the fourth quarter?

Buddy Piszel

It’s hard to project, month ofOctober was a not a good month when that closed out. You know, the fair valueresults 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 orwhere OASs have gone, so, this assumes that nothing improves if nothingimproves, it may not be as bad as the third quarter, but it’s not going to bepretty.

Fred Cannon - KBW

Okay. So, it could be again $10or so head--? It is kind of follow up to obviously a number of us who trying toget a handle on the size of the capital raised and I know it’s difficult foryou guys to discuss that directly. I was wondering though in terms of just bymath 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 about600 million over your 30% cap number, if you had a $2 billion loss you probablywant 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 $4billion in terms of the capital needs of the company?

Buddy Piszel

Well, let me just say a couple ofthings, without giving you a number. Fred, we are looking to raise capital toget beyond the first quarter, really to get through '08 and to the end of thecredit cycle. And secondly, this will be a large transaction. Third, we are notlooking to do common. And fourth, we will be doing something assuming our Broadsupports in a very, very near-term.

Fred Cannon - KBW

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

Operator

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

Brad Ball - Citi

Thanks, Buddy. I just had afollow-up on the question about your reserve relative to your guidance. So, youare looking for eight basis points of losses in '08 and another 11 basis pointsin '09 and it peaks in '09. You've got 2.6 billion of reserves today and youare 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 forincrease provisioning or is there where am I wrong and at the end of '09 whencredit begins to improve what level of reserving do you expect to hold into thefuture, in others words, what do you expect your normalized loss rate to be? Whenwe get back to the sort of mid single digits or we get back as those threebasis points? Thanks.

Buddy Piszel

Remember the way this works Bradis 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 2010and those charge-offs will be coming down on a going forward basis. And so thatwould be imply that assuming that our assumptions are right our provisioningwould be going down accordingly. So, that's the way that works, I believe Isaid that we trying to cover in total some $10 billion of total credit costthat could got through the GAAP numbers. So, if we provided right now with themark-to-market, we've gotten a long way there, I think we are almost 50% of waythere already through this year but on a provisioning basis that will emergeovertime some thing on the six to seven years.

Brad Ball - Citi

And what about normalized lossrates?

Buddy Piszel

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

Patti Cook

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

Brad Ball - Citi

Okay. Thank you.

Operator

Thanks. And our next questionthen comes from the line of [William Wong] with Morgan Stanley. Please goahead.

Ken Posner - Morgan Stanley

Hi. it's actually Ken Posner. Iwanted to ask a clarifying question about the 30% capital surcharge. Rationalefor 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 bechecked off at which point, I know you can speak for (inaudible) but at whichpoint you go to (inaudible) and say we have, corrected every thing that you'vepretty much point to?

Buddy Piszel

Well, we know that the criticalthings that are on the path are getting back on time and reporting, which wekeep on closing the distance every quarter. We were pleased that we got this ina quarter out in the timeframes that we have. We have been taken that time inevery quarter, yearend, we will be on time, and we will be continuing that in2008. So, timeliness is one.

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

The third is becoming an SECregistrant. We said that we would be an SEC registrant by mid-2008. We haveactually started the engagement with the SEC as we speak. Those are three clearpoints.

So, there could be a question,clearly the regulator has discretion here and that we've not gotten a clearstatement that if you do these things, that 30% cuts off. So, we are indiscussions about what other considerations could be made, but at least thosethree points, without getting those done, we know that there is really nodiscussion. Thank you.

Operator

Thanks. And our next questionthen comes from the line of Bruce Harting with Lehman Brothers. Please goahead.

Bruce Harting - Lehman Brothers

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

And then in the exercise, we tryto do each quarter in reconciling GAAP to operating, I'll leave some of thosealone. 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 toworsen. 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 begoing dramatically in the other direction on both the OAS adjustment as well asthe GO, Guarantee Obligation adjustment that you're talking about?

Patti Cook

All right. We're going to gobackwards and answer the OAS question first. There are two observations aboutthe 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 thewhole portfolio is marked at 70 basis points versus 30; that in and of itselfgives you more cushion, if you will, around subsequent widening.

So, for example, if you had 40basis 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 avery different outlook. So, my point would be, even if spreads just stayed thesame, you have the wind at your back from a fair value perspective.

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

Bruce Harting - Lehman Brothers

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

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

The other two elements that theGO has in it is an REO cost, which again goes through measure out in time andpresent 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 couldwalk you through that, because we are able to move between the two models atthis point. And the information we disclosed is a sub-component of the GO.

Next question, please.

Operator

Great Thank you. Yes and nextquestion comes from the line of [Claudie Mcphearson] with HSBC. Please goahead.

Claudie Mcphearson - HSBC

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

Ray Romano

This is Ray Romano. Let me firstsay that we aggressively manage our counter party risk and have a long trackrecord of being proactive in managing these risks. Having said that, we haveexamined all of our mortgaging insurance for writers, as well as our financialguarantors, on an individual basis, and in on whole. We are comfortable withour exposure to these sectors. At the same time, we do have within our toolchess that our disposal ways in which we can manage those risks and we have executedon that throughout 2007 and we will continue to do so to manage that kind ofexposure.

Buddy Piszel

Do you have any further questions?

Claudie Mcphearson - HSBC

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

Ray Romano

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

Claudie Mcphearson - HSBC

Okay. Thank you.

Operator

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

George Sacco - JP Morgan

Hi. First, with regards to theloans purchased from your PCs did the market values reflect credit enchantmentyou'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 insuranceany pool insurance that you may have purchased would actually be an offsettingrecovery against some of that at some point?

Ray Romano

Yes. I would just add also, wehave other contractual obligations associated with our purchasing environmentso, those are also available.

George Sacco - JP Morgan

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

Ray Romano

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

George Sacco - JP Morgan

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

Buddy Piszel

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

George Sacco - JP Morgan

Great. Thank you.

Operator

Thanks. And our next questionthen 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 yourloss provision for the third quarter was that you were getting ahead of thecurve and you put up a 25 basis point provision. Just in the short-term in thenext two or three quarters can we expect to continue trying to push to getahead of the curve or would we expect the provision to move closer to theactual expected losses that you described as 8 and 11 basis points in 2008 and2009.

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 '07book and the '06 book as we change the way or methodology responding to theemerging trends.

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

Thomas Mitchell -Miller Tabak

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

Patti Cook

Actually there's two aspects, two answers whether you aretalking about GAAP or fair value. In GAAP phase, because of mark-to-marketthere is an interest rate component to our GAAP results that doesn't have anyeconomic component and you're right if rates didn't change it will eliminatethat volatility from GAAP. On an option adjusted spread basis the fair valuechange is a direct of fund, it’s a direct function of those changes in OAS. A 1basis point change in the overall portfolio can be as worth as much as $300million plus. So stabilization in both interest rates and in spreads wouldyield 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 ofPaul Miller with FBR. Please go ahead.

Paul Miller - FBRCapital Markets

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

Patti Cook

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

Dick Syron

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

Paul Miller - FBRCapital Markets

Okay and then the other question I had on these OAS spreadsthat are I think you published that in the graph on your table that is like is60 to 70 basis points?

Patti Cook

Yes.

Paul Miller - FBRCapital Markets

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

Patti Cook

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

Paul Miller - FBRCapital Markets

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

Patti Cook

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

Paul Miller - FBR Capital Markets

Okay. Thank you very much.

Operator

Thanks. And our last questionthen comes from the line of Howard Shapiro with Fox-Pitt, Kelton. Please goahead.

Howard Shapiro - Fox-Pitt, Kelton

Hi. Dick I was wondering if Icould ask you may be a more general question on kind of implications of allthis for the mortgage market. You've sold almost $50 billion of your portfoliointo the marketplace in the last two months, which by my understanding meansthat $50 billion less of liquidity available for borrowers out there. If youcouldn’t raise money or if it was too expensive to raise money or if you are growthconstrained in general what would you say the general implications are for thedown turn we are seeing in the mortgage market right now?

Dick Syron

Well, Howard, actually you raiseda very, very important point its kind of [dear to my heart as an ex-fed person orregulator]. Clearly, it is not productive in this market for the mortgagemarkets or the macro-economy for us to be selling into the markets. And I thinkthat's implicit in your question. And that is why we have made the decision painfulas 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 stabilityand liquidity given the capital requirements we have the only way we can dothat, is not by necessarily shrinking the organization, but by going out andtaking the steps that we will be talking to you about in the almost immediatefuture, and being able to be a valuable contributor of the market.

Howard Shapiro - Fox-Pitt Kelton

Thanks.

Dick Syron

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

Patti Cook

Thank you

Ed Golding

Operator, could you give us thereplay number.

Operator

I certainly can and thank you.And ladies and gentlemen this conferences will be available for replay startingtoday Tuesday, November 20th, at 1:30 PM Eastern Time and it will be availablethrough Monday, December 3rd, at mid night Eastern Time and you may access theexecutive playback service by dialing 1800-475-6701 for within the UnitedStates 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 are1800-475-6701 for within the United Statesor Canada or 320-365-3844, fromoutside the US or Canadaand again enter the access code of 891911. And that thus conclude ourconference for today. Thanks for you participation and for using AT&T'sexecutive 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!