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

Executives

Mary Lou Christy - Senior Vice President of Investor Relations

Daniel Mudd. - President and Chief Executive Officer

Steve Swad - Executive Vice President and Chief Financial Officer

Rob Levin - Executive Vice President and Chief Business Officer

Mike Quinn - Senior Vice President, Single-Family Credit Risk Management

Peter Niculescu - Executive Vice President of Capital Markets

Eric Schuppenhauer - Senior Vice President of Accounting Policy

Tom Lund - Senior Vice President Single-Family Mortgage Business

Analysts

David Hochstim - Bear Stearns

Howard Shapiro - Fox-Pitt, Kelton

Bruce Harting - Lehman Brothers

Annette Frank - FBR Capital Markets

Brad Ball - Citi

Gary Gordon - Portales Partners

Bob Napoli - Piper Jaffray

Presentation

Operator

Ladies and gentlemen, thank you for standing by and welcome to the Fannie Mae Investor Analyst Conference Call. For the conference all the participant lines will be in a listen-only mode. However, there will be an opportunity for your questions and instructions will be given at that time. (Operator Instructions). As a reminder today's call is being recorded.

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

Mary Lou Christy - Senior Vice President of Investor Relations

Thank you. Good morning and welcome to today's Investor Analyst conference call. I am Mary Lou Christy, Senior Vice President of Investor Relations. Dan Mudd, Fannie Mae's President and Chief Executive Officer will lead off today's call followed by Mr. Steve Swad, Executive Vice President and Chief Financial Officer and Rob Levin, Executive Vice President and Chief Business Officer. After Rob, a question-and-answer session will start where we will be joined by other members of senior management.

In addition to the 2008 10-Q and the press release we posted to our website an investor summary, which provides an overview of our financial performance and key drivers for the period, as well as detailed information on our credit book including new disclosures related to Fannie Mae's Alt-A and Private Label Securities.

Please note that this conference call will include forward-looking statements including statements related to our future capital position, market share and credit losses, our expectation regarding the housing, credit and mortgage market, and volatility in our results. Future results may turn out to be very different from what is discussed on this call. Please see the risk factors section in our 2007 Form 10-K and in our Form 10-Q for a description of the issue that may lead to different results.

Now let me turn the call over to Dan Mudd.

Daniel Mudd - President and Chief Executive Officer

Good morning and thanks for joining us on the call. Three points, I want to make today. First, we took a 2.2 billion Q1 loss as credit losses and market volatility swamped, revenue growth, expense reductions, and the ongoing alignment of our operating and accounting results. Second, as the initial shock of home price declines dissipates and markets settle down from the enormous volatility of the past nine months, we are seeing terrific opportunities in all three businesses. Strong pricing for strong credit and increasing share in single-family; the best investment spreads in over a decade for our capital markets business; and continued market leadership, strong credit performance in HCD.

As the market recovers we will be a prime beneficiary. I am also delighted and appreciate that OFHEO has decided to lift the consent order of May 2006 and announce it would release another increment of the capital surcharge. And more broadly, that we are being asked to play a broader role in the future of US housing.

Our third point for today, we are commencing the capital raise that has been much discussed recently, a total of $6 billion raised from a combination of preferred, convertible and common, as well as dividend actions plus a continued release of regulatory capital, will put us in the position to protect the balance sheet as the housing crisis plays itself out. And as importantly it will enable us to attack the full range of market opportunities without capital restrictions.

Steve Swad will give you a more detailed look at the financials in a minute, but let me touch on the main points. The loss was driven by $3 billion in fair value losses on derivatives as rates fell and $1.2 billion in fair value losses on trading securities as credit spreads blew out to 22 year highs during the first quarter. We increased our loan loss reserves by $1.8 billion, driving the credit-related expense line from $3 billion up to $3.2 billion. The total reserve is now $5.2 billion and it is building, which is another reason for us to be low on capital, which I will discuss in a minute.

More positively, net revenue was up $700 million, or 22% at $3.8 billion. The book of business grew by $80 billion for a total of $3 trillion. G-fee income' in single family was up 8% with markets share over 50%. Capital markets net interest income grew 49% to 1.7. All this occurred in one of the most challenging environments, most of those have seen in our careers. So let me just say a word about that. I think that right now we are in the belly of the cycle. The initial period of high volatility and big shocks in the market place seems to be dissipating. The capital markets are recovering balance and spreads are returning back to normal relationships. But with that healing in the capital markets, I think we are now beginning a period of adjustment that will work its way through the consumer in the commercial fronts.

Home prices concurrently have declined faster than anyone anticipated. So we are updating our forecast. In the first quarter home prices, national average home prices fell by about 3%. Given that decline which was accelerated from the prior, we changed our outlook for home price declines for the whole year. Instead of a 5 to 7% decline and ensuing 13 to 17% peaks-to-trough which is what we talked about the last time, we now see home prices falling about 7 to 9% for the year which would then lead to 15 to 19% peak-to-trough decline average national home prices.

With that change which is one of the key drivers on our credit loss lines, we moved our credit loss ratio from the prior range of 11 to 15 basis points to a range of 13 to 17 basis points for this year. The summary is; we still believe that '08 and '09 will be tough years as home prices return to the trend line. So no news there, but an updated forecast there.

The key variable for this recovery this time -- the key variable for the recovery, I think is time. That’s the part of the equation that is unknown. And that’s time not only for prices to adjust, but for the policies that have been put in place to take effect for home owners to work through the softer economy and for mortgages to migrate from the concentration of complex lower quality products that characterize the '06 and the '07 books, to a book that will be more characterized by better credit, by more fixed rate mortgages and with the higher equity component, higher down payment component for 2008 and forward.

Let me touch on this return to sensible standards for a moment. We are announcing today an initiative that’s called the "Keys to Recovery" that address’s for our part the needs to restore liquidity, and affordability, and stability to this marketplace. The sub-theme there is that I think we need to recommit to home ownership as a goal for this industry and for our company and not just home buying. That implies a return to standards, and it demands that companies, including ours and including other members in the industry, to step up.

So to kick start the effort we are announcing four changes effective immediately that we think will have a positive impact on the recovery of the market. First to help borrowers,who are current on their loans but trapped and unable to refinance into the better loans that are available, we will allow refinancing of Fannie Mae loans that are upto 20% underwater into safe, affordable fully amortizing loans.

Secondly we are renewing our partnership with state housing finance authorities across the country by providing $10 billion in financing for qualified first time home buyers. This will channel mortgage liquidity directly to the families and communities that need the most help.

Third, because stabilizing neighborhoods and stabilizing communities matters so much in this recovery, we are teaming up with the Self-Help Credit Union, one of our long time partners in some of the worst hit communities, in order to get families into REO foreclosed properties on a rent-to-own basis. We think this helps stabilize communities as we continue that process. We will also continue to be the nations largest investor in multi-family or a apartment financing, to ensure that there is good shelter not just for home owners, but for renters.

And finally effective immediately we will buy new jumbo conforming loans at a price which is flat to conforming or portfolio asset acquisitions through the end of the year. What this means is that though jumbos are not TBA eligible, though we think they should be, we will be pricing them as if they were TBA eligible. That should help provide critical liquidity to the market. And in order to do that we are basically eating the liquidity premium in order to jump start the portion of the jumbo market that we have been allowed to enter.

We will also institute concurrently with that a set of prudent lending guidelines to ensure the jumbo borrowers can own and not just occupy those homes in high cost areas. Overall, I think this plan is prudent use of capital and good business to invest in housing market. We will continue to rollout initiatives for liquidity and affordability and stability until the market recovers. And I believe, I know that the recovery of the market and its long-term health and stability are good for this company and good for the investors in this company.

Let me now close out on the brief discussion of the capital plan. Our strategy for working through this period is to protect and grow. That means protecting the company by building and conserving capital and setting aside the right amount of loss reserves as we continue to work to reduce foreclosure and credit losses. This strategy also means growing our business as we help stabilize the market and perform our mission. That also takes capital.

So today we are undertaking a plan to rise in total $6 billion in new capital. We plan to raise this capital through public offerings of common convertible preferred and perpetual, preferred securities. The road show for that starts today. Our Board of Directors also intends to reduce our common dividend in the third quarter of this year by 29% to $0.25 a share a quarter.

Importantly as I noted, our regulator OFHEO, as I said that it lifted our May 2006 consent order, based on the remediation we have completed. And OFHEO also said it would indicated that it would reduce the capital surplus requirement to about half of what it was at year end when we complete this capital raise. So taken together, all of those factors mean that we will have more capital to protect the balance sheet, to grow the business and to serve the market. So all told, including this perspective capital raise that we are undertaking started today will go into the belly of this cycle with about $48 billion in core capital, which is about $17 billion above our statutory capital level.

We've said before that this is the time to be long capital and this plan firmly gets us there. We've plan to harness the capital we are raising for three goals. One, to attain a position of unquestioned capital strength; two, to pursue the best business opportunities we have seen without constricting capital; and three, to step out and play a major role in helping the market recover better and sooner and to the benefit of all investors and housing, whether there will be consumers or originators or realtors or home builders; or investors in Fannie Mae.

You already know from participating in past calls that we have made huge investments in systems, infrastructure, people and finance in order to create the foundation for a strong profitable business. Now add to that the capital to protect and grow the company through the downturn and then as we emerge from the housing crisis, you will have a company that will hold a solid position at the center of a large critical market, a leading market share, and a role that remains humble and customer focused, but is pivotal nonetheless. As the market turns and takes its move upward into the right, our numbers will respond in kind.

Let me stop there and turn to Steve Swad our CFO for the details, that’s on our filing today.

Steve Swad - Executive Vice President and Chief Financial Officer

Thank you Dan. The main theme underlying our Q1 performance was strong revenue growth that was more than offset by increases in fair value charges and credit related expenses. These results came at a time of significant uncertainty and volatility in the market, with interest rates declining, yield curves steepening, and credit spreads widening to historic levels and further deterioration in the housing market.

Let me start with revenue, which increased by 22% in Q1 compared to Q4. Removing some non-recurring items, it increased by 14% driven by growth in both net interest income and guaranteed fees.

Net interest income increased by 49% to $1.7 billion compared with Q4 of 2007. This included a significant benefit from the redemption of step-rate debt, because the debt was called before its maturity and the interest we ultimately paid was below the average amount accrued. Backing out this item net interest income grew by 29%.

Slide five of our investor summary provides more detail. For a net interest yield, the gold line backs out the impact of our step-rate debt redemption. And as you can see on this basis, we've recorded an increase from 57 basis points in Q4 to 69 basis points in Q1. This increase was largely a function of lower funding costs and a steep yield curve.

The other main component of revenue was guaranteed fee income. The feeing here is a continuous trend of solid growth with G-fee income rising to $1.8 billion, up 8% over the fourth quarter. The increase came from growth in our guarantee booked and higher affective G-fees. Slide six gives the details. The average guarantee book grew a little over 4% in the quarter with reflecting gains in the market share. And our average effective G-fee increased from 28.5 basis points in Q4 to 29.5 basis points in Q1.

On new business, our average charged fee declined in Q1 by about 3 basis points from the previous quarter to 25.9 basis points mostly because we cut our riskier high-fee business out. But this rate increased to 27.9 basis points in March, as we began to see the impact of pricing increases implemented during that month.

Now let me turn to our two largest fair net value items, our derivatives and held-for-trading marks which are presented on slide 7. There are two key drivers here. First the five year swap rate declined 88 basis points in Q1 and this led to a $3 billion decline in the fair value of our derivatives book, which consists primarily of net pay-fixed swap postitions. Second, credit spreads widened dramatically on the assets in our trading account, especially our CMBS and private label securities. This caused a $1.2 billion fair value loss on our trading portfolio.

Now looking me move to our credit results. Slide 12, shows credit related expenses. As you can see these expenses were up about $200 billion from Q4. This item consists of four components. The first, is charge-offs excluding the affect of SOP 03-3. In Q1 our charge-offs were $630 million or 9 basis points, up over $300 million compared with the fourth quarter. The increase in charge-off was from a higher number of defaults and higher severities.

The second component foreclosed property expenses adjusted for the impact of 03-03 increased slightly in Q1 to $250 million or 3.6 basis points. This increase was from lower property values on our yield. Brining these first two components together results in our credit loss ratio for Q1 of 12.6 basis points. The third component of credit related expenses is losses on delinquent loans purchased out of trust. Our average fair value pricing on loan purchased out of trust declines 62% of par in Q1 from 70% of par in Q4. But the volume of loans purchased out of trust was lower. The result was a fair value loss of $728 million in Q1 versus $559 million in Q4.

The final driver of credit related expenses is the addition to our loss reserves. We used comprehensive models to estimate defaults over the next 24 months and then we estimate severity based on experience in the most recent quarter. In Q1, we increased our reserves by another $1.8 billion bringing total reserves to $5.2 billion. Our quarter-end combined reserves represents 18 basis points of our guaranteed book of business, compared to 12 basis points in Q4 and two times our annualized Q1 charge-offs. That’s the credit story from an income statement perspective.

Let me make just a few comments on the credit book characteristics and our key areas of focus. I‘d encourage you to review the credit information in investor summary including a great deal of additional data on Alt-A book. The first point is our overall book is still largely a traditional conforming fixed rate book with low LTV's, moderate loan sizes, and high FICO scores, and a very low level of investor properties. The second point is our Alt-A book is a very key area of focus for the company.

Slide 24 shows that 43% our credit losses in Q1 came for Alt-A book. We expect our Alt-A book will continue to drive an out-sized portion of our overall credit losses. But there are a few important distinguishments between our Alt-A book and the PLS Alt-A securities in the market. For example, slide 32 shows that for the 2005 through 2007 vintages, cumulative default rates at our Alt-A book were approximately one-half the default rates in the overall PLS Alt-A market.

Moving onto point three, geography is an important part of the credit story. Part of this is because a high proportion of our Alt-A exposure is in states that saw the most severe price run-ups in recent years. Florida and California represent over 32% of our Alt-A book. The other geographic issue is, is that struggling economies in the upper Midwest, especially Michigan, Ohio, and Indiana have lead to high incidence of default and foreclosures. Michigan alone represented about 3% of our single-family book at the end of the Q1, but accounted for 23% of credit losses during the quarter.

A strategy for managing credit performance in the book is twofold. First on the front end we have significantly tightened underwriting and eligibility standards. Second we have ramped up our loss litigation efforts on the back end. We are focused first on keeping qualified buyers in their homes which is normally NPV positive for Fannie Mae and the best outcome for the borrower. If foreclosures are unavoidable we are working to accelerate the process and minimize realized credit losses.

Now let me move to our fair value balance sheet, which is summarized on slide 16. The fair value of our net assets was $12.2 billion at the close of Q1. That represents a $23.6 billion decline from Q4. There are two key items to consider here. The first one is the severe widening of the mortgage-to-debt spreads led to $8.4 billion Q1 decline in the fair value of our portfolio. The second item is an increase in the fair value of our guarantee obligation, what we call our GO, contributed approximately $16 billion to the decline. The increase in GO was driven by two factors. First we saw an increase in the underlying risk of the credit guarantee book to business as delinquencies increased and declining home prices caused mark-to-market values to worsen. This accounted for approximately 40% of the increase in our guarantee obligation.

Second, the risk premium that is considered in the fair value of the GO also went up. The best evidence of this is what we are seeing around pricing. We and the rest of the market are pricing up for the risk we see. This causes the GO to go up. So the higher prices we charge on a guarantee business in March, had the affect of increasing the value of GO on the historical book.

Let me just repeat that. Higher pricing on new business, obviously an economic positive, leads to fair value loss on existing business. The greater the pricing increase, the greater the fair value loss on our previously priced book. So we have a substantial decline in our fair value balance sheet. But as a long-term holder of these assets and liabilities, we expect to recover much of this decline.

Before I close I want to highlight a few items that have changed since our last call that I believe make our results more meaningful. First losses on certain guarantee contracts have been eliminated with the adoption of FASB 157. This statement permits us to use pricing on our own recent transactions to estimate the fair value at the time we enter into a new contracts. This changes perspective, so we will continue to benefit from the amortization of previously recorded losses.

Second, we implemented hedge accounting in mid April. This will allow us to offset the fair value changes on some of our derivative instruments against the corresponding fair value changes on specific hedged assets. Net-net, our implementation of the hedge accounting should substantially reduce the volatility of the financial results attributable to changes in interest rates.

Third, we are working to mitigate fair value losses from loans purchased out of trusts through our HomeSaver initiative. This initiative lets us get to delinquent borrowers sooner with the goal of getting them back on a current payment track. We are able to do this without having to buy loans out of the trust and while it's still a fairly new program, we should expect to see more impact from this over time.

Let me close with a brief outlook on some key items. First, we believe that the positive trend we have seen on the revenue side will continue into Q2. Specifically, if current market conditions continue, we expect our net interest yield to rise further on a normalized basis as lower margin assets continue to roll off and we continue to add higher margin assets to our book.

On the guaranty side, we expect to see continued solid growth in our credit book of business and we also expect to see further increases in the average effective G fee as the March pricing takes hold and we implement additional increases in June.

On credit, we expect credit losses of between 13 to 17 basis points for the year and we expect 2009 to exceed 2008. We also see reserves increasing for 2008 as default and severity trends worsen from their current levels. And lastly, we continue to trend down toward $2 billion run rate in our G&A expenses.

With that, let me pass it to Rob.

Robert Levin - Executive Vice President and Chief Business Officer

Okay, great. Steve thank you very much. Good morning everybody. I am going to focus on our business going forward, the offensive side of the ball so to speak. The gist of my comments is that we are creating a significant long-term shareholder value as we ramp everything up to serve our mission and I'd like to make five key points about this.

The first point is that all three of our businesses are operating full bore. We have no capital rationing going on. Each business, the portfolio business, the single family business, and the multi family business, are pursing attractive business opportunities and with our capital raise, should be able to continue to do so without being short capital.

I will give you an example. Our portfolio committed to purchase over $28 billion in the assets during April. That was almost four times our average monthly commitments in the first quarter. Also, our single family mortgage-backed security issuances are around 50% of the entire market and our multi family business is agile. We continue to lead in that market and this business stands out from all other businesses by performing very well from a credit standpoint.

The second key point I have is that returns on all new business and all other businesses are well in excess of our cost of capital. Option-adjusted spreads are more than double what they were in August 2007. Guaranty fee pricing is up. New flow acquisition in March were about 29 basis points versus 23 basis points for all of 2007, 29 versus 23. This reflects pricing increases effective in March but it does not yet include another pricing increase slated to begin in June.

Our credit profile is also way better from what it was. We are seeing lower loan to value ratios and higher FICO scores. This bodes very well for the future and for the books profitability.

The third major point I want to make is that we have staunched the bleeding from some of our volatile mark to market items that have created uncertainty in our bottom line and capital planning. This bleeding was about $3 billion in the fourth quarter and over $4 billion in the first quarter, mostly because of the derivatives mark-to-market. We do not expect to see numbers of this magnitude going forward, because of our new hedge accounting.

The fourth major point I want to make is that a number of our new initiatives are gaining traction. Now I would like to give you two examples. The first example is in jumbo conforming. We took delivery of our first loan on April 1st and we anticipate that our pricing announcement today will provide a boost to the market. We expect that this will be good for our revenues and also good for our mission.

The second example I have is a workout ratio. Our goal is to workout at least 50% of our troubled loans. In March, we workout 56% of our troubled loans. That is good for credit losses and good for stabilizing neighborhoods. And the last key point I want to make is that we are very focused on identifying and attacking the trouble spots in the business.

Let me use Florida as an example, but I will be blunt about this. Florida is very over built. It will take a long time to correct. Values continue to fall and delinquencies continue to increase hitting 232 basis points in March, up from about about 160 basis points in December, and up from 49 basis point a year ago.

We are attacking this problem with three main strategies. First we are making sure every delinquent borrower is contacted and offered a workout. Secondly, we are performing underwriting reviews on defaulted loans and if the loans were not underwritten to our guidelines, we will require the servicer to buy them back or make us hold. And third we are pursuing deficiency judgment against investors and second home borrowers.

Now let me close my talk here by saying this, there are certain things that we can't control like home prices and the overall condition of the economy. And until they improve, they will be a drag on our old book, although we are doing everything we can to mitigate the drag on our old book. However we do control the new business we are putting on and we feel very good about it and our opportunities going forward. We expect good growth, good expected returns, and believe we are creating significant long-term shareholder value while we are making a significant impact on our mission.

And with that, I will turn it back over to Dan.

Daniel Mudd - President and Chief Executive Officer

Okay, thanks Rob. We covered a lot of material, so why don’t we go directly to questions.

Question-and-Answer Session

(Operator Instructions). And our first question is from the line of David Hochstim with Bear Stearns. Please go ahead.

David Hochstim - Bear Stearns

Yeah, hi. Dan could you just explain the link between the consent order and the remaining 15% capital surcharge, why don’t remove all the consent order or eliminate that surcharge completely?

Daniel Mudd

Well, first of all I think we have made an off a lot of progress in terms of addressing the items in the consent order and addressing our obligation to be a professional regulatee as part of the process which we've talked about in the call before. I think it is quite normal in the course of a regulatory agreement for the regulator to ensure that compliance is not just momentary, but that compliance is ongoing. So I think that process continues. What the change in terms of excess capital requirement does is not to reduce the overall level of capital that we’re holding, in fact we are raising capital as I pointed out in the call, and we are well above the levels of minimum capital. I think both we and OFHEO and most everybody you would talk to in the market at this point agrees that’s it prudent to be long on capital, but as you restore that number back toward the original levels of capital, it provides us with the additional flexibility to respond to the market on both sides.

David Hochstim - Bear Stearns

So basically it’s just a negotiation with the regulator?

Daniel Mudd

The discussions are on going and continuing. Yes.

David Hochstim - Bear Stearns

Okay. And then I wanted Rob to elaborate on what he was talking about in Florida and other places where you are pursuing lenders and borrowers who kind of misrepresent what they were doing. How significant has that activity have been recently?

Daniel Mudd

Well, let me start and then Either Rob or Mike Quinn, who is our Single-Family Chief Credit Officer can jump in. So as you know, we are not originator, we are not engaged in the primary market, and most of our business model is built off of the set of reps and warrantees that the originators provide to us. So we have always had a history of enforcing those reps and warrantees, because the documentation is lower in the Alt-A book which is after all the point of Alt-A. That’s an area that we make sure that we focus on. With that I would like Mike Quinn to pick up.

Mike Quinn

Thanks Dan. Every loan that defaults, we do an underwriting review to make sure it did tie out so that our guidelines and what our contract with the lender was. So we are doing those reviews of all loans that default. Ww are issuing more may call repurchase request, the volume has increased of that. And, second is we are pursuing deficiencies. Florida happens to be a state that allows lenders to go after deficiencies if borrowers have other assets and we are starting to ramp up that effort to pursue those deficiencies.

David Hochstim - Bear Stearns

Does it turn out that a lot of your Alt-A exposure is more in Florida or California or neither or…?

Daniel Mudd

Yeah, over 30% in California and Florida.

David Hochstim - Bear Stearns

Of Alt-A.

Daniel Mudd

Yes.

David Hochstim - Bear Stearns

Okay. And finally just could somebody tells us how much of the 25 basis point delivery fee was recognized in March and how much of that is being deferred on average if you can.

Daniel Mudd

Yeah that was very artful way to get five questions in one segment (Multiple Speakers). Let's have Eric Schuppenhauer, that’s the CFO for that business, to address it.

Eric Schuppenhauer

David, this is Eric Schuppenhauer I think to what you can expect is that that is deferred over time. So some portion of it would have been recognized in the first month. So we just started charging that fee with March deliveries, and so you would expect if you use kind of average life of 4 years of our MBS. I think then you get to your models.

David Hochstim - Bear Stearns

Okay. So it's evenly distributed, your not recognizing a portion of it to trade up the value of the first month of delivery?

Eric Schuppenhauer

No we are not.

David Hochstim - Bear Stearns

Okay, thanks. Thanks a lot.

Fannie Mae (FNM) Q1 2008 Earnings Call May 6, 2008 10:30 AM ET

Operator

Okay. Next from the line of Howard Shapiro with Fox-Pitt, Kelton. Please go ahead.

Howard Shapiro - Fox-Pitt, Kelton

Hi. Just a question on the fair value and then a follow-up if I could. On page 16 and you talked a little bit about it in the presentation. You attribute about $17 billion of the declined fair value to the change in the GO, that’s about 25 billion I believe on a pre-tax basis. 40% of the increase in the fair value of the GO is due to an increase in the underlying risk in your credit guarantee book. Is that saying that your expectation of losses on your guarantee books has increased by 10 billion or is this just a reflection of wider spreads? And then I have follow-up?

Steve Swad

This is Steve Swad. Just the answer to your question is not a revision to our estimate of the expected losses. Just a few points on a fair value balance sheet, one is to remind you that it is a liquidation view of the company. Its as though we sell our assets and liabilities at current market prices. Second, probably the most significant theme is that moves it in the opposite direction of current business opportunities. And so the wider the spreads on the mortgage securities, the better is for new acquisitions, the worse it is for the existing portfolios. Similarly on the GO side of the business, the higher our ability to raise prices, the worst it is on the existing business. Now my last point is, as a long-term holder of this we expect to recover the spreads overtime.

Howard Shapiro - Fox-Pitt, Kelton

Okay. But that's on the 60%,,that change that’s resulted from new pricing, the 40% that's due to wider spreads. Do you also expect to recover that overtime?

Steve Swad

A portion of that will be incurred as losses and a portion is the markets estimate of variability around that number that we do not expect will be incurred.

Howard Shapiro - Fox-Pitt, Kelton

Okay. So that would be the market risk premium?

Steve Swad

That's correct.

Howard Shapiro - Fox-Pitt, Kelton

Okay. And then just a question on the change in accounting treatment for interest rates derivatives, I know you've said that it will substantially mitigate the volatility. Can you give us either more qualitatively or hopefully quantitatively what that would mean for example for a given basis point change in rates or some other measures that we could get a sense of how it has been mitigated?

Steve Swad

Let me direct you to slide 8. Slide 8 breaks out the $4 billion of market losses by interest rate and spread. And you can see on slide 8 that there is $1.2 billion of loss in Q1 relating to interest rate. The goal of our hedge accounting program is to reduce that number significantly.

Howard Shapiro - Fox-Pitt, Kelton

I'm sorry $1.2 billion is due to interest rate or due to spread?

Steve Swad

Due to interest rates, and its on slide 8.

Howard Shapiro - Fox-Pitt, Kelton

Okay. And then the $3 billion is due to what then?

Steve Swad

Spreads. I understand what your doing. The change in interest rate is 1.2 billion, it consists of two pieces, $3 billion of losses on derivatives and $1.8 billion of gains in the trading assets. The net affect of interest rate is 1.2 and all of this is on that slide 8.

Howard Shapiro - Fox-Pitt, Kelton

Okay. That's what you hope to minimize?

Steve Swad

That’s correct.

Howard Shapiro - Fox-Pitt, Kelton

Okay. Thank you.

Daniel Mudd

Howard let me just throw in one other point in terms fair value impacts, particularly with respect to GO. There is a lot of counter intuative movement in that, but the way that I kind of finally got it was to realize if you ever increase prices on a perspective basis. What that means is the entire book is trailing along behind you, is automatically under priced and flows through. So if you wanted to drive a fair value improvement through the GO line, the "smartest thing" you could do would be to decrease prices, which I think we could probably all agree on that one. It doesn’t make a lot of economic sense particular in this environment. So I zoom back up to 100,000 feet on the point here, we have said along these calls. I can almost quote myself that, change of fair value was one of the important measures to look at in the overall context for the company's in the current environment, blah, blah, blah. Well that's true and in this case, I think its important and particular to look at the environment and the economics and the situation we’re in, in the context of all the other disclosures and information we are providing. So thanks for allowing me to do that little advertisements. Let go to the next question.

Howard Shapiro - Fox-Pitt, Kelton

Thank you.

Operator

And next from Bruce Harting with Lehman Brothers. Please go ahead.

Bruce Harting - Lehman Brothers

Yeah, thank you. On page 6 the guarantee fee income. Can you give any kind of guidance in terms of where we go from here because it sounds like from Rob's comment the price increases is one is done, another maybe coming in June. And just in March alone it looks like it flipped flopped a little bit, was that just the average charge was 25.9 in the quarter, but ended the quarter at a slightly higher rate 27.6. So any kind of help you can give on a go-forward basis there and was that just because of the backing off of Alt-A, was the decline Alt-A decreased volumes?

Robert Levin

Bruce, let me have Tom Lund, who runs the single-family business, start with kind of the market dynamics and the structure on pricing. And then if there’s more, to a discussion of the accounting, therefore we will go Eric Schuppenhauer his CFO.

Eric Schuppenhauer

Okay. A couple of things, one is that as we have talked about in the past year we announced a couple of price increase that just took effect in the beginning of March. And you can start to see that in the numbers. If you turn to page 15 of the investor pack you will see for our flow business an isolation of that. We took to March pricing up to about 28.64 basis points versus 25 in the quarter and 23 all of 2007. But commensurate with that on that pace, we also have basically the credit quality associated with that. And if you look at the incredible improvement in both the credit scores, which is the quality of the borrower, as well as the amount of equity that they are putting in the property, you can see a dramatic shift in the credit quality. While the prices have improved significantly and therefore margins on this business are much improved.

Bruce Harting - Lehman Brothers

Thank you. And then in terms of your guidance saying that '09, I think you said '09 will be a little bit worse on credit than '08. Is that in reference to foreclosed property expense, is that the charge-off number, or the provisioning number, or all three? The way we kind of model it is we see -- you kind of provisioned in this quarter, if you will, at almost 40 basis point type annualized run rate, but you are saying charge-offs of 13 to 17 this year. So it seems as though you are front-end loading here. Is that the conclusion we should reach that you are going to use '08 to overbuild reserves such that even if charge-offs are higher in '08, provision comes down?

Steve Swad

I wouldn’t think of it quite like that. Let me direct your attention to slide 12, which breaks out the credit-related expenses. In Q1 we had $880 million of credit losses, that's 12.6 basis points. We guided that number to 13 to 17 basis points; that's point one. Point two is on that same page, in Q1 our credit-related expenses due to the increase in the allowance, went up by 1.8 billion. So the ending allowance is $5.2 billion. We guided that that number will increase throughout the year based on our delinquency trends, default trends, mix of business, and severity trends. And it is too early for us to predict exactly where that number would be, because those trends are not yet predictable. And then the third point we made was that the credit loss ratio going back up to the top, the ratio at the end of 2008 will be 13 to 17 basis points. We said 2009 will be greater than 2008.

Bruce Harting - Lehman Brothers

Okay. Thanks Steve.

Steve Swad

Thank you.

Operator

Your next question is from Paul Miller with FBR Capital Markets. Please go ahead.

Annette Frank - FBR Capital Markets

This is actually Annette Frank. Good morning. I have a followup question on the guarantee fee pricing. For the jumbo mortgage loans, the new pricing implementations, is that also applicable to the jumbo mortgage loans or are you using a different pricing methodology for the jumbo loans? And also are you expecting to keep some of the jumbo loans on the balance sheet or at this point are you expecting to sell off most of this product?

Daniel Mudd

Let me have Tom talk about it. What we're trying to accomplish, as just a way of background, is that we have been asked to play a role in certain high cost areas, so called conforming jumbo markets where actually have lot of the same credit characteristics that we see in the rest of our book. These are working families. They tend to be closer to metropolitan areas. Therefore the home prices tend to be higher. We've been asked to play a role in the market place and one of the things that is an issue affecting those jumbo markets is that there is not a lot of liquidity there. So we're basically going to absorb the liquidity premium and price not with respect to the credit piece of it, which is all individualized or the other risks, but the market liquidity premium we're going to price ourselves. That should translate into better pricing for the lenders and depending how the lenders price it on the street should provide a benefit to get some movement going to those markets. Tom?

Tom Lund

Dan hit most, but I would just add that we'll write price the risk on the product that’s coming in just the way we do today in our score business. We will look at the individual characteristic for the loans, the product types, and things of that nature and price that appropriately. And then Peter, do you want to talk to the portfolio purchase?

Peter Niculescu

Hi, Annette, this is Peter Niculescu. We were anticipating this product will come on balance sheet. At the moment there is not a strong securitization market there. We would love to see one develop, we think at some point it will. But at this point we plan to take this product on balance sheet and as you know we are committing to do this through the end of the year. So that’s the timeframe that we have in mind to see this product come on balance sheet.

Annette Frank - FBR Capital Markets

Okay. Thank you very much.

Operator

And next from the line of Brad Ball with Citi. Please go ahead.

Brad Ball - Citi

Thanks. My questions are on credit. I wondered if you could give us some sense as to what were the main factors that changed versus the end of February when you gave your prior guidance that caused you to update your guidance. Your new peak to trough loss expectations, that's probably part of it but you expect it to extend further than you had previously thought. I think you used to talk about the trough occurring sometime in late '09. I am just trying to get a sense as to how confident you are with the credit picture that you have now laid out or will we come back in August and get a new revised guidance once again?

Daniel Mudd

Well I don’t know whether you will come back and get a new revised guidance or not because what we are trying to do is provide the clearest, most accurate look of where the market is going to go based on all of the information that we have. And in that light, March was not a terrific month in the capital markets and the first quarter was not a terrific quarter in the housing markets. And so what has changed is that all of the data from the first quarter that represented an accelerating decline, if you think about that concept from those fronts, caused us to update two things: one is what we were going to see in the current year because you are already eaten the first quarter of the year. And secondly, what the implications would be for the peak-to-trough decline.

More broadly, our research indicates that over the long haul of time, literally going back toalmost the beginning of the 20th century, home prices appreciated about inline with GDP and at some points they overstriped that line and at some point they understriped that line. We got way over the line and now we are correcting back to the line, but what we are seeing doesn’t suggest that all of a sudden that home prices are going to decline and stop precisely on the line. There probably will be some overshoot in this context and our very best prediction as of now of where that’s going to be suggests the 13 to 17% peak-to-trough and 7 to 9% this year. The 7 to 9%, so you can calibrate by the way we just sort of use an algorithm to adjust ourselves to the Case-Shiller Index. That 7 to 9% decline will be a 12 to 14% Case-Shiller decline. So that is a pretty serious scenario.

We are sizing our capital and we are managing our risk to reflect actually being -- we have thousands of scenarios but think about it broadly as four or five scenarios. One scenario was things get better, not using that scenario. Another scenario was things stay flat, not using that scenario. The other scenario was our prior version, which has some declines in it and the next one shows about where we are right now. We are sizing capital to reflect home price declines that go beyond that. And that overall decline then produces a peak-to-trough number of 15 to 19% national home price average. And again to use the algorithm that puts you in a 25% plus Case-Shiller decline. So I think we are all kind of getting around to the same place on this with some adjustments on a quarter to quarter basis for any new data that we have. That is our best bet is their downside to it. Well the history has been that there has been more downside then upside recently. Yesterday's downside becomes today's base case. But I think as we move through it with this key variable being time, as time passes we have more data and we have more time for consumers and institutions to cure, for these policies to take effect, for the tie to stem some, and there is some very very early signs of that. I rather see conformation from a couple of months or a quarter before I go positive on you.

Brad Ball - Citi

Okay, fair enough. Just a quick follow-up. You highlighted Alt-A as a main source of deterioration more recently. Was that '06 and '07 vintages in particular or do you have Alt-A from other periods that are also performing weakly? And then the deterioration you saw in the Midwest, is that mainly driven by home price declines in that market, or is it unemployment, or is it a combination, what in particular is happening in the Midwest? Thanks

Dan Mudd

Okay, let me start and then I'll have Tom Lund jump in. With a four-year average book and with the product that we stopped largely doing Alt-A, a yearish ago, the concentration is late '05, '06 or early '07 kind of a book. And then we should just admit the fact, that the underwriting standards at the very peaky froth of the boom there were not everything that they should have been. So everybody has got a book and everybody has got a part of their book that worries them the most. In our case, it's the Alt-A book and we are focused on that. We put a lot of resources on it and that’s where we are seeing the disproportionate share of our losses. And the overall lost guidance that we've just been talking about incorporates that into it. Tom?

Tom Lund

Yeah, I will just say that in the Investor Presentation on pages 30 to 32, it gives you a lot of that detail and data. On the '06 and '07 are clearly the most problematic around that. It is correlated very much to the geographies and the home price declines taking place at that point in time. We have a significant emphasis on managing it and working these loans out. And you can also see that Alt-A book does have very different characteristics in the labor market in general. I would make a couple of comments.

When we did this business, we did it with our customers, we did with our guidelines, and we have a significant amount of credit enhancement on this. You can see on those graphs that it's performing better, it is much higher percent fixed rate than the general market and better overall characteristics. But it still is a problem, it represents about 47% of our credit losses. We are working it very very hard. We had basically mitigated any future exposure on new acquisitions. You can see there is very little coming in. We have made tremendous amount underwriting changes and pricing changes and I will just remind you that we also significantly price for this business and we will begin to get additional enhancement over time.

On the second piece of your question, the Midwest. That is currently being driven by the economy and it has been for a lengthy period of time, out migration and job losses are the biggest driver and my guess is that will continue for some period of time.

Brad Ball - Citi

Thanks.

Operator

Our next question comes from Gary Gordon with Portales Partners. Please go ahead.

Gary Gordon - Portales Partners

Okay, thank you. Question about the balance between your public policy role and your shareholder role. In two ways, one is keys to recovery program. For example, cutting pricing on the conforming jumbo would suggest there is public policies first before shareholders. Also the capital raise, to raise capital today and then to grow the current capital price of the stock would seem difficult to get a reasonable return on new business that wouldn’t dilute shareholders. How do you sort of think through that balance between, at this stage, between public policy and shareholders?

Daniel Mudd

Thanks for the question Gary. The two things go together actually and with us having the largest share of any component of the US mortgage that you want to look. As goes the market, so go we. So things that we can do to be helpful to the market generally accrue to us. If you take the two examples that you cited, on the jumbo pricing we have been asked to play a role in a market that we have not had access to before. Like in any other company when you enter a new market you want to get it going, you want to develop your position, you want to develop your products. In our case you certainly want to manage your risk prudently, but establishing that foothold probably cost you short term, but has enormous long term benefits.

Likewise, the types of opportunities that we are seeing to invest the capital that we are raising, we didn’t have access to before. We had a portfolio cap, we had limits on capital.

We were actually as you saw in the numbers, were liquidating on the portfolios side. Those things have changed and now we see access to opportunities that the portfolio hasn't seen since 1998 and the guaranty business hasn't seen since 2003. The odd things going on or they are both happening at the same time for the company and they are both also happening at the same time as we have the other half of our lives is managing the losses in the existing book. So with all of those things going on I kind of think of it as a bridge. We got to get across a bridge here, where we don’t miss the terrific opportunities we have. We are being prudent and we are being conservative and we are managing the capital because when we get to the other side of the bridge, I think our market position is very strong. We will feast off of this book of business that we are putting on for many years to come. We will have done our best in investing resources to mitigate the damage from the losses and fundamentally will have helped the market to recover sooner. And that’s all a good thing.

So I know there is a lot of noise in the marketplace about, are we are doing this because somebody is yelling at us, we are doing this because somebody is encouraging us to do this that and the other thing, and we are trying to keep everybody happy. And we are really not. We still look at all of these opportunities on a risk adjusted return basis whether that’s OAS spreads or on the guaranty side. And then we factor in like any other business would, are we prepared to invest to enter this market or to build up this position within the parameters and risk policies that we have. If the answer is yes, my argument would be we are doing a lot of things to drive the revenues and expenses in the short term, but we also have to not lose sight of the fact that we are also building a presence for ourselves in the marketplace longer term and that’s where those two things come together.

Gary Gordon - Portales Partners

Okay, thank you.

Dan Mudd

Thank you.

Operator

Our next question is from line of Bob Napoli with Piper Jaffray. Please go ahead.

Dan Mudd

Bob, you get the last one. We will be out and about discussing this capital raise with many of your firms and companies shortly and we look forward to continue those conversations, but go ahead, Bob.

Bob Napoli - Piper Jaffray

Great, thank you. On the net interest margin, I was wondering in the strategy, I think you got dinged a little bit on interest rate risk management from OFHEO. But interest rates right now are probably about as low as they are going to get at least on the short end of the curve and your margin. I was wondering if you can give a little bit of color on how much you expect the margin to go up if rates stay where they are today over the next several quarters? And thoughts on adjusting the mix of floating and fixed rate debt in order to maybe lock in, because the Fed isn't going on go any lower, and at some point housing prices are going to bottom out and there is inflation and the Fed fund rates could be 300 basis points higher than it is today two years from now. So what are your thoughts on managing that on improving the interest rate risk management as it relates to OFHEO and just broadly economically locking in attractive spreads for the longer term?

Steve Swad

This is Steve Swad. I will start and then I will pass it over to Peter Niculescu, who runs that business. From an net interest margin perspective, as you rightfully pointed out, it is very difficult to predict where interest rates are going to go and what margins we will be able to put on the book. If you look at page 5 of the investor pack, we highlight in gold net interest margin, excluding the if-effect of step rate debt and we had 69 basis points of spread in Q1. My comments said that that number was going to go up. In Q2 we are seeing wide spread business be put on our books. It's much more difficult to project beyond that. Peter, I don’t know if you have anything else to add?

Peter Niculescu

Yeah. Bob, thank you very much for the the question, I think it's a great question. First of all on the risk management side, we reported as you saw a duration gap of three months in March and we've noted in our investor analyst package. And it was two months in April and we stay in very close dialog with our regulator about risk management and interest-rate risk management, managed towards a great deal. As you can imagine the changing spread environment of the first quarter actually created some volatility to our duration that we haven't previously seen. Not some of rates, it was actually changing in spreads. But one of the important drivers here, I think you have noticed from our derivative are pay-fixed swap mark-to-market has rates for we've taken losses historically on pay-fixed swaps. But what that means is that our liability costs of funds drift down every time we take a loss. So, now we've locked in, with hedge accounting we have locked in a long-term cost of funds that is relatively low on our pay-fixed swap position and you are seeing that show up with higher margins.

In addition to that, we've been adding new business at starting quite attractive spreads. Although their sizes have been somewhat limited as liquidation is being somewhat limited, but that opportunity is there. I think you'll start to see more effect on margin in the future as we build the asset base with new investments at historically quite attractive spreads. I think that is something that will occur in the future.

Bob Napoli - Piper Jaffray

What were the spreads on loans for say originated in April?

Dan Mudd

I don't think we can breakdown on a monthly basis like that, but I think what we said before on this call is that we've been seeing option-adjusted spreads recently that are more than twice the sort of spreads that we saw in 2007. I think you can go to market indicators, I mean, we’re large enough. We sort of buying kind of the marketplace, that probably tells you what you need to know.

Bob Napoli - Piper Jaffray

Last question on credit losses and peak credit losses, in your base case or your most likely case, were 13 to 17 basis points. This year obviously you are at 12. So, you are looking for losses to move up through the year. When do you think credit losses from your forecast of housing for this year and next year – when do you think credit losses peak and can you give a range on the peak? Is the peak 20 to 30, is your best guesstimate today and where is that peak relative to what you're seeing in 2008 and when?

Steve Swad

This is Steve Swad. Let me start and then I’ll pass it to Dan. We gave current guidance of 13 to 17 basis points of credit losses for 2008. We also guided that 2009 would be above those numbers.

Bob Napoli - Piper Jaffray

Right.

Steve Swad

And that's really all we can do at this time. As I said earlier, these numbers are a function of defaults, severities, and a mix of product that comes through. And we're not able to really give more visibility at this time because those trends are not yet predictable. Dan?

Dan Mudd

The perspective I will give is really more historical. We're not going to try to call a moment at the bottom because quite frankly it's full variant. I think that from a historical perspective what we've seen here was a period of enormous volatility and unpredictability that extended from last July through March. If you say it was over in February you were wrong in March. It feels like a lot of those spikes have abated right now and we're sort of settling into working our way through the trough here. Our expectation based on what we've seen is that we'll go through that process. We'll see the 15 to 19 peak-to-trough declines. At the current rate is what underlies our expectation that '08 and '09 are going to be comparatively weak years, but it also suggests that some time toward the end of that period, some time in the early '10 period, you've worked your way through it and you are starting to see the various signs of life that re-enter the market through housing starts, inventories coming down, more movement, price go up, all of those type of things. So I'm not answering your question in terms of calling a spot, I'm just telling you here's how it might work out over time.

So, with that, let me just wrap up quite quickly. The summary I think to take away for today is the result showe we had another tough quarter although it was marginally better than the last. The results were really driven by the fair value and the credit losses. We have indicated that we will continue to build credit loss reserves because the housing forecast got worse. Revenues up, market share up, customer penetration up, and we continue to see lots of opportunities for high quality, well priced assets. We are raising 6 billion in capital, reducing the dividend, all to build capital to make sure we get through this belly in really impregnable shape. We will use this capital and protect the balance sheet through the downturn and we will use it to maximize these opportunities. We are happy that the regulator has helped us move back to a position of being in a more normal posture as a strongly regulated company, but out from other consent order and with some more capital to deploy in the market. And now, I think the question turns to both maximizing what we do with the business as well as helping the market recover, both of those things are interrelated.

So, thank you all very much for joining us today and we look forward to talking to you in the hours, days and weeks to come. Mary Lou?

Mary Lou Christy – Senior VicePresident of Investor Relations

You can actually read John the instructions for to call in.

Operator

Certainly. And, ladies and gentlemen, a replay of the call will be available for 30 days. That starts at 1:00 pm Eastern Time today May 6, through midnight Eastern Time on June 3rd. The replay number for the call is 1-800-475-6701 or for international callers 320-365-3844. The confirmation code is 920753. Miss Christy, any closing comments?

Mary Lou Christy – Senior Vice President of Investor Relations

No, thank you.

Operator

Again, ladies and gentlemen, that does conclude your conference for today. Thank you for your participation. 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: Fannie Mae, Q1 2008 Earnings Call Transcript
This Transcript
All Transcripts