Freddie Mac Q1 2008 Earnings Call Transcript

May.14.08 | About: Freddie Mac (FMCC)

Freddie Mac (FRE)

Q1 2008 Earnings Call

May 14, 2008 10:00 am ET

Executives

Edward Golding – Senior Vice President Investor Relations

Dick Syron – Chairman, CEO

Buddy Piszel – Chief Financial Officer

Patty Cook – Chief Business Officer

Analysts

David Hochstim – Bear Stearns

Howard Shapiro – Fox-Pitt

Paul Miller – FBR Capital Markets

Brad Ball – Citi

Bob Napoli – Piper Jaffray

Fred Cannon – KBW

Gary Gordon – Portales Partners

Moshe Orenbuch – Credit Suisse

Bruce Harting – Lehman

David Dusenbury – Dalton Greiner

Operator

Ladies and gentlemen, thank you for standing by, welcome to the Freddie Mac first quarter 2008 financial conference call. (Operator instructions) At this time I would like to turn the conference over to Edward Golding, Senior Vice President of Investor Relations. Please go ahead.

Edward Golding

Thank you and good morning, welcome to our investor presentation and conference call where we present to you our financial results for the first quarter of 2008. Speaking today are Freddie Mac’s Chairman and Chief Executive Officer, Dick Syron, our Chief Business Officer, Patty Cook and our Chief Financial Officer, Buddy Piszel.

Before we begin, let me make two important points. First, we have posted on our website a slide presentation and core tables which include additional details on our first quarter results. You may want to have these available as Buddy walks through the numbers.

Second, please note that today we may make certain forward-looking statements regarding our business results. These statements are based upon a set of judgments, estimates and assumptions about key business drivers and other factors. Changes in these factors could cause our actual results to vary materially from our expectations.

You’ll find a discussion of these factors in our 2007 information statement annual report and in today’s statement supplement, both of which are posted on our website. We strongly encourage you to review these factors.

One final note, we would like as many people as possible to be able to ask questions. Therefore, if you would please limit yourself to one question and a follow up, I’d be grateful. Time permitting, we will come back for a second round. Thanks and now let me introduce our Chairman and CEO, Dick Syron.

Dick Syron

Thanks Ed. Good morning and thanks to all of you for taking the time. During the first quarter we continued to see a housing market in distress. Throughout this period, Freddie Mac worked in a counter-cyclical way to support the housing finance market and to advance the recovery of the housing sector.

The company reported a net loss of $151 million for the quarter, down significantly from our fourth quarter loss of about $2.5 billion. Our results reflect a balance of three factors: one, growing revenues based on increasing volumes, two, changes in our accounting that more closely align with the underlying performance of our business and three, worsening credit conditions.

In our single-family business, we’ve improved our underwriting standards by insisting on better credit quality for new guarantees and reducing our volumes of riskier loan products. By combining these efforts with the use of risk based pricing, we assured continued credit access for America’s homeowners.

In our growing multi-family business, we have continued to finance residential rental properties despite the near shutdown of the CMBS market. By doing so, we have helped stabilize the market and made rental housing more affordable. This segment is especially important to our affordable mission at this point in the cycle.

In our retained portfolio, we continue to maintain a very low level of interest rate risk, even through a volatile Q1. Our ability to provide stability, liquidity and affordability during this market crisis was a major reason Congress and the Administration included our support for the conforming jumbo market as part of the economic stimulus package.

We recently began to buy conforming jumbo loans in 224 high cost markets. This is already helped drive a significant drop in the rates on these loans for consumers. We have also been active in helping delinquent borrowers seeking to avoid foreclosure and we are exploring constructive and creative ways to work out loan modifications for distressed homeowners.

Our purchase of MBS through our retained portfolio has helped lead to a marked reduction in spreads in that market. Continuing to support the recovery of the housing sector is crucial to US homeowners and the broader economy, since it’s clear we have not yet hit bottom in the housing market.

Previously we have said that we expected housing prices to fall at least 15% nationally, peak to trough and to date they have fallen about 9% through the measure we use which is relevant to our market. We want to take a better look at the spring housing market to see whether or not the data is beginning to firm up.

It’s premature at this point from a data perspective to make a change in our formal peak to trough estimate, however at this point, we must say that the risk to that forecast are strongly weighted on the downside. Given the severity of the price declines in the first quarter and the growing inventory of foreclosed homes, we have experienced an increase in charge off and REO expenses associated with higher loan loss severities.

As a result of this change, we raised our estimate for expected future default costs and increased our provision. Although credit will continue to be an overhang, significant advances in financial reporting, controls remediation, capital management and better returns on our growing new business volumes make me confident we can improve our bottom line results for 2008.

A healthy and profitable Freddie Mac is essential to the stability of the US housing system and for the benefit of the entire US economy. During the first quarter, improvements in our financial reporting policies that better align realization of income and expense reduced our GAAP income statement sensitivity to changes in credit and interest rate markets. That helped our first quarter results.

These new accounting policies will make our future financial results more comparable to other financial institutions and more reflective of our underlying economics. During the first quarter we also made significant strides in completing our work on controls. With our release in 44 days, we managed to slice 16 days off our schedule from year end and we’ve also completed the remediation of all of our material weaknesses.

The combined effect of our simplified financial reporting, stronger controls and improved returns in our new business put us in a position to manage our capital more effectively. With capital levels of more than $38 billion at the end of the first quarter, $6 billion above our mandatory target and $11.5 billion above the statutory requirement, we do remain in a strong and sound capital position.

Having said that, in an effort to continue to support the housing market and take advantage of the opportunities now available to our shareholders, Freddie Mac will raise $5.5 billion in new capital consistent with an agreement with OFHEO to reduce our surcharge to 15% on issue and ultimately to reduce our capital surcharge to 10% this fall.

This capital raise will be deployed in ways that we are convinced will benefit shareholders as well as help us stabilize and support the housing market. And that feeds our confidence that we can continue to improve our results for the year. Thank you for your time, and with that I’ll turn things over to Buddy.

Buddy Piszel

Thanks Dick and good morning everyone. Today’s results are clearly driven by the housing market but first let me pause and mark a major turning point. With today’s release, Freddie Mac has basically completed our major efforts to improve the timeliness, controls and transparency of our financial reporting.

This has three immediate benefits. First, as a result of these changes, our accounting policies and earnings emergence now better reflect the performance in our underlying business, improving their clarity and comparability to those of other large cap financial institutions.

Second, we have fully remediated all outstanding material control weaknesses. And finally, with this quarter’s demonstration that we can achieve timely quarters, we’ll be taking the ultimate step very shortly and will become and SEC registrant.

These actions close a long and very difficult chapter in Freddie’s history and one that will never be repeated. You have our commitment that we are on the way to being as well run a financial institution as any out there.

So returning to the first quarter, our loss was $151 million or $0.66 per share, compared to a loss of $2.5 billion or $3.97 per share in our fourth quarter. Much of that improvement was due to changes in our operational and accounting practices, specifically related to mark to market items.

Through the first quarter, our results do not yet reflect the anticipated positive effects of significant retained portfolio growth or improved pricing on our guaranteed portfolio. With that, let me take you through a high level summary of the first quarter and how we see 2008 shaping up. If you’d please turn to slide 1.

For the first quarter, holding aside the mark to market items, NIM was essentially flat and the GP revenue grew with portfolio balances, but credit costs also remained high. Compared to the fourth quarter, in the first quarter guarantee revenues increased by $91 million or roughly 13%, mostly due to growth in our average PC balance and a higher total guarantee fee rate.

Net interest income increased by $24 million. Portfolio balances were essentially flat, but nonetheless, given the yield curve steepening, you would have expected greater NIM expansion. Credit related expenses increased by $536 million as higher loan loss severities and serious delinquency rates produced greater provision and REO expenses.

Finally, we did not record any credit related impairments on our portfolio of private label asset backed securities. Let me give you a little color on why the net interest margin was essentially flat for the quarter. During February and March, the significant flight to quality in the front end of the yield curve, that’s between the one and three month maturities, produced a mismatch in the reset rates of our floating rate assets compared to the turnover on our short term debt portfolio.

Very simply, since our assets reset on a monthly basis, that reset was down. Our short term debt, which at year end had about an 80 day average maturity did not reset as quickly. The result was a reduction in NII of about $210 million contributing net spread compression of about 11 basis points.

This impact was accentuated since during the first quarter we took conservative funding measures and actually lengthened our short term maturities to approximately 90 days. All this compression was offset by margin expansion on the fixed rate assets, the net result was a flat NIM.

Absent the floating rate compression, we would have actually increased our NIM to about 60 basis points. And the important point to note is that this should not be a recurring item and we expect NIM expansion throughout 2008 as retained portfolio purchases increase with wide initial GAAP margins.

As we committed at our investor day, increased visibility into our results have given us greater comfort in providing additional guidance on revenue and credit results for full year 2008 versus 2007. Based on the current growth opportunities and credit environment, we would expect to achieve 15-20% revenue growth and contractual guarantee fees and delivery fees.

We expect this to result in higher G fees on new business and around 10% growth in our guaranteed portfolio. We’d also expect to achieve 40-50% revenue growth in net interest income. We expect this to come from significantly higher NIM on new purchases and strong portfolio growth, much of which through today has already occurred.

As we’ve indicated on the credit side, we also expect to see an increase in our 2008 provision to now approximately $5-$6 billion. Based on the strong revenue growth opportunities we are seeing tied to the expanded role of the GSEs that Dick talked about, we’ve decided to raise an additional amount of capital to fund future growth.

While we expect to formally launch the transaction in the very near term, I am comfortable enough with our status to give you some high level elements of our plan. Our plan is to raise $5.5 billion, split roughly 50/50 between a non-convertible preferred and common.

We do not currently anticipate further reductions in dividend payments. As we indicated on our investor day, we are proceeding thoughtfully in our capital raise process and will initiate the offerings once our SEC registration is complete, which again should be very shortly.

So from a registration perspective, that means we are ahead of where we expected to be. If you’d now turn to slide 2, this slide gives you a high level overview of our current capital position and how we would expect to look once we complete our issuance.

Raising this amount of capital will provide three benefits. First, it will provide for flexibility and strength that will help fund profitable growth opportunities in our business. Second, OFHEO has told us that upon completion of our planned capital offerings, the intent is to reduce our mandatory target capital surplus amount to 15% from the current level of 20%.

In addition, OFHEO has informed us that it intends to further reduce the surplus amount to 10% based on the following: completion of the SEC registration process, completion of the remaining consent order requirement to separate the position of Chairman and CEO and our commitment to continue to hold capital well above the regulatory requirement, and lastly, no material adverse change to our ongoing regulatory compliance.

Finally, the capital will provide us with additional downside protection in the event of dramatic credit deterioration. Just as important to strong capital is the fact that given our reduced mark to market sensitivity, there is a greatly reduced risk of fresh capital being used to fill a hole.

Let me now take you briefly through slide 3, and that shows the improvement we’ve experienced in the first quarter and the reduced potential for adverse capital impacts going forward.

As you can see on line 11, during the first quarter our results benefitted from a reduction of $3.6 billion in pretax mark to market losses. These were split roughly half and half between interest rate and credit related items. On the interest rate side, as we’ve previously discussed, we’ve taken two steps to reduce our interest rate sensitivity.

First, line 1, shows the combined impact of a shift in the composition of our derivatives portfolio and a steepening yield curve. Our mark to market losses fell by $923 million in the first quarter. We did begin to benefit in the quarter from our hedge accounting efforts and continued expansion of hedge accounting will have a greater positive effect on our interest rate sensitivities going forward.

Second, effective January 1, we adopted FAS 159, the fair value option. By identifying a basket of assets to mark to fair value through our income statement and effectively offset the valuation changes in the guarantee asset. Lines 2 and 3 illustrate the first quarter effect of this change and as you can see, it’s working.

On the credit side, we made one really big change in the first quarter, the elimination of losses on certain credit guarantees, our day one difference. In the first quarter and going forward, we have modified our processes so that we will now record the GO on new guarantees as a similar valuation of the GA on those assets.

Giving effect to this change resulted in a reduction of $1.3 billion of losses compared to the fourth quarter of 07 as shown here on line 6. One more item I should point out is the losses on loans purchased out of securities shown on line 7. While we made the change in our operating policy of buying loans out of securities in December, this is the first full quarter of the new policy.

Due to sharply lower loan purchase volume, we recorded a loss of only $51 million on this item, almost $700 million less than in the fourth quarter. Turning to slide 4, as we discussed on investor day, we have set a goal for the company of getting our overall interest rate sensitivity down to about $1 billion for a 100 basis point move or about $10 million per basis point.

While we’re not quite there, you can see that thanks in part to the implementation of the fair value option and hedge accounting, our sensitivity was down significantly from that in the fourth quarter. Keep in mind that this level could be adversely impacted by spread risk based on the assets and liabilities we now record at fair value.

Moving to slide 5, one question we received over the past several quarters is how are the adverse mark to market items that we have previously taken reverse through earnings. As you can see at the end of the year, our retained earnings and capital included previously recorded pretax losses attributed to losses on loan purchased and losses on certain credit guarantees of about $3.8 billion.

While the changes we have made to our financial reporting will help safeguard our regulatory capital against future losses of this sort, the historical amounts will reverse over the next several years through the income statement line item shown.

During the first quarter reversal of these markets resulted in a re-accretion of $536 million pretax. As a clarification, the reversal of the $234 million shown here on line 2 as losses on certain credit guarantees is a component of the income on the guarantee obligation on our income statement and is about $80 million higher than we would normally expect to recover in a single quarter.

The reason for that is during the first quarter, this re-accretion was accelerated as a component of income in GO. Under our new GO accounting, we record stepped up amortization income when house prices decline significantly in a quarter. While this may seem counterintuitive, the policy allows us to better reflect earnings emergence through GO income with the recognition of higher incurred losses.

During the first quarter, total income on the GO increased to $1.2 billion from $528 million in the fourth quarter. While the rate of recapture on the GO will vary from period to period, in general we would expect it to be recovered within a few years as the loans underlying the securities we guarantee pay down.

If you turn to slide 6, as Dick noted earlier, as a result of the more severe house price deterioration in the first quarter, increasing delinquencies and higher severity rates, we experienced a significant increase in charge offs and REO expense in the first quarter, moving to an annualized quarterly loss rate of 11.6 basis points compared to 5.4 basis points in the fourth quarter.

These same factors drove an increase in our expected charge offs for 2008 and 2009 and raised our guidance for full year 2008 provision. On slide 6 you can see that our estimated credit losses for 08 have increased to 16 basis points with our 09 estimate increasing to a range of 20-25 basis points respectively.

Just to be clear, our 2009 estimate for total credit losses now includes the affect of our expected 2008 new business. Finally, slide 7 shows that despite the continued high level of charge offs, we remain very adequately reserved for our expected losses. As of the end of March, our ratio of reserves to expected charge offs was 1.6 times consistent with where we were at at year end.

Another way to think about reserve coverage is as a ratio to recent period losses. On this metric, our reserve to annualized first quarter charge off is about 3 times. One final point before I turn things over to Patty. We did not take any impairments on our ABS portfolio in the quarter.

As we’ve discussed in the past, we perform a very rigorous security by security analysis and given both our intent and our ability to hold the securities until maturity, we have not identified any securities where losses are probable. We’re watching all aspects of our ABS holdings very closely, in particular a limited subset of our holdings, including a small percentage of our alt A securities and a few $100 million of originally triple A rated securities backed by second liens.

Likewise, a subset of our holdings are backed by monoline insurers which is factored into the recovery expectations for those securities. At this point we are not expecting to impair any material amounts of our ABS portfolio over the next several quarters. This evaluation is done on a quarterly basis and could change as market conditions evolve or if the realized or expected performance of individual securities significantly deteriorates.

So to sum it up, from a financial perspective the key takeaways for the first quarter are credit costs are up, but manageable. Interest rate and credit market sensitivity has greatly improved, we are expecting significant revenue growth for the balance of the year and the combination of our existing capital base, our capital raise and the regulatory relief puts us in a very strong capital position.

With that, let me turn things over to Patty.

Patty Cook

Thanks Buddy. The first quarter continued to present us with significant house price declines, volatile financial markets and significant credit losses. However, unlike prior periods, the opportunities to deploy capital at very attractive returns and support the mortgage market were many.

My comments will focus on the steps Freddie Mac is taking to manage through the turmoil and the actions we are taking to improve future results. I want to highlight four themes in particular. First, the house price correction is happening more quickly than we expected which contributed to us raising our expectation for total default cost. While we are not yet ready to change our national peak to trough estimate of a bit over 15%, the risks as Dick mentioned, are clearly to the downside.

Second, continued high GSE market share coupled with improvements in credit quality and pricing makes the forward-looking returns in our single-family and multi-family businesses more attractive.

Third, resumed growth in the retained portfolio at wide nominal and OAS spreads will generate very attractive returns and NIM growth in our investment business. Finally, to ensure that we remain able to meet the liquidity, stability and affordability needs of the mortgage market through growth in all three of our businesses, we are preparing to raise an additional $5.5 billion in capital.

So first, the decline in house prices in the first quarter and the impact on credit. I’ll refer you to slides 8 and 9. According to our own index, house prices declined 4.2% in the first quarter, bringing the realized quarterly peak to trough decline to about 9%. This includes regional realized declines of as much as 20% plus in California and Nevada and 16% in Florida.

In considering an adjustment to our total declines, we would first like to see how the second quarter develops for home prices, a season typically more favorable for housing. It also appears that the outlook for the economy and financial markets may be showing signs of improvement as unemployment has remained relatively stable and financial institutions have significantly recapitalized.

These factors also play a role in expected defaults. Given that there is downside risk to our house price forecast, I want to take a couple of moments about the connection between house price declines and expected default costs.

First, the speed of decline affects the total EDC. So as I just mentioned, the rapid decline we saw in the first quarter, all else equal, raises the EDC estimates. Second, we use a model to estimate our expected default costs over the life of the loan. Through a Monte Carlo simulation around a base case house price pass, the model produces an estimate of lifetime expected defaults.

We can evaluate the defaults and severities the model produces in the context of historical data and current delinquency information to discern the reasonableness of the output. Given the unusual times we are in, it is important to recognize the uncertainty inherent in these estimates.

For example, a mid-teens peak to trough house price pass could produce defaults of 4% and severities of 30% which is high by historical comparisons, resulting in about $18 billion of EDC. In consideration of further house price declines, but in recognition of the unusual relationship today between house prices and the economy, we would view a range of $15-$20 billion EDC as a reasonable current estimate.

Third, we have disclosed that a 5% reduction in house prices increases our EDC by about $5 billion. So if you want to consider a bigger drop in house prices, you can use that relationship to estimate the increase in total EDC. Remember that these losses will occur over several years.

And lastly, even with defaults of 6% on the entire portfolio and severities of 35%, similar to what was realized in California in the early 90’s, but for the entire portfolio, we could manage the resulting losses, which would approximate the fair value of our GO with the intended capital raise and revenue growth.

Moving on to the credit losses we are realizing in our portfolio, I will refer you to slide 10, they are occurring for one of two principle reasons. Either they are loans in regions with depressed economies like Michigan and Ohio, or they are in regions with rapid house price declines and a high percentage of loans with the combination of high total loan to value ratios, low FICO scores and little documentation, like California and Florida.

As you can see on line 15, the eight worst performing states in our 2000 and book represent about 80% of 2006 losses in the first quarter. 2007, which is not shown here, has very similar characteristics. While stress in the Midwestern states has been observable for a couple of years, the rapid emergence of defaults and delinquencies in the rapidly declining states is a new phenomenon, associated primarily with our 2006 and 2007 originations.

As you can see on the top of slide 10, about half of our first quarter realized losses came from those two book years and we expect future losses to continue to be disproportionately related to 2006 and 2007 originations.

Detailed analysis of the 2006 book has allowed us to attribute this poor credit performance to certain risk variables. For example, low FICO scores, high TLTVs and low documentation loans as I mentioned earlier. This performed the foundation for the risk based delivery fees we have introduced over the last several months and which will be fully effective by the end of the second quarter.

In addition to these increases, we also tightened some credit terms. On slide 11 you can see how these changes have dramatically reduced the proportion of our deliveries with low FICO scores, high TLTV, low documentation and loans that have second lien exposure since the peak in September, October of last year.

As a result of these changes, the expected lifetime default costs on the worst quintile of new guarantees has fallen by more than 40% from its peak. We believe these changes to our terms of business will allow us to provide the liquidity the mortgage markets need in a responsible, risk disciplined way that is endurable.

So while credit losses will continue to be a drag on earnings for several quarters, the underlying fundamentals of our business have greatly improved. Beginning in early 2007, as other mortgage investors were trenched, our penetration of the conventional conforming market increased.

The GSE’s share rose from 39% in the first quarter of 2006 to more than 80% at March 31, as shown on slide 12. Initially this increase in share wasn’t at attractive terms. The credit quality was worse and we weren’t getting paid for the additional risk. However, with the tightening of terms and the increases in fees that we have begun to implement, the expected returns on our current flow are substantially better.

We would expect GCs on fourth quarter volume to be around 25-30 basis points, depending on the mix of business. This is down slightly from the level we discussed in our investor day, primarily based on our expectations of the credit quality of new deliveries for the remainder of the year.

While all in reported GCs on our total portfolio climbed to more than 20 basis points in the first quarter, up from 18 in the fourth, the majority of this increase reflects product mix and stepped up amortization of deferred fees. So as our old book runs off and 2008 deliveries come on at higher fees, we should naturally see our all in GCs migrate higher.

Coupled with our expectation for guaranteed portfolio growth for 2008, this should produce revenue growth of 15-20% for the year. While much smaller in dollar volume, the multi-family business has enjoyed a similar resurgence, higher volumes, better pricing and better terms. This adjustment allows us to continue to provide the liquidity needed in this market.

Let’s turn now to the retained portfolio, slide 13. This is one area where our strategy has changed meaningfully since the investor day. While our purchase activity picked up significantly in late February in response to the widest spreads we had seen in decades, the improved outlook on the capital front resulting from the reduction in the capital surplus and planned capital raise and the improve GAAP income picture, allowed us to maintain this more active posture and begin to grow our retained portfolio.

The left hand panel in slide 13 shows the surge in commitments that has occurred in March and then again in April. Most of these will settle within the next couple months, producing sharp growth in our settle portfolio balance. As with the guarantee business, these volumes have come at increasing levels of profitability and provided material support to mortgage market liquidity.

The graph on the right shows the LIBOR OAS levels for plain vanilla agency fixed rate and floating rate securities between July of 07 and today. An important point to note is that while the graph shows directionally where spreads have gone, we have done better, both because our debt funds below LIBOR and because we can concentrate our purchases in the specific products that provide the best risk adjusted returns.

From early March through mid May, Freddie Mac entered into approximately $100 billion new purchase commitments, including both fixed and floating rate agency mortgage securities. The purchases executed during March and April were done at average levels of about 90 basis points of agency OAS and initial GAAP NIM of about 150 basis points.

Since GAAP NIM does not reflect our long term funding cost or the cost of hedging interest rate risk, it is higher than the OAS. Based on the increased availability of capital and attractive opportunities, we expect to grow the portfolio significantly in 2008 and thus continue to support the liquidity and stability of the mortgage market.

Putting volume and price together, we estimate that the effect of new portfolio adds should be in the range of 40-50% revenue increase from net interest income in 2008 versus 2007. So to sum up, while house price declines have led to continued credit losses, the improvement in our underwriting standards, increased pricing of guarantee fees, growing retained portfolio purchases and significantly higher ROEs on new business give us confidence in the future return prospects for Freddie Mac.

The additional release of regulatory capital surplus announced today by our regulator and the issuance of $5.5 billion in securities will provide for flexibility and growth in our business. With that, I’ll turn it over to Dick.

Dick Syron

Thanks Patty. Well we’ve taken a lot of your time talking at you so I’ll try to be very quick. First, as far as the broad political and economic environment goes, I think the big picture is that more than at any time in at least since I’ve been here, the GSEs are understood to be a vital part in solving the nation’s housing crisis, affecting homeowners in the broader economy.

In this environment, we have sought to link the importance of our ability to attract shareholder capital with our ability to serve our vital housing mission. We are hopeful about the process and continue to support sound legislation going forward. Turning back to the business, we’ve tried to set forth a clearer picture for you.

It’s plain we’ve reduced our losses from the fourth quarter considerably, and with the benefit of our improved financial reporting, all you have to do is look under the hood to see that our 2008 book of business and going forward is on track to be much higher in quality, large in volumes, increasing in guarantee returns and wider in investment spreads.

Simply put, we are confident that the capital we are raising will enable us to both advance our mission and increase our returns to shareholders. So yes, our credit losses are increasing in this environment, but they are concentrated and we believe under any reasonable scenario, manageable and mitigated by attractive revenue growth going forward.

Thanks very much for your time.

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes from David Hochstim – Bear Stearns.

David Hochstim – Bear Stearns

Could someone talk about slide 26, just the reconciliation between GAAP net interest income and the adjusted net interest income and the changes in derivative expense and whether those are kind of onetime items related to market volatility or if those are recurring.

I guess I’m trying to understand the guidance about net interest income growth and I guess maybe that was GAAP net interest income, but how do we think about adjusted net interest income over the course of the year?

Buddy Piszel

You know one of the most difficult things we had in putting together the adjusted version of our earnings is trying to figure out how to look at our hedging activities and amortize that on a ratable basis with the emergence of the earnings that were being hedged. And we do a very detailed instrument by instrument transaction by transaction amortization process when we came out with this.

And we showed the last eight quarters, the process we used worked pretty well. And it looked like there was stability in it. Now in the first quarter, we found out for the first time it doesn’t work as well as we thought and so there is some disruption from the way that we’re amortizing the derivatives. But there’s a couple of real things going on too. So I mentioned the spread compression from the short assets versus the short liabilities, that also affected the AOI NIM.

Secondly, we are hedging, we ramped up commitments big in the first quarter and we started to take the loss on the carry on those hedges in the first quarter. That dampened the NIM on this schedule. And lastly, due to the way that we do hedges, some of the short term hedges that we entered into got pushed, the gains on those got pushed to the second quarter from the first.

So this is a little distorted compared to where we would expect it to be. If you look at it on a full year basis, it’ll recover close to where we were in the previous quarters and then it’ll start to grow as overall spreads improve and as the growth in the portfolio improves. So this is an anomaly for the quarter.

David Hochstim – Bear Stearns

Patty is there anything you can say about the capacity, the issue, large quantities of debt to fund the purchases that you see in the market now at very attractive spreads?

Patty Cook

Yes, one of the resilient aspects of being a GSE is the availability to funding. So if you look at our debt spreads and let’s look at the long end of the curve first and you look at ten year notes, there was a period where our ten year debt got to LIBOR plus 45. It was a short period of time and I’d say right now it goes back and forth, plus or minus LIBOR.

On the front end of the curve, our short term debt has continued to be placed at levels substantially below LIBOR, LIBOR minus 50 basis points. So we remain quite confident about our access to the debt market at levels that are attractive relative to LIBOR.

Operator

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

Howard Shapiro – Fox-Pitt

I wanted to ask a question on the mark to market volatility. Buddy I think you said there’s still some more to do in terms of adopting hedge accounting treatment and that it would further reduce the volatility. Can you just tell us where you are in the process, what more needs to be done and would that bring the kind of volatility range below the $1 billion you’ve been talking about or is that still what we should be looking.

Buddy Piszel

Two points, one is, by the end of the first quarter we had only been able to put on about $4 billion notional of hedge positions for accounting purposes. And we’ve increased that substantially. So I think as of right now, we’re sitting with north of $13 billion. So we’ve ramped that up and we need to continue to ramp that up because we’re growing the portfolio fairly substantially.

So I don’t think we’re going to get beyond $1 billion, I would still keep the $1 billion, but you can see as of the first quarter we were north of that. So that’s where I said we have more work to do.

Operator

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

Paul Miller – FBR Capital Markets

There’s a headline out there talking about Freddie Mac level three assets of $157 billion and I don’t see that in any of your releases. I was just wondering, is that true and where did that number come from? And is that related at all to the markup of the trading securities on page 4 of the $1.2 billion gain?

Buddy Piszel

No it’s not. We made a determination in the first quarter that given how wide, the pricing we were getting on the ABS portfolio, that it no longer made sense to leave that into level two. And so we essentially moved the entire ABS portfolio into level three. We are still using the mean price that we’re getting from the pricing services and the dealers, so we’re not using a model price, but that’s what all of that is. It has nothing to do with the trading portfolio.

Operator

Your next question comes from Brad Ball – Citi.

Brad Ball – Citi

On the ABS portfolio, slide 21, I wondered if you could spend a few minutes just describing what’s in there and if there’s any major changes versus the presentation in the first quarter. And what gives you confidence that there aren’t any permanent impairments in the subprime ABS?

Buddy Piszel

Our view of the subprime portfolio has not changed, so this does not reflect a deterioration or a change in our expectations. What I liked about this slide is it just reflects how well protected the subprime portfolio is. And if you look on the most right hand side, there’s a percentage of these securities that you cannot model a loss on. And then as you go across the page, you can see the level of defaults that you have to incur in order to penetrate the protection that’s there.

So we continue to do a very, very rigorous evaluation, security by security. Our expectations are that we are not going to have impairments in this portfolio without dramatic degradation of credit from where it is today. And we still feel pretty good. So, no changes at all in the way we think about things. We just thought this slide was helpful to sort of put this in perspective.

Brad Ball – Citi

On the capital raise, you said you’d look to do roughly half of the $5.5 billion in the straight preferred market, just roughing the numbers out, that probably means that your preferred to total capital would be approaching 40%. Is that a level at which the regulator or the agencies are comfortable, how do you feel about the preferred to total capital amount?

Buddy Piszel

We’re clearly at the very high end of where this should be on sort of a steady state basis. When we thought about what we were going to do, we certainly took that into consideration. W e did have discussions with the rating agencies and part of this is sort of what’s your plan to get back to the 25-30% range I think long term should be the way that we look at our capital structure.

And given earnings projections and the way we see things playing out, you’re in a two to three year period to get back to normal and we think that that’s reasonable given the period that we’re going through right now.

Operator

Your next question comes from Bob Napoli – Piper Jaffray.

Bob Napoli – Piper Jaffray

Question on delinquency trends within your portfolio, I think this is page 18 within the summary of selected financial information. If you look at the trend, obviously foreclosures are up dramatically and continued even in the first quarter to spike. But the delinquencies stabilized in the first quarter.

But seasonally credit quality tends to stabilize in the first quarter, you even had a decline in the Southwest and the increase in the West was a lot less than it was the prior quarter. Are you seeing signs overall that there is stabilization in credit? Obviously delinquencies have to slow before foreclosures slow, or is this a seasonal event?

Patty Cook

I would say that it’s a little early to say that we’re seeing stabilization in credit. I think the rapid rate of house price declines in the first quarter actually gave us reason to increase the lifetime expected default costs. Now how that emerged is quarter to quarter through our delinquencies, our severities and our charges offs is going to be a little different. But I think it’s too early to say that we’ve seen stabilization.

Bob Napoli – Piper Jaffray

How does April look versus March on the delinquency front for you guys and Mae to date?

Patty Cook

I don’t have good statistics at this point for the month of April that I can share on the call.

Bob Napoli – Piper Jaffray

Patty you had given an overview of what you thought was a reasonable worst case credit scenario and I was hoping you could kind of go through that.

Patty Cook

What I wanted to point out is, you know, we’ve tried to give guidance on what we think our total present value of future default costs is likely to be. So that would allow you to kind of look at current charge offs and put it in context of long term expectations. So that’s when I refer to a range of $15-$20 billion, trying to put in context what that means.

So the point would be this, if you were forecasting mid-teens reduction in house prices, we run that through a model, Monte Carlo simulation, so there’s downside and upside relative to that and what comes out of the model is an expected EDC number with certain defaults and certain severities.

My point is that when you use that model today, you’re getting default severities that are pretty high by historical standards, 4% defaults, 35% severities. So I’m just trying to put in context the connection between house prices, the resulting EDC number, the uncertainty around the measure and yet the confidence that we have the ability to manage to those level of defaults through the combination of capital and future growth in revenue.

Bob Napoli – Piper Jaffray

And if you translated that into your guidance for credit losses for 09 and to a worst case?

Patty Cook

They’re consistent. So the long term expectation of a $15-$20 billion range is consistent with the total credit losses as they’re emerging through GAAP, they’re connected.

Operator

Your next question comes from Fred Cannon – KBW.

Fred Cannon – KBW

I note that the deferred tax asset jumped by a little over $6 billion in the quarter and is now greater than the shareholder’s equity and I was wondering if a lot of that increase had to do with the growth in OCI and with that, what some of the other factors might have been. And also is there risk of needing to take a valuation allowance against that deferred tax asset given its size?

Buddy Piszel

You hit it, that the growth of it is related to taking, just think about it, the amount of marks that we’ve taken that were unrealized marks between 07 and we’ve continued to do it in 08, is really what’s driving the size of the deferred tax asset. So a couple points to make around that, first of all, we’ve represented on every call that we think that the marks are not representative of real, true, expected cash losses.

And so as things revert to normal, they will just naturally revert and you’ll be recovering that deferred tax assets. Secondly, even if you assume that they were all going to result in real losses, when you project out our taxable income, we have never had a year where we didn’t have taxable income and we do not project a year now where we don’t have taxable income. So between carry back and carry forward, there is no exposure to us not realizing our deferred tax asset.

Fred Cannon – KBW

On adjusted operating income, maybe just a clarification, you kind of restated that and you’re calling it total segment reporting income I believe now. And it swung from a positive in the fourth quarter to a negative in the first quarter and if I remember the investor day you kind of encouraged us to look at that metric as kind of a true representation of kind of what’s going on with the company.

I was wondering if we should, if some of the things that you’re talking about, should we back away from using that metric or is this kind of a onetime issue where it turned negative.

Buddy Piszel

I would say two things. First of all, we had to change the name because it’s gone through the SEC process, the SEC didn’t like adjusted operating income, so I have to stop using it and thank you for catching me on that. So it will be segment earnings going forward. Secondly, the only thing that’s a little off in AOI for this quarter is the anomaly that I spoke about earlier on the NIM. Other than that, it would be down in the first quarter because the provisioning is much higher.

So if you look at the GC business it actually looks the way we think is reasonable. The retained portfolio business is a little understated because we’ve surpassed the NIM recognition and multi-family looks about right. So I think it’s still a relevant and a good measure. It’ll make a little bit more sense after you get a couple quarters averaged together.

Operator

Your next question comes from Gary Gordon – Portales Partners.

Gary Gordon – Portales Partners

One, again on accounting, on page 3 you show mark to market loss of about $1.4 billion, back to the segment reporting it’s zero. So I’m wondering how the mark to markets work their way into the segment reporting.

Buddy Piszel

In the segment reporting, what we’re doing is we are not reporting marks but instead we’re reporting the cost of the derivative, the real cost of the hedging activity, amortizing against net interest income over the entire period. So it’s literally an instrument by instrument.

The real cost of hedging is being amortized to get against net interest income and the temporal marks are disregarded, because if you think about what we’re doing, we are economically hedging the portfolio and the right way for the earnings to emerge is to reflect hedging costs as your earnings emerge. And so it’s a different model, so you don’t have the same kind of bouncing around from derivative marks that you’ll see on our GAAP side.

Gary Gordon – Portales Partners

It sounds like the $1.4 billon of marks up front, some roughly reflect sort of accrual charges that you’re making in the segment reporting.

Buddy Piszel

There is included in the $1.3, there’s about $340 million of derivative carry and that is included in the segment reporting and additionally there is the carry from previously closed out hedges that we’re also running through.

Gary Gordon – Portales Partners

On your purchase for portfolio, I believe I heard you said you bought the bulk of your purchases for the year already, the $100 billion you talked about, is that accurate and then obviously there seems to be a correlation between your commitments and OAS spreads. Are, if you’re largely your way through your purchases, what potential impact does that have on OAS spreads.

Buddy Piszel

We’re not largely through but what we did is we started early. So we made $100 billion of purchases which is way above what we normally would have been purchasing on a monthly basis. So we’ve already sort of gotten into the portfolio, so we’ll start to generate the income faster. That does not mean we’re not going to continue to grow. So we’ve done a big deposit on the growth of the retained portfolio as we’ve said today and we’ll get the whole benefit of that in the second half of the year.

Patty Cook

Looking forward, we will continue to provide liquidity to the mortgage market as it needs it. And there’s a high correlation between wider spreads and the need for that liquidity. So our activity in the market is going to be correlated with your observation on wider spreads. And hopefully by virtue of that activity, as well as the market’s expectation for the continued activity, it provides good support in the secondary market for mortgage spreads.

Operator

Your next question comes from Moshe Orenbuch – Credit Suisse.

Moshe Orenbuch – Credit Suisse

Buddy you had alluded to the fact that you thought you were ahead of schedule on the SEC registration, can you kind of elaborate a little bit on that because the appendix that you put out showed that there still were some control areas that needed to be remediated, what has to be done between now and then? What’s the process going to look like?

Buddy Piszel

We said that we were targeting mid-year 08 to be a registrant. We have made a lot of progress with the SEC, they’ve given us their feedback, we’ve responded as to the changes we would be making related to our yearend disclosures. And we’re sort of just going through and completing the comment process.

So from that standpoint, we’re pretty close to the finish line on being able to finalize the feedback from the SEC and with that register. So we are ahead of schedule from that standpoint. As far as the outstanding control points, they’re really not a factor in becoming an SEC registrant. You can register with control issues. Now I will say, we’ve remediated all of the significant ones, so the material weaknesses are all remediated.

And having a handful of significant deficiencies, every single financial institution has a handful of significant deficiencies, we’re no different than anybody. I’d say in a lot of respects we probably have fewer than many companies. So that is no longer an issue and has really nothing to do with our registration time.

Moshe Orenbuch – Credit Suisse

So you would expect to have their comments back and be able to respond to them and re-file by June 30?

Buddy Piszel

We clearly should be in that position by the end of June, if not sooner.

Moshe Orenbuch – Credit Suisse

Could you just talk about the process for the capital raise? You’ve raised, at least preferred prior to being registered.

Buddy Piszel

The reason we would wait Moshe is you’d never want to be in a position where even though it’s unlikely, there could be something in resolving things with the SEC that you wouldn’t want to do a capital raise without finishing that process. And just from a risk to the franchise standpoint, we don’t want to raise capital unless our disclosures are pristine and completely supported by a thorough review by the SEC and we just think that makes good sense.

Operator

Your next question comes from Bruce Harting – Lehman.

Bruce Harting – Lehman

Buddy, had you said in the past that your target is to make this year’s provisioning your peak year and if you did say that, is that still the case?

Buddy Piszel

I think we did say that. When we looked at this originally I think we had 08 being the peak and 09 being a little less, but not a lot. With our increase in 08, it’s still by our own reckoning would be the peak but 09 goes up too. So it’s more that the hill got a little, it plateaud a little bit longer and then 010 is dramatically lower. So it’s really like two years of pretty heavy provisioning. But again given the expected revenue growth, we are in a very good position to be able to mange through that.

Bruce Harting – Lehman

And then the basis point guidance you’re giving [inaudible] specifically charge offs, does that include REO expense also and can you just segment the various credit costs and [inaudible] doesn’t include.

Buddy Piszel

It does include REO expense, what we call total credit costs. One thing I would say, if you look historically what the relationship between REO and charge offs, it’s a little aberrant in the first quarter because in the first quarter we adjusted, we took about a $115 million adjusted to our REO expense to catch up on the severities that we’re seeing based on the inventory. So it’s a little higher than normal, it’ll revert back to normal if you think about the full year guidance, and that ratio should be about right going forward.

Bruce Harting – Lehman

And then in terms of the excess capital decreases that are pending and the amount of capital you’re raising, let’s just say all else equal, you’re at about $14-$15 billion of excess capital by say September and it seems like the pro-cyclical nature at the bottom or at the worst part of the cycle, raising capital and building reserves.

Question would be, based on sort of the strong growth you’re targeting you still by my calculation, it only uses about maybe $3-$4 billion of capital over the next 12 months. So you’re still going to be in a very significant overcapitalization situation say by mid to late 09 you know as credit costs you know hopefully peak and start to come down.

And it seems like there’s other redundancies in terms of reserves, I know it’s early days to start thinking about how to deploy the redundancies, but you know by 2010 you know, what would likely give in terms of you know some of these reserve redundancies and excess capital or would you really just grow you way into the excess capital? Or you know are you thinking that some of the preferred might have a non-call two or three feature or that sort of thing, to, you know, thanks.

Buddy Piszel

We are deliberately putting ourselves in a very, very strong capital position. I think your observation is right, that even with the kind of growth that we’re anticipating, we’ll end the year in a very strong capital position. We are doing this capital raise to make sure that even if credit goes way worse than were currently expected, we’ve got the capital position to be able to sustain that.

You’re right also that once you get, if in fact things go the way we’re planning, at some point you can get back to a more rational capital structure. If we can grow our way, whether we can grow our way to absorb that depends on where the spread opportunities are.

And if they’re not there then over time we’re going to have to get our capital structure back in line and that’s the way we would look at it. But at this point I think we’re better off being in a very, very strong position than hoping for the best. So that’s the way we’re thinking about it.

Operator

Your next question comes from David Dusenbury – Dalton Greiner.

David Dusenbury – Dalton Greiner

On your direction in terms of house price decline and the impact on credit costs. Have you looked at the impact that rising LTVs have on projected credit costs? In other words as people get close to and then get underwater, the propensity for them to default, does that go up geometrically and is that captured in your numbers?

Patty Cook

Yes, clearly it is. And you know you’ve identified one of the key attributes if you will of the loans in 06 and 07 that are contributing to the higher defaults.

And as I think I mentioned in my prepared remarks, that has led us to do a couple of things, it’s to look hard at what the maximum TLTV is we’re willing to purchase and it also results in our raising delivery fees on that portion of the population. So it clearly is contributing to higher expected default costs, it is captured in our numbers and we have responded with both tightening of terms and raising of prices.

David Dusenbury – Dalton Greiner

What have you seen, just out of curiosity, is it in line with historical default rates as they get underwater or does it?

Patty Cook

No, it’s different. The rate of increase and defaults in that part of the population is much steeper. And if you think about it, I’d summarize it this way, for those borrowers that bought a home based on rapid house price appreciate as a way to grow wealth, if they find themselves quickly underwater, we’re even seeing it when we go and try and modify or renegotiate those loans, they’re walking away.

They’re finding it not constructive. So I do think the ramp in defaults for that portion of the population is steeper than historical observations and we are reflecting that in our expectations.

Operator

Your last question comes from Howard Shapiro – Fox-Pitt.

Howard Shapiro – Fox-Pitt

For Patty on the EDC discussion, I’m trying to understand, you’ve got to GO on the balance sheet right now as about $13 billion or so and I’m assuming that’s the expectation of future losses over time. But you’re saying kind of a base case in your Monte Carlo simulation is $15-$20 billion of losses. Is the GO reflecting a lower level of losses or am I misunderstanding the relationship?

Buddy Piszel

The GAAP base GO is not a reflection of expected credit losses. What you have to do is you want to get the market’s view of expected credit losses, you look to the fair value GO which I think is the number that Patty was referring to.

Patty Cook

And that number is closer to $30 billion.

Dick Syron

Thank you all very much, we appreciate your taking as much time as you have with us this morning. And if there are further questions you know how to pursue them with Ed Golding.

Edward Golding

Operator could you give us the replay number information.

Operator

This conference will be available for replay beginning today at 12:30 pm Eastern, running through May 28 at Midnight. The dial in numbers for the replay are 800-475-6701, international participants should dial 320-365-3844 with the access code of 919633.

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