Federal Home Loan Mortgage Corporation

Sharon McHale - Vice President-Corporate Communications and Marketing Don Layton - Chief Executive Officer Jim Mackey - Executive Vice President and Chief Financial Officer Bill McDavid - General Counsel

Joe Light - The Wall Street Journal Kate Berry - American Banker. John Prior - Politico

Good morning everyone, and thank you for joining us as we discuss Freddie Mac’s third quarter 2015 financial results. We’re joined today by the Company’s Chief Executive Officer, Don Layton; Chief Financial Officer, Jim Mackey; and General Counsel, Bill McDavid.

Before we begin, we would like to point out that during this call, Freddie Mac’s executives may make forward-looking statements, which are based upon a set of assumptions about the Company’s key business drivers and other factors. Changes in these factors could cause the Company’s actual results to vary materially from its expectation.

A description of these factors can be found in the Company’s 10-Q report filed this morning. As a company in conservative shift, Freddie Mac’s commentary will be limited to business and market topics.

As you know, we are not able to comment on the development of public policy or legislation concerning Freddie Mac. As a reminder, this is a call for the media and only they will have the ability to ask questions, this call is being recorded and a replay will be made available on Freddie Mac’s website later today.

With that, I will turn the call over to Don Layton, Chief Executive Officer at Freddie Mac.

Good morning and thank you for joining us for a discussion of our third quarter financial results. In the last several quarters, I have been reviewing our financial results with you and pointing out the large GAAP earnings volatility embedded in our businesses.

This volatility to remind you stems from our usage of derivatives to hedge interest rate risk and an accounting mismatch associated with that activity. This quarter showed a continuation of that volatility as the accounting mismatch produced a negative $1.5 billion GAAP impact on earnings which was enough to chip us into the comprehensive income loss of about $500 million for the quarter.

This morning I will go through the background of our earnings results. I will also discuss how business fundamentals were strong in terms of volumes, credit quality and our ongoing reduction of tax payer risk, and I will point out the market sensitivity of the company’s earnings to credit spreads which also contributed GAAP and economic losses, in this case they are the same of about $600 million.

I note that both of these markets sensitive items, the GAAP accounting for our hedging with derivatives, and the credit spread risk on our balance sheet were strongly positive for us in the second quarter and almost equal at offsetting amounts. By way of background, the large sequential quarterly volatility of our GAAP earnings reflects the strong volatility of the financial markets with very large moves in each quarter and interest rates in all the securities prices, albeit in opposite directions during the last two quarters.

And before getting to the specifics, I want to emphasize that this loss was only 28% of the allowed capital reserve of $1.8 billion there will therefore be no draw requested from the U.S. treasury.

Let me get to some specifics. First, I will go through more on the derivatives usage, second I will go into the business results and third I will cover the market sensitivity of our balance sheet to changes in fixed income credit spreads.

First up more on derivatives, we reported a net income loss of $475 million and a comprehensive income loss of $501 million in the third quarter. As a reminder, comprehensive income is the more important measure for us because it directly impacts our network and thus our dividend obligation to or draw request from treasury.

Again, this negative result was driven primarily by the difference of approximately $1.5 billion between GAAP accounting and the underlying economics associated with our usage of derivatives. If you listen to these calls in past quarters you know that we currently prefer a mix of derivatives, and shorter term debt to fund much of the investment portfolio we hold and we also utilize derivatives to more broadly hedge our interest rate risk.

Our primary reason for this strategy is that economically this is a much less costly method of funding our balance sheet and of hedging our risk. In addition, this strategy provides us with much more flexibility in the future as it enables us to avoid the potentially large cost that can result from selling assets as the investment portfolio as we are directed to do by the FHFA.

We being the turn [ph] debt used to match fund those assets still outstanding, something commonly known as stranded debt. That said, utilizing a derivatives hedging strategy can result in GAAP accounting volatility even though the economics makes prudent business sets.

That’s because we fair value or mark-to-market the derivatives but we do not fair value all of the assets being hedged and the accounting mismatch. As a broad generalization, we will have an accounting loss if rates decline and a gain if rates increase.

In the last two quarters there were very large quarterly movements of interest rates in opposite directions. For example, 10-year LIBOR increased by 42 basis points in the second quarter and fell by 44 basis points in the third quarter, hence the $1.5 billion loss in Q3 following a $1.5 billion gain in Q2.

An issue that has existed for some time now but has been highlighted by our results this quarter is how to deal with this earnings volatility as the allowed capital reserve in the preferred stock purchase agreement or PSPA that’s the support agreement from treasury declined to zero in 2018. Simply put, we monitor this exposure and we’ll be monitoring it more tightly in the future as is appropriate as the capital reserve itself becomes tighter and declines.

Our core decision making at the company will be based primarily on economic returns, however we also consider many other factors including GAAP earnings duplications [ph] and we may take actions that will reduce the risk of a drop from treasury as the capital reserves decline. It is clear however that regardless of any actions we do or do not take with respect to derivatives you searched [ph] or other such transactions the decline of the capital reserve to zero creates real risk of our needing a draw.

At the very lease this risk is significant if the U.S. economy were to enter another recession and national home prices commensurately decline.

Moving on now to the second topic, our business results. Net interest income was robust again this quarter at $3.7 billion with single-family guarantee income a growing revenue source for the company.

Guarantee income is now about 40% of our net interest income, helping to offset the decline in net interest income resulting from the government mandated shrinkage of the retained portfolio. Our improved business fundamentals are driving these results.

In the Single-family business this reflects a strong post 2008 book of business, which is now 65% of the single-family portfolio with an additional 18% of HARP and other relief refinance loans as well as generally growing business volumes. In fact, year-to-date single-family purchase volumes are up nearly 50% compared to a year ago.

Multi-family purchase volumes are also way up, year-to-date they are more than double what they were during the same period last year. Our overall credit risk profile also continues to improve, but single-family series delinquency rate is at the lowest level since late 2008, and multi-family rates are near zero.

In addition, less liquid assets are down 42% from the end of 2012 further reducing credit risk. And now the third topic affecting our results credit spreads which like interest rates are volatile quarter-to-quarter.

I first note that credit spreads sensitivity is inherent in the company’s business model. This quarter we saw a very large increase in credit spreads on our fair value assets or mark-to-market assets.

The result was an approximately $600 million after tax loss which partially offset our strong business fundamentals. Last quarter’s credit spreads tightened, we have mirror [ph] benefit in the opposite direction of a similar magnitude it was a $700 million gain.

All in all, despite strong adverse market moves our net loss was only a fraction that’s the 28% I previously mentioned of what would be needed to cause a draw and we therefore ended the quarter with a positive net worth of $1.3 billion. I will also note that we continued to be profitable year-to-date earnings $4.2 billion and returning $4.7 billion to tax payers through dividends.

Finally, as I mentioned earlier, we are obviously not required to pay treasury and dividend based on the quarter’s results so total dividends cumulatively paid still stands at $96.5 billion, $25 billion more than we have received. Now let me turn to our progress outside of the strict financial statements results.

In our efforts to build the better Freddie Mac and a better housing finance system, one that benefits families, our customers and the U.S. tax payer.

In the third quarter, we continued to deliver on our charter mission by making Home Possible for more than 600,000 families and helping another 22,000 family avoid foreclosure. One of the ways we're doing more is through the 97% LTV product that we introduced in the first quarter which is exceeding our targeted expectation.

We continue to work on ways to responsibly increase access to this mortgage. We're also on track to manage our best year financing mortgages for first time home buyers since the crisis.

On the multifamily side, we are funding record levels of affordable rentals. Earlier this year we funded $34 billion in rentals, the vast majority of which are affordable to families at or below the area of median income; exceeding the previous record of $29 billion in all of 2012.

The momentum is strong in the multifamily business and we're growing all multifamily market segments. We're proud to have reached two different $1 billion milestones in providing affordable housing for working families, first, to our small balance loan program and second to our manufactured housing community loans.

In terms of our single family lender customers, we've stepped up our efforts and help them grow their business as lenders and lower their cost. A primary focus of these efforts is working to meet the needs of a fuller range of such lender customers.

Increasingly, families are obtaining mortgage loans from smaller and middle size lenders. About 50% of our business is now with these lenders compared to just 16%, 1-6, yes that is one-third of this level before the financial crisis.

Another important way we're working to do better for our lender customers is through technology. We aim to give our customers greater certainty and confidence about the loans they're selling to us, and hopefully lower their cost of producing and selling us good quality and well manufactured loans.

This is being done through our just announced Loan Advisory Suite of smarter, more efficient systems applications for them. We're competing aggressively for our customers business and they are noticing.

In fact, overall customer satisfaction increased significantly for the second year running and it now is equalling the levels of satisfaction delivered by top performing companies of all types including large financial institutions. Finally, before I open up for questions, let me make a few points about our work to shift risk away from tax payers.

The most important and innovative way we're doing this is through our pioneering credit risk sharing programs. To date, through our single family risk transfer structures, we're shifting a significant amount of risk to our new business flows to investors in the capital markets.

In the single family business we are now selling off the clear majority of non-catastrophic risk and -- new mortgages. Depending upon how you measure it, there is no standard way.

You could argue we are already shedding between two-thirds and three quarters of that non-catastrophic loss risk already. We continue to evolve our single family credit risk program during the third quarter.

We modified our STACR, that's our brand name for our offerings, offering to transfer even more risk by fully transitioning to an actual loss instead of fixed or varied structure. And we also introduced the first senior subordinate structure offerings which we called WLS, the Whole Loan Security.

We were also in-track to have another record year of – another year of record issuance in our well-known Multifamily K-Deal program. More than 90% of multifamily mortgage is purchased in the third quarter are being processed for securitization to K-Deals, which lays off the vast majority of the expected credit risk to investors.

On the opposite spectrum, we're also focused on actively reducing legacy risk by taking advantage of the strong market for impaired mortgage asset. We sold another $4.1 billion of less liquid assets during the third quarter including approximately $640 million in NPL non-performing loans sales.

Underlying all these efforts is our work with FHFA to modernize and upgrade the mortgage market. Together with them, we continue to effect positive meaning change that is making the industry more stable and lowering the cost of housing for both owners and renters.

With that, let me wrap up by saying that we continue to make significant progress this quarter towards our goal building a better Freddie Mac and a better housing finance system, which is clearly evidence in our strong and improving business fundamentals. I'll now open it up for your questions, Sharon.

Thank you, Wes [ph]. I'll turn it over to you.

Good morning. Thanks for taking the question.

Yes. Maybe this is a pretty straightforward one.

Can you walk through what happened in the event that you had a loss driven by these derivative issues a few years from now when you – I guess what caused your network to swing negative? I mean, is it a simple as you need a bail out and you get money from the treasury department.

Or how would that work?

All right, you thrown the few things in there, Joe, and I'll try to answer it with non-incendiary language despite you have been thrown it in there. First of all, we are paid to be intelligent managers of the Company.

We'll not necessarily do exactly the same things when the capital reserve allowing the PSPA shrinks. We will manage somewhat differently possibly.

We do stress scenarios and how much this derivative – you grow this derivative stuff something like that. How much the derivative mismatch accounting can impact us?

And those stress scenarios show that while it could have put us into a loss which it did. There was a lot of cushion between that and what would cause a draw which was true this quarter also with the $1.3 billion remaining cushion.

That's an after tax numbers, so $2 billion pretax. So, we will be managing more tightly and we'll consider potential for draw and how we run things.

I also note that the need for derivatives will peak and shrink because it is tied to – a lot of this tied to funding the investment portfolio which we have mandated also to shrink. So do not assume the risk profile will be same in the future when the capital reserve allowed a small versus now when it's much larger.

As matter of mechanics, if we have a negative than we will draw under the PSPA and that's the way this whole system works.

Great. How much of a kind of economic – I guess, how much economic benefit would you lose if you started having to use I guess hedges interest risk with instruments that provide more of a – they don't cause these accounting problems?

Yes. That is not a number in our 10-Q disclosure, so I can't give number.

I'll say that it’s a large number. We're not doing this for something small.

Got it. Thanks.

Hi, Don. You mentioned that the 97% product is exceeding your targeted expectation.

Can you release – do you release numbers on the amount of the product of loans that you're doing that are 97%?

No, I do not believe. We publicly released and we do report them to the FHFA as our conservator and regulator.

But I will note as we said when we introduced the product it is very targeted, and so the percentage of the new loan flow that is canoed for this is well below any welcome to reality for reporting.

Okay.

Thanks, Don. FHFA has said in a report this week that you missed the couple of housing goals.

I know it was a preliminary report. But are you considering any changes to address these problems considering that you miss the goals in 2014 as well?

Yes, there are if you add up, I’m going through memory here, I believe between single-family, multi-family there are 10 separate goals and I believe we made 8 of them and missed two, [Indiscernible] in both years I believe. So, we’ve made the best majority of the goals but not all of them.

The two we missed are in single-family and in terms of your question your tense is wrong, it’s not a question of what will we do we recognize this issue started sometime ago and we have set up a new unit, we recruited and experienced outside with a great deal of experience in affordable housing, working both for non-profits and for vendors to head it he’s been hiring much of this year and he has wrapped the partnerships going with various non-profits and such. So the answer is we’re putting a reasonably full quarter press on this and given the normal lags between starting and results we’re kind of in the middle right now, but this is not just something starting now, we started quite a while ago.

Okay. Thank you.

Yes. Thank you for joining us.

I hope our explanation of what went on in our financials was clear, since it’s hard to understand sometimes. And that you understand also that the underlying business fundamentals were going quite well especially in terms of volumes and dramatically improving credit quality in the single-family business.

On that note, thank you and have a nice day.