Federal Home Loan Mortgage Corporation PFD 5.1% SAL

Sharon McHale - Corporate Communications and Marketing VP Don Layton - CEO Jim Mackey - CFO Bill McDavid - General Counsel

Joe Light - Bloomberg News Denny Gulino - Market News International Laura Kusisto - Wall Street Journal Brena Swanson - HousingWire

Thank you. Good morning, everyone, and thank you for joining us for a discussion of Freddie Mac’s third quarter 2016 financial results.

We are joined today by the company's Chief Executive Officer, Don Layton; Chief Financial Officer, Jim Mackey; and our General Counsel, Bill McDavid. Before we begin, we’d 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 expectations. A description of these factors can be found in the company’s 10-Q report filed today and its annual report 10-K.

Freddie Mac’s executives may also discuss non-GAAP financial measure. For more information about these measures, please see our earnings press release and related materials which are posted on the Investor Relations section of our website at freddiemac.com.

Our commentary today 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 ask that this call not be rebroadcasted or transcribed. As a reminder, this is a call for the media and only they can ask questions.

This call is being recorded and a replay will be made available on Freddie Mac’s website shortly. We ask that this call not be again recorded or rebroadcast.

With that, I'll now turn the call over to Don Layton, Chief Executive Officer of Freddie Mac.

Good morning. And thank you for joining us.

Today as I've done in previous quarters, I'm going to discuss two things. First I'll start with an overview of our financial results, then I'll highlight our progress in becoming a more competitive company, but first I would like to make a quick observation.

It was another very solid quarter for Freddie Mac both in terms of financial results and business results. By almost every measure we're a stronger and more competitive company than ever before.

Business volumes are robust, credit quality is good and improving and legacy risk continues to decline. In 2015 we had already shifted to being mostly focused on the future and moving the company forward with efforts to address legacy issues becoming modest overall.

This has been even more pronounced in 2016 as we've continued to step up our game, strengthening our relationships with customers, running a better operating company and finding even more ways to support the market, reduce taxpayer exposure to our risk and responsibly provide broader access to credit by borrowers. Importantly this work is not only building a stronger Freddie Mac for today and the future, but it's also building a better U.S.

housing finance system for working families. Let me now turn to our financial results.

This morning we reported that GAAP net income and comprehensive income were both $2.3 billion for the third quarter. These results reflect our strong and improving business fundamentals, coupled with continued market related volatility, which moved in our favor this quarter.

Specifically the downward movement in credit spreads had a positive impact on our third-quarter results producing a $700 million after-tax gain, primarily in PLS and multifamily markets. By comparison the credit spread impact was negligible in the second quarter.

This quarter the impact from interest rates was near zero whereby contrast last quarter it reduced comprehensive income by $400 million. While rates increase and we typically benefit from rising long-term interest rates, this positive impact was offset by a flattening of the yield curve for short-term interest rates rose more than long-term rate.

I know these types of interest rate impacts are due to accounting asymmetries rather than real economic gain or loss. Last quarter we began to provide certain financial measures on an adjusted basis.

As a reminder those are the non-GAAP measures we make available in addition to our GAAP results. We use these adjusted measures to better understand internally and to explain externally how we generate revenues.

We do not adjust either net or comprehensive income. On a GAAP basis, we reported net interest income of $3.6 billion.

This includes the spread earned from the investments in our balance sheet. It also includes the guarantee fees earned by the single-family business, but excludes multifamily guarantee fees which are recorded separately as other noninterest income.

Our adjusted figures realign these GAAP revenue results to clearly delineate revenues generated from the balance sheet investing activities versus revenues generated from both mortgage credit guarantee businesses. We believe this treatment increases the transparency of how our activities generate revenue.

Adjusted guarantee fee income was up nearly 10% from the second quarter to $1.8 billion. This increase was primarily due to the accelerated recognition of deferred fees with single-family refinance activity was up this quarter.

I will also note that our guarantee fees will have a bias to continue to increase over the long run as the older vintages in the portfolio run off and are replaced by newer vintages that carry higher level of guarantee fees. On the other hand, our adjusted net interest income was roughly $800 million, a decline of $100 million from the second quarter.

This decline continues to partially reflect the mandated reduction of our retain portfolio, which shrank by nearly $13 billion during the quarter. It also reflects some additional cost this quarter to hedge our interest-rate risk, in particular mortgage prepayment risk and please remember as background, we manage our interest-rate risk exposure to a low level on an economic basis according to our models.

Together our continued strong performance is enabling us to return another $2.3 million to taxpayers, which will bring the total cumulative cash payments to the U.S. treasury to more than $100 billion, $30 billion more than we have received.

Under the preferred stock purchase agreement with U.S. Treasury, we have over $100 billion of funding remaining, over $140 billion of funding remaining.

This is more than 2.5 times the losses under the severely adverse stress scenario specified by the most recent regulatory mandated stress test, which were published in August. So we would have ample available capital even under such a severely negative scenario.

This is important for us to preserve top-notch capital market access. In addition this coming January, the capital buffer allowed by the agreement is scheduled to decline to $600 million from its current $1.2 billion level.

This is relevant to whether we would have drawn that $140 billion remaining funding under the agreement, which would naturally come under significant scrutiny. So we continue to focus on reducing the likelihood of such a future draw from treasury and have taken some actions to date which are helping reduce our GAAP sensitivity and may take further ones.

Now let's switch gears and talk about our progress in building a better and more competitive Freddie Mac. I'll start with the single-family business.

Purchase volumes were very strong again this quarter up nearly 30% to $116 billion from the second quarter. In fact researching refi volume driven by post Brexit declines and mortgage rates, help to make it our biggest quarter since late 2013.

Our economist also say that the industry is on track to have the best year in home sales in a decade. These new loans are strong and profitable.

The series delinquency rate on loans made since the financial crisis is 19 basis points, which reflect quality underwriting, plus the important tailwind of rising house prices since 2009. The serious delinquency rate on our entire single-family mortgage book inclusive of pre-2009 loans is down 30 basis points since the beginning of the year and just a little over 1% is at the lowest level in eight years that is from just before conservatorship.

Our core new book of business is now 71% of our portfolio and HARP and other relief refi loans make up an additional 16%. Continuous innovation is a primary focus for us and there is no better example of this than our loan advisor suite platform of technology tools, whose tools that are not only simplifying the loan manufacturing process, but most importantly reducing costs for our customers.

By the spring of 2017, we will have introduced new capabilities to the loan advisor suite, which will ultimately benefit increasing numbers of potential borrowers. These include a no-cost automated alternative type appraisal, automated borrower income verification, automated borrower asset verification and automated assessment of borrowers with tough credit scores.

In addition to these cost reducing enhancements, automated relief from many representation warranty requirements will also be available early next year. Together these capabilities mark a significant transformation in how users of loan advisor suite originate loans.

Ultimately as adoption of the tools continues and we've made great progress to date, lenders will be able to make more loans to qualified borrowers. Of course innovation does not stop with our customers or technology, but also extends to how we manage the risk on the loans we purchase.

Thanks to the growing number and types of credit risk transactions we have now executed, 46% of the current UPB of our entire post-crisis single-family book carries credit protection, that's up from 39% at the end of the year -- end of last year. Such credit risk transfer continues to transform how the residential housing market is funded and is becoming a permanent fixture in the fixed income market.

At the end of the third quarter we had transferred a significant portion of risk on more than $570 billion of single-family mortgages since 2013, providing $23 billion of lost coverage for taxpayers. And finally I want to mention the significant progress we're making in the single-family business against one of our core objectives, responsibly broadening access to credit.

For us this is not an add-on, but an integral part of our business and another area where we are innovating. For example we have a growing number of test-and-learn pilots underway with selected customers and industry partners to help develop responsible ways to broaden access to credit.

We previously announced partnerships with Quicken and separately with the joint venture of Bank of America and the Credit Union Self-Help. This quarter we launched the third pilot with new American funding and also with Alterra Home Loans, which involves working to develop a better process to underwrite mortgages for potential borrowers who work in the cash-only economy, a clearly nontraditional and underserved market.

More broadly our loan down payment mortgage program called Home Possible continues to grow and is serving first time at low and moderate income borrowers as intended with the majority of these loans going to first-time homebuyers and borrowers at or below 80% of the area median income. So far the credit quality of this portfolio is performing satisfactorily.

Let me now turn to our multifamily business, the fundamentals of this business continue to be very, very strong with high demand and quality credits and we are providing a reliable flow of capital to multifamily markets. As of the end of the third quarter, our 2016 multifamily purchase volume was $39 billion, an increase of 15% over the same period last year, which as you may recall was record-breaking.

Our multifamily portfolio performance remains solid as we have maintained a delinquency rate near zero. The affordable segment is Freddie Mac's multi-family sweet spot with close to 90% of the eligible apartments we are financing being affordable to families earning at or below the area median income.

And just as we're doing in our single-family business, we're innovating to provide new options and lower cost for our customers. To that end, we launched a Green Advantage program is third quarter, a suite of financing options to promote energy-efficient rental properties, while supporting rental housing affordability.

This helps our customers reduce their operating costs while also helping working families to be able to better afford quality rental housing, inclusive of the cost of their utility bills. In fact we did an interesting study of our multifamily loans last year.

It showed that if utility costs were lowered by 10% in all rental units, than 10% more apartments would be affordable to renting families who make at the 50% of the area median income. We're hoping to make this access to credit reality through our Green Advantage program and that's on top of the positive impact of the environment.

We're also growing our small balanced loan program, which funds smaller apartment properties. So far this year, we've funded almost $3 billion on more than 1,200 properties, which represent more than 50,000 apartments, more than in all of 2015.

Such smaller apartment properties make up about a third of the total rental market. Importantly, we're funding all this business at very little risk to the tax payer through our through our K-Deal program and we continue to lead the industry in multifamily securitization and credit risk transfer.

In the seven years since we debuted K-Deal we have transferred a very significant portion of mortgage credit risk on about $165 billion in UPB of multifamily loans. We have never realized any credit losses on our K-Deal guarantees.

I’ll make a few points about our investment business before I wrap up. We continue to make progress in actively reducing the less liquid assets in our portfolio in the third quarter, almost all of which are also impaired.

We sold another $3.3 billion of single-family non-agency securities that is PLS, bringing that balance down another 16% to $17 billion. To put that $17 billion into context in 2013 we had nearly $65 billion in such securities, almost four times as much.

We also reduced our liquid assets through nonperforming loan sales. During the quarter, we introduced our first multiservice or NPL sale, which gives us more flexibility in our program.

Since 2013 we sold $6 billion in NPL’s including $600 million in the third quarter of this year. I know all this year sales include requirements to include borrower outcomes and stabilize communities as specified by the FHFA.

Absent these sales, our single-family delinquency rate would have been 1.18%, 16 basis points higher than it was. This is a significant difference.

On in, as I said it beginning of these remarks it was a very good quarter for Freddie Mac in both the financial and on business fronts. Let me now end with that note and open it up to your questions.

Good morning. Thanks for taking the question.

I was wondering if you could talk a little bit more about the provision for credit losses. As you guys said it had to do both with classifying fewer seriously delinquent single-family loans from held-for-investment to held-for-sale, but also that you changed your modeled estimate for the probability of default.

Can you talk a little bit more about that second part and whether that reflects any concerns that the cycle is starting to turn or anything like that?

I'm actually going to turn that over to Jim Mackie, our CFO.

Yes, nothing we're seeing in our portfolio at all. We're certainly seeing other asset classes and another institution see a modest pickup in delinquencies.

So we took that into account when we set out reserve levels for this quarter. So again nothing specific to our portfolio, but it does appear that changes in delinquencies and other asset classes could be a precursor to some delinquency changes in mortgages.

Thank you.

Hi, thanks. Could you just explain, probably routine but the -- what was the $4 billion turnaround in the derivatives portfolio?

Are you referring to the income statement effect that line -- the loan derivatives?

Right.

Okay. As you recall from my remarks and for the last several quarters we tried to keep our interest rate risk here very low as best we can estimate by our models.

That is a combination of using of having assets in the balance sheet, liabilities to fund those assets and we use derivatives to help manage the net interest income lower. The accounting asymmetries we're talking about is that the derivatives are fair valued also not as mark-to-market.

Some of the assets are also fair valued also not as mark-to-market. Some of the assets are also fair valued but not as much.

So economically they offset, but there's an accounting asymmetry that some of the fair value derivatives help offset the instate risk of assets, which are not fair valued. So all you're seeing there is the impact on the accounting of interest rates moving up or down with the shape of the yield curve on our derivatives and that's all what's going on there.

It's like one hand clapping, you don't see the other side in that line.

Got you. Thanks.

Hi. So, I was just going to ask you said you saw a 15% increase in multi-family volume.

There is certainly some evidence of that market being somewhat oversupplied. You said your delinquency rates are still very low.

Are you concerned about that going into the next few quarters at all?

Okay. The multifamily market fundamentals have been very good for quite some time.

This shows up in the average rent going up strongly over several years. This shows up in vacancy rates having been very low and it's become therefore a good asset class for investors and so there are more properties being built.

What we see in the market is not negative trends but just less strong good trend. Rents are still up, but not as higher percentage.

Vacancy rates have generally flattened out. So we see the market doing fine just not anywhere as strong as it had been.

We have if you look at the -- some total of new housing in this country being produced single-family and multifamily because you can't divorce them. It is still very much under levels that the population and household formation would say is stable i.e.

it's never fully recovered. Single family is still well behind.

Multifamily is just catching up, but all that single-family unused demand that cannot be met with housing means more people are renting. So we're pretty comfortable in the market but say its decompressing a strong soft landing pattern, whatever phrase you would like.

But we don't see any particular negatives yet.

Thank you.

Hi good morning. Thanks for the call.

I just wanted to clarify, last quarter you guys weren't able to talk about the low down payment products because they weren't exactly driving an increase. Are you able to speak anymore to that this quarter now that you have another quarter of data to go off of?

What I can tell you consistent with our quarterly SEC disclosures, which we filed I guess today is that you're talking about 97% product called Home Possible, it is growing rapidly but is from very small numbers and we don't disclose the numbers specifically.

All right. Thank you.

Thanks again. Just if you have a moment for Mr.

Mackey to just talk a little bit more about these precursors you see in some other institutions, what's the general factors that would contribute to some deterioration down the road for anybody, not just Freddie?

The economic environment, unemployment rate, home prices all the typical things basically your models look at past history and extrapolate future performance and so if you've been in a period of good performance, the models are necessarily going to pick up future performance and that's why you apply judgment to your reserve level. So what we’ve done this quarter is we've booked at other asset classes and what they're doing and typically you start to see, in credit cards or autos and loan sectors like that tend to see changes in delinquency rates before you see it in mortgages.

So nothing specific, but more judgmental about where delinquency rates may go in the future.

Got you. Thanks.

Again thank you for joining us this morning. The year is wrapping up nicely and we continue to feel good about our progress and momentum going into 2017 and we'll talk you again in three months.

Good morning.