Federal Home Loan Mortgage Corporation PFD 5.1% SAL

Jeffrey Markowitz - SVP, External Relations and Corporate Communications Donald H. Layton - CEO James G.

MacKey - EVP and CFO William McDavid - EVP, General Counsel, and Corporate Secretary

Good morning everyone and thank you for joining us for a discussion of Freddie Mac’s second quarter 2018 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’d like to point out that during the call, Freddie Mac’s executives may make forward-looking statements, which are based upon the expectations about the company’s key business drivers. These expectations involve a number of assumptions, judgments, estimates, 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 quarterly report on Form 10-Q and the company's earnings results press release and financial supplement included in the company's Form 8-K filed today.

Freddie Mac’s executives may also discuss non-GAAP financial measures. For more information about these measures, please see our Form 8-K with our earnings results press release and financial supplement and our Form 10-Q for the second quarter of 2018 which are available on the Investor Relations page of our website at freddiemac.com/investors and the SECs website at www.sec.gov.

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 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 rebroadcasted or transcribed. With that, I will now turn the call over to Don Layton, Freddie Mac’s CEO.

Good morning. We always look forward to reviewing our results with you and answering your questions after my prepared remarks.

The second quarter was another very good quarter for Freddie Mac. Our net income was $2.5 billion and our comprehensive income which is the number we are most focused on while on conservatorship was $2.4 billion.

This included a $264 million after tax gain from a good outcome in litigation involving certain non-agency mortgage related securities. Our quarter reflects a combination of strong business results and specific strategies to transform these operating results into strong and stable financial performance.

This quarter my comments will mostly focus on the latter topic, that is how we are building a franchise that produces strong and stable financial results from the underlying operating performance of our guarantee businesses. To start let me say that there are three broad themes that are the pillars of building a long-term track record of such strong and stable financial performance.

First, good stability of our earnings, both tactical as markets are volatile and strategic as we face the mortgage business cycle. Second, building a strong credit quality addressing both legacy and ongoing risk management strategies.

And third, the fundamental new business model we have built in conservatorship based upon distributing credit risk away from our balance sheet by attracting diverse and attractively priced sources of credit risk taking private capital. This is key to producing strong results as I will explain later.

Our growing track record of strong and stable financial performance is producing in turn a solid foundation upon which we can further prioritize our mission, our customers, and innovation to create a better Freddie Mac and a better housing finance system. So first up is good earning stability.

Last quarter I spoke to you about the increasing stability of our earnings. That stability is no accident.

It is the result of conscious decisions we have made in all three lines of business and at the corporate level. We pursue subject at two levels, first tactical where earnings can move significantly based upon fair value accounting for market sensitive aspects of our business.

And second strategic since our earnings are very much exposed to the mortgage credit cycle. On the tactical side this speaks to actions that include one, managing our interest rate risk to low levels on an economic basis; two, using hedge accounting so that this low economic risk exposure translates into relatively modest GAAP earnings volatility; three, officially disposing of legacy assets that have significant credit spread risk.

That's mainly our portfolio of private label mortgage securities now down to just $3 billion which is 98%, it's 98 below its peak. And four, modifying some business practices and engaging in some limited types of hedging to keep the spread risk including those subject to fair value accounting at appropriate levels.

While our earnings will always be sensitive to fluctuation and market conditions especially given the fair value accounting, we're now developing a track record containing the net impact of these fluctuations to modest levels. Over the last six quarters for example the net impact has averaged $125 million after tax.

On a strategic basis we've faced the mortgage credit cycle full on given our model line charter and mission. But we have most assuredly learned from the financial crisis.

We began years ago to emphasize credit risk transfer as a core part of our business model. First in multifamily starting in 2009 with the advent of the modern KPO and then in single family starting in 2013 with the first stack of bond issuance.

And to put it bluntly we have pioneered almost every aspect of GSE CRT. To date the objective of using CRT has mostly been through [indiscernible] for model capital required under the conservatorship capital framework which I would simply call CCF capital required which is in turn tied to a severe adverse stress scenario, more about that later.

But we are now also beginning to ramp up using CRT to reduce our exposure to credit losses in more routine markets. I will also discuss this topic in more detail a bit later.

Moreover with CECL approaching that is the new FASB current expected credit loss, CECL accounting would be implemented in 2020, credit provisions would become work market sensitive each quarter. As a result our efforts to reduce exposure to credit risk in routine markets via CRT will become particularly valuable to address this new source of potential GAAP earnings and stability.

The second pillar of our financial results is delivering strong credit quality. Our credit quality today is strong in both our mortgage businesses.

This is a testament to a combination of factors all moving in the same positive direction that is specific business decisions we have made related to responsible lending and also to distributing credit risk to private investors along with a very favorable housing market these last several years. I note that the favorable housing market itself reflects a strong economy with the low unemployment rate as one measure.

It also reflects a strong housing market with limited production of new homes among other factors has lead to steady gains in housing prices on a nationwide average basis ever since the bottom was reached in 23011. On the business side we have been aggressive in first officially reducing legacy single family assets which still contribute significantly to our credit risk exposure profile.

Second, laying off credit risk versus CRT, and third running an appropriate responsible post crisis credit box. In single family that credit box as a reminder is designed to deliver the consumer equivalent of investment grade credit risk results.

Turning to our mortgage businesses let me start with multifamily. This business has a fabulous track record of low credit losses.

This quarter delinquency rates are down to just one basis point along with currently zero real estate owned properties. This reflects not just the strong rental market which is indeed quite strong but also superior underwriting along with a business model where that underwriting is not delegated.

It is the apartment house equivalent of kicking the tires with our own feet. And on top of this multifamily transfer is about 90% of the credit risk on almost all new purchases as measured by a reduction of CCF capital required.

This reduces our earnings exposure to losses even more and almost all of these multifamily risk transfers include credit loss protection starting from first dollar loss. The single family business is naturally similarly focused on delivering strong credit quality.

First, in terms of legacy asset disposition the real challenge has been to develop several different transaction structures to cost effectively reduce our exposure to legacy single family credit risk assets which are indeed still significant. For example we were the first GSE to sell non-performing loans, the first to execute a senior subordinate structure to reduce credit risk on weak performing loans and so on.

In fact such legacy type assets are now down to only 33% of our mortgage related investments portfolio versus 58% just five years ago. We regard this as a great success.

Second, we have a strong responsible post 2008 credit box. It is as I've already said designed to be the consumer equivalent of investment grade, a term from the corporate bond markets.

It's all very carefully monitored as to various measurements of potential loss statistics for example. For single family to date credit restraints were around the guarantee book as this is almost exclusively driven by the economics of reducing CCF capital required.

I remind everyone that the biggest cost component of the G fee, the guarantee fee is indeed the cost of capital. So this prioritization was totally appropriate.

We have more recently begun to test drive CRT transactions that also transfer losses in more normal markets rather than just severe stress ones. We are in consultation now with the FHFA about expanding this program.

As a result our serious delinquency rate in single family is now down to 0.82%, the lowest since 2008 despite the hurricane losses of 2017. On the post legacy book it is just 0.25% reflecting our investment grade center credit box combined with strong house price appreciation since 2011.

We also then use CRT to additionally reduce our credit risk on new flow business. Again as measured by CCF capital required by about 60%, part of CRT innovations in the pipeline should increase that percentage.

I do want to state as a major mortgage market participant that credit risks are long due to among other things the underlying failure of the marketplace to produce enough new living units versus historic norms and current demand. Whether they are standalone or multiunit dwellings, whether they are owned or rented.

This shortage creates upward pressure for both house prices and rents, both of which are good for credit quality in our business. But for the country and the economy overall it is not a good after a point.

In addition this shortage is felt most acutely at the lower price points which speaks to affordability. So I worry that we are at a rate of house price appreciation that may be above a good equilibrium and sustainable level due to the shortage of production.

Freddie Mac as a guarantor is doing what it can to help address this problem. For example by purchasing certain types of multifamily loans tied to rehabilitation and refurbishment but we can only work at the margins by the nature of our charter.

Still a broader response is needed and I look forward to policymakers successfully addressing the issue hopefully in the not too distant future. The third pillar that supports our financial results is the new business model we have built based upon credit risk transfer which we have pioneered.

If you look back historically you will see this is in many ways an extrapolation of the prior GSE business model evolution where the pass through security was developed in 1971 to move interest rate risk and liquidity risk away from GSE balance sheets and to the capital markets. CRT now extends this concept to credit risk.

The result is a solution that has transformed our business and is changing the away a significant portion of the U.S. housing market is funded.

Our leadership in this space shifting risk away from taxpayers in an economically efficient way is a great source of pride for the company. These transactions are also providing new investment opportunities for investors and we believe more broadly strengthening American housing finance.

And importantly CRT investors are providing frequent market feedback on our credit quality and our credit risk management in both the single-family and multi-family businesses. So we have many sets of eyes providing risk feedback to us today.

By transferring risk away from our company in responsible way that does not reduce liquidity or adversely affect the availability of mortgage credit, we are in turn increasing our own corporate stability through the credit cycle in good times and also more challenging times. That stability is a key objective of ours as per our charter.

As some of you may have noticed we surpassed a major credit risk transfer milestone this quarter. Freddie Mac single family has now transferred a portion of the risk in mortgages with an unpretentious -- unpaid principal balance of over $1 trillion.

Given that the market didn't truly exist as little as five years ago that's quite an accomplishment, one that we believe has made Freddie Mac and the entire system far more safe, sound, and stable. The primary driver of much of our CRT activities as earlier has been to reduce the CCF capital required to support our credit risk.

Now that CCF has been established it serves as a tool for communicating a quantification of that risk reduction to our regulators, the markets, and the policy community. Previously we totally rely on our internal economic models as a reference point.

In addition for good reason we have found that the capital raised via CRT is inexpensive in comparison to our estimate of what the marketplace would demand if we held a credit risk as was traditional pre-conservatorship. The result is to drive the underlying returns on our business is higher on the reduced credit risk we retain.

Today in conservatorship this means taxpayers are earning a better return on their support of the company. In a potential future state it means capital would be easier and cheaper to raise.

As you may have for the first time since conservatorship our quarterly financials discussed return on CCF capital required which we treat as a proxy for return on equity, ROE. Let me provide some color, in 2017 the FHFA issued guidance to use a conservatorship capital framework CCF to evaluate and manage our financial risk and also to make our economic business decisions widely conservatorship.

This capital system is generally as per the FHFA broadly consistent with the Dodd-Frank Stress Test in its approach and stress assumptions. We now use this capital system to measure internal transactions and lines of business from a risk return perspective.

It provides us with a metric to determine whether a given transaction or some business line makes economic sense to do. Since our support comes from the American taxpayer via the U.S.

Treasury we owe it to those taxpayers to make sure that we engage in transactions and run our businesses on that kind of smart economic basis. So for example when we do a single family CRT transaction we compare the GCP [ph] away to investors with the economic value of the amount of risk reduction which requires a capital system like the CCF to measure.

That way we ensure we don't overpay for risk reduction. We're always careful stewards of the taxpayer support.

For the second quarter adjusting for the significant item we estimated that a return on the CCF capital required was 16.4% representing an increase from 12.9% in the second quarter of last year. We also note that these numbers are not fully indicative of what our ROE would be in some possible or likely future post conservatorship state.

Our post conservatorship ROE would likely be lower we estimate for a variety of reasons possibly substantially. At beginning when I mentioned the objective, a strong and stable earnings I did not elaborate on the definition of strong.

For a financial institution like Freddie Mac the most common measure of earning strength is in fact return on equity. With the CCF in place enhanced by its inclusion in the FHFA's recent proposed rule on enterprise capital published in the federal register we now feel comfortable disclosing the CCF based proxy for ROE for the first time and as you can see it indicates that our earnings have gotten to the point of indeed being strong.

CRT as a core business model has been key in delivering those results. I would note again that the CCF based proxy for ROEs is likely to be higher than an actual ROE in a possible future state because as one example, mostly four proposals call for us to pay an explicit fee with some amount for federal support on our balance sheet.

We know it no over accounting expense. Finally, let me conclude with this important point, the strength and stability of these financial results as supported by the three interrelated pillars of one tactical or strategic earnings stability; two, strong credit quality; and three, our new CRT based business model have given us the foundation necessary to grow our businesses and to focus our mission on innovation.

As a result our origination volumes remain strong. Single family new originations this quarter were $84 billion with purchase volume up 29% from the prior year, while refinancing volumes were up 7% given the higher interest rate environment.

Multifamily new originations were $16 billion this quarter up 13% from the prior year. Our guarantee book continues to grow moving up 6% year-over-year to reach nearly $2.1 trillion demonstrating how we are fully participating in mortgage market growth.

We also provided a $103 billion of liquidity into the mortgage markets in the second quarter. That funded more than 362,000 single family homes and 191,000 multifamily rental units.

In single family our support for first time home buyers is at the highest level in the last ten years at 46% of new purchase loans. Meanwhile for multifamily 80% of the eligible rental units financed -- 87% of the eligible rental units financed were affordable to families earning at or below [indiscernible] incomes.

Without the underlying strength and stability of our financial results it's difficult to see how we could be so strongly focused to make this kind of progress in accomplishing our mission. Thank you for joining me to discuss our second quarter financials, I look forward to your questions.

Alright, well thank you very much and we appreciate everybody joining us for the call and thank you for your time.