q2 2008 fannie mae investor/analyst conference call on aug. 08. 2008 /...

F I N A L T R A N S C R I P T

FNM - Q2 2008 Fannie Mae Investor/Analyst Conference Call

Event Date/Time: Aug. 08. 2008 / 10:30AM ET

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C O R P O R A T E P A R T I C I P A N T S

Mary Lou ChristyFannie Mae - SVP of IR

Dan MuddFannie Mae - President and CEO

Steve SwadFannie Mae - EVP and CFO

Peter NiculescuFannie Mae - EVP of Capital Markets

Tom LundFannie Mae - EVP of Single-Family Mortgage Business

Eric SchuppenhauerFannie Mae - SVP of Accounting Policy

Enrico DallavecchiaFannie Mae - EVP and Chief Risk Officer

Scott BlackleyFannie Mae - SVP of Accounting Policy

Mark WinerFannie Mae - SVP for Business Analytics and Decisions

C O N F E R E N C E C A L L P A R T I C I P A N T S

David HochstimBuckingham Research Group - Analyst

Howard ShapiroFox-Pitt Kelton Cochran Caronia Waller - Analyst

Bob NapoliPiper Jaffray - Analyst

Paul MillerFriedman, Billings, Ramsey Group, Inc. - Analyst

Ken BruceMerrill Lynch - Analyst

Mark DeVriesLehman Brothers - Analyst

Gary GordonPortales Partners - Analyst

Fred CannonKeefe, Bruyette & Woods - Analyst

P R E S E N T A T I O N

Operator

Ladies and gentlemen, thank you for standing by, and welcome to the Fannie Mae investor/analyst conference call. My nameis Kristin and I will be your conference operator today. All lines have been placed on mute to prevent any background noise.

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Aug. 08. 2008 / 10:30AM, FNM - Q2 2008 Fannie Mae Investor/Analyst Conference Call


After the speakers' remarks, there will be a question-and-answer session. (OPERATOR INSTRUCTIONS).

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

Mary Lou Christy - Fannie Mae - SVP of IR

Thank you. Good morning and welcome to today's investor/analyst conference call. I'm Mary Lou Christy, Senior Vice Presidentof Investor Relations. Dan Mudd, Fannie Mae's President and Chief Executive Officer will lead off today's call, followed by SteveSwad, Executive Vice President and Chief Financial Officer. After Steve's remarks, a question-and-answer session will start, andwe will be joined by other members of senior management.

In addition to the 2008 10-Q and the press release, we published an investor summary on our website, which provides anoverview of our financial performance and key drivers for the period as well as detailed information on our credit book.

Please note that this conference call will include forward-looking statements, including statements related to our futureperformance, capital position, credit-related expenses and credit losses, our expectations regarding the housing, credit, andmortgage market, and our planned actions in connection with capital and credit.

Future events may turn out to be very different from what is discussed in this call. Please see the Risk Factor section of our 2007Form 10-K and our Form 10-Q for a description of issues that may lead to different results.

Now let me turn the call over to Dan Mudd.

Dan Mudd - Fannie Mae - President and CEO

Thank you. Good morning, everyone, and thanks for joining us today. This morning, we filed our results for the second quarter-- a $2.3 billion loss, slightly higher than the first quarter. We also announced a number of additional actions on capital andcredit, including a dividend reduction, a price increase, and the wind-down of our Alt-A business that's driven our credit expenses.

I'm going to begin this call by discussing the market, the results, our outlook, our plans; and our CFO, Steve Swad will thenprovide more detail on the financials. And we'll try to devote the bulk of time on the call today to your Q&A.

To start, it's been three months since our last filing. I have to say, it does seem even longer. But let me briefly chronicle the mainevents of the quarter. In April, we began taking delivery of jumbo conforming mortgages. In May, we raised $7.4 billion in capital,which added to what we did in December; drove a total raise of $14.4 billion. And our regulator also, in May, lifted our consentorder. In June, the Senate took up the Housing Relief bill, which included as a component, GSE legislation, and set the stage forthe passage of that legislation in July.

Then in the market, the conditions which many of us had already described as the worst in a generation, took a turn for moreworse after the quarter ended. You will recall, by way of background, that even though our second quarter books closed onJune 30, subsequent events factor in, and in fact, heavily weight our outlook and our expectations going forward. And thoseevents in July loom significantly in that calculus.

That week of July 7 was one of the worst Fannie Mae has experienced in the debt and equity markets. The Treasury-fed backstopplan that was announced on July 13 calmed the market somewhat, and the passage of the Housing bill on the 26th of Julyadded more certainty. But on the downside, July was a tough month for our credit performance. We experienced higher defaultsand higher loan loss severities in the markets that were experiencing the steepest home price declines. And that gave us highercharge-offs than we had experienced in any month in the second quarter, and higher than we had expected.






We also saw a higher proportion of foreclosures coming from states and products with higher loan balances, which increasesthe absolute dollar losses. In terms of severity, the loss that we experienced when a loan defaults also increased from 19 basispoints in the first quarter to 23 basis points in the second quarter. And that rose again in July to 27 basis points.

We are now seeing average initial charge off severities of 40% for loans in California. Home prices have cratered in certainmarkets since the peak -- Cape Coral, Florida, down 50%; Las Vegas, down 35%; northern Virginia, down 30%; and in California,Modesto, and Stockton, down 50%; Riverside, down 40%. The list goes on.

Alt-A foreclosures have doubled in southern California. Our average serious delinquency rate in Florida increased in June toover 3% -- four times the average on our total book of business last year. Almost 2% of the loans in our Florida book are nowreferred to foreclosure.

So, the housing market has returned to earth fast and hard. Some signs do offer rays of positive light. Foreclosures actually fellin Michigan. Same-period home sales were up in California. And as the GSEs provide most of the liquidity to the primary market,that market is functioning, and a safe center of credit risk pricing and product is being restored.

All told however, that story all put together led us to again revise our credit loss estimate upward from the year, from 13 to 17basis points to 23 to 26 basis points. And that, as you will note, commensurately drives our addition to loss reserves of almost$4 billion.

In that, there are a few larger questions that I think remain open. What about the impact of job losses and fuel costs onhomeowner's ability to pay? -- a more broad macroeconomic question. Many of you have asked the question phrased in oneform or another, what inning are we in? That reflects your uncertainty and reflects our uncertainty as to when home prices hitbottom and how long they will stay there once they're there.

There is progress, but we have a long way to go. Home prices and inventories need to reach equilibrium. Fixed income liquidityand depth have to recover. The macroeconomic downturn has to play out. And at that point, I think, forward visibility will againbecome more science than judgment.

Now, with that environment as background, let me turn to our second quarter results. In the midst of this market, our secondquarter results were down from the first as credit provisioning, once again, outweighed the revenue line. Total credit-relatedexpenses were $5.3 billion of which $3.7 billion was a boost to loss reserves. Those loss reserves now stand at a total of $8.9billion; 31 basis points on the total book of business.

Under GAAP, as you know, it's our policy to provision today for the losses on the existing book that we expect to realize overthe next 18 to 24 months, and that's where we are.

These reserves are, of course, supported in fact, over time, by the revenue line. So in some sense, therefore, our ongoingoperations fund future losses. And in this quarter, the revenue story remained quite solid -- up $189 million to $4 billion, or 5%over the first quarter, and 46% higher revenue line than last year. The main driver here was wider investment spreads due tolower funding costs.

The business overall continued to grow, as we added nearly $200 billion to the overall book. And during the same period, wesignificantly increased our multi-family investor spread charge fees as well as market share. So we closed -- on the front ofcapital, we closed the quarter with $47 billion in capital, $9.4 billion above our OFHEO directed minimum, and $14.3 billionabove our statutory minimum.

And let me pause there and assert that we continue to believe that this is an environment where it's important to remain longon capital.






I also believe that our critical role in this market and our actions in response to the challenges we face will make an appreciableand positive difference as housing works through this crisis, and as our investors -- whether debt or equity -- and our stakeholders-- whether customers or homeowners, policymakers, or related industries like home-building or real estate -- all of thoseconstituencies will benefit from our success as we work through this downturn.

Let me, therefore, describe our additional actions around capital and credit, and do so with the caveat that there is somethinghere for every single constituency to dislike.

One -- we are conserving $1.9 billion in capital through 2009 by reducing our common stock dividend to $0.05 a share. Andwe're maintaining our access to future capital by paying all of our preferred series as scheduled.

Second, we increase pricing on all loans by adding 25 basis points to our adverse market delivery charge, bringing that chargeto 50 basis points, effective October 1, and we instituted other risk-based pricing changes; that's the fourth such increase so farthis year.

Third, we continue to support market liquidity with a particular focus on the less liquid sectors, which by the way, reveals thepositive turn in the model, because these sectors, the less liquid ones, are the ones that carry the highest spreads and deliverthe best revenue per dollar of risk capital.

Fourth, we're going to reduce ongoing operating expenses another 10% by year-end '09, following the delivery that we did onthe 35% reductions in the '06 through '08 timeframe.

Credit -- we are attacking credit across the board. We have installed new standards in our automated underwriting engine, DU7.0, to mitigate the risk of most of the lower credit quality product features that we don't like to see. We've tightened up on ourMyCommunityMortgage and early approval products. And we will cease purchasing newly originated Alt-A loans by year-end.As you saw in the disclosure, Alt-A loans generated 50% of our Q2 credit losses; a significant portion of the additional balancecame out of MCM and EA, and we have tightened those up from an intake level.

We have also increased our reviews of defaulted loans -- the loans that we get back -- we've increased that five-fold. And we'refocusing especially on Alt-A. So, we would expect to increase our recoveries for contractual violations substantially this yearand next.

Some of these changes are already in progress. We've already initiated them. And we've continued to push even further. Examples-- we've boosted loan work-outs now, and we now plan and believe we can hit a 60% rate, which was up from 50% last year.We're opening on-site offices in two of the more challenging states, Florida and California, with the intention of reducing defaultsand managing our REO in those states. Real estate is at some level local; it makes sense to be local.

We're adding hundreds of staff, as well as contractors to our loss mitigation team. And we have effectively quintupled theamount of senior management that is dedicated to this effort.

We continue to move property, to move REO in this strained market. We are processing much more REO at the same throughputand at the same cycle times, using a lot of innovative ways to get the property out the door. I do not think this is a time to beholding on to REO and hoping for a better day. So we're doing a good job at moving that inventory back out onto the market.

Now, to wrap up, the market remains extraordinarily challenging. We're taking aggressive action to preserve capital and controlour credit losses. Underneath all of that, the fundamentals of the business are strong. We've generated nearly $8 billion ofrevenues at the six-month mark. Since last spring, we've provided roughly $1 trillion of liquidity to the market, which is helpingto keep this sector operating.






We will do more in the context of clear regulatory guidance and compliance in terms of capital. And we will continue to workwith government and industry to ensure that we continue to deliver on our mission. Our actions, I think, that I just describedon capital and credit, combined with the revenues that we're generating, will help us manage through this tough, tough market.

Let me stop there and turn to our CFO, Steve Swad, for details on the filing and the other announcements we've made today.Steve?

Steve Swad - Fannie Mae - EVP and CFO

Thank you, Dan. My comments will cover five key points. One, the Company had solid revenue trends in the quarter. Two, wehad substantially higher credit-related expenses, mostly driven by the reserve build. Three, we made progress in loweringinterest rate-driven volatility. Four, I'll provide an outlook for the second half of 2008. And five, I'll close on where we stand withcapital.

Let me start with net interest income. As you can see on slide eight of the investor summary, our tax equivalent net interestincome was $2.1 billion in Q2, up nearly 21% over Q1. The gold line on this slide shows that our net interest income, backingout the impact of debt redemptions and adding in expenses relating to swaps, which we view as part of our funding costs. Onthis basis, our net interest yield moved from 68 basis points in Q1 to 85 basis points in Q2. The key driver here was the impactof lower short-term borrowing costs.

Moving to guarantee fee income on slide nine, you can see that G fees were $1.6 billion, down approximately 8% in Q2 comparedto Q1, but up 44% compared to Q2 2007.

Slide 10 shows positive trends we've seen on our average charge rate for new business -- an increase to 28 basis points, up from25 basis points in Q1. In addition, we saw a 3% growth in our average guarantee book.

But while our book and average charge fees on new business both increased, the average life of our loans extended, as mortgagerates rose during the quarter. So we amortized less in deferred guarantee fee items during the second quarter. And this morethan offset the positive impacts of both book growth and higher charged fees on new business.

Net-net, the fundamentals of our G fee revenue stream remain strong, as evidenced by a steady increase in the average chargedfee on our book if you assume a four-year average life for all periods.

Now let's move to fair value items, which are shown on slide twelve. We recognized a $517 million gain in Q2 compared witha $4.4 billion loss in Q1. Two key points here -- first, we implemented hedge accounting in mid-April, which virtually eliminatedinterest rate risk driven by volatility on hedged items.

Second, spreads tightened, which led to a fair value gain of $739 million compared to a loss of $3 billion in Q1. Unfortunately,since June, we've seen spreads widen to levels exceeding what we saw in the first quarter, so we gave back our Q2 gains andmore. For your reference, slide 13 breaks out the impact of a 1 basis point increase in spreads on the various products in ourtrading portfolio.

Now let's move to credit. As you can see on slide 14, credit-related expenses increased to $5.3 billion in Q2. The key point here,current period credit losses -- which I view as cash out the door -- are up. However, the single most significant driver ofcredit-related expenses remained to be the addition to our allowance for losses. This addition pulls forward losses inherent inour book well before they're recognized in cash. Let me get into the specifics.






Credit losses were $1.3 billion in Q2, up 42% compared to the prior quarter. This increase was driven by higher defaults andmore of them coming from states with the sharpest home price declines. As in the first quarter, our Q2 credit losses fall intothree buckets, which are broken out on slide 16.

First, geography. 48% of our credit losses were from four states -- California, Arizona, Nevada, and Florida. These states saw themost dramatic run-up in prices and are now seeing the most rapid declines. Additionally, 18% of our Q2 credit losses were fromMichigan and Ohio, where borrowers are being hit by weak local economies and job losses.

The second bucket is vintage. Loans originated in 2006 and 2007 accounted for almost 60% of Q2's credit losses. Early perioddefault rates for these vintages are much higher than what we have experienced on earlier vantages, and you can see this clearlyon slide 31.

The third bucket is product. Our Alt-A represents just under 11% of our credit book, but accounted for almost 50% of Q2 losses.So that's what's driving current period cash losses. But again, the single biggest driver of credit-related expenses was the additionto our loss reserves. In Q2, we increased our reserves by $3.7 billion, bringing our combined loss reserves to $8.9 billion. Thisequals 31 basis points of our guarantee business, almost 9.5 times our Q2 charge-offs, and 2.4 times our annualized Q2 charge-offs.

This significant reserve build is shown on slide 15, and you can see clearly the pull-forward effect of GAAP provisioning.

As you may recall from prior discussions we've had, the reserve is built by looking at default curves for the book and capturingdefaults out 18 to 24 months. Then we apply a severity assumption based on our current quarter's experience. As you climb upthe loss curve and you see severities worsened, this requires more reserve building. And that's exactly what we're seeing today.

Now let's move on to impairments. The same market dynamic that drove our credit-related expenses also led to higherimpairments. And these are summarized on slide 19. In Q2, we recorded a $507 million charge, primarily related to impairmentson Alt-A and subprime securities. As a reminder, since the beginning of 2007, we have recorded $3.4 billion of write-downs onthese securities -- $2.7 billion in the trading loss line item and $706 million in impairments.

Slides 40 through 42 are also provided for your reference, so you can see how these bonds are modeled to perform under arange of default and severity scenarios.

Now let me address our outlook. First, we expect to generate revenues in the second half of 2008, largely in line with the revenuesgenerated in the first half of the year. Second, we provided guidance of 23 to 26 basis points for our full year credit loss ratio.And this compares to an annualized 15 basis points for the first half of the year. So you can see that we expect credit losses willcontinue to accelerate throughout 2008.

This will contribute to higher credit-related expenses. But importantly, we expect 2008 to be our peak year for credit-relatedexpenses because of a one-two punch, elevated credit losses, and substantial reserve build. We expect this will change in 2009,as the need for additional reserves should slow or stop. This will take away the most significant driver of credit-related expensesthat we are experiencing in 2008. The result is that we expect credit-related expenses to remain elevated in 2009, but to comein lower than 2008.

The last item on outlook is administrative expenses. We expect administrative expenses to trend around $2 billion for the year,with the efficiency measures that Dan described having an impact in 2009.

Now let's us move on to capital. At June 30, our core capital was $47 billion -- $9.4 billion over the 15% surplus requirement,and $14.3 billion over our statutory minimums. You can see on slide 22 the most significant capital item in the quarter was $7.2billion of capital raised in May. This raise and the lowering of our surplus requirement from 20% to 15% added $8.8 billion toour capital surplus. These adds were partially offset by our net loss for the quarter, dividend payments, and capital investmentsin our business.






We currently expect that we'll [rein] above the surplus capital requirement for the remainder of 2008. But due to the volatilemarket conditions that Dan described, we now have less visibility into our capital position in 2009. The actions we announcedtoday are intended to help us conserve and enhance our capital position, as we work through the challenges of this market,while continuing to play a key role in supporting its recovery.

With that, I'll turn it back to Dan.


Thanks. I think we're going to go to questions now.

Q U E S T I O N S A N D A N S W E R S

Operator

(OPERATOR INSTRUCTIONS). David Hochstim, Buckingham Research Group.

David Hochstim - Buckingham Research Group - Analyst

I wonder if you could -- I guess if Peter's there, he could talk about the changes in market conditions in July and how that'saffecting funding costs and spreads, and how much you might grow, given your need to preserve capital?

And then my follow-up now would be -- I wonder if you could talk about the underwriting of Alt-A loans over the last threeyears that led to the credit problems that you're experiencing today. Are the problems related to fraud and you're going to havemassive recoveries that I guess would be factored into your reserve build? Or were the underwriting models really defective?


Thanks, David. I'll have Peter start on capital market conditions, and then have Tom Lund talk about Alt-A book compositionactions and so forth. Peter?

Peter Niculescu - Fannie Mae - EVP of Capital Markets

Good morning, David. To be quite candid, the debt markets in July were turbulent and the times are challenging, as I thinkpeople recognize. And we've seen a lot of different ebbs and flows in the agency debt market over the last several weeks.Mortgages have reacted by seeing some fairly sharp widening in yield spreads through the course of July and into August tolevels, that in my experience, are among the widest historically we've seen really for 20 years or more. So, really an extraordinarychange in the makeup of supply and demand in the marketplace.

This means that it makes our actions here highly dependent on market conditions, highly opportunistic. We certainly haveaccess to adequate short-term and long-term funding, but there are challenges here that are not typical for us. I do think thatcurrent acquisitions are likely to be extraordinarily profitable going forward for Fannie Mae. But we have to recognize thatfunding access in the agency debt market is key. And we will look at this on a day-by-day basis as we fund so we can acquire.Given even mild improvements in agency debt, we could see a modest growth in balances; I'm not making any particularprojections here.






I will say that balance growth will have to be prudent. And we're going to be balancing a lot of different variables, includingfunding requirements, including our capital, as well, of course, as the economics of the transaction, and finally, the liquiditymission that we have to markets. I think we have a significant central role here. We will continue to play that central role inproviding liquidity to mortgages, and we're conscious that's a very important element of what we do.


Should we expect that the portfolio could grow slightly, given these conditions? Or you just replace run-off? Or you won't evenreplace run-off?


I think that our actions are going to be opportunistic. Our actions are going to be opportunistic. I think that modest growth ispossible. I think that we're going to make those decisions on a day-to-day basis.


Tom?

Tom Lund - Fannie Mae - EVP of Single-Family Mortgage Business

Okay, David, on the question of Alt-A. Clearly, Alt-A is experiencing problems in the portfolio. To give you some context, a largepart of the Alt-A book is in the states that have experienced the largest home price declines throughout the country. When youcombine that with -- and I would refer you to page 37 in the investor pack -- when you combine that with -- a significant portionof this business was below 80, therefore, not having primary mortgage insurance, that increases some of the severity on thatproduct as well.

We purchased a significant amount of back-end MI, and after the deductibles are met, we'll begin to see some of that kick in tooffset some of that performance.

I would also point you to the charts on page 37 that show the performance of our book relative to other private label securitiesin the market. In terms of underwriting standards, we did it better than the market, but it's being dramatically impacted by theareas that we've done it in.


Right, but -- (multiple speakers)


Finally, what I would say is -- as these loans go bad, we're reviewing a significant amount of these for any misrepresentationthat might have occurred on this product. And we anticipate that there will be some repurchases as a result of that.







Right, but if you look at your slide on page 30, you see there's a huge difference in the risk profile of the Alt-A book with lessthan 80%, I think, as principal residences. So, I guess, were those permitted under DU? Or did it turn out that lenders were veryclever and figured out ways to deliver loans to you that really didn't meet your risk tolerances?


Well, just to be clear, a significant portion of Alt-A doesn't go through DU. And then secondly, one of the components thatwould define it as Alt-A is investor properties, for example, that have different characteristics. And that's why it would be putin the Alt-A bucket. So that's a part of the reason why you see a differential in terms of first homes versus second homes versusinvestors.


Right. And certain kinds of investor properties you're comfortable with and certain you aren't. I guess I'm still wondering if youexpect to see substantial recoveries or your losses are still going to be 40% from Alt-A that's really your fault?


Well, I think as we mentioned a little bit earlier in this call, when these loans go into default, we are looking at every loans tolook for things like misrepresentation. Those loans, for example, that would have represented themselves as a primary residencethat turned out to be an investor would be a misrepresentation; things like that, we see more prevalent in this kind of book.


And finally, just one last quick thing -- is there a reason that the delivery fee can't go up by more than 25 basis points?


Well, what I would tell you is when we -- let me start with a couple of things. One, to date, David, we have put more priceincreases into the market this year alone. As we do that, we look at a lot of things. We made a bunch of underwriting changesin the process. And we also look at the competitive environment in which we operate against. To date, we continue to serveabout 45% to 50% of the market. And we have begun to see some of that market that we previously served move over to theFHA. So we evaluate all of those components; we evaluate the risk factor and we evaluate the markets.

Having said that, where we are today, given all the underwriting changes that we have made through DU 7.0 and on other tailcuts, along with these price increases, we believe that we have very strong margins to compensate for what is a volatile market.


Okay, David, thanks. We'll have to get some other folks out of the queues. Thank you.


All right, thanks.






Operator

Howard Shapiro, Fox-Pitt.

Howard Shapiro - Fox-Pitt Kelton Cochran Caronia Waller - Analyst

Just a couple questions on capital. You've said you have less visibility into your capital status in 2009 and you've run somescenarios where you are capital-adequate and where you're capital-deficient.

I'm just wondering if you can help us more narrowly define the scenarios in which you would be capital-deficient and howcapital-deficient? If you would put it in terms of maybe unemployment or further declines in home values or frequency orseverity, just so we can get a sense of how potentially capital-deficient you might be?

And then on a related note, if you were to need to raise capital in one of those situations, are you contemplating using theTreasury authority to buy equity? Or would you be accessing the capital markets? And would you be able to raise preferred orwould it all have to be in the form of common?


Okay, Howard. Let me touch upon the various parts of your question. Ultimately, whether the answer is helpful or not, I'll leaveit to you to determine.

First, we're affirming that our capital is in good position for '08. As I indicated in my remarks, we're well above regulatory capital.The forward projection -- as you know, there are projections from us and from Case-Shiller and from Freddie and from Goldmanand from a whole lot of other folks that don't have a whole lot of correlation. So there are many, many, many different scenariosout there.

And they involve projecting variables, which have become significantly less clear as we've worked our way through the summer.What are losses going to be? Where is credit going to go? Where are home prices going to bottom? How long is that going tolast? What's the overall impact of the macroeconomy? What are funding liquidity in the capital markets? All of these scenariosthat everybody has are highly, highly sensitive to the variables and the assumptions that you make. And none, in my view, are[conclusary] enough to have full visibility into where they wind up in '09. As '09 approaches, that will be clear and we'll do that.

What we've chosen to do is instead of giving us a set of variables and assuming that the results are in that grid of variables, asyou know, both from the 10-Q and from the investor pack, we have provided an enormous amount of data on the credit book,and in particular, on the at risk segments, which has been augmented every time we've done it, that would enable somebodyto take a look and apply their own favorite scenario to that situation.

So I would emphasize that we remain with good visibility and in a comfortable position through '08; as '09 approaches, we willcontinue to tack that down.

On the second question, none of the plans that we've advanced contemplate access to any Treasury line. We've not asked themand they have not offered. And the remarks I made before in terms of helpful back-stop in terms of market confidence stand;but no update whatsoever to that. So, thank you.

Can we go to the next question?






Operator

Bob Napoli, Piper Jaffray.

Bob Napoli - Piper Jaffray - Analyst

A question on the change and the charge-off outlook -- pretty significant increase in charge-off guidance. And you've really gotto ramp up the credit losses to get to that average for the full year. In doing so, what were the biggest drivers in that big of aramp-up? Dan, to the extent that you can put some type of your best -- Fannie Mae's kind of the middle-of-the-range whereyou think credit losses are going to peak and when?


Yes. Let me have Steve start, because, Bob, your question's got two aspects to it. One is sort of a mechanical aspect and one isan outlook aspect. So let me have him take you through the first part and then I'll follow up. Steve?


Thanks, Bob. A couple of points, Bob. The HBI estimate that we provided, our national estimates, and they haven't changedfrom Q1 to Q2, although we have moved to the higher end; and that movement to the higher end caused an increase in ourcharge-off -- our credit loss estimates.

But probably more important than that, is in those national numbers are estimates of regions, and between Q1 and Q2, areestimates of the housing prices. And some of those regions went up and in some of the regions, they went down. The regionsthat went down more than we originally expected were California, Nevada, Arizona, and Florida. And that's what drove theincrease in our credit loss estimates Q1 to Q2.

As I said in my comments, we have about a 15 basis point annualized credit loss ratio for the first half. We are guiding 23 to 26.And so we're expecting credit loss ratios in the 30s in the second half. And we also said that we expect the credit losses toincrease '09 versus '08.


Yes, okay. On that, and maybe, Dan, on the outlook and what percentage of that is coming from Alt-A?


Where we are right now is we see the home price decline on average through the cycle being -- we gave you a range of 15%to 19%. We're at the high end of that range. We took in about 4% of that in 2007. We took in about 9% of that in -- we anticipatein 2008. That puts us at 13% with some direction to go.

That said, as we said earlier in the call, something on the order of 50% of the credit losses that we're seeing in the book comeout of the Alt-A book. And that continues to be the first area that's experiencing the losses. We have not given a disclosure onwhere we expect the losses to be on a piece-by-piece of the book, but I think it's sensible to look at where we have seen themcoming so far and what we see as the highest risk portions of the book -- which we've also given that disclosure on -- is the mainplaces I would look there, Bob.







And the peak, Dan, I mean, could it be 60 to 70 basis points next year? Do you expect a peak in credit losses in '09? Those aremy last questions. Thanks.


This is Steve. We're not providing '09 specific guidance. As we close out '08, we will provide some sort of update.

Eric Schuppenhauer - Fannie Mae - SVP of Accounting Policy

This is Eric Schuppenhauer, the CFO of single-family. I would only build upon that, that we have stated in our release today that2008 will be our peak year for credit expense.


Right. For provisions.


Why is that? Well, for credit expense in total. And what we see is we see the 2006, 2007 vintages being our most problematicvintages. The book we're putting on now in 2008 has much better credit performance, as outlined for you on page 10 of theinvestor pack.

And we would expect that, given that we provide in our allowance for loan losses about 18 to 24 months worth of emergingcredit losses or charge-offs that this would be our peak year for provisioning for 2006 and 2007 vintages.

And so that's kind of what we see in the outlook. And that frontloading that Steve referred to in his remarks, credit expenses,puts us at a peak year this year for credit expenses. However, we do anticipate 2009 credit expenses will be significant.

Operator

Paul Miller, FBR Capital Markets.

Paul Miller - Friedman, Billings, Ramsey Group, Inc. - Analyst

I want to commend you guys for the disclosure. This is great disclosure today, and I really do appreciate it, and we all do.

The question I have is really to Peter. We already know that Freddie Mac has pretty much said that they're not going to growtheir portfolio and they're having some capital issues. And you're making a comment today that we're going to make veryprudent purchases in the portfolio but it's really going to depend on what is available and how you can issue debt.

The issue is you guys are the two biggest net buyers of mortgages right now. I mean, without you guys, a lot of liquidity in themarket would be dried up and we'd be in worse shape than we are today. But now that you guys are starting to step back, whatdo you think is going to happen to the market? Is interest rates going to go up to the 6.5% to 7% level? And does that furthergive a negative feedback loop to the whole mortgage market because those guys on the margin aren't able to refi out? Canyou address that? Because that's one of the big things that I know a lot of people are very concerned about.







Paul, thank you for the question. I appreciate the concern and I think we absolutely share it.

I think this Company has and should have a central role in providing mortgage finance to homeowners in the United States;that's what we do. I think we've already seen what you're talking about happen to a degree in the marketplace. In July, you sawa very significant widening in mortgage yield spreads -- increase in mortgage rates relative to other interest rates in themarketplace. So you've seen it happen.

I think actually coming into this meeting this morning we saw a modest tightening in mortgage spreads. But you've alreadyseen the big effect already happen. The markets are efficient and they move relatively rapidly. So going forward, you're dealingwith an efficient market. You're dealing with a lot of flows. There are a number of other investors that have, I think, removedthemselves from mortgages over the last few months. And there may be some others that are coming in.

I will note that the share of adjustable-rate mortgages being originated still remains at its current low level. So, the fixed rateGSE market remains very, very important. And I think it's going to remain very important in the time to come.

There are pockets of (technical difficulty) liquidity out there. There are specific areas within the mortgage market that are lesswell served than the generic [PDA] market. Those are places where we are trying to concentrate. We've certainly been very, veryhelpful, I believe, in the jumbo conforming market, which probably wouldn't be doing well without our sponsorship; in themulti-family area and similar other areas [that] see less good sponsorship. We're certainly going to focus our efforts on the areasthat are both most illiquid and therefore have some of the highest returns for shareholders and really need us the most.

But going forward, this is a big market. I acknowledge that we (technical difficulty) a large investment, we're probably not goingto play as vibrant a role collectively as we might have in years gone past. And a lot of that is going to depend on what happensto the agency debt market and flows in the agency debt market.

As I said, we're going to be balancing funding, agency debt, capital, economics for shareholders, and of course, our liquiditymission to the markets.


And then, Peter, just as a quick follow-up, though, I mean, it's only been about one month since you guys have been out of themarket. Do you see -- I'm not trying to -- I mean, do you see mortgage rates stabilizing? And I guess they're right now 6.5% witha point, basically? And if it goes to 7%, I mean, could it cause more credit issues? I mean, or do you think that the rate right nowis probably going to stick around 6.5%, given the liquidity and the supply and demand in the market?


That, Paul, is really tough to predict market rates in an efficient and very liquid, very large market; very, very tough thing to do.I'm not an economist. I'm not going to make any comment like that. I'm just going to stay away from that.

The larger point that high rate did not help credit is manifestly true; the more refinancing opportunities people have, the easierfor them. But that's a much broader macroeconomic question involving the long-term treasury rates, inflation, and other thingsof that, so I'll probably just have to leave that one there.







All right, thank you very much for trying to answer, Peter. I appreciate it. Thank you, guys.

Operator

Ken Bruce, Merrill Lynch.

Ken Bruce - Merrill Lynch - Analyst

Dick Syron had indicated recently that he believes that the role of private capital in the GSEs needs to be addressed morespecifically in terms of some type of either guaranteed return or where shareholders stand with these two enterprises goingforward. Do you agree with that position? And if you do, how do you see that being addressed going forward?


Well, I mean, I think -- thanks for the question, Ken. I think that the way the whole model works is that we have an attractivelong-term investment proposition that causes investment capital to come into the US housing market and earn a competitivereturn.

I think that everybody I talk to -- Jim Lockhart is a business man; he understands that. Hank Paulson ran an investment bank;he understands that. And it's very important that there be an attractive shareholder proposition so that investment comes intothe Company, so that the Company's capital is built, so that we continue to attract that global capital that we can invest anddefray the cost of US housing and keep all these markets liquid.

So I think that's understood. And if you read carefully around the commentary of the importance of having these companiesplay a role in the market, the importance of these companies continuing in their present form, I think all of those commentsare supportive of the notion of what has really worked well over the fullness of time here, which is private capital being employedfor a public purpose.

Right now we're going through the 99th year of a 100-year storm and we're having the discussions that we're having. We'regoing to get through it. We're going to manage our way through it. That's what we're talking about here today. And we're goingto be able to manage through it while we still continue to make that mission and business model work.

So there is some hysteria out there on the fringes, I think. But I think the responsible commentators and the folks who knowthe business and the folks who are in the market understand how important it is that we get this right and keep it going. Andthat's the direction this is moving in.


I mean, you're not suggesting that Mr. Syron's comments are part of the hysterical side of that, I assume?


I think Dick should speak for himself. And what I said is what I said. Freddie is a good company and a tough competitor for usevery day. I don't have any insight other than from the competitive battlefront there. But I think in all the conversations I've hadwith him or with Jim Lockhart or with anybody else, the question is, what do you do to make sure that this market functions






and that the way that we have built the market continues to help get the economy, as a broad matter, and the capital markets,as a small matter, and the housing market back to the right place?


Okay. And as it relates to some of the put-backs that were mentioned earlier that should relieve some of the credit costs at somepoint in the future, have they been factored into your outlook? Is there an expectation for that currently in your outlook? Andspecifically, I guess included in that would be the MI deductibles that Tom had mentioned earlier? And if that is the case, whatis your view as to when those would begin to occur, just from a timing perspective? Thank you.


Yes, let me start. Yes, they've been conservatively factored in. Two, Mike Williams, who's here, is one of our EVP's and Mike, whohas run a number of the big process management complicated processes around the Company, has picked up kind of globalresponsibility for making sure that the back end of all of our credit efforts are resourced, staffed, focused on, measured andintegrated. And he can take you through how we've built those numbers up. Mike?

Mike Williams. Thanks, Dan, and thanks, Ken, for the question. Once again, the purpose here is what we want to do is make surewe're reviewing every loan where Fannie Mae has incurred a loss or could incur a loss due to fraud or improper lending practices.This actually serves two purposes for us.

One, it ensures our lending practices and guidelines are being adhered to in the marketplace and allows us to recover losseswe should not have incurred. Clearly, some of those have been factored into our plan. But as we mentioned today, we areramping up our efforts in this area. We are increasing the number of cases that we have planned to review by year-end, expandingour anti-fraud efforts, and also looking at QC of certain products that Tom mentioned, particularly Alt-A, for the purposes ofmaking sure that we are recovering all losses that we should recover.

And with that, let me turn it over to Tom to talk about MI.


On the MI front, the expectation would be that we would begin to receive some of those proceeds from the back endenhancement policies I talked about, beginning in '09.

Operator

Mark DeVries, Lehman Brothers.

Mark DeVries - Lehman Brothers - Analyst

A two-part question which is actually related to the previous one. Could you discuss the extent to which, if at all, you had factoredin counter-party risk with the financial guarantors and the MI's in your reserving and impairments that you've taken?


Yes, let me start and then I'll ask Enrico Dallavecchia, our Chief Risk Officer, to talk about how we think about counterpartysweeps.






As a broad matter, we've moved -- with the installation of the Chief Risk Officer function, we have created the systems and theability to look at our counterparty exposure to all of our counterparties on a divisible basis or on an aggregate basis. We lookat that, we measure that, we understand where the risk is. And as you've seen some of the larger counterparty changes alongthe way with respect to some of the originators or some of the servicers that have changed form or as, for example, in the caseof Indy Mac, we've been able to manage through those by using that system, getting ahead of the curve and having a very highdegree of recoveries.

So with that, let me turn it over to Enrico. And Enrico, thanks.

Enrico Dallavecchia - Fannie Mae - EVP and Chief Risk Officer

I will start with just some general comments and then one of my colleagues, the CFO, will pick up on the specifics.

We analyze all the counterparts. And we do not necessarily rely in our analysis to external rating. For -- in my industry in particular,we have obtained a very detailed copy of their exposure, not only with Fannie Mae but to the industry as a whole. And we haverun that through a number of stress scenarios. And we also have been focusing very heavily on the financial guarantors.

And I'll leave it to one of my colleagues to explain how we factor the [rein] with regard to the financial guarantors in particular,which I thought was your question.

Scott Blackley - Fannie Mae - SVP of Accounting Policy

This is Scott Blackley. I'm the CFO for our Capital Markets business. With respect to the financial guarantors in our subprimesecurities and Alt-A securities, we've got about [five point billion dollars] of those securities that have some additional creditenhancement from the financial guarantors.

The way we do our impairment analysis and execute our accounting policies, we first look at whether or not those securitieshave a break loss without any of the benefit of those guarantors. And if we do find securities where there is a break loss expected,so we may be taking credit losses in the future. In that situation, we look at whether or not the financial guarantor is one of thestronger guarantors. And at this point, we are only relying on the strongest of the guarantors in determining our impairments.

In the current period, we had about $35 million of our total impairments that were associated with a security where we did notplace reliance on the financial guarantor.


And as it relates to the mortgage insurance counterparties, let me just add to that -- this is Eric Schuppenhauer again. Theallowance for loan losses contemplates the amount of primary mortgage insurance we would expect on the charge-offs thatare contemplated in the allowance for loan losses. It does not contemplate any amounts due on pool insurance policies.

Furthermore, as we've stated in the 10-Q that we filed today, we continue to see the mortgage insurance counterparties haveclaim paying ability, and we've seen no problem in that claim paying ability with respect to current claims and how claims arebeing processed currently. And we don't anticipate and have not taken a haircut in the allowance for loan losses for MIcounterparties.


Okay, thanks. Let's go to the next one.






Operator

Gary Gordon, Portales Partners.

Gary Gordon - Portales Partners - Analyst

Two questions, hopefully one a quick one. It looks like your 17% to 19% home price decline equates to about a 30% decline inthe reported Case-Shiller number, is that right?


Gary, it's not a bad algorithm; in fact, it's similar to the one that I use. I think if you -- the way that you map from Case-Shiller toours is usually about a 10-ish point difference. That's not a very scientific answer. Mark Winer, that does the modeling in thisarea, can give you a few more thoughts in terms of Case-Shiller. Mark?

Mark Winer - Fannie Mae - SVP for Business Analytics and Decisions

Yes, I think we disclosed in the investor package on page 25 the comparisons that you can do. As Dan said, it is about a 10%difference when you add in the way that Case-Shiller aggregates, and when you [enclose] the foreclosed properties that theyown [are in there].


Okay, thanks. The other is the counterparty risk on your loss mitigation efforts. Obviously, the people you're going back tocollect in most cases are your clients, your customers delivering loans. How does that limit your ability to collect? And obviously,there have been a number of bankruptcies of lenders; how does that limit your ability to collect?


Yes, I think -- let me start and then let Tom Lund pick up on the customer side a bit. I mean, I kind of go back to the old adagethat your customers are the people that are paying you. So we enforce our rights and our reps and warrants in the process. Andwe take very seriously and we review very hard, any cases where there have been exceptions or differences there.

You're right, that these are customers and that for those customers that are paying if there is a disagreement on, we have QCefforts that go through and work this out on a full-time basis.

So, now that said, in the situations that have been more publicized recently, I think it would go back, Gary, to my prior comment,which is we monitor these in advance; we see where there are signs of stress. The big concern there for us is that we're able toget in, in front and ensure that there is uninterrupted servicing, because by and large, the underlying quality of the loans iswhat it is. But it's the servicing you don't want to have interrupted. And we have been able to very efficiently, very quickly andsomewhat painlessly move those servicing books into hands where the servicing will continue uninterrupted.

With that, Tom can give you a little flavor of the discussions.







Sure. Let me just reiterate what Dan said. This is a practice that we have had in place forever. This is the way we operate withour customers. Our customers understand this. And as a team, we've done a very good job in a very tough environment managingcounterparties. And I think part of the reason is we've got people on the ground, we're inside these people's shops. We have agreat understanding of what they do.

In terms of the rep and warrant, our customers make rep and warrants to us and with the products that they sell me the contracts.They're very clear about what they do, they know how we do this. We have ongoing discussions. This is not a surprise to them.I wouldn't even put this in an adversary way. This is an understanding about how this business gets done. It partly creates theefficiency of the secondary market. And it's well accepted. So, I would say these continued discussions are ongoing and we'resuccessful on that as we go forward.


Sorry, a little confused. You said -- you're sounding here like it's business as usual, yet you're suggesting upfront that there'smore of an effort.


Well, what I would -- the way I would answer that is the standard industry practice in terms of how this goes on, the issue is inthe environment that we're in, the number of defaults that we're seeing particularly around the Alt-A product, there has beena significant ramp-up that has occurred.


So the process is there, the amount of effort around the process and the amount of focus has been tremendously heightened.That's the way I kind of summarize it, Gary.

Okay, we'll do one more.

Operator

Fred Cannon, KBW.

Fred Cannon - Keefe, Bruyette & Woods - Analyst

Just a question on a somewhat different area, is the tax rate that declined fairly significantly in the quarter. I was wondering --kind of two-part question -- one, if you could provide a little bit more clarity on what occurred in that, because it does appearyou might be losing some of the tax shield on the losses you're taking.

And secondly, I believed your deferred tax asset rose to about $20 billion at the end of the quarter. Is there any risk to that asseton either a GAAP or a regulatory framework, on a go-forward basis?


Hey, Fred, this is Steve Swad. I'll hit the effective tax rate first. We, like most companies, have a policy to estimate our annualeffective tax rate and then apply it to the quarters. And our effective tax rate changed from 57% in Q1 to 43% for the first half.






And Q2 is essentially the true-up mechanism to get that effective tax rate from 57% to 43%. And the reason that happened isour view on credit losses increased, causing us to modify downward our effective tax rate. So that's that.

And with respect to deferred tax assets, just a few points on that. Starting with most financial institutions have deferred taxassets. And they arise when the expenses for book are greater than -- or take longer than the expense for tax. And the simplestexample, and there are many, but the simplest is the reserve building. That is an expense for book that doesn't hit your taxreturn until you have a charge-off. And what we do is we make an assessment on the recoverability based on the taxable incomethe Company generates.

And just remember that our taxable income is higher than our book income because there is no reserve building expense.There's no 303 charge. There's no spreading of G fees that we get in cash. And so based on that, we think it's sufficient to recoverthe asset.

We put a bunch of disclosure on our tax assets and our effective rate in our filing. And so you may want to look at that as well.


Okay. In the 10-Q?


Yes.


All right. Just finally on that, in terms of regulatory capital, the banks face a more onerous hurdle on regulatory capital than youguys have historically. I mean, I believe the bank regulatory rule only allows like a two-year look-back and a one-year look-forwardto value the asset. Is that of concern as we move into a new regulatory regime?


Fred, I agree with your observations on the bank regulation that is different than our current regulation. I can't speculate orimply or -- for Peter, I don't know if you have something to add to that?


Yes. Hi, Fred, this is Peter Niculescu. I think that the point you're making is the one that our new regulator [FITHA] will bepromulgating regulations with the next period of time. And they have considerable latitude, as they should have, as a world-classregulator of really the entire mortgage finance system.

And I expect that what they will do is move to a model that aligns our capital and risk. Beyond that, of course, this is up to themto make the decisions that they see as correct and prudent.


Great. All right. Thank you very much.







Yes. With that, thank you, everybody, for joining us on the call. I just want to summarize the key points we made today.

First, the fundamentals of the business remain strong. The book is growing. The share is solid. The revenues are solid. And ourrole in the market is solid and, in fact, reaffirmed.

Secondly, the housing crisis that we all observe as we drive home every single day continues to strain our results and our capital.And we're still in the tunnel working our way toward the other end of the light. So that will be the tough challenges that thisCompany is focused on in months to come.

Third, recognizing that and recognizing what it takes to work through that tunnel, we're taking -- we're ratcheting up the stepsthat we're taking -- some are painful, but all of them are prudent -- to manage our capital, hold down our credit losses and keeppeople in their homes.

Broadly, though, we are reminding ourselves every single day how important it is to keep this Company healthy so we can helpget this market back to healthy. And we know it's critically important to get that right. It's important to us. It's important to me.It's important to Fannie Mae employees. And it's important to you, I think, whether the shareholders that own this enterpriseor partners in the housing industry, people that hold jobs, in the economy, in the government, and on up from there foreverybody that is working through the housing crisis.

For our part, I assure you that we will do everything that we can to keep working through it. We will keep providing the liquidityand the stability that we talked about. And we will keep you and everybody else that has a stake in housing informed as we doso.

So we appreciate the time, we appreciate the attention. And we will look forward to hearing from everybody the next time.Thank you again.

Operator

A replay of the call will be available for 30 days starting at 2:00 p.m. Eastern time on August 8 through midnight Eastern timeon September 5. The replay number for the US and Canada is 800-642-1687 or for international callers, 706-645-9291. Theconfirmation code is 55011092. This concludes today's conference call. You may now disconnect.

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Cover PageCorporate ParticipantsMary Lou Christy (1 Turn)Dan Mudd (17 Turns)Steve Swad (6 Turns)Peter Niculescu (5 Turns)Tom Lund (8 Turns)Eric Schuppenhauer (3 Turns)Enrico Dallavecchia (1 Turn)Scott Blackley (1 Turn)Mark Winer (1 Turn)

Conference Call ParticipantsDavid Hochstim (7 Turns)Howard Shapiro (1 Turn)Bob Napoli (4 Turns)Paul Miller (3 Turns)Ken Bruce (3 Turns)Mark DeVries (1 Turn)Gary Gordon (3 Turns)Fred Cannon (4 Turns)

PRESENTATION1. Operator2. Mary Lou Christy3. Dan Mudd4. Steve Swad5. Dan Mudd

QUESTIONS AND ANSWERS1. Operator2. David Hochstim3. Dan Mudd4. Peter Niculescu5. David Hochstim6. Peter Niculescu7. Dan Mudd8. Tom Lund9. David Hochstim10. Tom Lund11. David Hochstim12. Tom Lund13. David Hochstim14. Tom Lund15. David Hochstim16. Tom Lund17. Dan Mudd18. David Hochstim19. Operator20. Howard Shapiro21. Dan Mudd22. Operator23. Bob Napoli24. Dan Mudd25. Steve Swad26. Bob Napoli27. Dan Mudd28. Bob Napoli29. Steve Swad30. Eric Schuppenhauer31. Bob Napoli32. Eric Schuppenhauer33. Operator34. Paul Miller35. Peter Niculescu36. Paul Miller37. Peter Niculescu38. Paul Miller39. Operator40. Ken Bruce41. Dan Mudd42. Ken Bruce43. Dan Mudd44. Ken Bruce45. Dan Mudd46. Tom Lund47. Operator48. Mark DeVries49. Dan Mudd50. Enrico Dallavecchia51. Scott Blackley52. Eric Schuppenhauer53. Dan Mudd54. Operator55. Gary Gordon56. Dan Mudd57. Mark Winer58. Gary Gordon59. Dan Mudd60. Tom Lund61. Gary Gordon62. Tom Lund63. Dan Mudd64. Operator65. Fred Cannon66. Steve Swad67. Fred Cannon68. Steve Swad69. Fred Cannon70. Steve Swad71. Peter Niculescu72. Fred Cannon73. Dan Mudd74. Operator

Disclaimer

q2 2008 fannie mae investor/analyst conference call on aug. 08. 2008 /...

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