Equity Research

Equity Research

Company Update

October 19, 2009

Mortgage Finance

Rating Change Price Target Change

An Augean Task: A Government Exit Strategy to Recap FNM & FRE

Bose George

Summary--

212-887-3843 [email protected]

Fannie Mae and Freddie Mac have been at the heart of the U.S. housing boom, bust and recovery. As the mortgage market moves away from crisis mode, the future of the government-sponsored enterprises (GSEs) has to be addressed. In order for the GSEs to survive going forward, we believe they need to be recapitalized through investments from the banks that benefit from their role in the secondary market. Additionally, we believe the ownership structure should be shifted over time to a cooperative of banks similar to the Federal Home Loan Bank (FHLB) system.

Frederick Cannon 212-887-3887 [email protected]

Jade J. Rahmani 212-887-3882 [email protected]

Key Points-■ There have been many recommendations made about potential structures for the GSEs. The most noteworthy is the Government Accountability Office (GAO) report which presents options for the companies ranging from becoming full government entities to returning to being stock-holder corporations. What all the recommendations to date have not done—including the ones in the GAO reports—in our view is address the most crucial issue regarding the agencies: how to recapitalize them. ■ In our view, in order for Fannie Mae and Freddie Mac to survive going forward, they need to be recapitalized through investments by the banks that benefit from their guarantee. Under such an approach, any bank that originates an agency conforming loan and wishes to sell the loan to the GSEs would be required to retain 5% of the loan balance as an equity investment in the GSEs. Thus, the new agencies would be recapitalized at a solid 5% level of the new expanded balance sheets under FAS 166/167. ■ In this scenario, both the common and preferred equity of the GSEs should be worthless. Our bad bank analysis suggests that the companies will still owe the government almost $100 billion by the end of year ten. As a result, we are downgrading FNM and FRE common shares to Underperform and are cutting our price targets to $0. Rating

Market

Target

Current Qtr.

2009E EPS

2010E EPS

Symbol

Price

To

From

To

From

To

From

To

From

To

From

FNM

$1.46

Underperform

Market Perform

$0.00

$1.00

($4.09)

($4.09)

($11.21)

($11.21)

($6.90)

($6.90)

FRE

$1.72

Underperform

Market Perform

$0.00

$1.00

($3.14)

($3.14)

($5.99)

($5.99)

($2.85)

($2.85)

Please refer to important disclosures and analyst certification information on pages 12 - 15.

October 19, 2009 An Augean Task: A Government Exit Strategy to Recap FNM & FRE

The Future of the GSEs: A Government Exit Strategy to Recapitalize Fannie Mae and Freddie Mac Fannie Mae and Freddie Mac have been at the heart of the U.S. housing boom, bust and recovery. Since being put into receivership last summer, the U.S. government has put $98 billion of capital into the two organizations and their guarantee has become more explicit. The combination of increased support for the GSEs and the slowdown in originations in the private sector has resulted in the GSE volume growing sharply. Fannie Mae and Freddie Mac accounted for 68% of all originations in 2009. (The government's Federal Housing Administration program accounted for a large percentage of the remainder.) Exhibit 1 shows the historical market share of the GSEs. Exhibit 1: GSE Market Share Growth 100% 80% 60% 40% 20% 0% 90

91

92

93

94

95

96

97

98

99

00

01

02

03

04

05

06

07

08

09

Note: 2009 data is for 1H09. Source: Inside Mortgage Finance.

As James B. Lockhart III—the Director (CEO) and Chairman of the Oversight Board of the Federal Housing Finance Agency that was the regulator of Fannie and Freddie at the time of conservatorship—stated when the U.S. government seized them, "Fannie Mae and Freddie Mac are no longer in the business of maximizing shareholder value." Rather, in our view, the two agencies are now in the business of stabilizing the U.S. housing market. Thus, Fannie Mae and Freddie Mac today are acting as a direct arm of the federal government providing massive federal aid to support and revive the U.S. housing market in the midst of a crisis. At the same time, their operating structure is as private companies operating under the conservatorship of the U.S. government. This is not a sustainable structure as is documented in a recent report from the Government Accountability Office ("Fannie Mae and Freddie Mac: Analysis of Options for Revising the Housing Enterprises' Long-term Structures" dated September 10, 2009). The Problem of Capital The GAO report presents options for Fannie and Freddie ranging from becoming full government entities to returning to being stock-holder corporations. What the GAO report is missing, in our view, is addressing the most crucial issue regarding the agencies: how to recapitalize them. There are three financial issues of note that we believe help define the restructuring needs of the two agencies: ■

■

Operating under conservatorship, Fannie and Freddie create an unlimited government liability, as evident by the GAO estimated need of $389 billion government support; Accounting changes will balloon the balance sheets of the two companies to approximately $5.5 trillion in 2010 from under $2 trillion today as a result of FAS 166/167, illustrating the capital needs of the companies; and

Please refer to important disclosures and analyst certification information on pages 12 - 15.

Page 2

October 19, 2009 An Augean Task: A Government Exit Strategy to Recap FNM & FRE

■

Large banks are generating large amounts of mortgage banking income as a result of the government operations in the mortgage business. Wells Fargo, now the nation's largest mortgage lenders, had mortgage banking income in excess of $3.5 billion in the first half of 2009.

In our view, the only viable option to limit taxpayer expense and recapitalize Fannie Mae and Freddie Mac is to set up a Bad Fannie and Bad Freddie with the existing portfolios, and a new Fannie Mae and Freddie Mac as cooperatives of bank mortgage lenders, along the lines of the other GSEs—the Federal Home Loan Banks. New Agencies as Cooperatives of Mortgage Banks There is general consensus that the primary role of the agencies in the future is in the loan guarantee business and not in the investment business. By creating "bad banks" of the existing portfolios and putting the existing portfolios into receivership, the government can limit its losses and define its role in supporting the mortgage industry through the crisis and create an exit strategy. In order for Fannie Mae and Freddie Mac to survive going forward, we believe they need to be recapitalized through investments from the banks that benefit from their role in the secondary market. Additionally, we believe ownership structure should be shifted over time to a cooperative of banks similar to the Federal Home Loan Bank system. Under such an approach, the banks that originate an agency conforming loan would be required to retain 5% of the loan balance as an equity investment in either Fannie Mae or Freddie Mac. Thus the new agencies would be recapitalized at a solid 5% level of the new expanded balance sheets under FAS 166/167. The capital would provide a significant buffer to bondholders in the new agencies from future losses. Further we expect that this level of capital would allow the government to sunset an explicit guarantee of the new agencies' debt over time. We would expect the government to initially guarantee the debt of the new agencies for a period, possibly up to five years, in order to establish the credibility of the new agencies. We recognize that the returns on the stock investment in the new agencies would be modest given the high level of capitalization. In Exhibit 2, we present the "normalized" balance sheet and earnings of the new agencies, assuming guarantee fees are kept modest, investment portfolios are strictly limited to liquidity needs, and credit quality is maintained at historically high levels. As shown, the return on the stock investment we estimate is under 5%. We believe that this would be acceptable to the bank owners if structured correctly for three reasons: ■ ■

■

By participating as owners the mortgage banks generate significant fees; Risk weightings of 100% on the stock would allow leverage to the banks (currently FHLB stock is risk weighted at just 20%); and The new agencies would have very limited investment portfolios. Historically, the retained portfolio growth at the GSEs was something that banks resented.

Please refer to important disclosures and analyst certification information on pages 12 - 15.

Page 3

October 19, 2009 An Augean Task: A Government Exit Strategy to Recap FNM & FRE

Exhibit 2: GSE Normalized Returns Combined "Normalized" Returns ($ Millions) Interest Earning Asset Hedged Net Interest Yield Net Interest Income

$

Guarantee Assets Guarantee Fee Credit Expense Operating Expense Net Guarantee Spread Net Guarantee Income

$ 5,000,000 0.25% 0.05% 0.05% 0.15% $ 7,500

Net Income Pre-Tax Tax Rate Net Income After-Tax

$

Return of Assets Capitalization Level Equity Return on Equity

$

$

$

500,000 0.80% 4,000

11,500 35% 7,475 0.14% 5.00% 275,000 2.7%

Source: KBW Research. The size of the new agencies would likely grow quickly, as we expect agency originations to average roughly $1.3 trillion annually for the next several years. The new agencies could be structured as one or two separate agencies, or regionally along the lines of the Federal Home Loan Bank system. Exhibit 3 shows the potential growth trajectory for the new entities. It suggests that just with normal prepayment activity, the new GSEs will account for over 40% of the mortgage market and have largely replaced the old GSEs within a ten year time frame. Our model assumes that the retained portfolios at the old GSEs run off and that the new GSEs keep a very limited balance sheet for liquidity purposes. Exhibit 3: Expected Growth Outlook for New Agencies $ in billions Total Originations GSE Percentage GSE Volume GSE Prepayments GSE Capital Created Redeemable Capital Total GSE Capital Prepayments GSE Book of Business Mortgage Debt Outstanding GSE Percentage of market GSE Capital Ratio

2011 2,000 65% 1,300 65 65 15% 1,300 11,000 11.8% 5%

2012 2,000 63% 1,260 (195) 63 (10) 118 15% 2,365 11,220 21.1% 5%

2013 2,000 61% 1,220 (355) 61 (18) 162 15% 3,230 11,444 28.2% 5%

2014 2,000 59% 1,180 (485) 59 (24) 196 15% 3,926 11,673 33.6% 5%

2015 2,000 57% 1,140 (589) 57 (29) 224 15% 4,477 11,907 37.6% 5%

2016 2,500 55% 1,375 (895) 69 (45) 248 20% 4,956 12,145 40.8% 5%

2017 2,500 53% 1,325 (991) 66 (50) 265 20% 5,290 12,388 42.7% 5%

2018 2,500 51% 1,275 (1,058) 64 (53) 275

2019 2,500 49% 1,225 (1,101) 61 (55) 282

2020 2,500 47% 1,175 (1,126) 59 (56) 284

20% 5,507 12,636 43.6% 5%

20% 5,631 12,888 43.7% 5%

20% 5,680 13,146 43.2% 5%

Source: KBW Research.

Please refer to important disclosures and analyst certification information on pages 12 - 15.

Page 4

October 19, 2009 An Augean Task: A Government Exit Strategy to Recap FNM & FRE

The Bad GSEs: Losses at the GSEs are a result of poor performance of historical investments and rising losses on guaranteed loans. Current performance on Fannie and Freddie guaranteed loans of 2008 and 2009 vintage appear solid, in our view. The historical portfolios, in our view, create a sunk cost. Government investments have been necessary to absorb losses above those borne by common and preferred shareholders. (Current bondholders would be protected, resulting from the government's commitment.) Potential Losses at the Legacy Bad GSEs The potential losses at the existing GSE portfolios derive from two sources: (1) their guarantee business and (2) their investment portfolios. We look at each separately. GSE Guarantee Portfolios The GSEs have roughly $5 trillion that they currently guarantee. Exhibit 4 shows the growth in the GSE guarantee portfolios and where they currently stand. Exhibit 4:GSE Guarantee Portfolios $ in trillions $5.0

20% 15%

$3.0 10% $2.0 5%

$1.0

Guarantee Portfolios

Jul-09

Jan-09

Jul-08

Jan-08

Jul-07

Jan-07

Jul-06

Jan-06

Jul-05

0% Jan-05

$0.0

% Chg. YoY

$ in tril.

$4.0

YoY Growth

Source: Company data. The performance of the GSEs' books of business remains strong relative to the market as a whole. The current serious delinquency rate is 3.94% for Fannie Mae and 2.89% for Freddie Mac. The comparable number for the industry is 5.44%, which was the seriously delinquent rate for prime mortgages loans according the Mortgage Bankers Association National Delinquency Survey. However, we still anticipate significant losses. Despite their relatively small exposure in percentage terms to high-risk categories, in dollar terms, these exposures are very material. Exhibit 5 shows Fannie Mae's higher risk book of business and Exhibit 6 shows the same for Freddie Mac.

Please refer to important disclosures and analyst certification information on pages 12 - 15.

Page 5

October 19, 2009 An Augean Task: A Government Exit Strategy to Recap FNM & FRE

Exhibit 5: Fannie Mae High Risk Portfolio Categories Not Mutually Exclusive NegativeAmortizing

Loans Loans with Interest-

As of June 30, 2009

Loans Only Loans

Unpaid Principal Balance (billions)

$15.40

Share of Single-Family Conventional Credit Book

0.60%

Average Unpaid Principal Balance Serious Delinquency Rate

with FICO > 620

Loans with

Loans with

Original

FICO < 620 and

LTV Ratio >

Original LTV

Sub-total of Key Alt-A Subprime

Product

Overall

Loans

Features

Book $2,744.20

FICO< 620

and < 660

90%

Ratio > 90%

Loans

$195.90

$115.60

$242.30

$265.30

$25.40

$269.30

$7.90

$878.20

7.10%

4.20%

8.80%

9.70%

0.90%

9.80%

0.30%

32.00%

100.00%

$137,513

$242,048

$125,165

$140,431

$141,622

$118,569

$168,784

$149,958

$152,814

$150,966

8.48%

15.09%

13.07%

9.13%

9.66%

21.37%

11.91%

21.75%

9.36%

3.94%

Origination Years 2005-2007

61.30%

80.70%

55.80%

54.10%

56.80%

69.50%

73.30%

80.80%

60.60%

40.50%

Weighted Average Original Loan-to-Value Ratio

71.20%

75.80%

76.70%

77.40%

97.20%

98.10%

72.90%

77.20%

79.30%

71.60%

0.30%

9.30%

22.00%

20.90%

100.00%

100.00%

5.40%

6.80%

30.20%

9.70%

Weighted Average Mark-to-Market Loan-to-Value Ratio

97.50%

103.20%

80.40%

82.20%

101.90%

101.50%

89.00%

93.80%

88.60%

74.00%

Mark-to-Market Loan-to-Value Ratio > 100% and <= 125%

15.60%

23.10%

13.40%

13.90%

29.80%

31.20%

14.80%

17.00%

17.70%

9.10%

Mark-to-Market Loan-to-Value Ratio > 125%

33.00%

22.40%

6.60%

8.00%

13.20%

12.20%

15.30%

14.30%

11.40%

5.30%

702

724

588

641

695

592

718

623

686

727

9.10%

1.30%

100.00%

0.00%

9.60%

100.00%

0.70%

48.00%

13.20%

4.20%

Original Loan-to-Value Ratio > 90%

Weighted Average FICO FICO < 620 Fixed-rate

0.20%

39.60%

93.40%

92.20%

94.20%

95.50%

72.20%

74.40%

80.90%

91.10%

Primary Residence

69.70%

84.70%

96.70%

94.30%

97.20%

99.40%

77.30%

96.60%

89.30%

89.80%

Condo/Co-op

13.80%

16.50%

4.90%

6.60%

9.90%

6.00%

10.90%

4.60%

9.70%

9.30%

Credit Enhanced

74.40%

35.60%

33.50%

35.10%

91.00%

92.70%

38.90%

63.10%

43.90%

19.50%

% of 2007 Credit Losses

0.90%

15.00%

18.80%

21.90%

17.40%

6.40%

27.80%

1.00%

72.30%

100.00%

% of 2008 Credit Losses

2.90%

34.20%

11.80%

17.40%

21.30%

5.40%

45.60%

2.00%

81.30%

100.00%

% of 2008 Q3 Credit Losses

3.80%

36.20%

11.30%

16.80%

21.50%

5.40%

47.60%

2.10%

82.40%

100.00%

% of 2008 Q4 Credit Losses

2.20%

33.10%

11.50%

17.20%

23.10%

5.20%

43.20%

2.00%

81.00%

100.00%

% of 2009 Q1 Credit Losses

1.80%

34.20%

10.70%

16.00%

22.50%

6.50%

39.20%

2.00%

77.70%

100.00%

% of 2008 Q2 Credit Losses

2.20%

32.20%

9.20%

16.00%

19.70%

5.70%

41.20%

1.10%

76.00%

100.00%

Source: Company data.

Please refer to important disclosures and analyst certification information on pages 12 - 15.

Page 6

October 19, 2009 An Augean Task: A Government Exit Strategy to Recap FNM & FRE

Exhibit 6: Freddie Mac High Risk Portfolio Total Portfolio

FICO < 620 &

as of Attribute

Option

FICO

FICO

Original LTV

Original

June 30, 2009

Alt-A

IO

ARM

< 620

620-259

> 90%

LTV > 90%

Balance (UPB $ Billions)

$1,887.0

$165.2

$144.8

$11.6

$70.9

$156.2

$141.1

$13.2

Share of Total Portfolio

100%

9%

8%

1%

4%

8%

8%

1%

Original Loan-to-Value (OLTV)

71%

72%

74%

72%

77%

77%

96%

97%

OLTV > 90%

8%

4%

4%

2%

19%

17%

100%

100%

Current Loan-to-Value (CLTV)

75%

91%

103%

109%

85%

85%

102%

104%

CLTV > 90%

27%

46%

62%

66%

39%

39%

71%

70%

CLTV > 100%

17%

34%

47%

54%

26%

26%

47%

51%

CLTV > 110%

11%

26%

36%

45%

17%

17%

27%

32%

Average FICO Score

727

722

720

711

589

642

694

588

FICO < 620

4%

4%

3%

3%

100%

0%

9%

100%

2009

13%

0%

0%

0%

1%

2%

4%

1%

2008

14%

9%

11%

0%

9%

11%

14%

6%

2007

16%

31%

42%

2%

29%

23%

31%

40%

2006

13%

28%

30%

11%

16%

17%

12%

13%

2005

13%

17%

15%

59%

13%

15%

10%

8%

2004

9%

6%

2%

27%

10%

11%

8%

8%

<= 2003

22%

9%

0%

1%

22%

21%

21%

24%

Book Year

Source: Company data. Given the higher-risk loans in both portfolios we believe that the dollar amount of losses for both companies will be material although the percentage of losses is likely to remain moderate. Exhibit 7 shows our estimates for cumulative losses for both companies. We estimate that the serious delinquency rate on the high risk portfolios for both companies peaks in the 15% range while delinquencies on the prime portfolios peak at around 7%. We assume somewhat weaker performance for Fannie Mae's guarantee portfolio, which is consistent with trends to date. Exhibit 7 also shows our best case and stress case loss scenarios.

Please refer to important disclosures and analyst certification information on pages 12 - 15.

Page 7

October 19, 2009 An Augean Task: A Government Exit Strategy to Recap FNM & FRE

Exhibit 7: Base Case, Stress Case, and Best Case Loss Scenarios Base Case

Balance (UPB $ Billions) Mortgage loans

Stress Case

Best Case

Fannie

Freddie

Fannie

Freddie

Fannie

Mae

Mac

Mae

Mac

Mae

Freddie Mac

$2,744.2

$1,887.0

$2,744.2

$1,887.0

$2,744.2

$1,887.0

$386.4

$130.3

$386.4

$130.3

$386.4

$130.3

Total

$3,130.6

$2,017.3

$3,130.6

$2,017.3

$3,130.6

$2,017.3

Average UPB per loan

$150,966

$147,560

$150,966

$147,560

$150,966

$147,560

Fixed Rate (% of total portfolio)

90%

89%

90%

89%

90%

89%

Owner Occupied

90%

91%

90%

91%

90%

91%

% of Loans with Credit Enhancement

20%

17%

20%

17%

20%

17%

% Seriously Delinquent (90-day +)

3.94%

2.89%

3.94%

2.89%

3.94%

2.89%

Expected delinquency Rate

8.0%

6.5%

14.0%

12%

7.0%

5.5%

Expected default Rate

75%

75%

85%

85%

65%

65%

Expected loss severity

60%

60%

75%

75%

50%

50%

Cumulative Loss Rate

3.6%

2.9%

8.9%

7.7%

2.3%

1.8%

113

59

279.4

144.4

62.4

33.7

$ amount of loss ($ billions)

Source: Company data and KBW estimates.

GSE Retained Portfolios Our bad GSE model assumes that the current marks on the GSE retained portfolio accurately reflect potential losses. Exhibit 8 breaks out Fannie Mae's portfolio and Exhibit 9 breaks out Freddie Mac's portfolio. Exhibit 8: Fannie Mae Retained Portfolio Breakdown $ in millions Amortized At June 30, 2009

Cost

Markdown Percentage

Mortgage-related securities: Fannie Mae single-class€MBS

$242.7

Non-Fannie Mae single-class

92.3

Mortgage revenue bonds + Other Total Non-mortgage-related securities: Total investments in securities

15.6 350.6 15.7 366.3

Mortgage Loans

415.6

Total Mortgage Assets

781.9

377.3

-2.9%

Source: Company data.

Please refer to important disclosures and analyst certification information on pages 12 - 15.

Page 8

October 19, 2009 An Augean Task: A Government Exit Strategy to Recap FNM & FRE

Exhibit 9: Freddie Mac Retained Portfolio Breakdown $ in millions At June 30, 2009

Amortized

Total GAAP

Cost

$253.6

Markdown Percentage

Available-for-sale, at fair value: Freddie Mac

$247.3

2.5%

Subprime

39.9

63.9

-37.5%

Commercial mortgage-backed securities

49.2

63.0

-21.9%

6.5

15.0

-56.5%

Alt-A and other

12.3

21.0

-41.2%

Fannie Mae

40.0

38.9

3.0%

Obligations of states and political subdivisions

11.6

12.5

-7.1%

Manufactured housing

0.8

1.2

-29.7%

Ginnie Mae

0.4

0.4

7.1%

463.1

-10.5%

MTA Option ARM

Total mortgage-related securities Asset-backed securities Total available-for-sale securities, at fair value

414.4 6.2 420.7

5.8

7.4%

469.0

-10.3%

Trading, at fair value: Freddie Mac

202.4

Fannie Mae

36.1

Ginnie Mae

0.2

Other Total mortgage-related securities Other trading securities

0.0 238.7 11.9

Total trading securities, at fair value

238.7

Total investments in securities

659.4

Mortgage Loans

129.5

Total

788.9

Source: Company data. Total Losses at Bad GSEs We estimate that cumulative losses can be largely offset by the current reserve, charge-offs to date, and earnings from the portfolios in runoff. We estimate total losses of $116 billion for Fannie Mae and $59 billion for Freddie Mac. Our base case estimates suggest that at the end of year ten, the companies' debt to the government does not change meaningfully from current levels. This is primarily because the portfolio will continue to earn interest income and guarantee fee income in runoff which can be used to pay down the debt to the government. Exhibit 10 shows our loss expectations and the final capital positions for the legacy GSE portfolios. We believe that our numbers appear far more optimistic than the CBO numbers primarily because of our assumption that the companies can generate significant income as they run off.

Please refer to important disclosures and analyst certification information on pages 12 - 15.

Page 9

October 19, 2009 An Augean Task: A Government Exit Strategy to Recap FNM & FRE

Exhibit 10:Total Loss Expectation $ in billions Current Reserve 10-Year Revenues Total Expected Cumulative Losses Charegoffs to Date Year 10 Capital Position Current Debt to Government Net capital position year 10

Fannie Mae 55 38 93 (116) 18 (4) (45) (49)

Freddie Mac 25 37 63 (59) 8 12 (51) (39)

Source: KBW Research. Exhibit 11 and 12 show how we calculate future earnings for Fannie Mae and Freddie Mac in runoff. Note that we assume no taxes for each since both have deferred tax assets that should be able to offset income for the next ten years. Because the companies will need to build reserves now while their earnings offset will occur later, we believe the companies' debt to the government is likely to increase materially in the next 12-18 months. Our numbers suggest that Fannie Mae's total debt could reach $100 billion and Freddie Mac's debt could reach $75 billion before declining as the companies' earnings in runoff are used to pay down government debt. Exhibit 11: Fannie Mae Earnings Model $ in billions Interest Earning Asset Hedged Net Interest Yield Net Interest Income

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Total Earnings $ 780 624 499 399 319 256 204 164 131 105 1.00% 1.00% 1.00% 1.00% 1.00% 1.00% 1.00% 1.00% 1.00% 1.00% $ 8 $ 6 $ 5 $ 4 $ 3 $ 3 $ 2 $ 2 $ 1 $ 1

Guarantee Assets Guarantee Fee Credit Expense Operating Expense Net Guarantee Spread Net Guarantee Income

$ 2,450 0.25% 0.05% 0.05% 0.15% 3.7

1,960 0.25% 0.05% 0.05% 0.15% 2.9

1,568 0.25% 0.05% 0.05% 0.15% 2.4

1,254 0.25% 0.05% 0.05% 0.15% 1.9

1,004 0.25% 0.05% 0.05% 0.15% 1.5

803 0.25% 0.05% 0.05% 0.15% 1.2

642 0.25% 0.05% 0.05% 0.15% 1.0

514 0.25% 0.05% 0.05% 0.15% 0.8

411 0.25% 0.05% 0.05% 0.15% 0.6

329 0.25% 0.05% 0.05% 0.15% 0.5

Operating Expenses

-2.0

-1.8

-1.6

-1.4

-1.3

-1.2

-1.1

-0.9

-0.9

-0.8

Net Income Pre-Tax

9.5

7.4

5.7

4.4

3.4

2.6

2.0

1.5

1.1

0.8

20%

20%

20%

20%

20%

20%

20%

20%

20%

20%

Prepayment Rate

$

38

Source: KBW Research.

Please refer to important disclosures and analyst certification information on pages 12 - 15.

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October 19, 2009 An Augean Task: A Government Exit Strategy to Recap FNM & FRE

Exhibit 12: Freddie Mac Earnings Model $ in billions Interest Earning Asset Hedged Net Interest Yield Net Interest Income

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Total Earnings $ 780 624 499 399 319 256 204 164 131 105 1.00% 1.00% 1.00% 1.00% 1.00% 1.00% 1.00% 1.00% 1.00% 1.00% $ 8 $ 6 $ 5 $ 4 $ 3 $ 3 $ 2 $ 2 $ 1 $ 1

Guarantee Assets Guarantee Fee Credit Expense Operating Expense Net Guarantee Spread Net Guarantee Income

$ 1,841 0.25% 0.05% 0.05% 0.15% 2.8

1,473 0.25% 0.05% 0.05% 0.15% 2.2

1,178 0.25% 0.05% 0.05% 0.15% 1.8

943 0.25% 0.05% 0.05% 0.15% 1.4

754 0.25% 0.05% 0.05% 0.15% 1.1

603 0.25% 0.05% 0.05% 0.15% 0.9

483 0.25% 0.05% 0.05% 0.15% 0.7

386 0.25% 0.05% 0.05% 0.15% 0.6

309 0.25% 0.05% 0.05% 0.15% 0.5

247 0.25% 0.05% 0.05% 0.15% 0.4

Operating Expenses

(1.5)

-1.4

-1.2

-1.1

-1.0

-0.9

-0.8

-0.7

-0.6

-0.6

Net Income Pre-Tax

9.1

7.1

5.5

4.3

3.3

2.6

2.0

1.5

1.1

0.8

20%

20%

20%

20%

20%

20%

20%

20%

20%

20%

Prepayment Rate

$

37

Source: KBW Research. We Downgrade Fannie Mae and Freddie Mac to Underperform As part of this analysis we are downgrading both stocks to Underperform and cutting our price targets to zero (from $1). Ever since they were put into conservatorship by the government, these companies have essentially become government-owned entities; we believe that our ratings and price targets have not been very meaningful since then. Our change in ratings and price targets today is primarily being made to make them consistent with the outcome that we are expecting for the companies: that they become government-run organizations and their current shareholders will not get anything in the end because the debt to the government materially exceeds the value of the common and preferred equity. Fannie Mae had $20.4 billion of preferred equity and Freddie Mac had $14.1 billion of preferred equity. Even if we assume our best case scenario we end up with both companies in a negative equity position at the end of year ten. The primary risk to our price targets include stronger-than-expected performance of residential mortgage credit which could result in credit losses being materially lower than we estimate. Also, if the companies' retained portfolios perform materially better than the current marks suggest, the companies' capital positions could improve.

Please refer to important disclosures and analyst certification information on pages 12 - 15.

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October 19, 2009 An Augean Task: A Government Exit Strategy to Recap FNM & FRE

Rating and Price Target History for: Fannie Mae (FNM) as of 10-16-2009 01/12/07 I:MP:$62

11/21/07 MP:$25

03/03/08 MP:$32

03/20/08 OP:$48

08/11/08 MP:$10

09/08/08 MP:$1

75 60 45 30 15 Q3

Q1

Q2

Q3

2007

Q1

Q2

Q3

2008

Q1

Q2

Q3

0

2009

Created by BlueMatrix

Rating and Price Target History for: Freddie Mac (FRE) as of 10-16-2009 01/12/07 D:NR:NA

02/21/07 MP:$66

11/21/07 MP:$22

03/20/08 OP:$46

05/19/08 OP:$45

08/07/08 MP:$8

09/08/08 MP:$1

75 60 45 30 15 Q3

Q1 2007

Q2

Q3

Q1

Q2

Q3

2008

Q1

Q2

Q3

0

2009

Created by BlueMatrix

Distribution of Ratings/IB Services KBW *IB Serv./Past 12 Mos. Rating Outperform [BUY] Market Perform [HOLD] Underperform [SELL] Restricted [RES] Suspended [SP]

Count

Percent

Count

Percent

129 333 42 0 34

23.98 61.90 7.81 0.00 6.32

34 76 4 0 7

26.36 22.82 9.52 0.00 20.59

* Keefe, Bruyette & Woods, Inc. and Keefe, Bruyette and Woods Limited maintain separate research departments; however, the following chart, "Distribution of Ratings/IB Services," reflects combined U.S. and U.K. information related to the distribution of research ratings and the receipt of investment banking fees.

We, Bose George, Frederick Cannon, and Jade Rahmani, hereby certify that the views expressed in this research report accurately reflect our personal views about the subject company and its securities. We also certify that we

Please refer to important disclosures and analyst certification information on pages 12 - 15.

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October 19, 2009 An Augean Task: A Government Exit Strategy to Recap FNM & FRE

have not been, and will not be receiving direct or indirect compensation in exchange for expressing the specific recommendation in this report. This communication is not an offer to sell or a solicitation to buy the securities mentioned. The information relating to any company herein is derived from publicly available sources and Keefe, Bruyette & Woods, Inc. makes no representation as to the accuracy or completeness of such information. Disclosures Keefe, Bruyette & Woods (KBW) Research Department provides three core ratings: Outperform, Market Perform and Underperform, and two ancillary ratings: Suspended and Restricted. For purposes of New York Stock Exchange Rule 472 and FINRA Rule 2711, Outperform is classified as a Buy, Market Perform is classified as a Hold, and Underperform is classified as a Sell. Suspended and Restricted ratings are classified as described below. Stocks are rated based on an absolute rate of return (percentage price change plus dividend yield).Outperform represents a total rate of return of 15% or greater.Market Perform represents a total rate of return in a range between -5% and +15%.Underperform represents a total rate of return at or below -5%.Suspended indicates that KBW's investment rating and target price have been temporarily suspended due to a lack of publicly available information and/or to comply with applicable regulations and/or KBW policies.Restricted indicates that KBW is precluded from providing an investment rating or price target due to the firm's role in connection with a merger or other strategic financial transaction.Companies placed on the KBW Best Ideas Outperform List are expected to generate a total rate of return (percentage price change plus dividend yield) of 20% or more over the following 12 months.Companies placed on the KBW Best Ideas Underperform List are expected to generate a total rate of return (percentage price change plus dividend yield) at or below -20% over the following 12 months.Research analysts employ widely used multiple valuation methodologies including, but not limited to, absolute, relative and historical Price/Earnings (P/E) and Price/Cash Flow multiples, absolute, relative and historical Price/Book Value multiples and Discounted Cash Flow Analysis.All KBW research analysts are compensated based on a number of factors, including overall profitability of the company, which is based in part on KBW's overall investment banking revenues. The following indices: KBW Bank Index (BKX), KBW Insurance Index (KIX), KBW Capital Markets Index (KSX), KBW Regional Banking Index (KRX), KBW Mortgage Finance Index (MFX), KBW Property & Casualty Index (KPX), and KBW Premium Yield Equity REIT Index (KYX), are the property of Keefe, Bruyette & Woods, Inc. (KBW). KBW does not guarantee the accuracy or completeness of the Index, makes no express or implied warranties with respect to the Index and shall have no liability for any damages, claims, losses or expenses caused by errors in the index calculation. KBW makes no representation regarding the advisability of investing in options on the Index. Past performance is not necessarily indicative of future results. The shares ("Shares") of KBW ETFs are not sponsored, endorsed, sold or promoted by Keefe, Bruyette & Woods ("KBW"). KBW makes no representation or warranty, express or implied, to the owners of the Shares or any member of the public regarding the advisability of investing in securities generally or in the Shares particularly or the ability of the KBW Regional Banking, Capital Markets, Bank, Mortgage Finance, and Insurance Indexes to track general stock market performance. KBW's only relationship to State Street Bank and Trust Company is the licensing of certain trademarks and tradenames of KBW and the KBW Regional Banking, Capital Markets, Bank, Mortgage Finance, and Insurance Indexes which are determined, composed and calculated by KBW without regard to State Street Bank and Trust, the fund, or the Shares. KBW has no obligation to take the needs of State Street Bank and Trust Company or the owners of the shares into consideration in determining, composing, or calculating the KBW Regional Banking, Capital Markets, Bank, Mortgage Finance, and Insurance Indexes. KBW is not responsible for and has not participated in any determination or calculation made with respect to issuance or redemption of the Shares. KBW has no obligation or liability in connection with the administration, marketing or trading of the Shares.

Please refer to important disclosures and analyst certification information on pages 12 - 15.

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October 19, 2009 An Augean Task: A Government Exit Strategy to Recap FNM & FRE

Before investing, consider the funds investment objectives, risks, charges and expenses. To obtain a prospectus which contains this and other information, call 1-866-787-2257 or visit www.spdrs.com. In general, ETFs can be expected to move up or down in value with the value of the applicable index. Although ETFs may be bought and sold on the exchange through any brokerage account, ETFs are not individually redeemable from the Fund. Investors may acquire ETFs and tender them for redemption through the Fund in Creation Unit Aggregations only, please see the prospectus for more details. Shares of the ETFs funds are not insured by the FDIC or by another governmental agency; they are not obligations of the FDIC nor are they deposits or obligations of or guaranteed by KBW or State Street Bank and Trust Company. Funds investing in a single sector may be subject to more volatility than funds investing in a diverse group of sectors. KBW ETFs are distributed by State Street Global Markets, LLC, member FINRA, SIPC. Past performance is not necessarily indicative of future results. ETFs trade like stocks, are subject to investment risk and will fluctuate in market value. Investing in non-U.S. securities, including ADRs, may entail certain risks. The securities of non-U.S. issuers may not be registered with, nor be subject to, the reporting requirements of the U.S. Securities and Exchange Commission. There may be limited information available on foreign securities. In general, foreign companies are not subject to uniform audit and reporting standards, practices and requirements comparable to those of U.S. companies. In addition, exchange rate movements may have an adverse effect on the value of an investment in a foreign stock and its corresponding dividend payment for U.S. investors. Net dividends to ADR investors are estimated, using withholding tax rate conventions, deemed accurate, but investors are urged to consult their tax advisor for exact dividend computations. Investors who have received this report from KBW or an affiliate may be prohibited in certain states or other jurisdictions from purchasing securities mentioned in this report from KBW or its affiliate(s). Please be advised that KBW provides to certain customers on request specialized research products or services that focus on covered stocks from a particular perspective. These products or services include, but are not limited to, compilations, reviews and analysis that may use different research methodologies or focus on the prospects for individual stocks as compared to other covered stocks or over differing time horizons or under assumed market events or conditions. KBW either expects to receive or intends to seek compensation for investment banking services from Fannie Mae during the next three months. KBW currently makes a market in this security FNM. KBW either expects to receive or intends to seek compensation for investment banking services from Freddie Mac during the next three months. KBW currently makes a market in this security FRE. For applicable current disclosures for all covered companies, please write to the Keefe, Bruyette & Woods Research Department at the following address: 787 7th Avenue, 4th Floor, New York, NY 10019 or visit our website at http://www.kbw.com/research/disclosures.html UK Disclaimers 1. This communication is only made to or directed at persons who (i) are outside the United Kingdom or (ii) have professional experience in matters relating to investments or (iii) are persons falling within Article 49(2)(a) to (d) ("high net worth companies, unincorporated associations etc") of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001 and (iv) who are Market Counterparties and/or Intermediate Customers as those terms are defined in the Rules of the Financial Services Authority (all such persons together being referred to as "relevant persons"). This communication must not be acted on or relied on by persons who are not relevant persons. Any investment or investment activity to which this communication relates is available only to relevant

Please refer to important disclosures and analyst certification information on pages 12 - 15.

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October 19, 2009 An Augean Task: A Government Exit Strategy to Recap FNM & FRE

persons and will be engaged in only with relevant persons. 2. This communication has been prepared by Keefe Bruyette & Woods Inc. (KBW) and while Keefe, Bruyette & Woods Limited (KBWL) believes this communication to be reliable, KBWL has not reviewed and/or approved the information contained herein. KBWL does not guarantee its accuracy, adequacy or completeness and is not responsible for any errors or omissions or for the results obtained from the use of such information. 3. Certain assumptions may have been made in connection with the analysis presented herein and changes to the assumptions may have a material impact on the analysis or results. Information with respect to past performance of a security is not necessarily a guide to its future performance. The research and information has been prepared as of a certain date and KBW and KBWL do not undertake to update or advise you of changes in the research and information. The investments discussed herein may be unsuitable for investors depending on their specific investment objectives and financial position. KBW and KBWL make no representation or recommendation as to investments discussed herein. Investors should independently evaluate each investment discussed in the context of their own objectives, risk profile and circumstances. Additional Disclaimers 4. This communication is only intended for and will only be distributed to persons resident in any jurisdictions where such distribution or availability would not be contrary to local law or regulation. This communication must not be acted upon or relied on by persons in any jurisdiction other than in accordance with local law or regulation and where such person is an investment professional with the requisite sophistication and resources to understand an investment in such securities of the type communicated and assume the risks associated therewith.

Please refer to important disclosures and analyst certification information on pages 12 - 15.

Page 15