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
212-887-3843 Summary--
bgeorge@kbw.com
Fannie Mae and Freddie Mac have been at the heart of the U.S. housing boom,
Frederick Cannon bust and recovery. As the mortgage market moves away from crisis mode, the
212-887-3887
future of the government-sponsored enterprises (GSEs) has to be addressed. In
fcannon@kbw.com
order for the GSEs to survive going forward, we believe they need to be
Jade J. Rahmani recapitalized through investments from the banks that benefit from their role in
212-887-3882 the secondary market. Additionally, we believe the ownership structure should
jrahmani@kbw.com
be shifted over time to a cooperative of banks similar to the Federal Home Loan
Bank (FHLB) system.

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.

Market Rating 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 $ 500,000

Hedged Net Interest Yield 0.80%
Net Interest Income $ 4,000

Guarantee Assets $ 5,000,000

Guarantee Fee 0.25%
Credit Expense 0.05%
Operating Expense 0.05%
Net Guarantee Spread 0.15%
Net Guarantee Income $ 7,500

Net Income Pre-Tax $ 11,500

Tax Rate 35%
Net Income After-Tax $ 7,475

Return of Assets 0.14%

Capitalization Level 5.00%
Equity $ 275,000
Return on Equity 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 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Total Originations 2,000 2,000 2,000 2,000 2,000 2,500 2,500 2,500 2,500 2,500
GSE Percentage 65% 63% 61% 59% 57% 55% 53% 51% 49% 47%
GSE Volume 1,300 1,260 1,220 1,180 1,140 1,375 1,325 1,275 1,225 1,175
GSE Prepayments - (195) (355) (485) (589) (895) (991) (1,058) (1,101) (1,126)
GSE Capital Created 65 63 61 59 57 69 66 64 61 59
Redeemable Capital - (10) (18) (24) (29) (45) (50) (53) (55) (56)
Total GSE Capital 65 118 162 196 224 248 265 275 282 284

Prepayments 15% 15% 15% 15% 15% 20% 20% 20% 20% 20%
GSE Book of Business 1,300 2,365 3,230 3,926 4,477 4,956 5,290 5,507 5,631 5,680
Mortgage Debt Outstanding 11,000 11,220 11,444 11,673 11,907 12,145 12,388 12,636 12,888 13,146
GSE Percentage of market 11.8% 21.1% 28.2% 33.6% 37.6% 40.8% 42.7% 43.6% 43.7% 43.2%
GSE Capital Ratio 5% 5% 5% 5% 5% 5% 5% 5% 5% 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%

$4.0
15%
$3.0
% Chg. YoY
$ in tril.

10%
$2.0
5%
$1.0

$0.0 0%
Jan-05

Jul-05

Jan-06

Jul-06

Jan-07

Jul-07

Jan-08

Jul-08

Jan-09

Jul-09

Guarantee Portfolios 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
Loans with Loans with Sub-total
Negative- Loans Loans with Original FICO < 620 and of Key
Amortizing Interest- with FICO > 620 LTV Ratio > Original LTV Alt-A Subprime Product Overall
As of June 30, 2009 Loans Only Loans FICO< 620 and < 660 90% Ratio > 90% Loans Loans Features Book

Unpaid Principal Balance (billions) $15.40 $195.90 $115.60 $242.30 $265.30 $25.40 $269.30 $7.90 $878.20 $2,744.20
Share of Single-Family Conventional Credit Book 0.60% 7.10% 4.20% 8.80% 9.70% 0.90% 9.80% 0.30% 32.00% 100.00%
Average Unpaid Principal Balance $137,513 $242,048 $125,165 $140,431 $141,622 $118,569 $168,784 $149,958 $152,814 $150,966
Serious Delinquency Rate 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%
Original Loan-to-Value Ratio > 90% 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%
Weighted Average FICO 702 724 588 641 695 592 718 623 686 727
FICO < 620 9.10% 1.30% 100.00% 0.00% 9.60% 100.00% 0.70% 48.00% 13.20% 4.20%
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 Option FICO FICO Original LTV Original
Attribute 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%

Book Year
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%

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 Stress Case Best Case
Fannie Freddie Fannie Freddie Fannie Freddie
Mae Mac Mae Mac Mae Mac
Balance (UPB $ Billions) $2,744.2 $1,887.0 $2,744.2 $1,887.0 $2,744.2 $1,887.0
Mortgage loans $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%
$ amount of loss ($ billions) 113 59 279.4 144.4 62.4 33.7

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 Markdown
At June 30, 2009 Cost Percentage

Mortgage-related securities:
Fannie Mae single-class€MBS $242.7
Non-Fannie Mae single-class 92.3
Mortgage revenue bonds + Other 15.6
Total 350.6

Non-mortgage-related securities: 15.7

Total investments in securities 366.3 377.3 -2.9%

Mortgage Loans 415.6

Total Mortgage Assets 781.9

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 Markdown
Total GAAP Cost Percentage

Available-for-sale, at fair value:

Freddie Mac $253.6 $247.3 2.5%
Subprime 39.9 63.9 -37.5%
Commercial mortgage-backed securities 49.2 63.0 -21.9%
MTA Option ARM 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%
Total mortgage-related securities 414.4 463.1 -10.5%
Asset-backed securities 6.2 5.8 7.4%
Total available-for-sale securities, at fair value 420.7 469.0 -10.3%

Trading, at fair value:

Freddie Mac 202.4
Fannie Mae 36.1
Ginnie Mae 0.2
Other 0.0
Total mortgage-related securities 238.7
Other trading securities 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 Fannie Mae Freddie Mac
Current Reserve 55 25
10-Year Revenues 38 37
Total 93 63
Expected Cumulative Losses (116) (59)
Charegoffs to Date 18 8
Year 10 Capital Position (4) 12
Current Debt to Government (45) (51)
Net capital position year 10 (49) (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
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Total Earnings
Interest Earning Asset $ 780 624 499 399 319 256 204 164 131 105
Hedged Net Interest Yield 1.00% 1.00% 1.00% 1.00% 1.00% 1.00% 1.00% 1.00% 1.00% 1.00%
Net Interest Income $ 8 $ 6 $ 5 $ 4 $ 3 $ 3 $ 2 $ 2 $ 1 $ 1

Guarantee Assets $ 2,450 1,960 1,568 1,254 1,004 803 642 514 411 329
Guarantee Fee 0.25% 0.25% 0.25% 0.25% 0.25% 0.25% 0.25% 0.25% 0.25% 0.25%
Credit Expense 0.05% 0.05% 0.05% 0.05% 0.05% 0.05% 0.05% 0.05% 0.05% 0.05%
Operating Expense 0.05% 0.05% 0.05% 0.05% 0.05% 0.05% 0.05% 0.05% 0.05% 0.05%
Net Guarantee Spread 0.15% 0.15% 0.15% 0.15% 0.15% 0.15% 0.15% 0.15% 0.15% 0.15%
Net Guarantee Income 3.7 2.9 2.4 1.9 1.5 1.2 1.0 0.8 0.6 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 $ 38

Prepayment Rate 20% 20% 20% 20% 20% 20% 20% 20% 20% 20%

Source: KBW Research.

Please refer to important disclosures and analyst certification information on pages 12 - 15. Page 10
 October 19, 2009
An Augean Task: A Government Exit Strategy to Recap FNM & FRE

Exhibit 12: Freddie Mac Earnings Model

$ in billions
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Total Earnings
Interest Earning Asset $ 780 624 499 399 319 256 204 164 131 105
Hedged Net Interest Yield 1.00% 1.00% 1.00% 1.00% 1.00% 1.00% 1.00% 1.00% 1.00% 1.00%
Net Interest Income $ 8 $ 6 $ 5 $ 4 $ 3 $ 3 $ 2 $ 2 $ 1 $ 1

Guarantee Assets $ 1,841 1,473 1,178 943 754 603 483 386 309 247
Guarantee Fee 0.25% 0.25% 0.25% 0.25% 0.25% 0.25% 0.25% 0.25% 0.25% 0.25%
Credit Expense 0.05% 0.05% 0.05% 0.05% 0.05% 0.05% 0.05% 0.05% 0.05% 0.05%
Operating Expense 0.05% 0.05% 0.05% 0.05% 0.05% 0.05% 0.05% 0.05% 0.05% 0.05%
Net Guarantee Spread 0.15% 0.15% 0.15% 0.15% 0.15% 0.15% 0.15% 0.15% 0.15% 0.15%
Net Guarantee Income 2.8 2.2 1.8 1.4 1.1 0.9 0.7 0.6 0.5 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 $ 37

Prepayment Rate 20% 20% 20% 20% 20% 20% 20% 20% 20% 20%

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. Page 11
 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 11/21/07 03/03/08 03/20/08 08/11/08 09/08/08
I:MP:$62 MP:$25 MP:$32 OP:$48 MP:$10 MP:$1

75

60

45

30

15

0
Q3 Q1 Q2 Q3 Q1 Q2 Q3 Q1 Q2 Q3
2007 2008 2009

Created by BlueMatrix

Rating and Price Target History for: Freddie Mac (FRE) as of 10-16-2009
01/12/07 02/21/07 11/21/07 03/20/08 05/19/08 08/07/08 09/08/08
D:NR:NA MP:$66 MP:$22 OP:$46 OP:$45 MP:$8 MP:$1

75

60

45

30

15

0
Q3 Q1 Q2 Q3 Q1 Q2 Q3 Q1 Q2 Q3
2007 2008 2009

Created by BlueMatrix

Distribution of Ratings/IB Services

KBW
*IB Serv./Past 12 Mos.
Rating Count Percent Count Percent
Outperform [BUY] 129 23.98 34 26.36
Market Perform [HOLD] 333 61.90 76 22.82
Underperform [SELL] 42 7.81 4 9.52
Restricted [RES] 0 0.00 0 0.00
Suspended [SP] 34 6.32 7 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. Page 12
 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. Page 13
 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. Page 14
 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