equity research

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

Company Update

Rating ChangePrice Target Change

Bose [email protected]

Frederick [email protected]

Jade J. [email protected]

Mortgage Finance October 19, 2009

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

Summary--

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, thefuture of the government-sponsored enterprises (GSEs) has to be addressed. Inorder for the GSEs to survive going forward, we believe they need to berecapitalized through investments from the banks that benefit from their role inthe secondary market. Additionally, we believe the ownership structure shouldbe shifted over time to a cooperative of banks similar to the Federal Home LoanBank (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 frombecoming full government entities to returning to being stock-holdercorporations. What all the recommendations to date have not done—includingthe ones in the GAO reports—in our view is address the most crucial issueregarding the agencies: how to recapitalize them.

■ In our view, in order for Fannie Mae and Freddie Mac to survive goingforward, they need to be recapitalized through investments by the banks thatbenefit from their guarantee. Under such an approach, any bank that originatesan agency conforming loan and wishes to sell the loan to the GSEs would berequired 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 newexpanded balance sheets under FAS 166/167.

■ In this scenario, both the common and preferred equity of the GSEs should beworthless. Our bad bank analysis suggests that the companies will still owe thegovernment almost $100 billion by the end of year ten. As a result, we aredowngrading FNM and FRE common shares to Underperform and are cuttingour 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)

Equity Research


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 intoreceivership last summer, the U.S. government has put $98 billion of capital into the two organizations and their guaranteehas become more explicit. The combination of increased support for the GSEs and the slowdown in originations in theprivate sector has resulted in the GSE volume growing sharply. Fannie Mae and Freddie Mac accounted for 68% of alloriginations in 2009. (The government's Federal Housing Administration program accounted for a large percentage of theremainder.) Exhibit 1 shows the historical market share of the GSEs.

Exhibit 1: GSE Market Share Growth

0%

20%

40%

60%

80%

100%

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 FinanceAgency that was the regulator of Fannie and Freddie at the time of conservatorship—stated when the U.S. governmentseized them, "Fannie Mae and Freddie Mac are no longer in the business of maximizing shareholder value." Rather, in ourview, 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 federalaid to support and revive the U.S. housing market in the midst of a crisis. At the same time, their operating structure is asprivate companies operating under the conservatorship of the U.S. government. This is not a sustainable structure as isdocumented in a recent report from the Government Accountability Office ("Fannie Mae and Freddie Mac: Analysis ofOptions for Revising the Housing Enterprises' Long-term Structures" dated September 10, 2009).

The Problem of CapitalThe GAO report presents options for Fannie and Freddie ranging from becoming full government entities to returning tobeing stock-holder corporations. What the GAO report is missing, in our view, is addressing the most crucial issueregarding 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 GAOestimated need of $389 billion government support;

■ Accounting changes will balloon the balance sheets of the two companies to approximately $5.5 trillion in 2010 fromunder $2 trillion today as a result of FAS 166/167, illustrating the capital needs of the companies; and

October 19, 2009



■ Large banks are generating large amounts of mortgage banking income as a result of the government operations in themortgage 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 aBad Fannie and Bad Freddie with the existing portfolios, and a new Fannie Mae and Freddie Mac as cooperatives of bankmortgage lenders, along the lines of the other GSEs—the Federal Home Loan Banks.

New Agencies as Cooperatives of Mortgage BanksThere is general consensus that the primary role of the agencies in the future is in the loan guarantee business and not inthe investment business. By creating "bad banks" of the existing portfolios and putting the existing portfolios intoreceivership, the government can limit its losses and define its role in supporting the mortgage industry through the crisisand create an exit strategy.

In order for Fannie Mae and Freddie Mac to survive going forward, we believe they need to be recapitalized throughinvestments from the banks that benefit from their role in the secondary market. Additionally, we believe ownershipstructure should be shifted over time to a cooperative of banks similar to the Federal Home Loan Bank system. Under suchan approach, the banks that originate an agency conforming loan would be required to retain 5% of the loan balance as anequity investment in either Fannie Mae or Freddie Mac. Thus the new agencies would be recapitalized at a solid 5% levelof the new expanded balance sheets under FAS 166/167. The capital would provide a significant buffer to bondholders inthe new agencies from future losses. Further we expect that this level of capital would allow the government to sunset anexplicit guarantee of the new agencies' debt over time. We would expect the government to initially guarantee the debt ofthe 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 ofcapitalization. In Exhibit 2, we present the "normalized" balance sheet and earnings of the new agencies, assumingguarantee fees are kept modest, investment portfolios are strictly limited to liquidity needs, and credit quality is maintainedat historically high levels. As shown, the return on the stock investment we estimate is under 5%. We believe that thiswould 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 just20%); and

■ The new agencies would have very limited investment portfolios. Historically, the retained portfolio growth at the GSEswas something that banks resented.

October 19, 2009



Exhibit 2: GSE Normalized ReturnsCombined "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 trillionannually for the next several years. The new agencies could be structured as one or two separate agencies, or regionallyalong the lines of the Federal Home Loan Bank system. Exhibit 3 shows the potential growth trajectory for the newentities. It suggests that just with normal prepayment activity, the new GSEs will account for over 40% of the mortgagemarket and have largely replaced the old GSEs within a ten year time frame. Our model assumes that the retainedportfolios 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%


October 19, 2009



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. Thehistorical portfolios, in our view, create a sunk cost. Government investments have been necessary to absorb losses abovethose borne by common and preferred shareholders. (Current bondholders would be protected, resulting from thegovernment's commitment.)

Potential Losses at the Legacy Bad GSEsThe potential losses at the existing GSE portfolios derive from two sources: (1) their guarantee business and (2) theirinvestment portfolios. We look at each separately.

GSE Guarantee PortfoliosThe GSEs have roughly $5 trillion that they currently guarantee. Exhibit 4 shows the growth in the GSE guaranteeportfolios and where they currently stand.

Exhibit 4:GSE Guarantee Portfolios$ in trillions

$0.0

$1.0

$2.0

$3.0

$4.0

$5.0

Jan-

05

Jul-0

5

Jan-

06

Jul-0

6

Jan-

07

Jul-0

7

Jan-

08

Jul-0

8

Jan-

09

Jul-0

9

$ in

tril.

0%

5%

10%

15%

20%%

Chg

. YoY

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 seriousdelinquency 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 NationalDelinquency Survey.

However, we still anticipate significant losses. Despite their relatively small exposure in percentage terms to high-riskcategories, in dollar terms, these exposures are very material. Exhibit 5 shows Fannie Mae's higher risk book of businessand Exhibit 6 shows the same for Freddie Mac.

October 19, 2009



Exhibit 5: Fannie Mae High Risk Portfolio

As of June 30, 2009

Negative-

Amortizing

Loans

Interest-

Only Loans

Loans

with

FICO< 620

Loans with

FICO > 620

and < 660

Loans with

Original

LTV Ratio >

90%

Loans with

FICO < 620 and

Original LTV

Ratio > 90%

Alt-A

Loans

Subprime

Loans

Sub-total

of Key

Product

Features

Overall

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%




Categories Not Mutually Exclusive


October 19, 2009



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%


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

October 19, 2009



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

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

Best CaseStress CaseBase Case

Source: Company data and KBW estimates.

GSE Retained PortfoliosOur 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


October 19, 2009



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


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

October 19, 2009



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)


Exhibit 11 and 12 show how we calculate future earnings for Fannie Mae and Freddie Mac in runoff. Note that we assumeno 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 thecompanies' debt to the government is likely to increase materially in the next 12-18 months. Our numbers suggest thatFannie Mae's total debt could reach $100 billion and Freddie Mac's debt could reach $75 billion before declining as thecompanies' 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%


October 19, 2009



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%


We Downgrade Fannie Mae and Freddie Mac to UnderperformAs 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 becomegovernment-owned entities; we believe that our ratings and price targets have not been very meaningful since then. Ourchange in ratings and price targets today is primarily being made to make them consistent with the outcome that we areexpecting for the companies: that they become government-run organizations and their current shareholders will not getanything 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 assumeour 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 whichcould result in credit losses being materially lower than we estimate. Also, if the companies' retained portfolios performmaterially better than the current marks suggest, the companies' capital positions could improve.

October 19, 2009



Q3 Q1 Q2 Q3 Q1 Q2 Q3 Q1 Q2 Q30

15

30

45

60

75

2007 2008 2009

01/12/07I:MP:$62

11/21/07MP:$25

03/03/08MP:$32

03/20/08OP:$48

08/11/08MP:$10

09/08/08MP:$1

Rating and Price Target History for: Fannie Mae (FNM) as of 10-16-2009

Created by BlueMatrix

Q3 Q1 Q2 Q3 Q1 Q2 Q3 Q1 Q2 Q30

15

30

45

60

75

2007 2008 2009

01/12/07D:NR:NA

02/21/07MP:$66

11/21/07MP:$22

03/20/08OP:$46

05/19/08OP:$45

08/07/08MP:$8

09/08/08MP:$1

Rating and Price Target History for: Freddie Mac (FRE) as of 10-16-2009

Created by BlueMatrix

Distribution of Ratings/IB ServicesKBW

*IB Serv./Past 12 Mos.

Rating Count Percent Count Percent

Outperform [BUY] 129 23.98 34 26.36Market Perform [HOLD] 333 61.90 76 22.82Underperform [SELL] 42 7.81 4 9.52Restricted [RES] 0 0.00 0 0.00Suspended [SP] 34 6.32 7 20.59

* Keefe, Bruyette & Woods, Inc. and Keefe, Bruyette and Woods Limited maintain separate researchdepartments; 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 bankingfees.

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

October 19, 2009



have not been, and will not be receiving direct or indirect compensation in exchange for expressing the specificrecommendation in this report.

This communication is not an offer to sell or a solicitation to buy the securities mentioned. The information relatingto any company herein is derived from publicly available sources and Keefe, Bruyette & Woods, Inc. makes norepresentation as to the accuracy or completeness of such information.DisclosuresKeefe, Bruyette & Woods (KBW) Research Department provides three core ratings: Outperform, Market Performand Underperform, and two ancillary ratings: Suspended and Restricted. For purposes of New York StockExchange Rule 472 and FINRA Rule 2711, Outperform is classified as a Buy, Market Perform is classified as aHold, 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).Outperformrepresents a total rate of return of 15% or greater.Market Perform represents a total rate of return in a rangebetween -5% and +15%.Underperform represents a total rate of return at or below -5%.Suspended indicates thatKBW's investment rating and target price have been temporarily suspended due to a lack of publicly availableinformation and/or to comply with applicable regulations and/or KBW policies.Restricted indicates that KBW isprecluded from providing an investment rating or price target due to the firm's role in connection with a merger orother strategic financial transaction.Companies placed on the KBW Best Ideas Outperform List are expected togenerate a total rate of return (percentage price change plus dividend yield) of 20% or more over the following 12months.Companies placed on the KBW Best Ideas Underperform List are expected to generate a total rate ofreturn (percentage price change plus dividend yield) at or below -20% over the following 12 months.Researchanalysts employ widely used multiple valuation methodologies including, but not limited to, absolute, relative andhistorical Price/Earnings (P/E) and Price/Cash Flow multiples, absolute, relative and historical Price/Book Valuemultiples and Discounted Cash Flow Analysis.All KBW research analysts are compensated based on a number offactors, including overall profitability of the company, which is based in part on KBW's overall investment bankingrevenues.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 & CasualtyIndex (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 impliedwarranties with respect to the Index and shall have no liability for any damages, claims, losses or expenses causedby errors in the index calculation. KBW makes no representation regarding the advisability of investing in optionson 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 anymember of the public regarding the advisability of investing in securities generally or in the Shares particularly orthe ability of the KBW Regional Banking, Capital Markets, Bank, Mortgage Finance, and Insurance Indexes totrack general stock market performance. KBW's only relationship to State Street Bank and Trust Company is thelicensing 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 regardto State Street Bank and Trust, the fund, or the Shares. KBW has no obligation to take the needs of State StreetBank and Trust Company or the owners of the shares into consideration in determining, composing, or calculatingthe KBW Regional Banking, Capital Markets, Bank, Mortgage Finance, and Insurance Indexes. KBW is notresponsible for and has not participated in any determination or calculation made with respect to issuance orredemption of the Shares. KBW has no obligation or liability in connection with the administration, marketing ortrading of the Shares.

October 19, 2009



Before investing, consider the funds investment objectives, risks, charges and expenses. To obtain a prospectuswhich 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. AlthoughETFs may be bought and sold on the exchange through any brokerage account, ETFs are not individuallyredeemable from the Fund. Investors may acquire ETFs and tender them for redemption through the Fund inCreation Unit Aggregations only, please see the prospectus for more details. Shares of the ETFs funds are notinsured by the FDIC or by another governmental agency; they are not obligations of the FDIC nor are they depositsor obligations of or guaranteed by KBW or State Street Bank and Trust Company. Funds investing in a singlesector may be subject to more volatility than funds investing in a diverse group of sectors. KBW ETFs aredistributed by State Street Global Markets, LLC, member FINRA, SIPC. Past performance is not necessarilyindicative 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 notbe 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 touniform audit and reporting standards, practices and requirements comparable to those of U.S. companies. Inaddition, exchange rate movements may have an adverse effect on the value of an investment in a foreign stock andits corresponding dividend payment for U.S. investors. Net dividends to ADR investors are estimated, usingwithholding tax rate conventions, deemed accurate, but investors are urged to consult their tax advisor for exactdividend computations. Investors who have received this report from KBW or an affiliate may be prohibited incertain states or other jurisdictions from purchasing securities mentioned in this report from KBW or itsaffiliate(s).Please be advised that KBW provides to certain customers on request specialized research products or services thatfocus 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 forindividual stocks as compared to other covered stocks or over differing time horizons or under assumed marketevents or conditions.

KBW either expects to receive or intends to seek compensation for investment banking services from Fannie Maeduring 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 Macduring 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 ResearchDepartment at the following address: 787 7th Avenue, 4th Floor, New York, NY 10019 or visit our website athttp://www.kbw.com/research/disclosures.htmlUK Disclaimers1. This communication is only made to or directed at persons who (i) are outside the United Kingdom or (ii) haveprofessional 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 thoseterms 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 relevantpersons. Any investment or investment activity to which this communication relates is available only to relevant

October 19, 2009


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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 theinformation contained herein. KBWL does not guarantee its accuracy, adequacy or completeness and is notresponsible 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 theassumptions may have a material impact on the analysis or results. Information with respect to past performance ofa security is not necessarily a guide to its future performance. The research and information has been prepared asof a certain date and KBW and KBWL do not undertake to update or advise you of changes in the research andinformation. The investments discussed herein may be unsuitable for investors depending on their specificinvestment objectives and financial position. KBW and KBWL make no representation or recommendation as toinvestments discussed herein. Investors should independently evaluate each investment discussed in the context oftheir own objectives, risk profile and circumstances.Additional Disclaimers4. This communication is only intended for and will only be distributed to persons resident in any jurisdictionswhere such distribution or availability would not be contrary to local law or regulation. This communication mustnot be acted upon or relied on by persons in any jurisdiction other than in accordance with local law or regulationand where such person is an investment professional with the requisite sophistication and resources to understandan investment in such securities of the type communicated and assume the risks associated therewith.

October 19, 2009


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