Freddie Mac 2004 Annual Report Download - page 45

same information, others could have reached diÅerent, reasonable conclusions. However, we believe the level
of loan loss reserves is reasonable based on internal reviews of the factors and methodologies used.
Interest Income Recognition and Impairment Recognition on Investments in Securities
For most of our mortgage-related and non-mortgage-related investments, we recognize interest income
using the eÅective interest method in accordance with SFAS No. 91, ""Accounting for Nonrefundable Fees
and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases,'' or SFAS 91.
Deferred items, including premiums, discounts and other basis adjustments such as changes in commitment-
period fair value, are amortized into interest income over the estimated lives of the securities using the
retrospective eÅective interest method. Under this method, we recalculate the constant eÅective yield based
on changes in estimated prepayments. Catch-up adjustments to the unamortized balance of premiums,
discounts and other deferred items that result from applying the updated eÅective yield as if it had been in
eÅect since acquisition are recognized through interest income.
For certain other investments in mortgage-related securities and non-mortgage-related securities classi-
Ñed as available-for-sale, interest income is recognized using the prospective eÅective interest method in
accordance with EITF 99-20. Under this method, changes in the eÅective yield are recognized as adjustments
to interest income in future periods. We speciÑcally apply such guidance to beneÑcial interests (including
undivided interests which are similar to beneÑcial interests) in securitized Ñnancial assets that:
‚ can contractually be prepaid or otherwise settled in such a way that we may not recover
substantially all of our recorded investment (such as interest-only stripped securities); or
‚ were not of high credit quality at the date that we acquired them.
We use actual prepayment experience and estimates of future prepayments to determine the constant
yield needed to apply the eÅective interest method of income recognition. In estimating future prepayments
and cash Öows, we aggregate securities by similar characteristics of their underlying collateral such as
origination date, coupon and product. For securities with structured cash Öow payments, such as Structured
Securities, we also consider the characteristics of other security classes within the same transaction structure
when estimating future prepayments and cash Öows.
Determination of the eÅective yield requires signiÑcant judgment in estimating expected prepayment
behavior, which is inherently uncertain. Estimates of future prepayments are derived from market sources and
our internal prepayment models. Our prepayment models contemplate a variety of assumptions about
borrower behavior in response to changes in interest rates and other macroeconomic factors. Judgment is
involved in making initial determinations about prepayment expectations and in changing those expectations
over time in response to changes in market conditions. The eÅects of future changes in market conditions may
be material. We believe that the above assumptions are comparable to those used by other market
participants. However, the use of diÅerent assumptions in our prepayment models could have resulted in
materially diÅerent income recognition results.
We recognize impairment losses on available-for-sale securities in our Retained portfolio and Cash and
investments portfolio when we have concluded that a decrease in the fair value of a security is other than
temporary. EITF 99-20 requires impairment recognition when there is both a decline in fair value below the
carrying amount and an adverse change in expected cash Öows. Determination of whether an adverse change
has occurred involves judgment about expected prepayments and credit events. For securities not accounted
for under EITF 99-20, we review securities for possible other-than-temporary impairment whenever the
security's fair value is less than its amortized cost. Impairment is evaluated considering a number of indicators
which include the severity of the decline in fair value, credit ratings and the length of time the investment has
been in an unrealized loss position. In addition to these indicators, we recognize impairment when qualitative
factors indicate that we may not recover the unrealized loss. When evaluating the impairment indicators and
qualitative factors, we consider our intent and ability to hold the investment until a point in time at which
recovery can be reasonably expected to occur. We apply signiÑcant judgment in determining whether
impairment loss recognition is appropriate. We believe our judgments are reasonable; however, diÅerent
judgments could have resulted in materially diÅerent impairment loss recognition. See
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