Freddie Mac 2005 Annual Report Download - page 72

This review is expected to continue throughout 2006 and contemplates the implementation of several planned system
enhancements to our accounting, Ñnancial reporting and operational infrastructure later in the year. This review will enable
us to further evaluate the risk severity of our existing deÑciencies and may identify new material weaknesses or other
deÑciencies. We believe that this process will provide consistency in evaluations and veriÑcation of the appropriateness and
completeness of our remediation activities. After a control deÑciency is identiÑed, the responsible business area is required
to establish a remediation plan to address it. Upon achieving milestones in our remediation plans, we will test the results.
To provide for Ñnancial reporting at the end of 2006, we will conduct an assessment of the existing material weaknesses and
deÑciencies and remediation activities. We will regularly monitor and report on our remediation progress to senior
management, our board of directors, OFHEO and our internal and external auditors.
In order to devote the resources needed to complete the review eÅectively and return to timely reporting as soon as
possible, we have decided to delay our interim Ñnancial reporting for 2006. We have also decided to limit the number of
initiatives we plan to undertake in 2006 and defer lower priority systems initiatives until we have progressed further with our
internal controls. It is our objective to return to quarterly reporting with our release of full-year 2006 Ñnancial results. After
we resume regular quarterly reporting, we will begin the process of registering our common stock with the SEC.
Our review of the internal control environment and our ongoing control remediation activities are intended to provide a
basis for our reliance on our internal control over Ñnancial reporting. Our ability to rely on internal controls is essential to our
return to timely reporting, because it will alleviate the need to perform substantive procedures to compensate for our
material weaknesses and other control deÑciencies.
The material weaknesses and signiÑcant deÑciencies in our internal control over Ñnancial reporting adversely aÅect our
ability to record, process, summarize and report Ñnancial data in a timely manner. Based on the continued existence of
material weaknesses at December 31, 2005, our Chief Executive OÇcer and President and Chief Operating OÇcer have
concluded that our internal control over Ñnancial reporting was not eÅective at December 31, 2005. In order to compensate
for the material weaknesses and other deÑciencies in our internal controls, we continue to perform extensive veriÑcation and
validation procedures to provide reasonable assurance that our consolidated Ñnancial statements are prepared in accordance
with GAAP. Therefore, in view of the alternative procedures we performed, we believe that these weaknesses do not prevent
us from preparing and issuing our consolidated Ñnancial statements in accordance with GAAP.
Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that the
information required to be disclosed by a company in its Ñnancial reports is accumulated and communicated to its senior
management team as appropriate to allow timely decisions regarding required disclosure. Full evaluation of our disclosure
controls and procedures has been delayed pending our completion of the design and implementation of these controls and
procedures and the testing program for evaluating their eÅectiveness.
Interest-Rate Risk and Other Market Risks
Our interest-rate risk management objective is to serve our housing mission by protecting shareholder value in all
interest-rate environments. Our disciplined approach to interest-rate risk management is essential to maintaining a strong
and durable capital base and uninterrupted access to debt and equity capital markets.
Sources of Interest-Rate Risk and Other Market Risks
Our Retained portfolio activities expose us to interest-rate risk and other market risks arising primarily from the
uncertainty as to when borrowers will pay the outstanding principal balance of mortgage loans and mortgage-related
securities held in the Retained portfolio, known as prepayment risk, and the resulting potential mismatch in the timing of our
receipt of cash Öows on our assets versus the timing of our obligation to make payments on our liabilities. For the vast
majority of our mortgage-related investments, the mortgage borrower has the option to make unscheduled payments of
additional principal or to completely pay oÅ a mortgage loan at any time before its scheduled maturity date (without having
to pay a prepayment penalty) or to hold the mortgage loan to its stated maturity.
Our credit guarantee activities also expose us to interest-rate risk because changes in interest rates can cause
Öuctuations in the fair value of our existing credit guarantee portfolio. We generally do not hedge these changes in fair value
except for interest-rate exposure related to net buy-ups and Öoat. Float, which arises from timing diÅerences between when
the borrower pays us and when we reduce the PC balance, can lead to signiÑcant interest expense if the interest rate paid to
a PC investor is higher than the reinvestment rate we earn on payments received from mortgage borrowers.
The types of interest-rate risk and other market risks to which we are exposed are described below.
Duration Risk and Convexity Risk. Duration is a measure of a Ñnancial instrument's price sensitivity to changes in
interest rates. Convexity is a measure of how much a Ñnancial instrument's duration changes as interest rates change. Our
convexity risk primarily results from prepayment risk. We actively manage duration risk and convexity risk through asset
selection and structuring (that is, by identifying or structuring mortgage-related securities with attractive prepayment and
56 Freddie Mac