Freddie Mac 2006 Annual Report Download - page 78

conditions by performing daily market stress tests. These tests evaluate the potential additional uncollateralized exposure we
would have to each of these derivative counterparties assuming changes in the level and implied volatility of interest rates
and changes in foreign-currency exchange rates over a brief time period.
To date, we have not incurred any credit losses on OTC derivative counterparties or set aside speciÑc reserves for
institutional credit risk exposure. We do not believe such reserves are necessary, given our counterparty credit risk
management policies and collateral requirements.
OTC Forward Purchase and Sale Commitments Treated as Derivatives. Because the typical maturity of our OTC
commitments is less than one year, we do not require master netting and collateral agreements for the counterparties of these
commitments. However, we monitor the credit fundamentals of our OTC commitments counterparties on an ongoing basis
to ensure that they continue to meet our internal risk-management standards. As indicated in Table 36, the exposure to
OTC commitments counterparties of $24 million and $35 million at December 31, 2006 and 2005, respectively, was
uncollateralized.
Credit Risks
Our credit guarantee portfolio is subject primarily to two types of credit risk: mortgage credit risk and institutional credit
risk. Mortgage credit risk is the risk that a borrower will fail to make timely payments on a mortgage or security we own or
guarantee. Institutional credit risk is the risk that a counterparty that has entered into a business contract or arrangement
with us will fail to meet its obligations. See ""PORTFOLIO BALANCES AND ACTIVITIES Ì Table 47 Ì Total
Mortgage Portfolio and Total Guaranteed PCs and Structured Securities Issued Based on Unpaid Principal Balances'' for
more information on the composition of our Total mortgage portfolio.
Mortgage Credit Risk
Mortgage Credit Risk Management Strategies. Mortgage credit risk is primarily inÖuenced by the credit proÑle of the
borrower on the mortgage, the features of the mortgage itself, the type of property securing the mortgage and the general
economy. To manage our mortgage credit risk, we focus on three key areas: underwriting requirements and quality control
standards; portfolio diversiÑcation; and portfolio management activities, including loss mitigation and the use of credit
enhancements. While we have historically focused on obtaining credit enhancements at the time of mortgage purchase, we
are continuing to expand our capabilities in this area to allow more active and ongoing credit portfolio rebalancing and risk
transfers.
Underwriting Requirements and Quality Control Standards. All mortgages that we purchase for our Retained
portfolio or guarantee have an inherent risk of default. We seek to manage the underlying risk by adequately pricing for the
risk we assume using our underwriting and quality control processes.
We use a process of delegated underwriting for the single-family mortgages we purchase or securitize. In this process,
we provide originators with a series of mortgage underwriting standards and the originators represent and warrant to us that
the mortgages sold to us meet these requirements. We subsequently review a sample of these loans and, if we determine
that any loan is not in compliance with our contractual standards, we may require the seller/servicer to repurchase that
mortgage or make us whole in the event of a default. We provide originators with written standards and/or automated
underwriting software tools, such as Loan Prospector» and other quantitative credit risk management tools that are designed
to evaluate single-family mortgages and monitor the related mortgage credit risk for loans we may purchase. Loan
Prospector» generates a credit risk classiÑcation by evaluating information on signiÑcant indicators of mortgage default risk,
such as loan-to-value ratios, credit scores and other mortgage and borrower characteristics. These statistically-based risk
assessment tools increase our ability to distinguish among single-family loans based on their expected risk, return and
importance to our mission. In many cases, underwriting standards are tailored under contracts with individual customers. We
have been expanding the share of mortgages we purchase that were underwritten by our seller/servicers using alternative
automated underwriting systems or agreed-upon underwriting standards that diÅer from our system or guidelines. We
regularly monitor the performance of mortgages purchased using these systems and standards, and if they underperform
mortgages originated using Loan Prospector», we may seek additional guarantee fee compensation for future purchases of
similar mortgages.
The percentage of our single-family mortgage purchase volume evaluated using Loan Prospector» prior to purchase has
declined over the last three years. As part of our post-purchase quality control review process, we use Loan Prospector» to
evaluate the credit quality of virtually all single-family mortgages that were not evaluated by Loan Prospector» prior to
purchase. Loan Prospector» risk classiÑcations inÖuence both the price we charge to guarantee loans and the loans we review
in quality control.
For multifamily mortgage loans, we use an intensive pre-purchase underwriting process for the mortgages we purchase,
unless the mortgage loans have signiÑcant credit enhancements. Our underwriting process includes assessments of the local
66 Freddie Mac