Freddie Mac 2006 Annual Report Download - page 96

Credit Losses
We maintain a Reserve for losses on mortgage loans held-for-investment to provide for incurred credit losses from our
mortgage loan portfolio. We also maintain a Reserve for guarantee losses on Participation CertiÑcates to provide for losses
incurred on mortgages underlying PCs or Structured Securities held by third parties that we guarantee. We use the same
methodology to determine our Reserve for losses on mortgage loans held-for-investment and our Reserve for guarantee
losses on Participation CertiÑcates, as the relevant factors aÅecting credit risk are the same. The Reserve for losses on
mortgage loans held-for-investment and the Reserve for guarantee losses on Participation CertiÑcates are collectively
referred to as the loan loss reserves.
To calculate the loan loss reserves for the single-family loan portfolio, we aggregate homogenous loans into pools based
on common underlying characteristics, using statistically based models to evaluate relevant factors aÅecting loan
collectibility, and determine the best estimate of loss. To calculate loan loss reserves for the multifamily loan portfolio, we
use models, evaluate certain larger loans for impairment, and review repayment prospects and collateral values underlying
individual loans.
We regularly evaluate the underlying estimates and models we use when determining the loan loss reserves and update
our assumptions to reÖect our own historical experience and our current view of overall economic conditions and other
relevant factors.
Determining the adequacy of the loan loss reserves is a complex process that is subject to numerous estimates and
assumptions requiring judgment. Key estimates and assumptions that impact our loan loss reserves include:
‚ loss severity trends;
‚ default experience;
‚ expected proceeds from credit enhancements;
‚ collateral valuation; and
‚ identiÑcation and impact assessment of macroeconomic factors.
No single statistic or measurement determines the adequacy of the loan loss reserves. We exercise a signiÑcant amount of
judgment in selecting the above factors. Changes in one or more of the estimates or assumptions used to calculate the loan
loss reserves could have a material impact on the loan loss reserves and provisions for credit losses.
We believe the level of our loan loss reserves is reasonable based on internal reviews of the factors and methodologies
used. An independent management group reviews the level of loan loss reserves, as well as the factors and methodologies
that give rise to the estimate, and submits the best point estimate for review by senior management. This review process
provides consistent implementation and disclosure.
Loan loss reserves associated with Hurricane Katrina in 2005 were established based on preliminary estimates that were
higher than current estimates. We have revised these estimates based on additional information about property damage and
recoveries. During 2006, our revised estimates of incurred losses related to Hurricane Katrina resulted in a reduction of
$82 million in the loan loss reserves originally recorded in 2005 for loans aÅected by the hurricane.
Amortization of Cost Basis Adjustments Using the EÅective Interest Method
We recognize interest income on certain mortgage-related and non-mortgage-related investments, using the retrospec-
tive 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, an amendment of FASB Statements No. 13, 60,
and 65 and a rescission of FASB Statement No. 17,'' or SFAS 91. Deferred items, including premiums, discounts and other
basis adjustments, are amortized into interest income over the estimated lives of the securities using the retrospective
eÅective interest method. SFAS 91 allows estimates of principal prepayments for pools of assets containing similar
characteristics where prepayments are probable and the timing and amount of prepayments can be reasonably estimated.
Most of our mortgage-related and non-mortgage-related investments meet this requirement. Therefore, we recalculate the
constant eÅective yield at each period end using our current estimate of principal prepayments. Adjustments that result
from applying the updated eÅective yield as if it had been in eÅect since the acquisition of the securities are recognized
through interest income.
For certain other investments in mortgage-related securities classiÑed as available-for-sale, interest income is
recognized using the prospective eÅective interest method in accordance with Emerging Issues Task Force Issue No. 99-20,
""Recognition of Interest Income and Impairment on Purchased BeneÑcial Interests and BeneÑcial Interests That Continue
to Be Held by a Transferor in Securitized Financial Assets,'' or EITF 99-20. Under this method, changes in the eÅective
yield due to changes in estimated lives are recognized as adjustments to interest income in future periods rather than as
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