Freddie Mac 2009 Annual Report Download - page 150

In the event of counterparty default, our economic loss may be higher than the uncollateralized exposure of our
derivatives if we are not able to replace the defaulted derivatives in a timely and cost-effective fashion. We monitor the risk
that our uncollateralized exposure to each of our OTC counterparties for interest-rate swaps, option-based derivatives,
foreign-currency swaps and purchased interest rate caps will increase under certain adverse market 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 certain changes in the level and implied volatility of interest rates and certain
changes in foreign-currency exchange rates over a brief time period.
As indicated in Table 55, the total exposure on our OTC forward purchase and sale commitments was $81 million and
$537 million at December 31, 2009 and 2008, respectively. These are treated as derivatives and are uncollateralized. Because
the typical maturity of our forward purchase and sale commitments is less than 60 days and they are generally settled
through a clearinghouse, we do not require master netting and collateral agreements for the counterparties of these
commitments. However, we monitor the credit fundamentals of the counterparties to our forward purchase and sale
commitments on an ongoing basis to ensure that they continue to meet our internal risk-management standards. At
December 31, 2009, we had purchase and sale commitments related to our mortgage-related investment portfolio, the
majority of which settled in January 2010.
Document Custodians
We use third-party document custodians to provide loan document certification and custody services for some of the
loans that we purchase and securitize. In many cases, our seller/servicer customers or their affiliates also serve as document
custodians for us. Our ownership rights to the mortgage loans that we own or that back our PCs and Structured Securities
could be challenged if a seller/servicer intentionally or negligently pledges or sells the loans that we purchased or fails to
obtain a release of prior liens on the loans that we purchased, which could result in financial losses to us. When a seller/
servicer or one of its affiliates acts as a document custodian for us, the risk that our ownership interest in the loans may be
adversely affected is increased, particularly in the event the seller/servicer were to become insolvent. We seek to mitigate
these risks through legal and contractual arrangements with these custodians that identify our ownership interest, as well as
by establishing qualifying standards for document custodians and requiring transfer of the documents to our possession or to
an independent third-party document custodian if we have concerns about the solvency or competency of the document
custodian.
Mortgage Credit Risk
We are exposed to mortgage credit risk on our total mortgage portfolio because we either hold the mortgage assets or
have guaranteed mortgages in connection with the issuance of a PC, Structured Security or other mortgage-related guarantee.
Mortgage credit risk is primarily influenced by the credit profile of the borrower on the mortgage, the features of the
mortgage itself, the type of property securing the mortgage and the general economy. All mortgages that we purchase or
guarantee have an inherent risk of default. To manage our mortgage credit risk, we focus on three key areas: underwriting
standards and quality control process; portfolio diversification; and portfolio management activities, including loss mitigation
and the use of credit enhancements.
Our single-family underwriting process evaluates mortgage loans using several critical risk characteristics, including the
borrower’s credit score, original LTV ratio and occupancy type. See “BUSINESS — Regulation and Supervision — Federal
Housing Finance Agency —Affordable Housing Goals” for a discussion of factors that may cause us to purchase loans that
do not meet our normal standards.
We have been significantly adversely affected by deteriorating conditions in the single-family housing and mortgage
markets during 2008 and 2009. In recent years, particularly 2005 to 2007, financial institutions significantly increased
mortgage lending and securitization of certain higher risk mortgage loans, such as subprime, option ARM, interest-only and
Alt-A, and these loans comprised a much larger proportion of origination and securitization issuance volumes during 2006
and 2007, as compared to prior or subsequent years. During this time, we increased our participation in the market for these
products through our purchases of non-agency mortgage-related securities, and, to a lesser extent, through our guarantee
activities. Our expanded participation in these products was driven by a combination of competing objectives and pressures,
including meeting our affordable housing goals, competition, the desire to maintain or increase market share, and generating
returns for investors. The mortgage market changed significantly since 2007. Financial institutions tightened their
underwriting standards, which has significantly reduced the amount of subprime, option ARM, interest-only and Alt-A loans
being originated. During 2008 and 2009, the market for issuances of non-agency mortgage-related securities has been nearly
non-existent, as many institutions ceased their activities in the residential mortgage finance business.
We believe the credit quality of the single-family loans we acquired in 2009 improved, as compared to loans acquired
in recent years, as measured by original LTV ratios and FICO scores. We believe this improvement was the result of:
(i) changes in underwriting guidelines we implemented during 2008 and into 2009; (ii) an increase in the relative amount of
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