Freddie Mac 2009 Annual Report Download - page 201

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Interest-Rate Risk and Other Market Risks
Interest-Rate Risk Management Framework
We utilize a disciplined and comprehensive approach to managing interest rate risk. Our objective is to minimize our
interest rate risk exposure across a wide range of interest rate scenarios. To do this, we analyze the interest rate sensitivity of
all financial assets and liabilities at the instrument level on a daily basis and across a variety of interest rate scenarios. For
risk management purposes, the interest rate characteristics of each instrument are determined daily based on market prices
and internal models. The prices of our assets, liabilities and derivatives are primarily based on either third party prices, or
observable market based inputs. These fair values, whether direct from third parties or derived from observable inputs, are
reviewed and validated by groups that are separate from our trading and investing function.
Our interest rate risk framework includes a comprehensive set of interest rate risk guidelines. Annually, our Board of
Directors establishes certain limits for risk measures, and if we exceed these limits we are required to notify the Business
and Risk Committee of the Board of Directors as well as provide our expected course of action to return below the limits.
These limits encompass a wide range of interest rate risks that include duration risk, convexity risk, volatility risk, yield
curve risk and basis risk associated with our use of various financial instruments, including derivatives. Also on an annual
basis, our Enterprise Risk Oversight division, or ERO, establishes management limits and makes recommendations with
respect to the limits established by the Board of Directors. These limits are reviewed by our Enterprise Risk Management
Committee, which is responsible for reviewing performance as compared to the established limits. The management limits
are at values below those set by our Board of Directors, which allows us to follow a series of predetermined actions in the
event of a breach of the management limits and helps ensure proper oversight to reduce the possibility of exceeding the
limits set by our Board of Directors.
Sources of Interest-Rate Risk and Other Market Risks
Our investments in mortgage loans and mortgage-related securities 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, known as prepayment risk, and the resulting potential mismatch in the timing of our receipt of
cash flows related to our assets versus the timing of payment of cash flows related to 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 off a mortgage loan at any time before its scheduled maturity date (without having to pay a
prepayment penalty) or make principal payments in accordance with their contractual obligation. We use derivatives as an
important part of our strategy to manage interest rate and prepayment risk. When determining to use derivatives to mitigate
our exposures, we consider a number of factors, including the cost, efficiency, exposure to counterparty risks and our overall
risk management strategy. See “MD&A — RISK MANAGEMENT” for a discussion of our exposure to credit risks, our use
of derivatives and operational risks of our business. See “RISK FACTORS” for a discussion of our market risk exposure,
including those related to derivatives, institutional counterparties and other market risks.
Our credit guarantee activities also expose us to interest-rate risk because changes in interest rates can cause
fluctuations 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 float. Float, which arises from timing differences between when
the borrower makes principal payments on the loan and the reduction of the PC balance, can lead to significant interest
expense if the interest rate paid to a PC investor is higher than the reinvestment rate earned by the securitization trusts on
payments received from mortgage borrowers and paid to us as trust management income. With our adoption of the
accounting standard for the fair value option for financial assets and liabilities on January 1, 2008, we began to designate
certain of our investments in PCs as trading assets, which provide a partial economic offset of our guarantee asset. See
“NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES — Recently Adopted Accounting Standards” to our
consolidated financial statements for more information.
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 financial instrument’s price sensitivity (expressed in percentage terms). We compute each
instrument’s duration by applying a 50 basis point shock, both upward and downward, to the LIBOR curve and evaluating
the market value impact. Convexity is a measure of how much a financial instrument’s duration changes as interest rates
change. Similar to the duration calculation, we compute each instrument’s convexity by applying a 50 basis point shock,
both upward and downward, to the LIBOR curve and evaluating the impact on duration. Our convexity risk primarily results
from prepayment risk. We seek to manage duration risk and convexity risk through asset selection and structuring (that is, by
identifying or structuring mortgage-related securities with attractive prepayment and other characteristics), by issuing a broad
198 Freddie Mac