Freddie Mac 2009 Annual Report Download - page 218

PCs
Our PCs are pass-through securities that represent undivided beneficial interests in trusts that own pools of mortgages
we have purchased. For our fixed-rate PCs, we guarantee the timely payment of interest and principal. For our ARM PCs,
we guarantee the timely payment of the weighted average coupon interest rate for the underlying mortgage loans. We do not
guarantee the timely payment of principal for ARM PCs; however, we do guarantee the full and final payment of principal.
In exchange for providing this guarantee, we receive a contractual management and guarantee fee and other upfront credit-
related fees.
Other investors purchase our PCs, including pension funds, insurance companies, securities dealers, money managers,
commercial banks, foreign central banks and other fixed-income investors. PCs differ from U.S. Treasury securities and other
fixed-income investments in two primary ways. First, PCs can be prepaid at any time because homeowners can pay off the
underlying mortgages at any time prior to a loan’s maturity. Because homeowners have the right to prepay their mortgage,
the securities implicitly have a call option that significantly reduces the average life of the security as compared to the
contractual maturity of the underlying loans. Consequently, mortgage-related securities generally provide a higher nominal
yield than certain other fixed-income products. Second, PCs are not backed by the full faith and credit of the United States,
as are U.S. Treasury securities. However, we guarantee the payment of interest and principal on all our PCs, as discussed
above.
Guarantee Asset
In return for providing our guarantee for the payment of principal and interest on the security, we may earn a
management and guarantee fee that is paid to us over the life of an issued PC, representing a portion of the interest collected
on the underlying loans. We recognize the fair value of our contractual right to receive management and guarantee fees as a
guarantee asset at the inception of an executed guarantee. We recognize a guarantee asset, which performs similar to an
interest-only security, only when an explicit management and guarantee fee is charged. To estimate the fair value of most of
our guarantee asset, we obtain dealer quotes on proxy securities with collateral similar to aggregated characteristics of our
portfolio. For the remaining portion of our guarantee asset, we use an expected cash flow approach including only those cash
flows expected to result from our contractual right to receive management and guarantee fees, discounted using market input
assumptions extracted from the dealer quotes provided on the more liquid products. See “NOTE 4: RETAINED INTERESTS
IN MORTGAGE-RELATED SECURITIZATIONS” for more information on how we determine the fair value of our
guarantee asset.
Subsequently, we account for a guarantee asset like a debt instrument classified as a trading security. As such, we
measure the guarantee asset at fair value with changes in the fair value reflected in earnings as gains (losses) on guarantee
asset. Cash collections of our contractual management and guarantee fee reduce the value of the guarantee asset and are
reflected in earnings as management and guarantee income.
Guarantee Obligation
Our guarantee obligation represents the recognized liability associated with our guarantee of PCs and Structured
Securities net of cumulative amortization. Prior to January 1, 2008, we recognized a guarantee obligation at the fair value of
our non-contingent obligation to stand ready to perform under the terms of our guarantee at inception of an executed
guarantee. Upon adoption of an amendment to the accounting standards for fair value measurements and disclosures on
January 1, 2008, we began measuring the fair value of our newly-issued guarantee obligations at their inception using the
practical expedient provided by the initial measurement guidance for guarantees. Using the practical expedient, the initial
guarantee obligation is recorded at an amount equal to the fair value of compensation we received in the related
securitization transaction. As a result, we no longer record estimates of deferred gains or immediate, “day one,” losses on
most guarantees. However, all unamortized amounts recorded prior to January 1, 2008 will continue to be deferred and
amortized using the static effective yield method. The guarantee obligation is reduced by the fair value of any primary loan-
level mortgage insurance (which is described below under Credit Enhancements) that we receive.
Subsequently, we amortize our guarantee obligation into earnings as income on guarantee obligation using a static
effective yield method. The static effective yield is calculated and fixed at inception of the guarantee based on forecasted
unpaid principal balances. The static effective yield is subsequently evaluated and adjusted when significant changes in
economic events cause a shift in the pattern of our economic release from risk (hereafter referred to as the loss curve). We
established triggers that identify significant shifts in the loss curve, which include increases or decreases in prepayment
speeds, and increases or decreases in home price appreciation/depreciation. These triggers are based on objective measures
(i.e., defined percentages which are designed to identify symmetrical shifts in the loss curve) applied consistently period to
period. When a trigger is met, a cumulative catch-up adjustment is recognized to true up the cumulative amortization to the
amount that would have been recognized had the shift in the loss curve been included in the original effective yield
calculation. The new effective yield is applied prospectively based on the revised cash flow forecast and can subsequently
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