Freddie Mac 2009 Annual Report Download - page 96

increased derivative cash amortization expense primarily associated with purchased swaptions. Because of a significant drop
in mortgage rates during the first half of 2009 and the introduction of the Freddie Mac Relief Refinance Mortgage
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product
in April 2009, the prepayment option risk, or negative convexity, of our mortgage assets increased significantly as measured
by our prepayment models. During the second quarter of 2009, and continuing into the early portion of the third quarter of
2009, we purchased swaptions in order to partially hedge our exposure to increasing negative convexity. The payments of up-
front premiums associated with these purchased swaptions are amortized prospectively on a straight-line basis into
Investments segment net interest income over the contractual life of the derivative. The up-front payments are amortized to
reflect the periodic cost associated with the protection provided by the option contract. Subsequently, we adjusted our
prepayment models to more accurately reflect expectations under our implementation of the MHA Program as well as
refinancing expectations in the expected interest rate environment.
During 2009, the mortgage-related investments portfolio of our Investments segment decreased at an annualized rate of
8.7%, compared to an increase of 11.7% for 2008. The unpaid principal balance of the mortgage-related investments
portfolio of our Investments segment decreased from $667 billion at December 31, 2008 to $609 billion at December 31,
2009. The portfolio decreased in 2009 due to a relative lack of favorable investment opportunities caused by tighter spreads
on agency mortgage-related securities as a result of the Federal Reserve’s and Treasury’s purchases of agency mortgage-
related securities. For information on the potential impact of the termination of these purchase programs and the requirement
to reduce the mortgage-related investments portfolio by 10% annually, beginning in 2010, see “LIQUIDITY AND CAPITAL
RESOURCES — Liquidity” and “NOTE 6: INVESTMENTS IN SECURITIES — Impact of the Purchase Agreement and
FHFA Regulation on the Mortgage-Related Investments Portfolio” to our consolidated financial statements.
We held $65.6 billion of non-Freddie Mac agency mortgage-related securities and $113.7 billion of non-agency
mortgage-related securities as of December 31, 2009 compared to $70.2 billion of non-Freddie Mac agency mortgage-related
securities and $133.7 billion of non-agency mortgage-related securities as of December 31, 2008. The decline in the unpaid
principal balance of non-agency mortgage-related securities is due primarily to the receipt of monthly remittances of
principal repayments from both the recoveries of liquidated loans and, to a lesser extent, voluntary prepayments on the
underlying collateral of these securities. Agency securities comprised approximately 72% and 74% of the unpaid principal
balance of the Investments segment mortgage-related investments portfolio at December 31, 2009 and 2008, respectively. See
“CONSOLIDATED BALANCE SHEETS ANALYSIS — Investments in Securities” for additional information regarding our
mortgage-related securities.
The objectives set forth for us under our charter and conservatorship and restrictions set forth in the Purchase
Agreement may negatively impact our Investments segment results over the long term. For example, the required reduction
in our mortgage-related investments portfolio unpaid principal balance to $250 billion, through successive annual 10%
declines commencing in 2010, will cause a corresponding reduction in our net interest income from these assets. We expect
this will negatively affect our Investments segment results. FHFA stated its expectation in the Acting Director’s February 2,
2010 letter that any net additions to our mortgage-related investments portfolio would be related to purchasing delinquent
mortgages out of PC pools.
Segment Earnings for our Investments segment decreased $3.2 billion in 2008 compared to 2007. Segment Earnings for
our Investments segment includes the recognition of security impairments during 2008 of $4.3 billion that reflect expected
credit-related losses on our non-agency mortgage-related securities compared to $4 million of security impairments
recognized during 2007. Prior to the second quarter of 2009, security impairments that reflected expected or realized credit-
related losses were realized immediately pursuant to GAAP and in Segment Earnings. In contrast, non-credit-related security
impairments of $13.4 billion were included in our 2008 GAAP results but are not included in Segment Earnings. Segment
Earnings non-interest expense for 2008 includes a loss of $1.1 billion related to the Lehman short-term transactions. Segment
Earnings net interest income increased $434 million and Segment Earnings net interest yield increased 5 basis points to
55 basis points for 2008 compared to 2007. The increases in Segment Earnings net interest income and Segment Earnings
net interest yield were primarily due to purchases of fixed-rate assets at wider spreads relative to our funding costs,
decreased funding costs due to the replacement of higher cost short- and long-term debt with lower cost debt issuances, and
growth in the mortgage-related investments portfolio. Partially offsetting these increases in Segment Earnings net interest
income and Segment Earnings net interest yield were the impact of declining rates on our floating rate assets as well as an
increase in derivative interest carry expense on net pay-fixed swaps as a result of decreased interest rates and higher notional
balances resulting from higher issuances of shorter-term debt. We use derivatives to synthetically create the substantive
economic equivalent of various debt funding structures. For example, the combination of a series of short-term debt
issuances over a defined period and a pay-fixed swap with the same maturity as the last debt issuance is the substantive
economic equivalent of a long-term fixed-rate debt instrument of comparable maturity. However, the use of these derivatives
exposes us to additional counterparty credit risk.
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