Freddie Mac 2010 Annual Report Download - page 278

Other Derivatives
Other derivatives mainly consist of exchange-traded futures, foreign-currency swaps, certain forward purchase and sale
commitments, and credit derivatives. The fair value of exchange-traded futures is based on end-of-day closing prices
obtained from third-party pricing services; therefore, they are classified as Level 1 under the fair value hierarchy. The fair
value of foreign-currency swaps is determined by using the appropriate yield curves to calculate and discount the expected
cash flows for the swap contracts; therefore, they are classified as Level 2 under the fair value hierarchy since the fair values
are determined through models that use observable inputs from active markets.
Certain purchase and sale commitments are also considered to be derivatives and are classified as Level 2 or Level 3
under the fair value hierarchy, depending on the fair value hierarchy classification of the purchased or sold item, whether a
security or loan. Such valuation techniques are further discussed in the “Investments in Securities” section above and
“Valuation Methods and Assumptions Not Subject to Fair Value Hierarchy — Mortgage Loans.”
Credit derivatives primarily include purchased credit default swaps and certain short-term default guarantee
commitments, which are valued using prices from the respective counterparty and verified using third-party dealer credit
default spreads at the measurement date. We classify credit derivatives as Level 3 under the fair value hierarchy due to the
inactive market and significant divergence among prices obtained from the dealers.
Consideration of Credit Risk in Our Valuation of Derivatives
The fair value of derivative assets considers the impact of institutional credit risk in the event that the counterparty does
not honor its payment obligation. Additionally, the fair value of derivative liabilities considers the impact of our institutional
credit risk. Based on this evaluation, our fair value of derivatives is not adjusted for credit risk because we obtain collateral
from, or post collateral to, most counterparties, typically within one business day of the daily market value calculation, and
substantially all of our credit risk arises from counterparties with investment-grade credit ratings of A or above. See
“NOTE 19: CONCENTRATION OF CREDIT AND OTHER RISKS” for a discussion of our counterparty credit risk.
Other Assets, Guarantee Asset
Our guarantee asset is valued either through obtaining dealer quotes on similar securities or through an expected cash
flow approach. Because of the broad range of liquidity discounts applied by dealers to these similar securities and because
the expected cash flow valuation approach uses significant unobservable inputs, we classified the guarantee asset as Level 3.
REO, Net
REO is carried at the lower of its carrying amount or fair value less costs to sell. The fair value of REO is calculated
using an internal model that considers state and collateral level data to produce an estimate of fair value based on REO
dispositions in the most recent three months. We use the actual disposition prices on REO and the current loan UPB to
estimate the current fair value of REO. Certain adjustments, such as state specific adjustments, are made to the estimated fair
value, as applicable. Due to the use of unobservable inputs, REO is classified as Level 3 under the fair value hierarchy.
Debt Securities Recorded at Fair Value
We elected the fair value option for foreign-currency denominated debt instruments and certain other debt securities.
See “Fair Value Election — Debt Securities with Fair Value Option Elected” for additional information. We determine the
fair value of these instruments by obtaining multiple quotes from dealers. Since the prices provided by the dealers consider
only observable data such as interest rates and exchange rates, these fair values are classified as Level 2 under the fair value
hierarchy.
Derivative Liabilities, Net
See discussion under “Derivative Assets, Net” above.
Consolidated Fair Value Balance Sheets
The supplemental consolidated fair value balance sheets in Table 20.6 present our estimates of the fair value of our
financial assets and liabilities at December 31, 2010 and 2009. The valuations of financial instruments on our consolidated
fair value balance sheets are in accordance with the accounting standards for fair value measurements and disclosures and the
accounting standards for financial instruments. The consolidated fair value balance sheets do not purport to present our net
realizable, liquidation, or market value as a whole. Furthermore, amounts we ultimately realize from the disposition of assets
or settlement of liabilities may vary significantly from the fair values presented.
During the second quarter of 2010 our fair value results as presented in our consolidated fair value balance sheets were
affected by a change in the estimation of a risk premium assumption embedded in our model to apply credit costs, which led
to a $6.9 billion decrease in our fair value measurement of mortgage loans. For more information concerning our approach to
valuation related to our mortgage loans, see “Valuation Methods and Assumptions Not Subject to Fair Value Hierarchy —
Mortgage Loans.”
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