Freddie Mac 2004 Annual Report Download - page 167

balance is not reduced for payments of principal until the Ñrst day of the next month and Freddie Mac releases
the cash (principal and interest) to the PC investor on the Ñfteenth day of that next month. The company
generally invests these principal and interest amounts received in short-term investments from the time
Freddie Mac receives the amounts until the time Freddie Mac pays the PC investor. Interest income resulting
from investment of principal and interest payments from seller/servicers is reported in interest income over
the period earned.
For unscheduled principal prepayment amounts, these timing diÅerences result in an expense accrual
upon prepayment of the mortgage as the related PCs continue to bear interest to the PC investor at the PC
coupon rate from the date of prepayment until the date the PC security balance is reduced, while generally no
interest is received from the mortgage on that prepayment amount during that same time period. The expense
recognized upon prepayment is reported in Interest expense Ì Due to Participation CertiÑcate investors.
Freddie Mac reports PC coupon interest amounts relating to its investment in PCs consistent with the
accounting practices generally applied by third party investors in PCs. Accordingly, the PC coupon interest on
prepayments of a mortgage pending remittance on PCs held by Freddie Mac is reported as both Interest
Income Ì Mortgage-related securities in the Retained portfolio and Interest expense Ì Due to Participation
CertiÑcate investors. Scheduled and unscheduled principal payments received by Freddie Mac that relate to
its investment in PCs are reported as a reduction to its investment in PCs on the consolidated balance sheets.
Mortgage Loans
Mortgage loans that management may sell are classiÑed as held-for-sale. If a decision is made to retain
the loan, the loans are transferred to the held-for-investment portfolio. Loans transferred to the held-for-
investment portfolio are transferred at lower of cost or market value. Lower-of-cost-or-market value
adjustments, in this case, are treated as basis adjustments of such mortgage loans and are subsequently
amortized into interest income over the period held.
Held-for-sale mortgages are included in the Retained portfolio and reported at lower of cost or market
value, on a portfolio basis, with losses reported in Gains (losses) on investment activity. Consistent with
SFAS No. 65, ""Accounting for Certain Mortgage Banking Activities'' (""SFAS 65''), premiums and discounts
on loans classiÑed as held-for-sale are not amortized as interest revenue during the period that such loans are
classiÑed as held-for-sale.
For a description of how Freddie Mac determines the fair value of its held-for-sale mortgage loans, see
""NOTE 16: FAIR VALUE DISCLOSURES.''
Mortgage loans that management has the ability and intent to hold for the foreseeable future or to
maturity are classiÑed as held-for-investment. These mortgage loans are reported at their outstanding principal
balances, net of deferred fees and costs (including premiums and discounts). These deferred items are
amortized into interest income over the estimated lives of the mortgages using the eÅective interest method.
The company uses actual prepayment experience and estimates of future prepayments to determine the
constant yield needed to apply the eÅective interest method. For purposes of estimating future prepayments,
the mortgages are aggregated by similar characteristics such as origination date, coupon and maturity.
The company recognizes interest income on mortgage loans on an accrual basis, except when manage-
ment believes the collection of principal or interest is doubtful.
Reserves for Losses on Mortgage Loans Held-for-Investment and Losses on PCs
Freddie Mac maintains a Reserve for losses on mortgage loans held-for-investment to provide for credit
losses inherent in that portfolio. The Reserve for losses on mortgage loans held-for-investment is determined
pursuant to the provisions of SFAS 5 and SFAS No. 114, ""Accounting by Creditors for Impairment of a
Loan Ì an Amendment of FASB Statements No. 5 and 15'' (""SFAS 114'') as more fully described below.
Freddie Mac also maintains a Reserve for guarantee losses on Participation CertiÑcates to provide for losses
incurred on mortgages underlying PCs or Structured Securities held by third parties. The Reserve for
guarantee losses on Participation CertiÑcates is determined pursuant to the provisions of SFAS 5 and
SFAS 114. The Reserve for losses on mortgage loans held-for-investment and Reserve for guarantee losses on
Participation CertiÑcates are collectively referred to as ""loan loss reserves.'' Increases in loan loss reserves are
reÖected in earnings as a component of the (Provision) beneÑt for credit losses. Decreases in loan loss reserves
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