Freddie Mac 2004 Annual Report Download - page 229

Derivative assets
Derivative assets, at fair value largely consists of interest-rate swaps, option-based derivatives, futures,
and forward purchase and sale commitments that Freddie Mac accounts for as derivatives, which are reÖected
at fair value on the GAAP consolidated balance sheets. The fair values of interest-rate swaps are determined
by using the appropriate yield curves to calculate and discount the expected cash Öows for both the Ñxed-rate
and Öoating-rate components of the swap contracts. Option-based derivatives, which principally include call
and put swaptions, are valued using an option-pricing model. This model uses market interest rates and
market-implied option volatilities, where available, to calculate the option's fair value. Market-implied option
volatilities are based on information obtained from broker/dealers. The fair value of exchange-traded futures
is based on end-of-day closing prices obtained from third-party pricing services. Derivative forward purchase
and sale commitments are valued using the methods described for mortgage-related securities valuation,
above.
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. Freddie Mac's fair value of derivatives is not adjusted for
expected credit losses because management obtains collateral from most counterparties typically within one to
three business days of the daily market value calculation and substantially all of Freddie Mac's credit risk
arises from counterparties with investment-grade credit ratings of A- or above.
Other assets
Other assets consists of accrued interest and other receivables, investments in qualiÑed LIHTC limited
partnerships that are eligible for federal tax credits, Ñnancial guarantee contracts for additional credit
protection on certain manufactured housing asset-backed securities, real estate owned, property, plant and
equipment, and other miscellaneous assets.
The receivables are Ñnancial instruments and are required to be measured at fair value for disclosure
purposes pursuant to SFAS 107. Because these receivables are short-term in nature, management believes the
carrying amount on the GAAP consolidated balance sheets is a reasonable approximation of their fair values.
For the LIHTC partnerships, the fair value of expected tax beneÑts is estimated using expected cash Öows
discounted at a market-based yield. For the credit enhancements on manufactured housing asset-backed
securities, the fair value is based on the diÅerence between the market price of non-credit impaired
manufactured housing securities and credit-impaired manufactured housing securities that are likely to
produce future credit losses, as adjusted for management's estimate of a risk premium attributable to the
Ñnancial guarantee contracts. The value of the contracts, over time, will be determined by the actual credit-
related losses incurred and, therefore, may have a value that is higher or lower than management's market-
based estimate.
The other categories of assets that comprise Other assets are not Ñnancial instruments required to be
valued at fair value under SFAS 107, such as REO properties. The fair market value of REO properties is
calculated using a model-based approach, incorporating market sales data, that estimates a discount to full fair
market value for a comparable property that has not been subject to foreclosure proceedings. This adjustment
is intended to capture the sale price discount generally evidenced in the market for properties that have been
subject to a foreclosure sale.
Other non-Ñnancial assets included in Other assets represent an insigniÑcant portion of the GAAP
consolidated balance sheets. Because any change in their fair value would not be a meaningful part of Freddie
Mac's fair value of net assets business results, Freddie Mac has not adjusted the carrying amount on the
GAAP consolidated balance sheets for estimates of the fair value of these non-Ñnancial assets.
Total debt securities, net
Total debt securities, net represents short-term and long-term debt used to Ñnance Freddie Mac's assets
and, for GAAP presentation, is net of deferred items, including premiums, discounts and hedging-related basis
adjustments. It includes both non-callable and callable debt as well as short-term zero coupon discount notes.
The fair value of the short-term zero coupon discount notes is based on a discounted cash Öow model with
market inputs. The valuation of other debt securities is generally based on market prices obtained from
broker/dealers, reliable third-party pricing service providers, or direct market observations. In the fourth
quarter of 2004, Freddie Mac began using newly available market prices received from broker/dealers and
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