Freddie Mac 2004 Annual Report Download - page 40

Even for instruments with a high degree of price transparency, fair value estimation involves our
application of signiÑcant, ongoing judgment. These judgments include:
‚ evaluation of the expected reliability of the estimate;
‚ reliability, timeliness and cost of alternative valuation methodologies;
‚ selection of third-party market data sources;
‚ selection of proxy instruments, as necessary; and
‚ adjustments to market-derived data to reÖect diÅerences in instruments' contractual terms.
While our general practice is to use consistent valuation methodologies over time, we periodically
evaluate our methodologies and may change them to improve our fair value estimates, to accommodate
market developments or to compensate for changes in data availability or other operational constraints.
For Ñnancial instruments with active markets and readily available market prices, we estimate fair values
based on independent price quotations obtained from third parties, including pricing services, dealer marks or
direct market observations, where available. We seek to use third-party pricing where possible. Independent
price quotations obtained from third-party pricing services are valuations estimated by an independent service
provider using market information. Dealer marks are prices that are obtained from third-party dealers that
generally make markets in the relevant products. The quoted price is an indication of the price at which the
dealer would consider transacting in normal market conditions. Market observable prices are prices that are
retrieved from sources in which market trades are executed, such as electronic trading platforms.
Certain instruments are less actively traded and, therefore, are not always able to be reliably valued based
on prices obtained from third parties. If quoted prices or market data are not available, fair value is based on
internal valuation models using market data inputs or internally developed assumptions, where appropriate.
Model-based valuations with signiÑcant market inputs are fair values that are estimated using one or more
models such as: interest rate models, prepayment models, option-adjusted spread models and/or credit
models. These models use market inputs such as interest rate curves, market volatilities and pricing spreads,
which can be validated using external sources such as third party pricing services, dealer marks and market
observable transactions. Model-based valuations without market inputs are required for products with limited
price discovery and are estimated using one or more of the models indicated or are based on our judgment and
assumptions. The use of diÅerent pricing models and assumptions could produce materially diÅerent estimates
of fair values.
The fair values for approximately 98 percent of our mortgage-related securities are based on prices
obtained from third parties or are determined using models with signiÑcant market inputs. The fair values for
the remainder of our mortgage-related securities are obtained from internal models with few or no market
inputs. The fair values for our non-mortgage-related securities are based on prices obtained from third parties,
unless their interest rates frequently reset, in which case the carrying value is presumed to be a reasonable
approximation of fair value. As few of the derivative contracts we use are listed on exchanges, the majority of
our derivative positions are valued using internally developed models that use market parameters as their basis.
Approximately 75 percent of the gross fair value of our derivatives portfolio relates to interest-rate and cross-
currency swaps that do not have embedded options. These derivatives are valued using a discounted cash Öow
model that projects future cash Öows and discounts them at the spot rate related to each cash Öow. The
remaining 25 percent of our derivatives portfolio is valued based on prices obtained from third parties or is
determined using models with signiÑcant market inputs. The fair values for all of our debt securities are based
on prices obtained from third parties or are determined using models with signiÑcant market inputs.
Some of our Ñnancial instruments are not traded in active markets. Examples include guarantee assets,
guarantee obligations and PC residuals. The fair values of these instruments are determined using internally
developed models that facilitate simulation of multiple future scenarios that may occur. Our internal models
incorporate empirical data coupled with the results of benchmarking default and capital assumptions observed
in comparable non-conforming securities market trades adjusted, as appropriate, to reÖect diÅerences in
underlying collateral and other factors. Material assumptions include:
‚ our projections of interest rates and housing prices;
‚ our expectations of prepayments, defaults and loss severity rates;
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