Freddie Mac 2004 Annual Report Download - page 49

The average balance of this portfolio declined by 22 percent during 2004 as we ceased the PC market-making
and support activities conducted through our Securities Sales & Trading Group business unit and our external
Money Manager program during the fourth quarter of 2004. The decline in the average balance of the Cash
and investments portfolio more than oÅset a 16 basis point increase in the yield we earned on this portfolio
during 2004 as compared to 2003, due to a change in the asset mix and increases in short-term interest rates
during 2004. During the Ñrst quarter of 2004, we implemented enhancements to certain assumptions and
calculations in the amortization process for deferred fees recorded as basis adjustments on assets in our
Retained portfolio. The eÅect on Net interest income of these enhancements, which were treated as changes
in estimates, was the recognition of $86 million of additional amortization expense during the Ñrst quarter of
2004.
During 2004, Total interest expense on debt securities increased by $990 million. Interest expense related
to long-term debt increased by $867 million, or 4 percent, during 2004 as the average balance increased by
approximately $53 billion, or 11 percent, oÅsetting the beneÑt from the maturity and repurchase of higher-rate
long-term debt and the issuance of new long-term debt at lower rates. Interest expense related to short-term
debt increased by $123 million, or 4 percent, in 2004 as average short-term interest rates were higher in 2004
than 2003, partially oÅset by a 10 percent decline in the average balance of short-term debt.
Income (expense) related to derivatives improved to income of $100 million during 2004 from expense of
($1,091) million in 2003 primarily as a result of the movement of certain pay-Ñxed swaps out of hedge
accounting relationships. As discussed below, in Derivative Gains (Losses) we determined that substantially
all pay-Ñxed interest-rate swaps and certain other derivatives that previously had been in cash Öow hedge
accounting relationships no longer met hedge accounting requirements in accordance with SFAS 133,
eÅective at the beginning of the second quarter of 2004. Consequently, we discontinued hedge accounting
treatment for these relationships, resulting in pay-Ñxed swaps with a notional balance of approximately
$108 billion being moved from the cash Öow hedge designation to no hedge designation. The movement of
these pay-Ñxed swaps to no hedge designation had a signiÑcant impact on Net interest income during 2004
because the related net interest expense is no longer reported as a component of Net interest income in periods
following the move, but as a component of Derivative gains (losses). We also voluntarily discontinued hedge
accounting treatment for the majority of our receive-Ñxed interest-rate swaps eÅective November 1, 2004,
resulting in receive-Ñxed interest-rate swaps with a notional balance of approximately $50 billion being moved
from the fair value hedge designation to no hedge designation.
Our Due to Participation CertiÑcate investors interest expense decreased by $933 million as liquidation
rates on outstanding PCs and Structured Securities declined to 29 percent in 2004 from 63 percent in 2003.
For a further discussion of how the prepayments of the collateral underlying outstanding PCs aÅect Net
interest income, see ""Analysis of Quarterly Results Ì Interest expense related to amounts Due to Participa-
tion CertiÑcate investors'' below.
As discussed above, in the fourth quarter of 2004, we decided to cease the PC market-making and support
activities accomplished through our Securities Sales & Trading Group business unit and our external Money
Manager program. By the end of 2004, we had divested the trading portfolio related to these activities in the
Cash and investments portfolio. See ""NOTE 5 Ì RETAINED PORTFOLIO AND CASH AND INVEST-
MENTS PORTFOLIO'' to the consolidated financial statements for further information. In conjunction with
these activities, our investments in mortgage-related securities were generally hedged by entering into forward
sales of mortgage-related securities. When determining the fair value of these positions, the held investment was
valued at the current market, or spot price, while the forward sale commitment was valued at the discounted
sales, or forward price. The spot-forward difference between the trading security and the forward sale
commitment resulted in a loss in Gains (losses) on investment activities that was offset by Net interest income
on the held position. This spot-forward difference was $976 million, $981 million and $938 million in 2004, 2003
and 2002, respectively.
Net interest yield on a fully taxable-equivalent basis decreased by 6 basis points to 124 basis points in
2004 from 130 basis points in 2003, as the decline in yields on interest-earning assets exceeded the beneÑt of
lower debt funding costs. The yield on interest-earning assets declined due to the Retained portfolio's
acquisition of relatively lower-yielding assets and the liquidation of higher-coupon securities, partially oÅset by
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