Freddie Mac 2004 Annual Report Download - page 54

following these moves, the interest income or expense associated with these swaps is included in
Derivative gains (losses).
Due to declining interest rates in 2002 and the Ñrst half of 2003, the expected lives of assets held in
the Retained portfolio decreased, requiring us to reduce the duration of our long-term debt funding from
an asset/liability management perspective. As a result, we terminated certain pay-Ñxed swaps and
entered into receive-Ñxed swaps. Receive-Ñxed swaps eÅectively convert a Ñxed-rate debt payment into a
variable-rate payment. Conversely, a pay-Ñxed swap requires us to make a Ñxed interest payment in
exchange for a variable rate payment. In the third quarter of 2003, we entered into additional pay-Ñxed
swaps to extend the duration of our debt portfolio as interest rates increased. During 2004, our debt
securities became more heavily weighted toward long-term debt. The average balance of long-term debt
increased approximately 11 percent while the average balance of short-term debt decreased by
approximately 10 percent.
Amortization of hedging gains and losses. Historically, certain derivative contracts were in hedge
accounting relationships, which resulted in basis adjustments to hedged items. These basis adjustments
are accounted for and are similar to premiums and discounts, as described above. However, as of
December 31, 2004, the majority of our pay-Ñxed and receive-Ñxed swaps are no longer in hedge
accounting relationships, as discussed in the analysis of 2004 full-year Net interest income results above.
For more information, see ""Non-Interest Income (Loss) Ì Derivative Gains (Losses).''
Certain derivative contracts (primarily pay-Ñxed swaps) have been accounted for as cash Öow
hedges of the variability of interest payments on forecasted debt issuances, while other derivative
contracts (primarily receive-Ñxed swaps) have been accounted for as fair value hedges of existing debt. In
both cases, termination of the hedge accounting relationship, including the actions we took in 2004
related to pay-Ñxed and receive-Ñxed swaps, resulted in the associated deferred hedging gain or loss being
amortized into Net interest income over the life of the hedged item. Amortization related to terminated
cash Öow hedges is generally included in Income (expense) related to derivatives or, if the deferred gain
or loss is related to a closed cash Öow hedge linked to long-term debt, in Interest expense on long-term
debt. The amortization related to terminated fair value hedges is also included in Interest expense on
long-term debt.
The impact of these drivers on Net interest income, discussed above, during the quarterly periods of 2004
and 2003 is discussed below.
4Q04 vs. 3Q04
Net interest income and net interest yield, both of which are presented on a fully taxable-equivalent basis,
decreased $249 million and 11 basis points, respectively, during the fourth quarter of 2004 compared to the
third quarter of 2004. The decline in Net interest income was primarily due to an increase in our short-term
funding costs resulting from increases in short-term interest rates during the fourth quarter and the movement
of a signiÑcant amount of our receive-Ñxed swaps to no hedge designation in November 2004. The decline in
net interest yield was primarily related to the increase in our short-term funding costs.
3Q04 vs. 2Q04
Net interest income and net interest yield, both of which are presented on a fully taxable-equivalent basis,
decreased $300 million and 20 basis points, respectively, during the third quarter of 2004 compared to the
second quarter of 2004. The decline in Net interest income was primarily due to increased amortization
expense related to net premiums and other security-related basis adjustments as a result of a decline in long-
term market interest rates from the second quarter of 2004. Additionally, our short-term funding costs
increased as a result of increases in short-term interest rates during the third quarter. The decline in net
interest yield was due to lower yields on Retained portfolio assets and an increase in short-term funding costs.
2Q04 vs. 1Q04
Net interest income and net interest yield, both of which are presented on a fully taxable-equivalent basis,
increased $499 million and 29 basis points, respectively, during the second quarter of 2004 compared to the
Ñrst quarter of 2004. The increase in Net interest income resulted from lower amortization expense related to
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