Freddie Mac 2005 Annual Report Download - page 158

available, fair value is based on internal valuation models using market data inputs or internally developed assumptions,
where appropriate.
During 2005 and 2004, our fair value results were impacted by several improvements in our approach for estimating fair
values of certain Ñnancial instruments. In the Ñrst quarter of 2005, we improved our approach for estimating the fair values
of certain Ñnancial instruments resulting in (a) a decrease in the fair value of Total net assets of approximately $0.8 billion
(after-tax) related to our guarantee-related assets and liabilities and (b) an increase in the fair value of Total net assets of
approximately $0.3 billion (after-tax) related to our multifamily whole loans, the minority interests in our consolidated
REIT subsidiaries and other Ñnancial instruments. Also, in the second quarter of 2005, we improved our approach for
estimating the fair values of certain securities we hold, which increased the fair value of Total net assets by approximately
$0.1 billion. The changes in our approach for estimating the fair values of these Ñnancial instruments are described below. In
the fourth quarter of 2004, we began using newly available market prices received from broker/dealers and third-party
pricing providers for the valuation of a greater portion of our debt instruments resulting in an increase in the fair value of
Total net assets of approximately $0.6 billion (after-tax).
The following methods and assumptions were used to estimate the fair value of assets and liabilities at December 31,
2005 and 2004.
Mortgage loans
Mortgage loans represent single-family and multifamily whole loans held in our Retained portfolio. For GAAP
purposes, we must determine the fair value of these mortgage loans to calculate lower-of-cost-or-market adjustments for
mortgages classiÑed as held-for-sale. We use this same approach when determining the fair value of whole loans, including
those held-for-investment, for fair value balance sheet purposes.
We determine the fair value of mortgage loans, excluding delinquent single-family loans purchased out of pools, based
on comparisons to actively traded mortgage-related securities with similar characteristics, with adjustments for yield, credit
and liquidity diÅerences. SpeciÑcally, we aggregate mortgage loans into pools by product type, coupon and maturity and
then convert the pools into notional mortgage-related securities based on their speciÑc characteristics. We then calculate fair
values for these notional mortgage-related securities using the process that is described in ""Mortgage-related securities.''
Part of the adjustments for yield, credit and liquidity diÅerences represent an implied guarantee fee. To accomplish this,
the fair value of the single-family whole loans, excluding delinquent single-family loans purchased out of pools, includes an
adjustment representing the estimated present value of the additional cash Öows on the mortgage coupon in excess of the
coupon expected on the notional mortgage-related securities. For multifamily whole loans, the fair value adjustment is
estimated by calculating the net present value of guarantee fees we expect to retain. This retained guarantee fee is estimated
by subtracting the expected cost of funding and securitizing a multifamily whole loan of a comparable maturity and credit
rating from the coupon on the whole loan at the time of purchase.
The implied guarantee fee for both single-family and multifamily whole loans is also net of the related credit and other
components inherent in our Guarantee obligation. For single-family whole loans, the process for estimating the related
credit and other Guarantee obligation components is described in the ""Guarantee obligation'' section. For multifamily whole
loans, the process for estimating the related credit and other Guarantee obligation components employs a market-based
approach to estimate the potential credit obligation. This obligation is estimated by extracting the credit risk premium that
multifamily whole loan investors require from market prices on similar securities. This credit risk premium is net of
expected funding, liquidity and other risk premiums that are embedded in the market price of the reference securities.
Beginning in 2005, we reÑned the fair value estimates of multifamily whole loans by incorporating additional
information and guidance from active market participants into the pricing of notional mortgage-related securities. In
addition, beginning in 2005, for single-family whole loans that are extremely delinquent and have been purchased out of
pools, we obtained dealer indications on aggregated groups of similar loans that reÖect their current performance status.
These market price indications reÖect the estimated present value of all cash Öows related to the whole loans, including
expected credit losses and recoveries.
Mortgage-related securities
Mortgage-related securities represent passthroughs and other mortgage-related securities classiÑed as available-for-sale
and trading, which are already reÖected at fair value on our GAAP consolidated balance sheets. Mortgage-related securities
consist of securities issued by us, Fannie Mae and Ginnie Mae as well as non-agency mortgage-related securities.
The fair value of securities with readily available third-party market prices is generally based on market prices obtained
from broker/dealers or reliable third-party pricing service providers. Fair value may be estimated by using third-party quotes
for similar instruments, adjusted for diÅerences in contractual terms. For other securities, a market option-adjusted spread
approach based on observable market parameters is used to estimate fair value. Option-adjusted spreads for certain securities
142 Freddie Mac