Freddie Mac 2005 Annual Report Download - page 41

used to estimate prepayment speeds on mortgage-related securities and our approach for estimating uncollectible interest on
single-family mortgages greater than 90 days delinquent. We implemented these enhancements as changes in estimates,
resulting in a net decrease in interest income of $(166) million (pre-tax) during the Ñrst quarter of 2005.
Interest income related to our Investments portfolio declined by $943 million during 2005, as compared to 2004 as the
average balance of this portfolio declined. By the end of 2004, we divested the trading portfolios related to our SS&TG
business unit and our external Money Manager program in the Investments portfolio. This divestiture reduced the interest
expense for funding the Investments portfolio as well as the hedging costs associated with it, which were reÖected in Gains
(losses) on investment activity. Our investments in mortgage-related securities held by our SS&TG business unit and
external Money Manager program were generally hedged by entering into forward sales of mortgage-related securities. To
determine the fair value of these positions, the held investment was valued at the current market, or spot price, while the
forward sale commitments were valued at the discounted sales price, or forward price. For 2004 and 2003, the spot-forward
diÅerence between the trading securities and the related forward sale commitments resulted in a loss of $1,101 million and
$981 million, respectively, in Gains (losses) on investment activity that was oÅset by Net interest income on the held
position.
Interest income related to Securities purchased under agreements to resell and Federal funds sold increased by
$413 million for 2005, as compared to 2004, due to the increase in short-term interest rates discussed above, which more
than oÅset the 16 percent decline in the related average balance of such securities.
Total interest expense on debt securities increased by $3,490 million for 2005, compared to 2004. Interest expense on
short-term debt increased by $3,194 million for 2005, as compared to 2004, due to the increase in short-term interest rates
during 2005. Interest expense related to long-term debt increased by $296 million for 2005, as compared with 2004, as the
increase in rates more than oÅset the decrease in the average balance of long-term debt.
Interest expense related to amounts due on pass through payments to PC investors decreased by $157 million for 2005,
as compared to 2004, as liquidation rates on outstanding guaranteed PCs and Structured Securities declined to 24 percent
for 2005, as compared to 29 percent for 2004, driving the year-over-year decline in the average balance of Due to PC
investors.
Income (expense) related to derivatives in qualifying hedge accounting relationships decreased $1,158 million to an
expense of $1,058 million during 2005, as compared to income of $100 million during 2004, primarily as a result of the
increased interest expense associated with the accrual of periodic settlements related to our receive-Ñxed swaps and foreign-
currency swaps resulting from increases in LIBOR. Also contributing to this change was our decision in 2004 to discontinue
hedge accounting treatment for a signiÑcant amount of our pay-Ñxed interest-rate swaps and receive-Ñxed interest-rate
swaps. The net impact of this decision was that the net interest expense related to these interest-rate swaps was no longer a
component of Net interest income in 2005 but rather a component of Derivative gains (losses).
2004 versus 2003
Net interest income on a fully taxable-equivalent basis decreased by $321 million in 2004, as compared with 2003. Net
interest yield on a fully taxable-equivalent basis decreased by 6 basis points to 123 basis points in 2004 from 129 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 in 2004 due to the Retained portfolio's acquisition of relatively lower-yielding assets and the
liquidation of higher-coupon securities, partially oÅset by an improvement in the yield on our Securities purchased under
agreements to resell and Federal funds sold as short-term interest rates increased during 2004. The yield on interest-bearing
liabilities declined in 2004 due to the maturity and repurchase of higher cost long-term debt and the issuance of new long-
term debt at lower rates, coupled with a decrease in interest expense related to amounts due to PC investors. This decline in
yield was partially oÅset by higher short-term debt yields in 2004.
During 2004, interest income on mortgage loans and mortgage-related securities declined by $835 million, or 3 percent.
We earned lower interest income on these investments during 2004 compared to 2003 because we increased purchases of
lower-coupon non-agency mortgage-related securities (such as variable-rate securities that tend to earn lower initial yields
than Ñxed-rate securities), coupled with the continued liquidation of relatively higher-coupon assets during 2004. The
decline in our Retained portfolio yields during 2004 more than oÅset the additional interest income related to 7 percent
growth in the average unpaid principal balance of our Retained portfolio. We also earned lower interest income related to our
Investments portfolio as well as our Securities purchased under agreements to resell and Federal funds sold during 2004 as
compared to 2003. The average balance of these portfolios declined by 14 percent and 39 percent, respectively, during 2004
as we ceased the PC market-making and support activities conducted through our SS&TG business unit and our external
Money Manager program during the fourth quarter of 2004. The decline in these average balances more than oÅset a
28 basis point increase in the yield we earned on our Securities purchased under agreements to resell and Federal funds sold
during 2004 as compared to 2003, due to a change in the asset mix and increases in short-term interest rates during 2004.
25 Freddie Mac