Freddie Mac 2005 Annual Report Download - page 62

actively manage, or hedge, the majority of these risks to keep interest-rate risk exposures within prescribed limits. We do not,
however, hedge all interest-rate risk that exists at the time a mortgage is purchased or that arises over its life. Therefore, in
the normal course of business, we consistently have a limited net exposure to these risks, which will result in a net increase
or decrease in fair value for a given period. See ""RISK MANAGEMENT Ì Interest-Rate Risk and Other Market Risks''
for more information.
Core guarantee fees, net
Core guarantee fees, net represents the annual income of the credit guarantee portfolio, based on current portfolio
characteristics and market conditions. This estimate considers both contractual guarantee fees collected over the life of the
credit guarantee portfolio and credit-related delivery fees collected up-front when pools are formed, and associated costs and
obligations which include default and capital costs.
Change in the fair value of the guarantee portfolio
Change in the fair value of the guarantee portfolio represents the estimated impact on the fair value of the credit
guarantee business of additions to the portfolio (net diÅerence between the fair values of the Guarantee asset and Guarantee
obligation recorded when pools are formed) plus the eÅect of changes in interest rates and other market factors (e.g., impact
of the passage of time on cash Öow discounting and changes in projections of the future credit outlook) on the fair value of
the existing credit guarantee portfolio. In 2005, we changed our method for estimating the fair values of the Guarantee asset
and Guarantee obligation. See ""NOTE 2: TRANSFERS OF SECURITIZED INTERESTS IN MORTGAGE-
RELATED ASSETS'' to our consolidated Ñnancial statements for additional information.
We generally do not hedge changes in the fair value of our existing credit guarantee portfolio, with two exceptions
discussed below. While periodic changes in the fair value of the guarantee portfolio may have a signiÑcant impact on the fair
value of net assets, we believe that changes in the fair value of our existing guarantee portfolio are not the best indication of
long-term fair value expectations because such changes do not reÖect our expectation that, over time, replacement business
will largely replenish guarantee fee income lost because of prepayments.
We hedge interest-rate exposure related to net buy-ups (up-front payments made by us that increase the guarantee fee
that we will receive over the life of the pool) and Öoat (expected gains or losses resulting from our mortgage security
program remittance cycles). However, these value changes are excluded from our estimate of the change in fair value of the
guarantee portfolio, so that it reÖects only the impact of changes in interest rates and other market factors on the unhedged
portion of the projected cash Öows from the credit guarantee business. The value changes associated with net buy-ups and
Öoat are considered in return on risk positions (deÑned above) because they relate to hedged positions.
Fee income
Fee income includes miscellaneous fees, such as resecuritization fees, fees generated by our automated underwriting
service and delivery fees on some mortgage purchases.
Discussion of Fair Value Results
We believe fair value measures provide an important view of our business economics and risks because fair value takes a
consistent approach to the representation of substantially all Ñnancial assets and liabilities, rather than an approach that
combines historical cost and fair value measurements, as is the case with our GAAP-based consolidated Ñnancial
statements. We use estimates of fair value on a routine basis to make decisions about our business activities. In addition, we
use fair value derived performance measures to establish corporate objectives and as a factor in determining management
compensation. Our consolidated fair value balance sheets are an important component of our risk management processes,
as we use estimates of the changes in fair value to calculate our PMVS and duration gap measures.
Discussion of the estimated impact of mortgage-to-debt OAS on fair value results
We believe disclosing the impact of changes in mortgage-to-debt OAS on the fair value of net assets is helpful to
understanding our current period fair value results in the context of our long-term fair value return expectation. Our long-
term expectation is to generate returns, before capital transactions, over time on the average fair value of net assets
attributable to common stockholders in the low- to mid-teens. In discussing this long-term expectation, we qualify it by
noting that period-to-period returns may Öuctuate substantially due to market conditions. These market conditions include
changes in interest rates and other market factors that aÅect certain components of our fair value changes, including those
which we do not attempt to hedge or actively manage Ì speciÑcally, the change in mortgage-to-debt OAS with respect to
our Retained portfolio and the change in the fair value of the single-family guarantee portfolio.
Our estimate of the periodic increases or decreases in the fair value of net assets associated with Öuctuations in option-
adjusted spreads provides insight into a component of our fair value results that we do not believe will signiÑcantly aÅect the
46 Freddie Mac