Freddie Mac 2005 Annual Report Download - page 95

amounts into income and extinguishment when we purchase the related PCs and Structured Securities into the Retained
portfolio.
The estimation of fair values reÖects our judgments regarding appropriate valuation methods and assumptions. The
selection of a method to estimate fair value for each type of Ñnancial instrument depends on both the reliability and
availability of relevant market data. The amount of judgment involved in estimating the fair value of a Ñnancial instrument is
aÅected by a number of factors, such as the type of instrument, the liquidity of the markets for the instrument and the
contractual characteristics of the instrument.
Even for instruments with a high degree of price transparency, fair value estimation involves our application of
signiÑcant, ongoing judgment. These judgments include:
‚ evaluation of the expected reliability of the estimate;
‚ reliability, timeliness and cost of alternative valuation methodologies;
‚ selection of third-party market data sources;
‚ selection of proxy instruments, as necessary; and
‚ adjustments to market-derived data to reÖect diÅerences in instruments' contractual terms.
We periodically evaluate our methodologies and may change them to improve our fair value estimates, to accommodate
market developments or to compensate for changes in data availability or other operational constraints.
For Ñnancial instruments with active markets and readily available market prices, we estimate fair values based on
independent price quotations obtained from third parties, including pricing services, dealer marks or direct market
observations, where available. We seek to use third-party pricing where possible. Independent price quotations obtained from
third-party pricing services are valuations estimated by an independent service provider using market information. Dealer
marks are prices that are obtained from third-party dealers that generally make markets in the relevant products and are an
indication of the price at which the dealer would consider transacting in normal market conditions. Market observable prices
are prices that are retrieved from sources in which market trades are executed, such as electronic trading platforms.
Certain instruments are less actively traded and, therefore, are not always able to be reliably valued based on prices
obtained from third parties. If quoted prices or market data are not available, fair value is based on internal valuation models
using market data inputs or internally developed assumptions, where appropriate. Model-based valuations with signiÑcant
market inputs are estimated using one or more models such as: interest rate models, prepayment models, option-adjusted
spread models and/or credit models. These models use market inputs such as interest rate curves, market volatilities and
pricing spreads, which can be validated using external sources such as third party pricing services, dealer marks and market
observable transactions. Model-based valuations without market inputs are required for products with limited price
discovery and are estimated using one or more of the models indicated or are based on our judgment and assumptions. The
use of diÅerent pricing models and assumptions could produce materially diÅerent estimates of fair values.
The fair values for approximately 99 percent of our mortgage-related securities are based on prices obtained from third
parties or are determined using models with signiÑcant market inputs. The fair values for the remainder of our mortgage-
related securities are obtained from internal models with few or no market inputs. The fair values for our non-mortgage-
related securities are based on prices obtained from third parties, unless their interest rates frequently reset, in which case the
carrying value is presumed to be a reasonable approximation of fair value. As few of the derivative contracts we use are
listed on exchanges, the majority of our derivative positions are valued using internally developed models that use market
inputs. Approximately 68 percent of the gross fair value of our derivatives portfolio relates to interest-rate and foreign-
currency swaps that do not have embedded options. These derivatives are valued using a discounted cash Öow model that
projects future cash Öows and discounts them at the spot rate related to each cash Öow. The remaining 32 percent of our
derivatives portfolio is valued based on prices obtained from third parties or using models with signiÑcant market inputs.
The fair values for all of our debt securities are based on prices obtained from third parties or are determined using models
with signiÑcant market inputs.
Some of our Ñnancial instruments are not traded in active markets. Examples include the Guarantee asset, Guarantee
obligation and PC residuals. In 2005, our approach for valuing these items incorporated more third-party market-based
information in their valuations. Our valuation methodologies and the recent improvements are discussed in
""NOTE 2: TRANSFERS OF SECURITIZED INTERESTS IN MORTGAGE-RELATED ASSETS'' to our consoli-
dated Ñnancial statements.
As described above, the estimation of fair value requires judgment and we may have reasonably chosen diÅerent
methodologies or assumptions in the current period. The use of diÅerent pricing methodologies and assumptions could have
produced materially diÅerent estimates of fair value in the periods currently presented. However, we believe the fair values
we estimated are reasonable based on internal reviews of signiÑcant pricing models and methodologies as well as
79 Freddie Mac