Freddie Mac 2005 Annual Report Download - page 97

beginning of the second quarter of 2005, we voluntarily discontinued hedge accounting treatment for all new forward
purchase commitments and the majority of our new commitments to forward sell mortgage-related securities. On March 31,
2006, we voluntarily discontinued hedge accounting treatment for all derivatives, with the exception of certain commit-
ments to forward sell mortgage-related securities and one foreign-currency hedge strategy, in an eÅort to simplify our
operations.
Our total derivative portfolio is an eÅective component of our interest-rate risk management activities. We recognize all
derivatives, whether designated in hedging relationships or not, at fair value as either assets or liabilities on our consolidated
balance sheets. Derivatives that are expected to be highly eÅective in reducing the risk associated with the exposure being
hedged may be designated for accounting purposes as a hedge of:
‚ the cash Öows of a variable-rate instrument or a forecasted transaction, or a ""cash Öow hedge;''
‚ the changes in fair value of a Ñxed-rate instrument, or a ""fair value hedge;'' or
‚ foreign-currency fair value or cash Öow, or a ""foreign-currency hedge.''
We report the change in fair value of derivatives that are not in hedge accounting relationships in our consolidated
statements of income in the period in which the change in value occurs. We record the change in fair value of derivatives that
are in cash Öow hedge accounting relationships, to the extent these relationships are eÅective, as a separate component of
AOCI and reclassify this amount into earnings when the hedged item or forecasted transaction aÅects earnings. We record
the change in fair value of derivatives in fair value hedge accounting relationships each period in earnings along with the
change in fair value of the hedged item attributable to the hedged risk.
The determination of whether a derivative qualiÑes for hedge accounting requires judgment about the application of
SFAS 133. SFAS 133 requires contemporaneous documentation of our hedge relationships, including identiÑcation of the
hedged item, the hedging instrument, the nature of the hedged risk and the method used to assess the eÅectiveness of the
hedge relationship. Throughout 2005, we have used a comparison of the critical terms of the hedging instrument to those of
the hedged item to assess the eÅectiveness of hedges. If our documentation and assessments are not adequate, the
derivative does not qualify for hedge accounting.
Derivatives designated as cash Öow hedges generally hedged interest-rate risk related to forecasted issuances of debt.
For these hedging relationships to qualify for hedge accounting both at inception and over the life of the derivative, we must
estimate the probable future level of certain types of debt issuances. These estimates are based on our expectation of future
funding needs and the future mix of funding sources. Our expectations about future funding are based upon projected growth
and historical activity. If these estimates had been lower, a smaller notional amount of derivatives would have been eligible
for designation as cash Öow hedges and potentially material amounts that were deferred and reported in AOCI would have
been reported in Derivative gains (losses) in the consolidated statements of income in the period they occurred. If estimated
future fundings do not occur, or are probable of not occurring, potentially material amounts that were deferred and
reported in AOCI would be immediately recognized in Derivative gains (losses) in the consolidated statements of income.
We believe that the forecasted issuances of debt previously hedged in cash Öow hedging relationships are suÇciently likely to
occur so that we may continue recording previously deferred amounts in AOCI.
For a more detailed description of our use of derivatives and summaries of derivative positions, see ""CONSOLI-
DATED RESULTS OF OPERATIONS Ì Derivative Overview'' and ""NOTE 12: DERIVATIVES'' to the consolidated
Ñnancial statements.
Credit Losses
We maintain a Reserve for losses on mortgage loans held-for-investment to provide for credit losses incurred related to
those mortgage loans. At December 31, 2005 and 2004, the Reserve for losses on mortgage loans held-for-investment was
$119 million and $114 million, respectively. We also maintain a Reserve for guarantee losses on Participation CertiÑcates to
provide for losses incurred on mortgages underlying PCs or Structured Securities held by third parties. At December 31,
2005 and 2004, the Reserve for guarantee losses on Participation CertiÑcates was $295 million and $150 million, respectively.
The Reserve for losses on mortgage loans held-for-investment and the Reserve for guarantee losses on Participation
CertiÑcates are collectively referred to as the loan loss reserves. Increases in loan loss reserves are reÖected in earnings as a
component of the Provision for credit losses. Loan loss reserves decrease when charge-oÅs of such balances (net of
recoveries) occur or when we record realized losses.
The process for determining the level of loan loss reserves is subject to numerous estimates and assumptions that require
judgment. We regularly evaluate the underlying estimates and assumptions we use when determining the loan loss reserves
and update these assumptions to reÖect our own historical experience and our current view of overall economic conditions
and other relevant factors. Changes in one or more of these underlying estimates and assumptions could have a material
81 Freddie Mac