Freddie Mac 2005 Annual Report Download - page 98

impact on the loan loss reserves and the provision for credit losses. Key estimates and assumptions that could have an
impact on loan loss reserves include:
‚ loss severity trends;
‚ default experience;
‚ expected proceeds from credit enhancements;
‚ evaluation of collateral; and
‚ identiÑcation of relevant macroeconomic factors and assessment of their applications.
Our use of estimates and assumptions is based on all available information and our knowledge and experience in the
single-family and multifamily loan markets. We exercise a signiÑcant amount of judgment in selecting these factors and,
had we made diÅerent determinations in the selection of these factors, a materially diÅerent level of loan loss reserves
could have resulted. However, we believe the level of loan loss reserves is reasonable based on internal reviews of the factors
and methodologies used.
Interest Income Recognition and Impairment Recognition on Investments in Securities
For most of our mortgage-related and non-mortgage-related investments, we recognize interest income using the
eÅective interest method in accordance with SFAS No. 91, ""Accounting for Nonrefundable Fees and Costs Associated with
Originating or Acquiring Loans and Initial Direct Costs of Leases.'' Deferred items, including premiums, discounts and
other basis adjustments, such as changes in commitment-period fair value, are amortized into interest income over the
estimated lives of the securities using the retrospective eÅective interest method. Under this method, we recalculate the
constant eÅective yield based on changes in estimated prepayments. Catch-up adjustments to the unamortized balance of
premiums, discounts and other deferred items that result from applying the updated eÅective yield as if it had been in eÅect
since acquisition are recognized through interest income.
For certain other investments in mortgage-related securities classiÑed as available-for-sale, interest income is
recognized using the prospective eÅective interest method in accordance with EITF 99-20. Under this method, changes in
the eÅective yield due to changes in estimated lives are recognized as adjustments to interest income in future periods. We
speciÑcally apply such guidance to beneÑcial interests (including undivided interests which are similar to beneÑcial
interests) in securitized Ñnancial assets that:
‚ can contractually be prepaid or otherwise settled in such a way that we may not recover substantially all of our
recorded investment (such as interest-only securities); or
‚ were not of high credit quality at the date that we acquired them.
We use actual prepayment experience and estimates of future prepayments to determine the constant yield needed to
apply the eÅective interest method of income recognition. In estimating future prepayments and cash Öows, we aggregate
securities by similar characteristics of their underlying collateral such as origination date, coupon, and product. For
securities with structured cash Öow payments, such as Structured Securities, we also consider the characteristics of other
security classes within the same transaction structure when estimating future prepayments and cash Öows.
Determination of the eÅective yield requires signiÑcant judgment in estimating expected prepayment behavior, which is
inherently uncertain. Estimates of future prepayments are derived from market sources and our internal prepayment models.
Judgment is involved in making initial determinations about prepayment expectations and in changing those expectations
over time in response to changes in market conditions, such as interest rates and other macroeconomic factors. The eÅects of
future changes in market conditions may be material. We believe that the above assumptions are comparable to those used
by other market participants. However, the use of diÅerent assumptions in our prepayment models could have resulted in
materially diÅerent income recognition results.
We recognize impairment losses on available-for-sale securities when we have concluded that a decrease in the fair
value of a security is not temporary. For securities accounted for under EITF 99-20, an impairment loss is recognized when
there is both a decline in fair value below the carrying amount and an adverse change in expected cash Öows. Determination
of whether an adverse change has occurred involves judgment about expected prepayments and credit events. We review
securities not accounted for under EITF 99-20 for potential impairment whenever the security's fair value is less than its
amortized cost. This review considers a number of factors, including the severity of the decline in fair value, credit ratings
and the length of time the investment has been in an unrealized loss position. We recognize impairment when quantitative
and qualitative factors indicate that we may not recover the unrealized loss. One of the factors we consider is our intent and
ability to hold the investment until a point in time at which recovery can be reasonably expected to occur. We apply
signiÑcant judgment in determining whether impairment loss recognition is appropriate. We believe our judgments are
reasonable, however, diÅerent judgments could have resulted in materially diÅerent impairment loss recognition. See
82 Freddie Mac