Freddie Mac 2006 Annual Report Download - page 62

interest-rate paths, cash Öows and prepayment rates. We use these models and assumptions in running our business, and we
rely on many of the models in producing our Ñnancial statements and measuring, managing and reporting interest-rate and
other market risks. The use of diÅerent estimation methods or the application of diÅerent assumptions could result in a
materially diÅerent estimate of OAS impact.
We revised the method we previously used to report the impact that changes in OAS have on our fair value results. This
methodology change had no impact on the actual change in the fair value of net assets, only our attribution of that change.
This change was made in order to more closely align the process we use to report the impact of changes in OAS with the
interest rate risk management framework of our investment activities.
An integral part this framework includes the attribution of fair value changes to assess the performance of our
investment activities. On a daily basis, all interest rate sensitive assets, liabilities and derivatives are modeled using our
proprietary prepayment and interest rate models. Management uses interest-rate risk statistics generated from this process,
along with daily market movements, coupon accruals and price changes, to estimate and attribute returns into various risk
factors commonly used in the Ñxed income industry to quantify and understand sources of fair value return. One important
risk factor is the change in fair value due to changes in mortgage-to-debt OAS.
The method previously used to estimate the impact of mortgage-to-debt OAS changes on fair value was performed on a
monthly basis and excluded certain portions of the investment portfolio. The new methodology estimates the impact of
mortgage-to-debt OAS changes on fair value on a daily basis and includes all Ñnancial instruments.
On a pre-tax basis for 2006 and 2005, the reported OAS impacts using our new methodology were reductions in fair
value of $0.9 billion and $2.7 billion, respectively. Using our previous methodology, the OAS impacts were pre-tax
reductions in fair value of $0.6 billion and $2.0 billion, respectively.
Understanding our estimate of the impact of changes in mortgage-to-debt OAS on fair value results
A number of important qualiÑcations apply to our disclosed estimates. The estimated impact of the change in option-
adjusted spreads on the fair value of our net assets in any given period does not depend on other components of the change
in fair value. Although the fair values of our Ñnancial instruments will generally move toward their par values as the
instruments approach maturity, investors should not expect that the eÅect of past changes in OAS will necessarily reverse
through future changes in OAS. To the extent that actual prepayment or interest rate distributions diÅer from the forecasts
contemplated in our models, changes in values reÖected in mortgage-to-debt OAS may not be recovered in fair value
returns at a later date.
When the OAS on a given asset widens, the fair value of that asset will typically decline, all other things being equal.
However, we believe such OAS widening has the eÅect of increasing the likelihood that, in future periods, we will recognize
income at a higher spread on this existing asset. The reverse is true when the OAS on a given asset tightens Ì current
period fair values for that asset typically increase due to the tightening in OAS, while future income recognized on the asset
is more likely to be earned at a reduced spread. Although a widening of OAS is generally accompanied by lower current
period fair values, it can also provide us with greater opportunity to purchase new assets for our Retained portfolio at the
wider mortgage-to-debt OAS.
For these reasons, our estimate of the impact of the change in OAS provides information regarding one component of
the change in fair value for the particular period being evaluated. However, results for a single period should not be used to
extrapolate long-term fair value returns. We believe the potential fair value return of our business over the long term
depends primarily on our ability to add new assets at attractive mortgage-to-debt OAS and to eÅectively manage over time
the risks associated with these assets, as well as the risks of our existing portfolio to ensure that we realize anticipated
returns on our business. In other words, to capture the fair value returns we expect, we have to apply accurate estimates of
future prepayment rates and other performance characteristics at the time we purchase assets, and then manage
successfully the range of market risks associated with a debt-funded mortgage portfolio over the life of these assets.
LIQUIDITY AND CAPITAL RESOURCES
Liquidity
Our business activities require that we maintain adequate liquidity to make payments upon the maturity or repurchase
of our debt securities, purchase mortgage loans, mortgage-related securities and other investments, make payments of
principal and interest on our debt securities and on our guaranteed PCs and Structured Securities, make net payments on
derivative instruments, fund our general operations and pay dividends on our preferred and common stock.
We fund our cash requirements primarily by issuing short-term and long-term debt. Other sources of cash include:
‚ receipts of principal and interest payments on securities we hold or mortgage loans we have securitized and sold;
‚ sales of securities we hold;
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