Freddie Mac 2006 Annual Report Download - page 72

Disclosure Controls and Procedures
Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that the
information required to be disclosed by a company in its Ñnancial reports is accumulated and communicated to its senior
management team as appropriate to allow timely decisions regarding required disclosure. Full evaluation of our disclosure
controls and procedures has been delayed as our resources are focused on the remediation of our internal control over
Ñnancial reporting.
Interest-Rate Risk and Other Market Risks
Our interest-rate risk management objective is to serve our housing mission by protecting shareholder value in all
interest-rate environments. Our disciplined approach to interest-rate risk management is essential to maintaining a strong
and durable capital base and uninterrupted access to debt and equity capital markets.
Sources of Interest-Rate Risk and Other Market Risks
Our Retained portfolio activities expose us to interest-rate risk and other market risks arising primarily from the
uncertainty as to when borrowers will pay the outstanding principal balance of mortgage loans and mortgage-related
securities held in the Retained portfolio, known as prepayment risk, and the resulting potential mismatch in the timing of our
receipt of cash Öows on our assets versus the timing of our obligation to make payments on our liabilities. For the vast
majority of our mortgage-related investments, the mortgage borrower has the option to make unscheduled payments of
additional principal or to completely pay oÅ a mortgage loan at any time before its scheduled maturity date (without having
to pay a prepayment penalty) or to hold the mortgage loan to its stated maturity.
Our credit guarantee activities also expose us to interest-rate risk because changes in interest rates can cause
Öuctuations in the fair value of our existing credit guarantee portfolio. We generally do not hedge these changes in fair value
except for interest-rate exposure related to net buy-ups and Öoat. Float, which arises from timing diÅerences between when
the borrower pays us and when we reduce the PC balance, can lead to signiÑcant interest expense if the interest rate paid to
a PC investor is higher than the reinvestment rate we earn on payments received from mortgage borrowers.
The types of interest-rate risk and other market risks to which we are exposed are described below.
Duration Risk and Convexity Risk. Duration is a measure of a Ñnancial instrument's price sensitivity to changes in
interest rates. Convexity is a measure of how much a Ñnancial instrument's duration changes as interest rates change. Our
convexity risk primarily results from prepayment risk. We actively manage duration risk and convexity risk through asset
selection and structuring (that is, by identifying or structuring mortgage-related securities with attractive prepayment and
other characteristics), by issuing a broad range of both callable and non-callable debt instruments and by using interest-rate
derivatives. Managing the impact of duration risk and convexity risk is the principal focus of our daily market risk
management activities. These risks are encompassed in our PMVS and duration gap risk measures, discussed in greater
detail below. We use prepayment models to determine the estimated duration and convexity of mortgage assets for our
PMVS and duration gap measures. Expected results can be aÅected by diÅerences between prepayments forecasted by the
models and actual prepayments.
Yield Curve Risk. Yield curve risk is the risk that non-parallel shifts in the yield curve (such as a Öattening or
steepening) will adversely aÅect shareholder value. Because changes in the shape, or slope, of the yield curve often arise due
to changes in the market's expectation of future interest rates at diÅerent points along the yield curve, we evaluate our
exposure to yield curve risk by examining potential reshaping scenarios at various points along the yield curve. Our yield
curve risk under a speciÑed yield curve scenario is reÖected in our PMVS-Yield Curve, or PMVS-YC, disclosure.
Volatility Risk. Volatility risk is the risk that changes in the market's expectation of the magnitude of future
variations in interest rates will adversely aÅect shareholder value. Implied volatility is a key determinant of the value of an
interest-rate option. Since mortgage assets generally include the borrower's option to prepay a loan without penalty, changes
in implied volatility aÅect the value of mortgage assets. We manage volatility risk through asset selection and by
maintaining a consistently high percentage of option-embedded liabilities relative to our mortgage assets. We monitor
volatility risk by measuring exposure levels on a daily basis and we maintain internal limits on the amount of volatility risk
exposure that is acceptable to us.
Basis Risk. Basis risk is the risk that interest rates in diÅerent market sectors will not move in tandem and will
adversely aÅect shareholder value. This risk arises principally because we generally hedge mortgage-related investments with
debt securities. We do not actively manage the basis risk arising from funding Retained portfolio investments with our debt
securities, also referred to as mortgage-to-debt option-adjusted spread risk. See ""CONSOLIDATED FAIR VALUE
BALANCE SHEETS ANALYSIS Ì Key Components of Changes in Fair Value of Net Assets Ì Changes in mortgage-
to-debt OAS '' for additional information. We also incur basis risk when we use LIBOR- or Treasury-based instruments in
our risk management activities.
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