Freddie Mac 2006 Annual Report Download - page 81

During the past several years, there was a rapid proliferation of nontraditional mortgage product types designed to
address a variety of borrower and lender needs, including issues of aÅordability and reduced income documentation
requirements. While features of these products have been on the market for some time, their prevalence in the market and
our Total mortgage portfolio increased in 2006 and 2005. See ""REGULATION AND SUPERVISION Ì OÇce of
Federal Housing Enterprise Oversight Ì Nontraditional Mortgage Product Risks'' and ""RISK FACTORS Ì Legal and
Regulatory Risks.'' We expect each of these products to default more often than traditional products and we consider this
when determining our credit and guarantee fees. Our purchases of interest-only and option ARM mortgage products
increased in 2006, representing approximately 18 percent of our Total mortgage portfolio purchases as compared to
11 percent in 2005. Despite this recent increase in purchases, these products represent a small percentage of the unpaid
principal balance of our Total mortgage portfolio. At December 31, 2006 and 2005, interest-only and option ARMs
collectively represented approximately 6 percent and 3 percent, respectively, of the unpaid principal balance of the Total
mortgage portfolio. We will continue to monitor the growth of these products in our portfolio and, if appropriate, may seek
credit enhancements to further manage the incremental risk.
Interest-only and option ARM loans. These mortgages are designed to allow borrowers to have Öexibility in their
payment terms. Interest-only mortgages allow the borrower to pay only interest for a Ñxed period of time before the loan
begins to amortize. Option ARM loans permit a variety of repayment options, which include minimum, interest only, fully
amortizing 30-year and fully amortizing 15-year payments. Minimum payment option loans allow the borrower to make
monthly payments that are less than the interest accrued for the period. The unpaid interest, known as negative
amortization, is added to the principal balance of the loan, which increases the outstanding loan balance. The amount of
option ARM mortgages within our Total mortgage portfolio was 1 percent for both 2006 and 2005 and the amount of related
negative amortization in both years was not material.
We also hold securities issued by third parties where the underlying collateral may include interest-only and option
ARM mortgage products. Delinquencies on total interest-only and option ARM products increased to 0.41 percent in 2006
from 0.08 percent in 2005. Mortgages generally have a lower rate of delinquency in the year in which they are originated.
We generally mitigate credit risk inherent in these securities through a guarantee from the third party issuer or the
underlying structure of the security. For additional information about the credit quality and credit risk management of non-
Freddie Mac securities we hold see ""Institutional Credit Risk Ì Non-Freddie Mac Mortgage-Related Securities'' and
""CONSOLIDATED BALANCE SHEETS ANALYSIS Ì Retained Portfolio.''
Subprime loans. Participants in the mortgage market often characterize loans based upon their overall credit quality
at the time of origination, generally considering them to be prime or subprime. There is no universally accepted deÑnition of
subprime. The subprime segment of the mortgage market primarily serves borrowers with poorer credit payment histories
and such loans typically have a mix of credit characteristics that indicate a higher likelihood of default and higher loss
severities than prime loans. Such characteristics might include a combination of high loan-to-value ratios, low FICO scores
or originations using lower underwriting standards such as limited or no documentation of a borrower's income. The
subprime market helps certain borrowers by increasing the availability of mortgage credit.
While we do not characterize the single-family loans underlying the PCs and Structured Securities in our credit
guarantee portfolio as either prime or subprime, we believe that, based on lender-type, underwriting practice and product
structure, the number of loans underlying these securities that are subprime is not signiÑcant. Also included in our credit
guarantee portfolio are Structured Securities backed by non-agency mortgage-related securities where the underlying
collateral was identiÑed as being subprime by the original issuer. At December 31, 2006 and 2005, the Structured Securities
backed by subprime mortgages constituted approximately 0.1 percent and 0.2 percent, respectively of our credit guarantee
portfolio.
With respect to our Retained portfolio, we do not believe that any meaningful amount of the agency securities we hold is
backed by subprime mortgages. However, at December 31, 2006 and 2005, we held approximately $124 billion and
$139 billion, respectively, of non-agency mortgage-related securities backed by subprime loans. These securities include
signiÑcant credit enhancement based on their structure and more than 99.9 percent of these securities were rated AAA at
December 31, 2006.
We announced on February 27, 2007 that we would implement stricter investment standards for certain subprime
ARMs with short adjustment periods originated after September 1, 2007. First, we will only buy ARMs, and mortgage-
related securities backed by those loans, for which borrowers have been qualiÑed at the fully-indexed and fully-amortizing
rate in order to help protect these borrowers from the payment shock that could occur when the interest rates on their
ARMs increase. Second, we will limit the use of low-documentation underwriting for these types of mortgages to help
ensure that borrowers have the income necessary to aÅord their homes.
69 Freddie Mac