Freddie Mac 2008 Annual Report Download - page 143

CREDIT RISKS
Our total mortgage portfolio is subject primarily to two types of credit risk: mortgage credit risk and institutional credit
risk. Mortgage credit risk is the risk that a borrower will fail to make timely payments on a mortgage or security we own or
guarantee. We are exposed to mortgage credit risk on our total mortgage portfolio because we either hold the mortgage
assets or have guaranteed mortgages in connection with the issuance of a PC, Structured Security or other borrower
performance commitment. Institutional credit risk is the risk that a counterparty that has entered into a business contract or
arrangement with us will fail to meet its obligations.
Mortgage and credit market conditions deteriorated in the second half of 2007 and more rapidly throughout 2008. These
conditions were brought about by a number of factors, which have increased our exposure to both mortgage credit and
institutional credit risks. Factors negatively affecting the mortgage and credit markets during 2008 included:
• changes in other financial institutions’ underwriting standards which allowed for new higher-risk mortgage products in
2006 and 2007 that resulted in historically high default rates;
• increases in unemployment;
• declines in home prices nationally;
• higher incidence of institutional insolvencies;
• higher levels of foreclosures and delinquencies;
• significant volatility;
• significantly lower levels of liquidity in institutional credit markets;
• wider credit spreads;
• rating agency downgrades of mortgage-related securities or counterparties; and
• declines in rental rates and increased vacancy rates affecting multifamily housing operators and investors.
Mortgage Credit Risk
Mortgage credit risk is primarily influenced by the credit profile of the borrower on the mortgage, the features of the
mortgage itself, the type of property securing the mortgage, home price trends and the general economy. To manage our
mortgage credit risk, we focus on three key areas: underwriting requirements and quality control standards; portfolio
diversification; and portfolio management activities, including loss mitigation and the use of credit enhancements.
All mortgages that we purchase or guarantee have an inherent risk of default. We vary our guarantee fee pricing relative
to differing levels of mortgage credit risk. The appointment of FHFA as Conservator and the Conservator’s subsequent
directive that we provide increased support to the mortgage market has affected guarantee pricing decisions by limiting our
ability to adjust our fees for current expectations of credit risk, and will likely continue to do so. We also seek to manage the
underlying risk by using our underwriting and quality control processes. Our underwriting process evaluates mortgage loans
and the borrowers’ ability to repay the loans using several critical risk characteristics, including the borrower’s credit score,
the borrower’s monthly income relative to debt payments, LTV ratio, type of mortgage product and occupancy type. See
“BUSINESS — Regulation and Supervision — Federal Housing Finance Agency —Housing Goals and Home Purchase
Subgoals” for a discussion of factors that may cause us to purchase loans that do not meet our normal standards.
Mortgage Market Background
We have been significantly adversely affected by deteriorating conditions in the single-family housing and mortgage
markets during 2007 and 2008. In recent years, financial institutions significantly increased mortgage lending and
securitization of certain higher-risk mortgage products, such as subprime, option ARM and Alt-A loans, and these loans
comprised a much larger proportion of origination and securitization issuance volumes during 2006 and 2007, as compared
to prior years. During this time, we increased our participation in the market for these products through our purchases of
non-agency mortgage-related securities, which we hold in our mortgage-related investments portfolio and, to a lesser extent,
through our guarantee activities. Our expanded participation in these products was driven by a combination of competing
objectives, including meeting our affordable housing goals, serving our customers and generating returns for investors. The
exposure to mortgage credit risk for a number of financial institutions also increased with the expanding use of leverage as
well as mortgage credit derivative products. We believe these products, such as credit default swaps, or CDS, and
collateralized debt obligations, or CDOs, obscured the distribution of risk among market participants. Moreover, the
complexity of such instruments made the overall risk exposure of the financial institutions using them less apparent. We
believe concerns about counterparties with significant exposures associated with these instruments further reduced transaction
volumes and new issuances of non-agency mortgage-related securities during 2008.
The table below illustrates the size of mortgage origination and securitization activities during the past three years
relative to our own market participation. We have not presented CDS or CDO market statistics, since there is no reliable data
that illustrates these exposures and we have not significantly participated in the market for these products. See “Table 75 —
140 Freddie Mac