Freddie Mac 2008 Annual Report Download - page 174

amount, which the entity failed to pay. We then exercised our right to seize collateral previously posted by the entity in
connection with the transactions. The collateral was insufficient to cover the settlement amount, leaving a shortfall of
approximately $30 million. During 2008, we recorded a $27 million reduction to our derivative assets which represents an
estimate of the probable loss on this transaction.
In the event of counterparty default, our economic loss may be higher than the uncollateralized exposure of our
derivatives if we are not able to replace the defaulted derivatives in a timely and cost-effective fashion. We monitor the risk
that our uncollateralized exposure to each of our OTC counterparties for interest-rate swaps, option-based derivatives and
foreign-currency swaps will increase under certain adverse market conditions by performing daily market stress tests. These
tests evaluate the potential additional uncollateralized exposure we would have to each of these derivative counterparties
assuming changes in the level and implied volatility of interest rates and changes in foreign-currency exchange rates over a
brief time period.
As indicated in Table 75, the total exposure on our OTC forward purchase and sale commitments of $537 million and
$465 million at December 31, 2008 and 2007, respectively, which are treated as derivatives, was uncollateralized. Because
the typical maturity of our forward purchase and sale commitments is less than 60 days and they are generally settled
through a clearinghouse, we do not require master netting and collateral agreements for the counterparties of these
commitments. However, we monitor the credit fundamentals of the counterparties to our forward purchase and sale
commitments on an ongoing basis to ensure that they continue to meet our internal risk-management standards. At
December 31, 2008, we had a large volume of purchase and sale commitments related to our mortgage-related investments
portfolio that increased our exposure to the counterparties to our forward purchase and sale commitment. The majority of
these commitments settled in January 2009.
OPERATIONAL RISKS
Operational risks are inherent in all of our business activities and can become apparent in various ways, including
accounting or operational errors, business interruptions, fraud, failures of the technology used to support our business
activities and other operational challenges from failed or inadequate internal controls. These operational risks may expose us
to financial loss, interfere with our ability to sustain timely financial reporting, or result in other adverse consequences.
Governance over the management of our operational risks takes place through the enterprise risk management framework.
Business areas retain primary responsibility for identifying, assessing and reporting their operational risks.
Our business processes are highly dependent on our use of technology and business and financial models. While we
believe that we have remediated material weaknesses in our information technology general controls, we continue to face
challenges in ensuring that the new controls will operate effectively. Although we have strengthened our model oversight and
governance processes to validate model assumptions, code, theory and the system applications that utilize our models, the
complexity of the models and the impact of the recent turmoil in the housing and credit markets create additional risk
regarding the reliability of our model estimates.
We continue to make significant investments to build new financial accounting systems and move to more effective and
efficient business processing systems. Until those systems are fully implemented, we continue to remain more reliant on end-
user computing systems than is desirable. We are also challenged to effectively and timely deliver integrated production
systems. Reliance on certain of these end-user computing systems increases the risk of errors in some of our core operational
processes and increases our dependency on monitoring controls. We are mitigating this risk by improving our documentation
and process controls over these end-user computing systems and implementing more rigorous change management controls
over certain key end-user systems using change management controls over tools which are subject to our information
technology general controls.
In recognition of the importance of the accuracy and reliability of our valuation of financial instruments, we engage in
an ongoing internal review of our valuations. We perform analysis of internal valuations on a monthly basis to confirm the
reasonableness of the valuations. This analysis is performed by a group that is independent of the business area responsible
for valuing the positions. Our verification and validation procedures depend on the nature of the security and valuation
methodology being reviewed and may include: comparisons with external pricing sources, comparisons with observed trades,
independent verification of key valuation model inputs and independent security modeling. Results of the monthly
verification process, as well as any changes in our valuation methodologies, are reported to a management committee that is
responsible for reviewing and approving the approaches used in our valuations to ensure that they are well controlled and
effective, and result in reasonable fair values. For more information on the controls in our valuation process, see “CRITICAL
ACCOUNTING POLICIES AND ESTIMATES — Valuation of a Significant Portion of Assets and Liabilities — Controls
over Fair Value Measurement.”
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