Freddie Mac 2008 Annual Report Download - page 177

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our mortgage-related investments portfolio and credit guarantee activities expose us to three broad categories of risk:
(a) interest-rate risk and other market risks; (b) credit risks; and (c) operational risks. Risk management is a critical aspect of
our business. See “RISK FACTORS” for further information regarding these and other risks. We manage risk through a
framework that recognizes primary risk ownership and management by our business areas. Within this framework, our
executive management responsible for independent risk oversight monitors performance against our risk management
strategies and established risk limits and reporting thresholds, identifies and assesses potential issues and provides oversight
regarding changes in business processes and activities. See “MD&A — CREDIT RISKS” and “MD&A — OPERATIONAL
RISKS” for a discussion of credit risks and operational risks and see “CONTROLS AND PROCEDURES” for a discussion
of disclosure controls and procedures and internal control over financial reporting.
Interest-Rate Risk and Other Market Risks
Sources of Interest-Rate Risk and Other Market Risks
Our mortgage-related investments 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 our mortgage-related investments portfolio, known as prepayment risk, and the resulting
potential mismatch in the timing of our receipt of cash flows related to our assets versus the timing of payment of cash flows
related to 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 off a mortgage loan at any time before its
scheduled maturity date (without having to pay a prepayment penalty) or make principal payments in accordance with their
contractual obligation.
Our credit guarantee activities also expose us to interest-rate risk because changes in interest rates can cause fluctuations
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 float. Float, which arises from timing differences between when the
borrower makes principal payments on the loan and the reduction of the PC balance, can lead to significant interest expense
if the interest rate paid to a PC investor is higher than the reinvestment rate earned by the securitization trusts on payments
received from mortgage borrowers and paid to us as trust management income. With our adoption of SFAS 159 on
January 1, 2008, we began to designate certain of our investments in PCs as trading assets, which provide an economic offset
of our guarantee asset. See “NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES — Recently Adopted
Accounting Standards” to our consolidated financial statements for more information.
The market environment was increasingly volatile throughout 2008. Throughout 2008, Freddie Mac adjusted interest
rate risk models to reflect rapidly changing market conditions. In particular, prepayment models were dynamically adjusted
to more accurately reflect the current environment. Due to extreme spread volatility, we adjusted interest-rate risk hedging
methodologies to more accurately attribute OAS spread volatility and interest rate risk.
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 financial instrument’s price sensitivity to changes in interest rates. Convexity is a measure of
how much a financial instrument’s duration changes as interest rates change. Our convexity risk primarily results from
prepayment risk. We seek to 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 and written options. 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 affected by differences 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 flattening or steepening) will adversely
affect GAAP stockholders’ equity (deficit). 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 different 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 specified yield curve scenario is reflected 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 affect GAAP stockholders’ equity (deficit). Implied volatility is a key determinant of the value of an interest-
rate option. Since prepayment risk is generally inherent in mortgage assets, changes in implied volatility affect the value of
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