Freddie Mac 2009 Annual Report Download - page 308

or 3 depending on the significance of the inputs that are not observable. In addition, the fair values of the retained interests
in our PCs and Structured Securities reflect that they are considered to be of high credit quality due to our guarantee. Our
exposure to credit losses on loans underlying these securities is recorded within our reserve for guarantee losses on
Participation Certificates. See “NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES — Investments in
Securities” for additional information.
Certain available-for-sale mortgage-related securities whose fair value is determined by reference to prices obtained
from broker/dealers or pricing services have been changed from a Level 2 classification to a Level 3 classification since the
first quarter of 2008. Previously, these valuations relied on observed trades, as evidenced by both activity observed in the
market, and similar prices obtained from multiple sources. In late 2007, however, the divergence among prices obtained from
these sources increased, and became significant in the first quarter of 2008. This, combined with the observed significant
reduction in transaction volumes and widening of credit spreads, led us to conclude that the prices received from pricing
services and dealers were reflective of significant unobservable inputs. During 2009, our Level 3 assets increased because the
market for non-agency CMBS continued to experience a significant reduction in liquidity and wider spreads, as investor
demand for these assets decreased. As a result, we observed more variability in the quotes received from dealers and third-
party pricing services and transferred these amounts into Level 3. These transfers were primarily within non-agency CMBS
where inputs that are significant to their valuation became limited or unavailable. We concluded that the prices on these
securities received from pricing services and dealers were reflective of significant unobservable inputs, as the markets have
become significantly less active, requiring higher degrees of judgment to extrapolate fair values from limited market
benchmarks.
Derivative Assets, Net
Derivative assets largely consist of interest-rate swaps, option-based derivatives, futures and forward purchase and sale
commitments that we account for as derivatives. The carrying value of our derivatives on our consolidated balance sheets is
equal to their fair value, including net derivative interest receivable or payable, trade/settle receivable or payable and is net
of cash collateral held or posted, where allowable by a master netting agreement. Derivatives in a net unrealized gain
position are reported as derivative assets, net. Similarly, derivatives in a net unrealized loss position are reported as derivative
liabilities, net.
The fair values of interest-rate swaps are determined by using the appropriate yield curves to calculate and discount the
expected cash flows for both the fixed-rate and variable-rate components of the swap contracts. Option-based derivatives,
which principally include call and put swaptions, are valued using option-pricing models. These models use market interest
rates and market-implied option volatilities or dealer prices, where available, to calculate the option’s fair value. Market-
implied option volatilities are based on information obtained from broker/dealers. Since swaps and option-based derivatives
fair values are determined through models that use observable inputs, these are generally classified as Level 2 under the fair
value hierarchy. To the extent we have determined that any of the significant inputs are considered unobservable, these
amounts have been classified as Level 3 under the fair value hierarchy.
The fair value of exchange-traded futures and options is based on end-of-day closing prices obtained from third-party
pricing services, therefore they are classified as Level 1 under the fair value hierarchy.
The fair value of derivative assets considers the impact of institutional credit risk in the event that the counterparty does
not honor its payment obligation. Additionally, the fair value of derivative liabilities considers the impact of our institutional
credit risk. Our fair value of derivatives is not adjusted for credit risk because we obtain collateral from, or post collateral to,
most counterparties, typically within one business day of the daily market value calculation, and substantially all of our
institutional credit risk arises from counterparties with investment-grade credit ratings of A or above.
Certain purchase and sale commitments are also considered to be derivatives and are classified as Level 2 or Level 3
under the fair value hierarchy, depending on the fair value hierarchy classification of the purchased or sold item, whether
security or loan. Such valuation methodologies and fair value hierarchy classifications are further discussed in the
“Investments in Securities” and the “Mortgage Loans, Held-for-Sale” sections above.
Guarantee Asset, at Fair Value
For a description of how we determine the fair value of our guarantee asset, see “NOTE 4: RETAINED INTERESTS
IN MORTGAGE-RELATED SECURITIZATIONS.” Since its valuation technique is model based with significant inputs that
are not observable, our guarantee asset is classified as Level 3 in the fair value hierarchy.
REO, Net
For GAAP purposes, subsequent to acquisition REO is carried at the lower of its carrying amount or fair value less
estimated costs to sell. The subsequent fair value less estimated costs to sell is a model-based estimated value based on
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