Freddie Mac 2015 Annual Report Download - page 143

Management's Discussion and Analysis Risk Management | Interest Rate Risk and Other Market Risks
Freddie Mac 2015 Form 10-K 141
INTEREST-RATE RISK AND OTHER MARKET RISKS
Our core businesses have embedded exposure to interest-rate risk and other market risks. Interest-rate
risk is consolidated and managed by the Investments segment, while spread risk is owned and managed
by each individual business segment. Interest-rate risk and other market risks can adversely affect future
cash flows, or economic value, as well as earnings and net worth.
The majority of our interest-rate risk comes from our mortgage-related assets (securities and loans) and
the debt we issue to fund them. Typically, an existing loan or bond investment is worth less to an investor
when interest rates (yields) rise and worth more when they decline. In addition, for a majority of our
mortgage-related assets, the borrower has the option to make unscheduled principal payments at any
time before maturity without incurring a prepayment penalty. Thus, our mortgage-related asset portfolio is
also exposed to the uncertainty as to when borrowers will exercise their option and pay the outstanding
principal balance of their loans. We face similar (and in most cases directionally opposite) exposure
related to unsecured debt. Unsecured debt is typically worth less to an investor when interest rates
(yields) rise and more when they decline. In addition, we issue debt with embedded options, such as an
option to call, which provides us flexibility concerning the timing of our debt maturities. We actively
manage our economic exposure to interest rate fluctuations.
Our primary goal in managing interest-rate risk is to reduce the amount of change in the value of our
future cash flows due to future changes in interest rates. We use models to analyze possible future
interest-rate scenarios, along with the cash flow of our assets and liabilities over those scenarios.
The choice of the benchmark rate used to model and hedge our positions is a significant assumption. The
effectiveness of our hedges ultimately depends on how closely the different instruments (assets, liabilities,
and derivatives) react to the underlying chosen benchmark. In the simplest example, all instruments
would have interest-rate risk based on the same underlying benchmark, in our case, the swap rate. In
practice, however, different instruments react differently versus the benchmark rate, which creates a
spread between the benchmark rate and the instrument. As the spreads of these instruments move
differently, our ability to predict the behavior of each instrument relative to the others is reduced,
potentially affecting the effectiveness of our hedges.
Although the mortgage-related investments portfolio is the main contributor of interest-rate risk to the
company, other core businesses also contribute to our interest-rate risk and may be managed
differently. Unlike the mortgage-related investments portfolio's long-term holding period for assets, the
securitization pipeline typically has a much shorter holding period. Since these assets are typically sold
shortly after purchase, the risk from these assets is generally tied to changes in current market prices (vs
long-term future cash flow value). Hedging these businesses at times requires additional assumptions
concerning risk metrics to accommodate changes in pricing that may not be related to the future cash
flow of the assets. This could create a perceived risk exposure as the hedged risk may differ from the
model risk.
We employ a risk management framework that seeks to maintain certain interest rate characteristics of
our assets and liabilities within our risk limits through a number of different strategies, including:
• Asset selection and structuring, such as acquiring or structuring mortgage-related securities with
certain expected prepayment and other characteristics;
• Issuance of both callable and non-callable unsecured debt; and
• Use of interest rate derivatives, including swaptions and swaps.