Derivatives Weigh Down Freddie Mac.(fair value )

First, the bad news. Despite solid operational performance, Freddie Mac's 2004 net income declined by $2 billion, reflecting a substantial decrease in the value of derivatives that are used to manage interest rate risk exposure.

Now, the good news: investors didn't panic.

Freddie Mac earned $2.8 billion last year, down from $4.8 billion in the record-breaking home loan year of 2003. While business volume and interest margins contracted a bit last year, the big culprit was Freddie Mac's derivatives portfolio. Those derivative securities are key to offset interest rate risk in Freddie's investment portfolio, but they don't qualify for hedge accounting treatment. Hence, Freddie Mac reported a $4.5 billion loss related to the portfolio.

Still, Freddie Mac executives explained to investors that the impact of the derivatives does not paint a full picture of the company's condition. A better measure than GAAP earnings, they suggested, is the "fair value" of the enterprise, which puts all assets and liabilities on the same page.

Freddie Mac said its fair value rose to $26.7 billion last year, from $22.9 billion at the end of 2003. That's a 17% increase from a year earlier.

Patricia Cook, executive vice president at Freddie Mac, said in a conference call with investors and analysts that the fair value measure eliminates the "bias" that changes in derivative gains and losses have on earnings under GAAP.

The fair value measure better takes into account "the risk management of the overall portfolio," she said.