Fannie Mae 2004 Annual Report Download - page 165

beyond our control and driven to a large extent by changes in interest rates. In addition, funding mortgage
investments with debt results in mortgage-to-debt OAS risk, or basis risk, which is the risk that interest rates
in different market sectors will not move in the same direction or amount at the same time.
Our Capital Markets group is responsible for managing interest rate risk subject to corporate risk policies and
limits approved by the Board of Directors. In 2006, our Board of Directors approved a policy that prescribes
interest rate risk dollar limits and requires escalation to senior management and the Board of Directors if risk
limits are exceeded. The Chief Risk Officer provides corporate oversight of the interest rate risk management
process and is responsible for measuring and monitoring interest rate risk and providing regular reports to
senior management and the Board of Directors. The Capital Markets Investment Committee, a management-
level committee that includes senior officers in the Capital Markets group, meets weekly to review our current
interest rate risk position relative to risk limits. The Capital Markets Investment Committee develops and
monitors near-term strategies that comply with our risk objectives and policies. The Capital Markets
Investment Committee reports interest rate risk measures on a weekly basis. As discussed in “Supplemental
Non-GAAP Information—Fair Value Balance Sheet,” we do not attempt to actively manage or hedge the
impact of changes in mortgage-to-debt OAS after we purchase mortgage assets, other than through asset
monitoring and disposition. We accept period-to-period volatility in our financial performance due to
mortgage-to-debt OAS consistent with our corporate risk principles.
Interest Rate Risk Management Strategies
Our portfolio of interest rate-sensitive instruments includes our investments in mortgage loans and securities,
the debt issued to fund those assets, and the derivatives we use to manage interest rate risk. These assets and
liabilities have a variety of risk profiles and sensitivities. We employ an integrated interest rate risk
management strategy that includes asset selection and structuring of our liabilities to match and offset the
interest rate characteristics of our balance sheet assets and liabilities as much as possible. Our strategy consists
of:
• issuing a broad range of both callable and non-callable debt instruments to manage the duration and
prepayment risk of expected cash flows of the mortgage assets we own;
• supplementing our issuance of debt with derivative instruments to further reduce duration and prepayment
risks; and
• on-going monitoring of our risk positions and actively rebalancing our portfolio of interest rate-sensitive
financial instruments to maintain a close match between the duration of our assets and liabilities.
Debt Instruments
The primary tool we use to manage the interest rate risk implicit in our mortgage assets is the variety of debt
instruments we issue. Our ability to issue both short- and long-term debt helps in managing the duration risk
associated with an investment in long-term fixed-rate assets. We issue callable debt to help us manage the
prepayment risk associated with fixed-rate mortgage assets. The duration of callable debt changes when
interest rates change in a manner similar to changes in the duration of mortgage assets. See “Item 1—
Business—Business Segments—Capital Markets—Funding of Our Investments” for additional information on
our various types of debt securities and “Liquidity and Capital Management—Liquidity—Debt Funding.”
Derivative Instruments
Why We Use Derivatives
Derivatives also are an integral part of our strategy in managing interest rate risk. We use interest rate swaps
and interest rate options, in combination with our issuance of debt securities, to better match both the duration
and prepayment risk of our mortgages. We are generally an end user of derivatives and our principal purpose
in using derivatives is to manage our aggregate interest rate risk profile within prescribed risk parameters. We
generally only use derivatives that are highly liquid and relatively straightforward to value. We have derivative
transaction policies and controls to minimize our derivative counterparty risk that are described in “Credit Risk
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