Fannie Mae 2006 Annual Report Download - page 248

assets exchanged, we defer the excess as deferred profit, which is recorded as an additional component of
“Guaranty obligations.” If the fair value of the guaranty obligation exceeds the compensation received, we
recognize a loss in “Losses on certain guaranty contracts” in the consolidated statements of income at
inception of the guaranty fee contract. We recognize a liability for estimable and probable losses for the credit
risk we assume on loans underlying Fannie Mae MBS based on management’s estimate of probable losses
incurred on those loans at each balance sheet date. We record this contingent liability in the consolidated
balance sheets as “Reserve for guaranty losses.”
We subsequently account for the guaranty asset at amortized cost. As we collect monthly guaranty fees, we
reduce guaranty assets to reflect cash payments received and recognize imputed interest income on guaranty
assets as a component of “Guaranty fee income” under the prospective interest method pursuant to EITF 99-20.
We reduce the corresponding guaranty obligation, including the deferred profit, in proportion to the reduction
in guaranty assets and recognize this reduction in the consolidated statements of income as an additional
component of “Guaranty fee income.” We assess guaranty assets for other-than-temporary impairment based
on changes in our estimate of the cash flows to be received. When we determine a guaranty asset is other-
than-temporarily impaired, we write down the cost basis of the guaranty asset to its fair value and include the
amount written-down in “Guaranty fee income” in the consolidated statements of income. Any other-than-
temporary impairment recorded on guaranty assets results in a proportionate reduction in the corresponding
guaranty obligations, including the deferred profit.
We account for buy-ups in the same manner as AFS securities. Accordingly, we record buy-ups in the
consolidated balance sheets at fair value in “Other assets,” with any changes in fair value recorded in AOCI,
net of tax. We assess buy-ups for other-than-temporary impairment based on the provisions of EITF 99-20 and
SFAS 115. When we determine a buy-up is other-than-temporarily impaired, we write down the cost basis of
the buy-up to its fair value and include the amount of the write-down in “Guaranty fee income” in the
consolidated statements of income. Upfront cash receipts for buy-downs and risk-based price adjustments on
and after January 1, 2003 are a component of the compensation received for issuing the guaranty and are
recorded upon issuing a guaranty as an additional component of “Guaranty obligations,” for contracts with
deferred profit, or a reduction of the loss recorded as a component of “Losses on certain guaranty contracts,”
for contracts where the compensation received is less than the guaranty obligation.
The fair value of the guaranty asset at inception is based on the present value of expected cash flows using
management’s best estimates of certain key assumptions, which include prepayment speeds, forward yield
curves and discount rates commensurate with the risks involved. These cash flows are projected using
proprietary prepayment, interest rate and credit risk models. Because guaranty assets are like an interest-only
income stream, the projected cash flows from our guaranty assets are discounted using interest spreads from a
representative sample of interest-only trust securities. We adjust these discounted cash flows for the less liquid
nature of the guaranty asset as compared to the interest-only trust securities. The fair value of the obligation to
stand ready to perform over the term of the guaranty represents management’s estimate of the amount that we
would be required to pay a third party of similar credit standing to assume our obligation. This amount is
based on the present value of expected cash flows using management’s best estimates of certain key
assumptions, which include default and severity rates and a market rate of return.
The initial recognition and measurement provisions of FIN 45 apply on a prospective basis to our guaranties
issued or modified on or after January 1, 2003. For lender swap transactions entered into prior to the effective
date of FIN 45, we recognized guaranty fees in the consolidated statements of income as “Guaranty fee
income” on an accrual basis over the term of the unconsolidated Fannie Mae MBS. We recognized a
contingent liability under SFAS 5 based on management’s estimate of probable losses incurred on those loans
at each balance sheet date. Upfront cash payments received in the form of risk-based pricing adjustments or
buy-downs were deferred as a component of “Other liabilities” in the consolidated balance sheets and
amortized into “Guaranty fee income” in the consolidated statements of income over the life of the guaranty
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FANNIE MAE
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)