Fannie Mae 2006 Annual Report Download - page 313

Notes to Fair Value of Financial Instruments
The following discussion summarizes the significant methodologies and assumptions we use to estimate the
fair values of our financial instruments in the preceding table.
Cash and Cash Equivalents—The carrying value of cash and cash equivalents is a reasonable estimate of their
approximate fair value.
Federal Funds Sold and Securities Purchased Under Agreements to Resell—The carrying value of our federal
funds sold and securities purchased under agreements to resell approximates the fair value of these instruments
due to their short-term nature.
Trading Securities and Available- for-Sale Securities—Our investments in securities are recognized at fair
value in the consolidated financial statements. Fair values of securities are primarily based on observable
market prices or prices obtained from third parties. Details of these estimated fair values by type are displayed
in “Note 5, Investments in Securities.”
Mortgage Loans Held for Sale—HFS loans are reported at LOCOM in the consolidated balance sheets. We
determine the fair value of our mortgage loans based on comparisons to Fannie Mae MBS with similar
characteristics. Specifically, we use the observable market value of our Fannie Mae MBS as a base value, from
which we subtract or add the fair value of the associated guaranty asset, guaranty obligation and master
servicing arrangements.
Mortgage Loans Held for Investment, net of allowance for loan losses—HFI loans are recorded in the
consolidated balance sheets at the principal amount outstanding, net of unamortized premiums and discounts,
cost basis adjustments and an allowance for loan losses. We determine the fair value of our mortgage loans
based on comparisons to Fannie Mae MBS with similar characteristics. Specifically, we use the observable
market value of our Fannie Mae MBS as a base value, from which we subtract or add the fair value of the
associated guaranty asset, guaranty obligation and master servicing arrangements.
Advances to Lenders—The carrying value of our advances to lenders approximates the fair value of the
majority of these instruments due to their short-term nature. Advances to lenders for which the carrying value
does not approximate fair value are valued based on comparisons to Fannie Mae MBS with similar
characteristics, and applying the same pricing methodology as used for HFI loans as described above. Prior
year amounts have been included to conform to current year presentation.
Derivatives Assets and Liabilities (collectively, “Derivatives”)—Our risk management derivatives and
mortgage commitment derivatives are recognized in the consolidated balance sheets at fair value, taking into
consideration the effects of any legally enforceable master netting agreements that allow us to settle derivative
asset and liability positions with the same counterparty on a net basis. We use observable market prices or
market prices obtained from third parties for derivatives, when available. For derivative instruments where
market prices are not readily available, we estimate fair value using model-based interpolation based on direct
market inputs. Direct market inputs include prices of instruments with similar maturities and characteristics,
interest rate yield curves and measures of interest rate volatility. Details of these estimated fair values by type
are displayed in “Note 10, Derivative Instruments.”
Guaranty Assets and Buy-ups—We estimate the fair value of guaranty assets based on the present value of
expected future cash flows of the underlying mortgage assets using management’s best estimate 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 the 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 reduce the spreads on interest-only trusts to adjust for the less liquid nature of the guaranty
asset. The fair value of the guaranty asset as presented in the table above includes the fair value of any
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)