Fannie Mae 2006 Annual Report Download - page 71

Management—Credit Risk Management—Institutional Counterparty Credit Risk Management.” In
circumstances where we cannot verify the model with market transactions, it is possible that a different
valuation model could produce a materially different estimate of fair value. As markets and products develop
and the pricing for certain derivative products becomes more transparent, we continue to refine our valuation
methodologies. There were no changes to the quantitative models, or uses of such models, that resulted in a
material adjustment to our consolidated statement of income for the years ended December 31, 2006, 2005
and 2004.
See “Risk Management—Interest Rate Risk Management and Other Market Risks” for further discussion of
the sensitivity of the fair value of our derivative assets and liabilities to changes in interest rates.
Amortization of Cost Basis Adjustments on Mortgage Loans and Mortgage-Related Securities
We amortize cost basis adjustments on mortgage loans and mortgage-related securities recorded in our
consolidated balance sheets through earnings using the interest method by applying a constant effective yield.
Cost basis adjustments include premiums, discounts and other adjustments to the original value of mortgage
loans or mortgage-related securities that are generally incurred at the time of acquisition. When we buy
mortgage loans or mortgage-related securities, we may not pay the seller the exact amount of the unpaid
principal balance. If we pay more than the unpaid principal balance, we record a premium that reduces the
effective yield below the stated coupon amount. If we pay less than the unpaid principal balance, we record a
discount that increases the effective yield above the stated coupon amount.
Pursuant to SFAS No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or
Acquiring Loans and Initial Direct Costs of Leases (an amendment of FASB Statements No. 13, 60, and 65
and rescission of FASB Statement No. 17) (“SFAS 91”), cost basis adjustments are amortized into interest
income as an adjustment to the yield of the mortgage loan or mortgage-related security based on the
contractual terms of the instrument. SFAS 91, however, permits the anticipation of prepayments of principal to
shorten the term of the mortgage loan or mortgage-related security if we (i) hold a large number of similar
loans for which prepayments are probable and (ii) the timing and amount of prepayments can be reasonably
estimated. We meet both criteria on substantially all of the mortgage loans and mortgage-related securities
held in our portfolio. For loans that meet both criteria, we use prepayment estimates to determine periodic
amortization of the cost basis adjustments related to these loans. For loans that do not meet the criteria, we do
not use prepayment estimates to calculate the rate of amortization. Instead, we assume no prepayment and use
the contractual terms of the mortgage loans or mortgage-related securities and factor in actual prepayments
that occurred during the relevant period in determining the amortization amount. For mortgage loans and
mortgage-related securities that meet the criteria allowing us to anticipate prepayments, we must make
assumptions about borrower prepayment patterns in various interest rate environments that involve a
significant degree of judgment. Typically, we use prepayment forecasts from independent third parties in
estimating future prepayments. If actual prepayments differ from our estimated prepayments, it could increase
or decrease current period interest income as well as future recognition of interest income. Refer to Table 2
below for an analysis of the potential impact of changes in our prepayment assumptions on our net interest
income.
We calculate and apply an effective yield to determine the rate of amortization of cost basis adjustments into
interest income over the estimated lives of the investments using the retrospective effective interest method to
arrive at a constant effective yield. When appropriate, we group loans into pools or cohorts based on similar
risk categories including origination year, coupon bands, acquisition period and product type. We update our
amortization calculations based on changes in estimated prepayment rates and, if necessary, we record
cumulative adjustments to reflect the updated constant effective yield as if it had been in effect since
acquisition.
Sensitivity Analysis for Amortizable Cost Basis Adjustments
Interest rates are a key assumption used in prepayment estimates. Table 2 shows the estimated effect on our
net interest income of the amortization of cost basis adjustments for our investments in loans and securities
56